International Monetary Fund managing director Christine Lagarde has suggested that India can tap sovereign bonds to overcome its current account deficit (CAD). In India, the idea of sovereign bonds as a means of financing the external debt was floated last year in the budget 2012-13 by former finance minister, Pranab Mukherjee, who included it in the Fiscal Responsibility and Budget Management (FRBM) statement for the first time. It has also been suggested that it could be used as a low-cost option of financing the budgetary deficit.
Can India really use sovereign bonds as a viable means of financing the burgeoning external debt, even against the backdrop of falling global interest rates (which have reached rock bottom) as also our own position of a “comfortable” level of foreign exchange reserves? What about using these as a source of “low-cost financing” of the budgetary deficit? Can it be a case of what’s good for the goose is good for the gander?
The CAD worsened to $22.3 billion in the second quarter of 2012-13. Much of this has been financed through short-term volatile foreign institutional investor inflows as also debt (both short term and long term). As the Reserve Bank of India report of the external sector (29 October 2012) notes, all the key indicators of external sector vulnerability such as the debt-GDP ratio, short-term debt as a percentage to total debt, as well as to foreign exchange reserves and import-cover, have deteriorated in 2012. At the end of December 2012, India’s total external debt stock stood at $376.3 billion (an 8.9% increase over March 2012), with the government (sovereign) external debt component being 21.7%.
Turning to the estimates of the budgetary deficit, the gross fiscal deficit of $67.5 billion (around Rs.3.6 trillion today) was financed through Rs.101.48 billion of external finance and Rs.4.93 trillion of market borrowings. The latter have been raised at a relatively steep average cost of 7.8-10.01%. The borrowing costs of the proposed sovereign bonds, at least in the short term, would depend on the fundamental conditions in the economy. The latter would increase the borrowing costs through at least three routes: the risk of default, monetization-driven depreciation and inflation. As regards the risk of default, India has been rated BBB- by Fitch, while other rating agencies have put India on a negative outlook. With Indian bonds assuming near junk-bond status, the sovereign bond yields would need to be very high to attract global investors. Similarly, the depreciating currency, as also high inflation levels would substantially increase the sovereign bond yields. India may have to pay a Libor-plus rate to attract investors. Such high borrowing costs would only exacerbate the problem of external debt.
Another concern posed by such sovereign bonds, essentially debt instruments issued in foreign currencies, is that they carry with them the problem of “Original Sin” (Eichengreen and Hausmann, 1999) for developing countries like India. The latter find themselves unable to raise external debt denominated in their own currency terms. Thus, with 56.8% of the external debt denominated in US dollars at the end-December 2012, the issue of sovereign bonds in a scenario of depreciating domestic currency, (and the difficulty of rolling over short-term debt) would lead to balance sheet problems which could become a key source of financial instability and possibility of default.
Sovereign bonds may provide a textbook solution to ameliorating the woes of debt-ridden developed economies, with debts denominated in their domestic currencies. However, in this case, what’s good for the goose (developed countries) is definitely not good for the gander (developing/emerging countries, India included). The quantum, as well as the nature of external debt, should provide warning bells to resist the temptation of going for quick-fix solutions to the complex problem of the twin deficit.
Tulsi Jayakumar is a professor at SP Jain Institute of Management and Research, Mumbai. Comments are welcome at firstname.lastname@example.org