Defending dollar debt

Defending dollar debt

FM Sitharaman’s proposal to issue foreign currency-denominated sovereign paper has merit.

In a recent column Raghuram Rajan, the former governor of the Reserve Bank of India made the case for why the Budget decision to issue foreign currency debt has no real benefit and poses enormous risks. While some of Rajan’s arguments are worth pondering, others are simply invalid. It is important, therefore, to subject these arguments to close scrutiny.

Rajan begins by erecting a few straw men purportedly proposed by investment bankers – that rupee yields can be compared with those in foreign currencies, and that the clientele for the foreign currency-denominated sovereign bonds is entirely different from the one for rupee-denominated bonds – and proceeds to demolish them. No serious analyst would have advocated such positions to begin with, and they are not worthy of serious consideration.

Rajan makes four other arguments that need to be addressed more carefully: that the notion a foreign currency-denominated Indian sovereign yield curve would be established by such issuance is wrong; the issuance of foreign currency-denominated Indian sovereign paper would hinder the internationalisation of the rupee; the issuance of additional foreign currency-denominated Indian sovereign paper would encourage a bond-issuing binge as an “addiction”; and since one could relax current ceilings on foreign portfolio investment and additional investment into rupee-denominated sovereign paper would occur, there is no point in issuing such paper.

Rajan’s first argument is reasonable. Small amounts of foreign currency-denominated sovereign bonds would not help establish a credible yield curve, especially as the amounts outstanding are likely to be small. Regarding his second argument, the aim of internationalisation of the rupee would be more of a hope and prayer for some time to come, especially when even much more important currencies such as the Chinese yuan have had their own challenges in doing so.

The only arguments that call for deeper examination are the third and the fourth ones. As for the third one, the prediction of a bond-issuing binge, for which there is no clear precedent, since India has not issued a sovereign foreign currency-denominated bond for decades, is pure speculation, and would not survive deeper investigation.

While a reasonable case can be made for both sides, the weight of the following arguments is in favour of the benefits from the issuance of such bonds: India has never defaulted on its sovereign obligations to multilateral agencies.

There is a strong fiscal and monetary framework in place, which would constrain unbridled expansion in sovereign debt.

As the finance minister has emphasised, the foreign currencydenominated bond issuance would come with tight restrictions, and would account for a small fraction of overall debt. The act of issuing foreign currencydenominated paper is likely to work as a disciplining influence on public borrowing. The proposed size of the issuance of such bonds is modest in relation to the central bank’s reserves, and there is little chance of a threat to the rupee.

Rajan’s fourth argument demands closer scrutiny. It is true that, with foreign participation, rupee-denominated and a foreign currency-denominated bonds are conceptually identical, but there are important informational and liquidity effects to be considered in making the comparison. While one can presume that the market sees through the trade-off between the present sovereign debt structure and future taxation at the macro-economic level, it is important to consider the micro-economic benefits that would eventually flow from the issuance of foreign-currency denominated bonds: Indian sovereign risk would be priced with lower liquidity/ risk premia, because the price of the foreigncurrency-denominated sovereign bond is discoverable.

A credible dollar-denominated sovereign curve would reduce the risk-premium implied in the foreign currency swap curves and dampen the volatility of the spot exchange rate.

The credit risk premium would be accurately estimated and reduce the emphasis on published credit ratings, which have been persistently overstating the true sovereign credit risk. A verifiable sovereign spread would provide a powerful argument to convince the rating agencies to at least move India up a notch or two. (Such an improvement did occur in the case of the Philippines and Indonesia.) The issuance of a series of sovereign obligations would allow the emergence of an Indian sovereign credit default swap (CDS) market, and may be beneficial to investors to hedge Indian sovereign risk.

The inclusion of the proposed bond/s in global indices would cause a reduction in yields as index-tracking funds buy the bond.

If the proposed bond is “special”, it may earn investors an additional convenience yield, leading to a lower yield for the issuer.

The reduction of these liquidity and risk premia would also have a beneficial impact on corporate bond yield spreads in the external commercial borrowing (ECB) market.

My own view, based on extensive research in sovereign bond markets in Europe and Asia, is that a foreigncurrency denominated sovereign bond, issued in modest quantities would have a salutary effect on the external rating and pricing of the Indian sovereign credit risk, and a step in the right direction. In any event, as Rajan concedes, “a small issuance will likely not be problematic”. I would concur and recommend that the finance minister ought to go ahead and implement the proposal.