Sovereign bonds arrive, but will these conquer? Financial Express July 17 2019

We do not really require forex reserves badly enough to justify such borrowings from the currency standpoint. Also, the cost factor has to be examined in greater detail before launching such issues

The idea of the Indian government borrowing from the overseas markets to partly finance the fiscal deficit for FY20 is interesting, because it will be the first time that such a thing is being done. There are foreign portfolio investors (FPIs) investing in government bonds, but the amounts involved are in rupees and, hence, they are like any other holder of government securities (G-Secs). In the past, there have been ideas of the government issuing sovereign bonds when there were problems on the external account, with forex reserves declining amidst a weakening rupee. The schemes used to shore up dollars—Resurgent India Bonds (RIB) and India Millennium Deposit (IMD)—through bonds or swaps targeting the NRI community and, hence, it was never a case of the government borrowing in overseas markets. This will change now.

It has been indicated that the government could borrow up to $10 billion, or 10% of the overall borrowing programme of Rs 7 lakh crore from the global market. Prima facie, it sounds like a good idea because of the attractiveness of this source, just like, say, external commercial borrowings (ECBs) for corporates. The LCF factor is in operation—liquidity, cost and forex earnings.

Domestic liquidity is protected in a way when the government borrows from international markets, and the so-called crowding-out effect is eschewed. Hence, banks will now have to invest less in such securities and can use their funds for lending. The cost of borrowing is always lower here as domestic rates are considered to be very high at even, say, 6.8% for a 10-year bond. This helps lower the interest outgo, which helps the budget, as the size of the borrowing increases.

Last, as the borrowing is in dollars, it adds to forex reserves and, hence, in a very unobtrusive manner steadies the exchange rate. The loans will have to be repaid only after, say, 10 years or more and, therefore, there are no pressures of outflows for this period.
Now, let us look at the counterpoint. We do not really require forex reserves badly enough to justify such borrowings from the currency standpoint. Therefore, this cannot be an argument, though it is a collateral benefit that comes along. Besides, the dollars (bonds) have to redeemed at some point of time and, thus, holding a naked position will not do, and just like how RBI has been exhorting companies to hedge part of their exposure, the government has to follow suit. The six-month forward rate is around 4.5%, and even if one uses the swap rate of 3.5% that was reckoned when the 2014 crisis erupted, this becomes an in-built cost that cannot be wished away.

Next will be the cost of borrowing. Will it really be that low? The US 10-year bond goes for around 2%, but India remains a just-above-investment-grade country with a rating in the BBB category, which is similar to that of Italy. Therefore, the cost will be greater than 2% for sure and, if one uses the 10-year yield of Italy, which is in the same bracket, the basic cost will be around 3%, unless the rating improves dramatically. To this must be adjusted the credit default swap (CDS), which is something that investors would look at when investing. Currently, for Italy, the CDS rate is around 1.75% for five-year bonds and, hence, the total return that the investor will look for at these levels would be at least 4.75-5%. To this must be added the hedging cost that can give a higher aggregate number than the current level of 6.8%. Hence, the cost factor has to be examined in greater detail before launching such issues.

A related problem with such borrowing is credit rating. India does get a sovereign credit rating from the Big Three and has always put forward a case for an upgrade on account of the steady progress made in terms of growth, inflation, external account, FDI and FPI, ease of doing business, fiscal management, etc. There is a valid argument in the financial world today that the rating agencies tend to be biased against emerging markets, and tend to give a lower rating as yardsticks of developed countries are used when modifications are required, given the specific economic conditions that prevail, like poverty, unemployment, population, etc. But, so far, the rating did not really matter in the practical sense for Indian governments as we had no external sovereign borrowing and, thus, it did not affect the state. Indian companies got affected due to this rating as it became a floor for them when looking to borrow overseas.

From now onwards, this rating will matter as it will alter the cost dynamics. Also, one has to be more tuned-in to what these agencies look at—such as aggregate fiscal deficit (Centre, state, municipal, PSUs, off-government, subsidies, cash transfers, etc). Every announcement that is against their scales gets recorded in their outlook, and events like sudden departures of RBI/government officials become events that are looked at more closely. In a way, almost everything can be a material event that has a bearing on the rating. This will be a perennial challenge.

At the market level, the dynamics will change. Currently, bond yields are largely driven by RBI policy. Lower repo rates will affect these yields instantaneously and OMOs can steady them. Often, it is felt that central bank intervention ensures that yields are low and that the government can borrow at more hospitable rates. But this will change in the global market where yields will be truly market-determined and be influenced more by what happens in the US. The Federal Reserve action will be more important than RBI action on rates and, hence, the matrix of influence will undergo a change. This is but natural when liquidity builds up, which, of course, is a precondition for any successful market.

Interestingly, market volatility will take a different course. While $10 billion in circulation in the US may not affect the overall yields in India, as volumes build up, there will be more volatility as players would tend to arbitrage. FPIs, in particular, will weigh the same G-Sec bond in the US and India and, in a way, would enhance efficient price discovery as yields equalise. At some point of time, when volumes are sizeable in overseas markets, depending on the interest in Indian G-Secs, price discovery would also take place on global exchanges. This, of course, is a matter of conjecture, but has to be kept in mind.

Therefore, issuance of sovereign bonds involves a gamut of factors that have to be weighed before launching them. Higher levels of borrowing will also increase the size of external debt, which, so far, is more of a private sector concern ever since India became virtually free from the loans of multilateral agencies in the 1970s and 1980s. On balance, one may take a view that going for such borrowing may send a different kind of signal to the global community that will be open for interpretation, especially so as the attainment of fiscal deficit targets seems to be getting elusive over time. With domestic savings not increasing and interest rates being driven lower, the available reservoir of funds is not adequate to meet various borrowing requirements. This could be the way the market would see it, considering that the foreign exchange position looks more than comfortable and is, hence, not the driving factor behind this move.