- During the recent Budget, the Indian finance minister announced plan of the government of India to borrow in foreign currency to finance the fiscal deficit.
- The plan is to raise up to 10-15% of government borrowing — $10 billion — from the first overseas sovereign bond.
How would it help?
- Foreign borrowing is critical if the government is to meet its target of Rs 100 lakh crore of infrastructure investment, and build a $5 trillion economy.
- Sovereign foreign borrowing in international markets would help in attracting more foreign capital and pushing up domestic investment beyond what India saves.
- The risk free rate (as it if sovereing borrowing) can serve as a benchmark for dollar borrowing by Indian corporates.
- It can help reduce the cost of capital for both governments and corporates.
Fiscal discipline is an essential prerequisite:
- However, to reap the benefits from foreign sovereign borrowing, fiscal discipline is an essential prerequisite.
- If fiscal discipline is not maintained, it can make foreign markets mistrust the government of India and raise the cost of borrowing.
- The Fiscal Responsibility and Budget Management (FRBM) Act and an inflation targeting monetary policy are in place in India but it needs greater fiscal transparency.
India’s CAD being funded through foreign inflows:
- When fiscal deficits become large, they spill over onto the current account and the country ends up with a large current account deficit (CAD).
- The CAD is financed by money from abroad or capital inflows.
- Until now, the government and RBI have been more comfortable with the Foreign Direct Investment (FDI) and Foreign Portfolio (FPI) flows, and less with foreign debt.
- Over the years, the fear of hot money (like in FPI) has reduced as despite having large foreign portfolio flows in the equity markets, India has not witnessed the crisis that were feared to accompany them.
Liberalized foreign debt policy in recent years:
- In the last few years, India’s foreign debt policy has been liberalising.
- This has happened for Rupee denominated bonds for both government and corporate, where limits for the bond holding by foreigners have been slowly hiked.
- India has also liberalised the regime for external commercial borrowing, or dollar borrowing by corporates.
Government of India’s international borrowing
International bond markets
- No direct borrowing:
- The Government of India has so far not borrowed directly in the international bond markets.
- Done through PSBs:
- Instances in the past when the government has borrowed in times of need has been done through public sector banks.
- Resurgent India Bonds and Millennium India bonds were issued through banks like the State Bank of India.
- Bonds were sold to the Non Resident Indians who were given high interest rates.
- RBI would compensate banks in case they suffered losses due to the currency risk they were taking.
Multilateral/Bilateral borrowing for specific projects:
- In addition to emergency borrowing through PSB and NRI bonds, the Government of India borrows through the bilateral and multilateral route.
- This is borrowing from countries, at negotiated interest rates in yen, dollar, for example from Japan, and from multilateral agencies like the World Bank or the Asian Development Bank.
- This borrowing is done by the ministry of finance and rates are concessional.
- The borrowing flows to central and state governments for projects approved by the ministry.
Much room for Indian govt to borrow more internationally:
- At present, global money markets are awash with liquidity.
- Emerging economies are able to borrow at low interest rates.
- With only 5% of Gross Domestic Product (GDP) being currently borrowed by the Indian government in foreign currency, there is room for the government to borrow more.
Government stayed away from sovereign foreign borrowing so far due to certain fears:
- Since the 1991 balance of payment crisis, sovereign foreign borrowing has terrified the government and the Reserve Bank of India (RBI).
- The proposal has come up internally a few times, but was rejected on concerns that cheap foreign money will be too attractive for governments and they may borrow too much.
- This could lead to balance of payment crisis, currency depreciation and greater difficulty in paying back the loan.
Borrowing without raising risks:
- The question today is whether such borrowing can be done in a prudent manner without raising risks for the economy.
- Even if the borrowing is kept in control, the costs of borrowing should also be kept low.
- Interest rate should not exceed the growth rate of the economy:
- For the debt to be sustainable, it should not blow up beyond our capability to service it.
- If the ratio of debt to GDP grows very fast, then we would reach a point when we are unable to pay back debt.
- Debt grows at the interest rate while GDP grows at the growth rate of the economy. This means that the stability of the debt to GDP ratio requires that the interest rate should not exceed the growth rate of the economy.
- Good quality economic data:
- To be able to borrow at low interest rates in foreign markets, it is not enough that we trust our data. Foreigners must also trust our data.
- In addition to transparent fiscal data, borrowing abroad should be accompanied by good quality GDP data.
- If the data is untrustworthy and markets suspect errors in budget estimates, off-budget borrowing, or delayed payments to achieve annual fiscal targets, it can make foreign markets mistrust the government of India and raise the cost of borrowing.
- This will mean paying for a higher expectation of default, even though we may never intend to default.
- This is the first time the proposal for foreign sovereign borrowing has made it to the budget speech, and it is being described as a bold move.
- For this to work, we need to produce good quality government data and national accounts and stick to FRBM and inflation target in letter and in spirit.
GS Paper III: Economy