- 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.
- The move also saw some criticism, with former RBI governor Raghuram Rajan saying it has no real beneﬁt and poses enormous risks.
- The major aspects of criticism from various analysts related to the following:
- The notion a foreign currency-denominated Indian sovereign yield curve would be established by such issuance is wrong.
- The issuance of foreign currency-denominated Indian sovereign paper would hinder the internationalisation of the rupee.
- The issuance of additional foreign currency-denominated Indian sovereign paper would encourage a bond-issuing binge as an “addiction”.
- Since one could relax current ceilings on foreign portfolio investment and additional investment into rupee-denominated sovereign paper would occur, there is no point in issuing such paper.
Basics: Yield Curve
- A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.
- A yield curve is a way to measure bond investors’ feelings about risk, and can have a tremendous impact on the returns you receive on your investments.
- This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth.
Sovereign yield curve:
- Government bonds in foreign currencies help set a sovereign yield curve.
- The sovereign rate is a handy reference point that makes it easier for companies to price their paper abroad.
- Many developing countries have sold sovereign securities abroad to establish a yield curve in overseas markets.
- Usually, government debt flotations precede corporate bonds in overseas markets. So far, though, Indian companies raising debt abroad have been working in reverse. They have floated paper of varying maturities in Europe and the US despite the lack of a sovereign yield curve.
Evaluating the criticism:
Establishing a yield curve:
- Critics of Budget announcement on sovereign foreign borrowing say that small amounts of foreign currency-denominated sovereign bonds would not help establish a credible yield curve.
- This argument is reasonable.
Internationalisation of the rupee:
- Critics say the government move will hinder the internationalisation of the rupee.
- However, the aim of internationalisation of the rupee is a matter of worry a long time from now, especially when even much more important currencies such as the Chinese yuan have had their own challenges in doing so.
Government will overborrow:
- There are 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.
- However, as this is the first time the government is issuing a sovereign foreign currency-denominated bond, the worry is purely speculatory.
- Arguments is in favour of the benefits from the issuance of such bonds:
- India has never defaulted on its sovereign obligations to multilateral agencies.
- There is a strong fiscal and monetary framework in place, which would constrain over expansion in sovereign debt.
- The foreign currency-denominated bond issuance would come with tight restrictions, and would account for a small fraction of overall debt.
- The act of issuing foreign currency-denominated paper is likely to work as a disciplining influence on public borrowing.
- The proposed size of the issuance of such bonds is modest in relation to the central bank’s reserves, and there is little chance of a threat to the rupee.
There is no point in issuing such paper:
- Critics note that there is no point in issuing such paper as the borrowing could instead be done by relaxing current ceilings on foreign portfolio investment and additional investment into rupee-denominated sovereign paper would occur.
- However, there are important informational and liquidity effects to be considered in making the comparison.
- Micro-economic benefits that would eventually flow from the issuance of foreign-currency denominated bonds:
- Indian sovereign risk would be priced with lower liquidity/ risk premia, because the price of the foreign-currency-denominated sovereign bond is discoverable.
- A credible dollar-denominated sovereign curve would reduce the risk-premium implied in the foreign currency swap curves and reduce the volatility of the spot exchange rate.
- The credit risk premium would be accurately estimated and reduce the emphasis on published credit ratings, which have been persistently overstating the true sovereign credit risk.
- A verifiable sovereign spread would provide a powerful argument to convince the rating agencies to at least move India up a notch or two. (Such an improvement did occur in the case of the Philippines and Indonesia.)
- The inclusion of the proposed bond/s in global indices would cause a reduction in yields as index-tracking funds buy the bond.
- The reduction of liquidity and risk premia would also have a beneficial impact on corporate bond yield spreads in the external commercial borrowing (ECB) market.
- A foreign-currency denominated sovereign bond, issued in modest quantities would have a beneficial effect on the external rating and pricing of the Indian sovereign credit risk, and a step in the right direction.
- The finance minister must ahead and implement the proposal.
GS Paper III: Economy