Sovereign Dollar Bonds for Financing CAD

Madhoo Pavaskar Sarang Venu Kala Rasha Lala Purpose of the Paper

With the widening of the current account deficit (CAD) to 4.8% of gross domestic product (GDP) in 2012–13 and the recent fall in the exchange value of the rupee, the Central government is seeking ways and means to encourage foreign capital flows. The Finance Minister in his budget speech this year highlighted the need for more capital inflows in the country through sources like foreign direct investments (FDI) and foreign institutional investments (FII). The significant reduction in financial inflows in recent months has led to the need for government to tap other sources for seeking foreign funds. One way of tackling this problem is for the government to issue dollar-denominated sovereign bonds. This paper examines the need for, and feasibility of, issuing such bonds.

The Indian economy is currently in a perilous state. Not only is the CAD quite alarming, and widening, but the fiscal deficit is also as high as 5%, or even more, of GDP. Worse still, both these deficits are feared to rise before the end of the present fiscal on March 31, 2014, unless more transparent actions are initiated promptly to take appropriate corrective steps. The long- term solution to these twin deficits essentially lies in ushering in strong economic growth through the development of a sound manufacturing base so as not only to increase revenues but also to promote exports. This is all the more necessary, as there are palpable constraints in restricting imports of such essentials as crude oil, gold, industrial metals, and capital goods. These are all required for stimulating economic growth. The obvious alternative is to encourage exports of processed and manufactured agricultural and industrial products. That calls for strengthening both physical and social infrastructure. But with the growing fiscal deficit, physical and social infrastructure cannot be reinforced in a big way by the state, without further deficit financing, adding to the fiscal deficit. Nor will the private sector likely to risk its resources for long-term investment in infrastructure, because huge capital outlays and long gestation periods make domestic private investors apprehensive of blocking their capital in such

1 infrastructural projects as power, transport, education, and health. Hence is the urgent need for the government to raise foreign capital to finance both CAD and infrastructure development.

Routing capital through government expenditure would make the economy investment driven, and the inflow of more foreign capital into government account could be diverted towards infrastructural undertakings, stimulating the manufacturing sector to increase its productivity and production, which, in turn, would help boost exports. The higher exports would put lesser pressure on balance of payments, thereby reducing CAD. The industry and export growth, in turn, would boost tax revenues to reduce fiscal deficit as well.

Financing Twin Deficits

While fiscal deficit is financed mostly through deficit financing domestically, CAD requires to be financed through external commercial borrowings (ECBs) and release of foreign exchange from its reserves by the Reserve Bank of India (RBI). To an extent, the RBI replenishes its foreign exchange reserves through either FIIs or FDIs. But with the fear of quantitative easing in the U.S. tapering off soon, foreign institutional investors seem keen to withdraw their investments from the securities markets. The consequent sluggish securities markets are dampening the domestic investment climate. Nor are foreign direct investments (FDIs) flowing into the country, with absurdly low caps on them, and intricate regulations on such investments by diverse regulatory bodies, in especially the social and physical infrastructure projects. While there are numerous restrictions for the inflow of FDIs in the health and insurance sectors, the government is yet to open up the education sector to FDI, even though several overseas universities and academic institutions seem to be willing to set up their campuses in India. Long bureaucratic procedures and rampant red-tapism are also proving to be serious impediments to attracting FDIs. Added to these are the costs arising from corruption at every stage of bureaucratic approval. Unsurprisingly, FDIs are reluctant to enter the country.

There is no denying that global economic uncertainties and inefficient domestic governance have also impacted the Indian economy negatively. This is quite evident from the recent reduction in the inflow of capital from sources like FDI and FIIs (Figure 1).

Figure 1: FDI and FII inflows into India Source: Data sourced from www.indexmundi.com

With the inflows of FIIs and FDIs falling, if not drying up, the government may have little choice, but to borrow either from international financial institutions or other bilateral overseas deals. But even these options are now almost closed, as developed countries have still not recovered from the recessionary after-effects of the 2008–10 global financial crisis, and are therefore unlikely to enter into bilateral deals with India. Meanwhile, India has also exhausted the possibility of borrowing from either the International Monetary Fund (IMF) or the World Bank, as it is already heavily indebted to them, with some of their liabilities falling due for repayment in the near future. What then?

Global Experience Globally, for developed countries, the ratios of external debt to GDP have been quite high (Figure 2). Thus, the U.S, Finland, and Germany had external debt to GDP ratios of 106%, 155%, and 142% respectively as on December 2012, whereas India had just 21%.

Total (Public plus Private) Gross External Debt to GDP Ratio 180% 160% U.S 140% 120% Finland 100% Germany 80% India 60% 40% 20% 0% 2000 01 02 03 04 05 06 07 08 09 2010

Figure 2: Total (public plus private) gross external debt to GDP ratio Source: reinhartandrogoff.com

Clearly, global experience shows the way out for India to meet the problems arising from both the deficits, fiscal as well as CAD. A low external debt to GDP ratio for India in comparison to such ratios for advanced economies suggests that prima facie India has enough scope to expand its foreign exchange reserves by issuing dollar-denominated sovereign bonds. Though, a high external debt may run the risk of endangering long-term financial stability because of the interest- and maturity-payment liabilities, funds realized from sovereign bonds must be utilized prudently and efficiently for promoting and developing export-oriented industries and activities by providing the requisite logistical and infrastructural services to them. Then such debt, and periodic interest liabilities on it, can be met without much difficulty, following the resulting increase in export earnings.

At present, ironically enough, lack of basic infrastructural facilities, and social welfare and skilled labour, amidst a multitude of other factors, make Indian domestic industries not infrequently prefer investment opportunities abroad to investing domestically. This trend could be effectively reversed through the issue and efficient utilization of dollar-denominated sovereign bonds.

