-- Economic Observer

In paragraph no. 103 of her Budget Speech, the Finance Minister said:

"India’s sovereign external debt to GDP is among the lowest globally at less than 5%. The Government would start raising a part of its gross borrowing programme in external markets in external currencies. This will also have beneficial impact on demand situation for the government securities in domestic market".

The purpose of this note is to argue that this idea of floating sovereign debt in external currencies is a sure recipe for disaster for the Indian economy.

Some conceptual issues  

The fact that the two major sources of government revenue are: (a) taxation (both direct taxes, like the income tax, and indirect tax, like the GST), and (b) borrowing is well known. Legitimately, all over the world, governments borrow from the public or financial institutions so that apart from the amount raised from taxation, the governments have money for undertaking different kinds of expenditure. Now, government borrowing can come from two distinct sources: (a) domestic public/companies/financial institutions or (b) foreign. What is the difference between citizens and foreigners in this regard?

When the government borrows from the citizens it borrows in rupee, which is our currency and hence can be printed by Reserve Bank of India (RBI) depending on the need of the economy. Such issuance of rupee is backed primarily by government securities and foreign securities (and very little by gold). Thus, if the inflation (i.e., rising price level) is under control, there is no harm for the government to borrow and spend the money on productive expenditure. Even if the government spends on the salaries and pensions of its employees, to the extent those salaries and pensions lead to a higher demand for different goods and services in the economy, economic growth will get a boost.

But borrowing from foreigners is different - it is primarily taken in dollars (or sometimes euro, or pound sterling or yen). And we cannot print a single dollar. Why does India need to borrow in dollars?

First, America's supremacy in the global economy is reflected in universal acceptance of the dollar as a currency. Professor Barry Eichengreen of University of California at Berkeley termed this advantage of the US as an "exorbitant privilege".

Second, as India's export earning is less than its import (dominated by petroleum, gold and electronics), India needs dollars. Two major sources of the dollar inflows are: software earning and remittances from abroad. However, in terms of financial assets there are three major sources of dollar inflow: (a) foreign direct investment; (b) foreign portfolio investment (comprising stock and bonds); and (c) external commercial borrowing.  These items under (a), (b), & (c) are called capital account. Note that India, for legitimate reasons of insulating its economy from global disturbances, has restrictions on capital account inflows.  This year's budget proposal on floating sovereign bonds wants to relax these restrictions.

But who buys such government debt papers or bonds? These are primarily held by foreign financial institutions like investment banks (e.g., Goldman Sachs or Merrill Lynch) which are primarily based in global financial centres like New York, London, Singapore or Hong Kong. What do these investment banks do? They calculate the risk free return from the particular bonds after deducting some measure of "riskiness of the country/government". And who evaluates riskiness? These are provided by the US-based credit rating companies like Standard & Poor's (S&P) or Moody's.

An illustration might make the point clear. Suppose the interest rate on Indian government bond is 10% and that of the US government bond is 2%. S&P's ratings on these two government bonds are, (say): 8.5% for India, and 0.75% for the US [In reality they assign an alphabetical score like AAA to denote the riskiness, but these can be converted in a numerical scale]. Then the risk free returns from Indian Government bond and the US government bonds are as follows:

• For India: 10% - 8.5% = 1.5 %
• For the US: 2% - 0.75% = 1.25%

In such a situation Investment banks will find Indian bonds to be more lucrative and buy those bonds and dollars will enter India.

But suppose, tomorrow the US Federal Reserve Bank (or, Fed, the US counterpart of RBI) says nice things about the US economy that it is going to grow at a very high growth rate, unemployment is down etc. As a result, S&P upgrades US bond's credit rating from 0.75% to 0.25%. Now the risk-free interest rates for the bonds are as follows:

• For India: 10% - 8.5% = 1.5 % (unaltered)
• For the US: 2% - 0.25% = 1.75%

Hence the US bonds have become more lucrative. Thus, dollars will flow out of India. Consequently, the exchange rate of the Indian rupee will fall (depreciate) and if the depreciation is very steep, India may head for a crisis with higher oil prices (as oil is imported in India and we have to pay in dollar). Thus, Indian economy will turn out to be dependent upon the whims and fancies of the US.

