Govt to make provision for hedging currency risk in overseas borrowingshttps://indianexpress.com/article/business/economy/govt-to-make-provision-for-hedging-currency-risk-in-overseas-borrowings-5828344/

Govt to make provision for hedging currency risk in overseas borrowings

Sources said after discussions with the Reserve Bank of India (RBI) on the sovereign bond issue, the government will put in place a mechanism to hedge its currency risk

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The government plans to borrow billion for the first time ever in the international markets.

While issuing sovereign bonds in foreign currency in international markets, the government is expected to keep a provision in its book to account for a potential currency fluctuation that may affect its liability.

Sources said after discussions with the Reserve Bank of India (RBI) on the sovereign bond issue, the government will put in place a mechanism to hedge its currency risk. The government plans to borrow $10 billion for the first time ever in the international markets. Finance Minister Nirmala Sitharaman had announced the government’s plans to raise a portion of the Centre’s borrowings in global markets in foreign currency. The government is planning to issue first such bonds in the middle of the year.

When foreign portfolio investors buy government bonds in Indian debt markets, they bear the risk of any untoward movement in the Indian rupee. But when the government raises funds in foreign currency, it has to the bear the risk of currency movements.

Explained

Risk on exchequer if funds raised in foreign currency

The government will for the first time raise resources from international markets to meet a portion of its borrowings. Unlike in the case of foreign investors putting in money in government bonds in India, the Centre raising funds in foreign currency puts the currency risk on the Exchequer. To hedge against this risk of currency volatility, the government’s plan to create a hedging mechanism will help in maintaining macroeconomic stability while at the same time take some load of the domestic bond market that is funding the deficit.

While the rate of interest in international markets is much lower at around 2-3 per cent, compared to around 7 per cent the government pays in India, the rate differential shrinks after accounting for the costs associated with hedging the currency risk. Depending upon the premium in the forward markets that are used to hedge the currency risk, such costs can be as high as 4 per cent.

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The overseas borrowing proposal, along with the government’s target of lowering the fiscal deficit to 3.3 per cent of the Gross Domestic Product by March-end 2020, have been received positively by the bond market, as reflected in sharp reduction in bond yields since the introduction of the Union Budget 2019-20.

When the government raises a portion of its borrowings overseas, it reduces the domestic supply of debt papers by an equivalent amount. This helps in lowering domestic borrowing costs for the government, while freeing up similar amount of fund that the banks can now lend to retail and commercial borrowers.

The Finance Ministry expects the depreciation of the Indian rupee not to exceed the interest rate differential between local and global borrowings — providing a natural hedge on its debt exposure. “When we allow foreigners to invest in rupee securities we pay them higher rate of interest, as compared to what the rate of interest they earn (outside). The differential in rate of interest is in a way towards the foreign currency risk. So in this case, you are taking a call on the foreign exchange risk for future, but our experience suggests very clearly that the differential that is there between the rupee interest rate and the foreign currency interest rate, is actually higher than the depreciation in the domestic currency. So hopefully the same trend will continue,” Finance Secretary Subhash Chandra Garg told The Indian Express on July 6.

“And I think we will make provisions for the differential also so that we don’t have asset liability mismatches and the Budget takes into account the real expected cost of money,” he said. Since this is the first time the Centre will raise funds abroad, the government and the RBI will now start work on putting in place a mechanism for flow of money, payment of interest and taxation among others. The RBI, which is debt manager of the government, has in the past been vary of proposal for global issuance of sovereign bonds, mainly because of currency volatility and its potential impact on macroeconomic stability.