The finance minister’s budget announcement that out of its total borrowing requirement, the government will raise a modest amount in foreign currency in foreign markets has become quite contentious with many critics panning the decision as needless adventurism. It’s not as if the government does not borrow from foreign parties; foreign portfolio investors are allowed, albeit within some limits, to buy the government’s onshore rupee bonds. The difference now will be that the bonds will be offshore, denominated in hard currencies, and the government, rather than the investor, will bear the exchange risk.
For a country that has often showed off its abstinence from sovereign foreign currency exposure, even under great temptation, as a badge of honour, this is a surprising move. It has triggered two broad questions. Why this foray into uncharted waters? And why now?
The budget proposal responds to these questions in typically parsimonious language. The statement claims that at 5 per cent, the ratio of India’s external debt to GDP is among the lowest in the world, thereby implying that the government can raise cheap money by tapping opportunistically into the global savings glut at a time when interest rates are at historic lows.
The other rationale advanced by the government is that by moving a part of its borrowing offshore, it will vacate space in the domestic capital market for corporates and thereby stimulate much needed private investment. This could have been a substantive motivation. An egregious consequence of our fiscal responsibility law has been for the government to keep its on-budget borrowing within the prescribed limits by pushing a significant amount of borrowing off-budget. Indeed, India’s total public sector borrowing today, on and off budget, not only gobbles up the entire financial savings of households but also eats into corporate savings. The government’s intent, perhaps, is to repair this damage.
It’s not as if the proposal is outrageous, as painted by some critics. From a purely objective point of view, a persuasive case can be made for the dollar bonds. By far the biggest benefit will be the intangible impact of the government signalling its confidence about opening up the economy. For a country that has an unsavoury reputation of being excessively cautious in liberalising its external sector, the positive externalities of this unexpectedly bold decision can be significant. We will attract not just larger foreign portfolio flows but, in time, also larger foreign direct investment.
It is true, as the critics have argued, that the cost of borrowing in external markets will not be any cheaper than borrowing in rupees in the domestic market. The lower coupon rate will be offset by the cost of hedging against the foreign exchange risk. But if we view this not just from the narrow perspective of the government but from the larger perspective of the overall economy, there will in fact be cost savings. This is because the sovereign will command a lower interest rate than any other entity. If the proposed foreign borrowing just means the government displacing external commercial borrowing within the same overall debt ceiling, there will be net welfare gains for the economy.
The policy shift will also pave the way for Indian bonds entering global indices which will draw in index-tracking funds and reduce yields overall. Further, a dollar bond will enable India’s risk premium to be more accurately estimated, potentially leading to a rating upgrade.
As against these putative benefits, there are formidable concerns. The biggest fear is that this adventurism will make India hostage to the wild swings of global sentiment. Investors are, after all, fair weather friends; they lend liberally when the going is good, but swiftly back out at the slightest hint of trouble, exposing the country to volatile exchange rates and ruthless market turmoil. For a country that had a devastating external payments crisis in 1991 and came close to another one during the taper tantrums of 2013, these are dire warnings.
Critics have also contended that issuing debt in foreign currencies is a route followed by countries which are unable to issue debt in their own currency. India is certainly not in that category. If the idea is to attract more foreign inflows, it could be done by raising the ceiling for foreigners into onshore rupee bonds.
Moreover, the proposed dollar bonds may not raise overall foreign funding. Many investors who are now buying rupee bonds in the domestic market will happily pass on the currency risk to the government and switch to dollar bonds in the external market.
By far the biggest and possibly clinching argument against moving forward is the peril of the “original sin” which has brought many emerging markets to grief. Experience shows that governments start off believing that they will remain prudent, open their doors wider, and soon become so addicted to foreign money they wouldn’t stop until a crisis hits them. To believe that markets can discipline governments is a stretch. The stories of Argentina and Turkey are telling examples.
There is no guarantee that India will not succumb to this temptation. Given our still fragile fiscal and financial sector situation, the costs of irresponsibility can be intolerably heavy. The government’s proposal is the right way forward but it’s an idea whose time has yet to come.
The writer is a former governor of the Reserve Bank of India