Are we being paranoid or forgetting the lessons of history?

A typical market fundamentalist might argue that this is an alarmist position and why not take the advantage of a low interest rate in the world and let the government borrow from foreigners in dollars. To such an 'argument', we have simply one thing to say. Such people favouring sovereign foreign debt do not remember the lessons of history.

To begin with, one may remember the East Asian crisis of the late 1990s when countries like Korea, Thailand and Malaysia faced a huge crisis with growth becoming negative and unemployment rates reaching double digit levels. It all started when the governments of these countries tried to fix their exchange rate despite having sufficient dollar denominated debt both by the government and the corporates. What the world has learnt from these crises is that - it is impossible to fix the exchange rate and still open the government debt market to the foreigners.

Later, Argentina got into the trap of borrowing in dollars; but failed to repay. In Argentina's case a worse thing happened. When a foreign financial institution like an investment bank buys bonds of any government, there is a fine print that in case of any conflict, the matter will be settled in the New York State Court of Law. Further, it is not that these bonds are bought and everyone forgets them. These bonds are traded in the bond market like the shares in Bombay Stock Exchange.  When Argentina was about to default, most of its debt were bought from the various investment banks by a group of financial institutions who are known as "Vulture Fund" at a throw away price (as market price of any defaulted bond will be low). These vulture funds consolidated their portfolio of all such defaulted bonds and then sued Argentina in the State of New York. It is no wonder that New York Court was sympathetic to the American cause and these vulture funds got a verdict in their favour arm twisting Argentina to pay at the term of these vulture funds. What would have happened if Argentina chose not to pay? As financial markets act as a cartel, Argentina would have become an international untouchable in the global financial market - no one is going to give them any loans, IMF, World Bank, global banks and so on. This was what happened in Argentina over the years, when a few years back the IMF arm twisted Argentina to start paying back all such loans.

Interestingly, at present foreigners can buy Indian government's bonds - but there are restrictions.   Even with such restrictions, India experienced a crisis-like phenomenon. During June-August 2013, the rupee-dollar exchange rate came down from 57 to 68, indicating a depreciation of nearly 16% over three months. Why did it happen? The Indian government did nothing wrong afresh. But, the US Federal Reserve (the Central Bank of the US) Chairman Ben Bernanke made a statement that the rate at which the US Federal Reserve is buying financial assets from the private sector would be reduced. Financial market players interpreted Bernanke’s statements as an indication that the US economy was about to grow much faster and started pulling out dollars from India. The fall in the rupee's exchange rate was arrested only after Bernanke issued some clarifications and the RBI imposed some controls.

Why the hurry to issue sovereign bonds then?

The government must be aware of all such flip sides of issuing sovereign debt. RBI in its different documents has warned against this temptation. Various RBI governors have spoken against it. Why then has the government floated this idea now? Note that this NDA government have not come to power on the basis of any economic plank. Despite high unemployment and farmers' distress, and abysmal failure on economic and social fronts, they came to power on the basis of religious divisions and anti-minority stance. Thus, they need new photo opportunities for their survival. Imagine our honourable PM going to New York and declaring that the sovereign bond is oversubscribed – you will hear slogans of India going from high to higher. By the time the crisis comes, people are going to forget all about it. And the government will be looking for a new jumla! But, the real message of this jumlanomics is fairly clear to all who care to read between the lines. In its bid to accelerate India's financial integration with global capitalism, the Modi government is abandoning the time-tested checks and cautions that have so far stood India in good stead. Sacrificing whatever limited economic or political autonomy India had from the United States can only be a recipe for disaster.