(Photo: iStock)
(Photo: iStock)

Opinion | Government bonds in foreign currencies: bad idea, bad debt

In a world of capital account liberalization, foreign exchange reserves could vanish rapidly in the event of a financial crisis

In the Union Budget presented last month, the government announced that it would start borrowing in external markets through bonds denominated in foreign currencies. While announcing this radical departure from the past, finance minister Nirmala Sitharaman was most economical in words. Yet, it is essential to analyse the rationale and understand the implications, because there is a real danger that the move could have serious consequences.

There were two explicitly stated reasons. First, India’s sovereign external debt is modest, at less than 5% of GDP. Second, such bonds would reduce the demand for government securities—a preferred debt instrument—in the domestic capital market, thereby making scarce resources available for private investment. There was a third unstated reason that such borrowing would be cheap, since interest rates in world financial markets are at an all-time low.

This reasoning is flawed. For one, India’s total external debt is 20% of GDP. The relatively modest sovereign external debt is neither an accident nor a coincidence. It is just past prudence to ensure that much of government debt is domestic, insulating it from exchange rate risk. And its low level, limited to borrowing from multilateral institutions like the World Bank, is no reason to borrow more. For another, foreign borrowing will not necessarily dampen domestic borrowing by the government. Moreover, if the Reserve Bank of India sterilizes such foreign exchange inflows, by buying dollars and selling government bonds, it will not reduce government securities available for purchase in the domestic capital market.

The unstated reason that government borrowing abroad will be cheaper is an illusion. Interest rates are low, but there is a currency risk. The rupee might depreciate, and hedging against this risk carries costs. In effect, the cost of borrowing through dollar bonds might turn out to be the same as—if not higher than—through government securities in the domestic capital market.

Flawed reasoning apart, for India, government borrowing abroad in international financial markets is a bad idea. There are several reasons. In principle, it makes no sense for a government to borrow abroad for meeting its domestic expenditure needs. The exchange rate risk is always there. In addition, interest and amortization payments are in foreign currencies, which would pre-empt scarce export earnings. In any case, only governments that cannot sell home-currency-denominated bonds to their own people in domestic capital markets often resort to issuing dollar bonds. India has no such problem.

Most importantly, government debt to its citizens is essentially “what we owe to ourselves". The UK emerged no poorer from two World Wars financed largely by government borrowing from people. Public debt was enormous, but it was owed to citizens with savings who held government securities. Last but not least, if the government wants to access more foreign resources, it has the much better option of raising the present ceiling of 6% on foreign portfolio investments in government securities. This will mobilize exactly the same foreign inflows from abroad, but through rupee-denominated government securities without any exchange rate risk.

The problem with this bad idea runs deeper. It could have far reaching longer-term consequences. Governments, always hard-pressed for mobilizing resources through taxation, are not known for their ability to exercise self-restraint or resist temptation, when softer options are available. Once the door—so far closed for such borrowing abroad—is opened, sovereign dollar bonds could become a soft option which might be resorted to more and more, until stopped by a crisis.

There is another implication that the government might not have recognized yet. Its sovereign dollar-denominated bonds issued in international financial markets will have to be rated by Moody’s or Standard & Poor’s. Government finances will be examined in microscopic detail. And it is not clear how this will turn out. In difficult times, that feel-good or show-off factor derived from issuing dollar-bonds, which is discernible now, might well turn into despair if and when there is a downgrade.

Foreign-currency-denominated government bonds will inevitably mean a further integration into international financial markets, which are characterized not only by volatility, but also by swings in perceptions, moods and sentiments. Investors in world markets are fair-weather friends. In good times, buying might lead to a surge in demand for India’s dollar bonds. In bad times, selling might lead to a dumping of India’s dollar bonds, which would not only erode international confidence but could also affect the domestic market for government securities.

The internationalization of government debt is somewhat akin to living in a house with a leaking roof. In good weather, there is no need to repair it. In bad weather, there is no opportunity.

This concern is validated by repeated financial crises, manifest in a run on domestic currencies, in recent history. Many economies—Mexico, Argentina, and Turkey—that followed a similar path, have come to grief. In fact, dollar-denominated government bonds constituted the beginnings of the teso bono currency crisis in Mexico.

The comfort, or warmth, of large foreign exchange reserves, in the range of $400 billion, could be illusory. By end-March 2019, India’s short-term external debt was $108 billion, while the outstanding stock of foreign portfolio investment (reported by the National Securities Depository Ltd) was $182 billion. Thus, short-term liabilities or liabilities that can be withdrawn on demand, taken together, are almost three-fourths of our reserves. In a world of capital account liberalization, foreign exchange reserves—however large—could vanish rapidly in the event of a financial crisis. Just think, inter alia, of Argentina, Brazil, Mexico, Russia, Turkey, Indonesia, Malaysia, and Thailand.

Deepak Nayyar is emeritus professor of economics, Jawaharlal Nehru University, New Delhi

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