External borrowers in India are likely to face a turbulent future in the near term due to a depreciating rupee.
In this context, this write-up seeks to explore what constitutes external debt and what are the factors influencing it.
What is external debt?
External debt is the money that borrowers in a country owe to foreign lenders.
Denomination - External debt may be denominated in rupee or any other foreign currency (most of India’s external debt is linked to the U.S. dollar).
As of December 2017, about 48% of India’s total external debt was denominated in dollars and 37.3% in rupees.
This means most Indian borrowers will have to pay back their lenders by first converting their rupees into dollars.
Debt Profile - External debt is classified as ‘External Commercial Borrowing’, ‘Currency Convertible Bonds’ and ‘Government Borrowings’.
India’s external debt was $513.4 billion at the end of December 2017, an increase of 8.8% since March 2017.
Most of it was owed by private businesses and other non-government entities (about 79%), which borrowed at attractive rates from foreign lenders.
What are the risks?
Interest Rates - There is greater unpredictability and unexpected changes in the interest rates can result in defaulting of loans and precipitate a crisis.
The raising of interest rates by the U.S. Federal Reserve has already caused borrowing rates to rise in various countries.
This including in India where bond yields have shot up sharply (the yield on the 10-year government bond has risen by 1.5% in the last 6 months).
Exchange Rate - Unexpected changes in the exchange rates of currencies, like say a steep fall in the value of the rupee, for instance, is a big risk.
This can cause severe difficulties for Indian borrowers who will now have to shell out more rupees than previously, to pay back dollar-denominated loans.
Lenders generally take possible currency fluctuations into account when determining their lending rates, but currency predictions are prone to failures.
While there could also be gains from such fluctuations, emerging market currencies usually tend to depreciate when the world economy is reviving.
Current Trend - Over the past year, rupee has fallen about 7% against the U.S. Dollar, which is also in line with other emerging market currencies.
Such currency movements are due to the increasing dollar demand by investors who wish to sell their assets in emerging markets.
Such sell outs pull capital out from emerging markets to invest them in developed markets, as yield there has been rising there lately.
What happens next?
U.S. Factor - The U.S. central bank, has already raised its benchmark interest rate twice this year, and is expected to further raise rates.
This is likely to cause more outflow of capital from the emerging markets, thus causing unexpected changes in borrowing rates and the value of the rupee.
Both government and non-government borrowers in India, who are exposed to foreign debt, could be in trouble in such a scenario.
RBI Rescue - The foreign exchange reserves, held by the Reserve Bank of India (RBI), were around $425 billion as on March 2018.
This is the firepower that the RBI can use to support the rupee and bail out borrowers who get into trouble.
RBI recently raised its benchmark interest rate (minimum rate charged on non-government securities) for the first time in more than four years.
While such a step could help to stem the capital outflow from the country and support the rupee, it could unleash uncertainty in domestic interest rates.
