India’s First Overseas Sovereign Bonds

Why in news?

As a first, the recent Union Budget 2019 proposed funding the fiscal deficit partially by borrowing from international markets in foreign currency.

What is the decision?

The government plans to raise as much as $10 billion from its first overseas sovereign bond.
It would start raising a part of its gross borrowing programme in external markets in external currencies.

What are sovereign bonds?

A sovereign bond is a specific debt instrument issued by the government.
They can be denominated in both foreign and domestic currency.
Just like other bonds, these also promise to pay the buyer a certain amount of interest for a stipulated number of years and repay the face value on maturity.
They also have a rating associated with them which essentially speaks of their credit worthiness.
The Yield of the sovereign bond is the interest rate that the government pays on issuing bonds.
The Yield of the bonds are dependent on primarily 3 factors -

creditworthiness - the issuing countries’ perceived ability to repay their debts; this can be obtained from rating agencies
country risk - external/internal factors like unrest and wars tend to jeopardize a country’s ability to pay off their debts
exchange rates- in cases where bonds are issued in foreign currency, fluctuations in exchange rate may lead to increased pay out pressure on the issuing government

What is the rationale?

Public-sector borrowing is putting significant pressure on market rates, along with liquidity in the system.
This, among other things, is affecting monetary policy transmission.
The government is already resource-constrained and so large levels of local borrowings could drive up interest rates and crowd out the private sector.
So, the next safe option is borrowing abroad, as the government can take advantage of low global interest rates.
Also, India’s sovereign external debt is less than 5% of its GDP, one of the lowest in the world.
This makes the move seem relatively risk-free.
The basic idea is that by shifting part of its borrowing abroad, the government will reduce the pressure on the domestic market.
This will, in turn, help keep interest rates at lower levels.

What is the need for caution?

The government should avoid going overboard because there are multiple inherent risks in the idea.
Currency risks - Primarily, the government will be taking currency risk.
A depreciation in the rupee will, in turn, increase the government’s liability.
On the other hand, the overall increase in the import of foreign capital could put upward pressure on the rupee.
This could eventually affect exports and make currency management more difficult for the central bank.
Volatility - Borrowing from international markets will increase the government’s exposure to the vagaries of global financial markets.
With borrowing through sovereign bonds, India’s loan repayments would be subject to exchange rate fluctuations.
Depending on the trend, India may have to repay more than it had originally taken as loan.
Investments - The move could potentially discourage foreign investors from investing in rupee-denominated government bonds.
This is because they will have the option of investing in hard-currency bonds and avoid the currency risk associated with the rupee.
This, in turn, could lead to higher volatility, both in the debt and currency markets.
This can further diminish the gains from accessing international markets.

Financial risks - Forex markets are irregular, especially now, with US-China trade tensions.
So, any adverse movement can throw off all calculations and make overseas borrowing even more costly than that from local markets.

Moreover, the domestic bond market serves as a signaling mechanism for the government by making price adjustments in response to the supply of bonds.
Large issuances in global markets can impede this process.
In fact, the government will have an incentive to take more of its borrowing abroad because it will help keep domestic interest rates in check.
Naturally, this will increase risks for financial stability.
Traditionally, it has been observed that the accumulation of foreign-currency debt can lead to difficulties.
Sources - The use of sovereign bonds indicates that the government may be running out of sources to borrow from within India.
Notably, India had the second worst debt-GDP ratio among emerging markets.
India’s debt-GDP ratio stands at 68.4%, next only to Brazil.
India’s total debt has risen by almost 50% since 2014.

What is the way forward?

It will be important for the government to explore and use this option carefully.
In this context, the government could constitute an independent fiscal council, as was also recommended by the N K Singh committee.
The council, which will evaluate fiscal management, can also advise the government on sustainable levels of foreign borrowing.
At a broader level, the council will instil more confidence in the market and, gradually, help reduce borrowing cost in the system.

Source: Financial Express, Business Standard