Sovereign Bonds—Historical Perspective

Sovereign bonds issued by national governments are debt securities denominated in either local or a global currency. When such bonds are issued in foreign currencies, these are usually either

4 dollar or euro denominated. The interest rate, which the government pays on bonds, is the yield on investments in these bonds.

The bonds issued by the Bank of England in 1765 to raise money from the public to finance war against France were the first sovereign bonds issued in the world. Investors earned dividends annually. In the past, European governments also issued bonds from time to time, with no maturity date, called ‘perpetual bonds’. The debt raised through these bonds was majorly utilized to fund wars and other government expenditures. The 20th century saw the emergence of bonds of limited duration.

Sovereign bonds are not new to India. The country had taken recourse to such bonds when in crisis. In 1991, the State Bank of India (SBI) had issued India Development Bond (IDB); a quasi- sovereign 5-year bond backed by the Indian government, offering a coupon rate of 9%. The subscription to the bonds was restricted to only non-resident Indians (NRIs). The issue managed to mobilize a mere $1.6 billion. In 1998, SBI again issued 5-year Resurgent India Bonds (RIB), with a coupon rate of 7.5%. The bonds were issued in dollar, pound sterling and deutsche mark. RIBs could fetch in the aggregate $4.2 billion equivalent. India Millennium Bonds (IMB) issued in 2000 offered a coupon rate of 8.5%, and garnered $5.5 billion.

Sovereign Bonds for CAD The demand for sovereign bonds of a country in overseas markets depends on various factors, including credit rating of the issuing government, political stability, exchange rate volatility, economic and export growth prospects, past performance of overseas borrowings through multilateral and bilateral deals, and other macroeconomic risks. The terms of the bond like the maturity period interest or coupon rate also much matter. The demand for bonds is also determined by the credit ratings assigned to the bonds by renowned rating agencies. A credit rating agency like Standard & Poor’s, Moody’s, and Fitch grade sovereign bonds by analyzing various risk parameters and considering several other factors, such as per capita income and GDP growth, inflation, external debts, history of defaulting, global and region-specific geo- politico-economic scenario, as also the terms and conditions of the bonds concerned. A highly rated bond is less risky, and could even offer smaller yield to investors, while reducing the cost of funding for the borrower.

A major objection to issuing sovereign bonds in overseas financial markets is that India’s credit rating may go down further, following the issue of such bonds. At present, Standard and Poor’s have assigned a rating of BBB- to India. But, it is the only agency to give India a negative rating. Most other international rating agencies like Moody’s, Fitch, and Japan Credit Rating Agency view India as a stable economy, with economic growth slated to be not less than 5% this year, even under the worst economic scenario. As India still boasts of a higher growth rate than most economies, including the developed ones, in the world, barring perhaps China, fear of the country being further downgraded is surely misplaced. True, riddled with corruption scandals and unbridled scams, coupled with continued inflation and virtual policy paralysis in the government at the centre, India seems to be standing at a crossroads. Yet, the fundamentals of the economy are undoubtedly still strong. Unlike most world economies, which are saddled with aging population, India is well set to reap the demographic dividend from its growing, young populace and highly skilled and educated middle-class that constitute the backbone of an economy aspiring to grow.

The Central government as well as the Planning Commission is determined to push for structural economic reforms for liberalizing the various sectors of the economy, including reforms in taxation, removal of land ceiling legislations, and relaxing labour laws. Disappointingly, such reforms are currently held up because of the ensuing general elections. The issue of sovereign bonds will, however, compel the government to initiate immediate action on these reforms. Once these reforms are ushered in, India’s credit rating will go up, for sure. In any case, India’s sovereign bonds per se are unlikely to depress its credit rating. In fact, insofar as the proceeds of these bonds are utilized for infrastructure development for promoting export-oriented activities and industries, they will ipso facto help to improve the credit rating.

With the Indian economy still growing, it can certainly offer better yields on its sovereign bonds than several other emerging economies, such as Brazil, Chile, Mexico, Turkey, Columbia, Peru, and Indonesia, which have floated sovereign bonds, with yields varying from 3.5–4.5%, for attracting global investors. It should therefore be possible for India to issue sovereign bonds at around 4.5% coupon rate. That rate will render the bonds easily marketable.

Strategy for Issuing Bonds Before issuing sovereign bonds, the government must vet their terms and conditions (including their duration and coupon rates) with international rating agencies, and international merchant bankers through whom the bonds will need to be floated. That presupposes elaborate discussions with the rating agencies and investment bankers concerned.

To attract even retail investors, the bonds need to be listed on leading global securities exchanges. While bulk marketing to foreign institutional investors and overseas major financial brokers may be advisable, consultations also should be made with various exchange-traded funds to develop exchange-traded India sovereign bond products for attracting retail investors. Exchange-traded India bond products, which will be issued in units of lower values, will reduce not only risks for investors, but also attract them to buy the bonds, especially when such exchange-traded products are also listed on securities exchanges. The reduced risks, combined with comfortable option to trade on stock exchanges, would make the long-term India Sovereign Bonds more liquid, positively influencing the demand for them.

Conclusion This paper offers a possible but apparently viable option for the country to issue sovereign bonds to resolve its problems from CAD as well as fiscal deficit. The paper is merely suggestive. Being essentially preliminary in nature, it provides a base for the authorities to develop suitable sovereign bond/s, in consultation with international rating agencies, investment and merchant bankers, exchange-traded funds, and reputed international securities brokers. It is imperative, however, that economic policy reforms must go hand in hand with the issue of dollar denominated sovereign bonds.