Anyone told of the terms of the loan may not believe “this thing," said Modi. It is good to be generous in praise of visiting foreign dignitaries. However, the reality might be different and the loan offered by Japan may not be as “unbelievable" as Modi claimed.
Generally, countries tend to invest abroad when they run out of opportunities to invest at home. This is the reason investment often flows from developed to developing countries. While investments in large-scale infrastructure projects might sometimes be strategic, lending countries often make sure that the funds are used to procure materials and services from the donor country.
Analysis of Japan’s lending to India shows that it has not abandoned this principle. Almost a quarter of Japan’s lending to India since 1982 for railway projects has been “tied", i.e. it mandates procurement from Japanese suppliers, according to information available from the website of the Japan International Cooperation Agency (JICA), the Japanese government arm coordinating such projects. Even in projects which are marked “untied", like the Delhi Metro, a large number of contracts have been awarded to Japanese companies.
Moreover, the apparently concessional rates of interest at which Japan lends for such projects appear less remarkable when compared to the prevailing interest rates in Japan. For example, when Japan provided 30-year loans for the Delhi Metro project in 1997 at an interest rate of 2.3%, its own 10-year domestic risk-free interest rate was also around 2.3%, i.e. the yield on the 10-year Japanese government bond (JGB).
Since then, Japan has seen periods of economic recession, deflation and interest rate cuts by the central bank. Consequently, the 10-year yield has fallen from around 2.3% in 1997 to 0.05% today. Thus, it is no coincidence that today Japan is ready to finance Indian railway projects at 0.1% (see Chart 1).
Of course, such an offer for a 50-year loan should still be deemed concessional because it is cheaper than the yield on the 30-year JGB, which is at around 0.9%.
Moreover, the 50-year repayment period in itself is much more generous than the 30-year loans that Japan has generally provided for railway projects.
However, the discount on interest rate is neither exceptionally large nor unprecedented. Thus, Japan’s latest offer does not appear truly unbelievable when seen in perspective.
Japan’s recent overtures appear to be driven by its own domestic economic compulsions, with a slowing economy forcing it to look for investment avenues abroad. Japan had reportedly made a similar offer of bullet trains to Indonesia too, offering finance at 0.1%.
This is not the first time that India has benefited from the largesse of other countries for projects of national importance. For example, the Opec Fund for International Development funded the Bombay High offshore project with loan agreements signed between 1981 and 1982 at an effective interest rate of 0.75% repayable over 20 years.
The rate of interest was much lower than the prevailing 10-year US treasury interest rate of around 13% in 1981-82.
Similarly, Russia in 1998 provided Dollar-denominated credit of up to $2.6 billion for the Kudankulam nuclear power station. The loan carried an interest rate of 4% per annum, lower than the then prevailing interest rate of 5.25% on a 10-year US Treasury bond. The repayment period was around 15 years.
Thus, the recent loan agreement on the bullet train only represents a continuation in the long history of bilateral external assistance on concessional terms.
Bilateral assistance—like that from Japan, Germany, Russia and so on—is often much cheaper compared to loans from multilateral agencies like the Asian Development Bank (ADB) and the World Bank’s International Bank for Reconstruction and Development (IBRD), according to a ministry of finance position paper in 2008, authored by then finance secretary D.Subba Rao.
However, the paper also noted that Japan accounts for a quarter of India’s sovereign debt portfolio and warned: “Indiscriminate borrowing in yen will scale up our exposure to yen, thereby increasing the currency risk".
Such risk can be hedged, but it entails a large cost; prevailing market conditions would suggest a cost of 4-5% per annum, in case hedging is carried out through simple forward contracts.
Adding 4-5% cost would largely defeat the purpose of low-interest loans from abroad. However, there exist more innovative ways to hedge through options.
Although the rupee has strengthened against the yen in the last few years owing to large scale quantitative easing by the Bank of Japan, Indian authorities should remain vigilant because currency markets are often unpredictable (see Chart 2).