Risky business

Indian Express, 11th April 2012

The government's proposal to borrow from foreigners could be dangerous if not properly handled

The finance ministry is looking for ways to borrow from foreigners. It may be better for the government to borrow from foreigners, who cannot be arm-twisted, rather than borrowing in India, where banks are forced to borrow from the government. The four key principles to be used to guide foreign borrowing are as follows: getting debt management out of the RBI; emphasising foreign investment in India rather than issuance abroad; establishing a clear target as a ratio of GDP for the stock of borrowing from foreigners; and building the high-quality institutional capability required to engage with global bond investors. Such borrowing can be dangerous when it is denominated in dollars, but not when it is denominated in rupees.

As The Financial Express reported on April 4, the finance ministry envisages movement towards foreign borrowing. This can be seen in the Union budget tabled earlier this month. Para 42 of the Fiscal Policy Strategy Statement, tabled along with the budget by Pranab Mukherjee, the finance minister, in Parliament on March 16, says that the government can explore selling its bonds abroad: "With a gradual decline in net inflow from multilateral institutions in the coming years, the government would have the option of exploring other sources of external debt in the form of sovereign bond issuance".

Traditional economists usually have a fear of foreign borrowing. In India's case, the rationale for opening up the capital account to private flows was to move away from official flows. Foreign borrowing by emerging economy governments was, at the time, possible only in dollars, and was thus associated with dollar debt. But today, emerging economy local currency debt is feasible. The currency in which borrowing is done matters greatly. Borrowing in foreign currency denominated loans is dangerous, because repayment becomes harder in the event of a big depreciation. When $10 billion has been borrowed and the exchange rate is Rs 50 to the dollar, the repayment of principal is Rs 500 billion. But if the rupee were to depreciate to Rs 75 to the dollar, the repayment would swell up to Rs 750 billion.

Generally, big currency depreciations take place when there are difficulties in the local economy. Borrowing abroad in foreign currency is thus doubly dangerous - either for a government or for a firm - because the stress faced in repayment comes about when times are hard.

This traditional wisdom of economists is appropriate and well placed. However, today there is a solution to this problem: to borrow from foreigners through bonds denominated in Indian rupees. A government that borrows Rs 50,000 crore from foreigners, through bonds denominated in Indian rupees, will have to repay Rs 50,000 crore regardless of what happens to the exchange rate. The currency risk is borne by foreigners. This way, the traditional fear of foreign borrowing is substantially addressed.

The second issue relates to market discipline. The government can borrow from locals or foreigners. Borrowing from locals today is a dangerous affair because of the extent to which the government can cheat. The RBI is the debt manager for the government, so the RBI distorts banking regulation or monetary policy when the going gets difficult on borrowing. The government owns a large part of the financial system and it can cheat by forcing PSU financial firms to buy government bonds. The government can ignore the interests of workers who hope to get support in their old age from the Employees Provident Fund Organisation or the National Pension Scheme by rigging those rules to force purchase of more government bonds.

These avenues are not available when borrowing from foreigners. Thus, it imposes greater market discipline upon the government.

Four key principles can then be identified. First, it is important to move faster in getting the debt management function out of the RBI. The RBI is riddled with conflicts of interest, and it is not appropriate for an organisation which regulates banks and controls monetary policy to have an interest in supporting low-cost borrowing for the government. In addition, a professional debt management office (DMO) is essential institutional machinery to engage with foreign investors.

Second, the government needs to establish a clear target in terms of a limit - such as 10 per cent of GDP - for the total borrowing from foreigners whether onshore or offshore. Everyone should know what this target is; there should not be an unstated and open-ended borrowing programme.

Third, the institutional machinery to borrow from foreigners is already in place in the form of FII investment in Indian government bonds denominated in rupees traded in India. It is easy and sensible for the government to achieve more borrowing from foreigners, denominated in rupees, by slowly further removing the capital controls that restrict this. One path worth pursuing is to place rupee denominated bonds - both government bonds and corporate bonds - on par with shares in terms of access to FIIs. Another path is to upgrade from the FII framework to the Qualified Foreign Investor (QFI) framework for both, which is also already under way. There is a case for issuing rupee denominated bonds in London if and only if it is clear that the purchase of bonds by foreigners on Indian soil - that is, if the purchase of rupee denominated bonds in India by QFIs - have not yielded a required target of say, 10 per cent of GDP.

Fourth, the government needs the capability to produce and disseminate fiscal data and projections to foreign investors with higher-standard economic data, analysis and projections. This would be a good time to set up the Fiscal Council, proposed by the 13th finance commission, which would be a watchdog on fiscal data and set the roadmap to the Fiscal Responsibility and Budget Management (FRBM) Act. The Fiscal Council and the DMO should be the two institutional faces of India when it comes to engaging with global bond investors.

In summation, the proposal to borrow from foreigners through sovereign bonds has both pros and cons. If not done properly, in the hands of a profligate government, it has the potential to be risky.

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