With the rupee continuing to be volatile, markets are currently agog with the possible launching of a sovereign bond issue. While the idea of bolstering the foreign exchange reserves by issuing a NRI bond/sovereign may be applauded, the issue is how feasible is such an idea? We believe that there are a couple of points that we need to understand better to fully appreciate the benefits and costs of such.
Issue no 1: It may be noted that last time these bonds were mobilised, it offered a significantly higher rate of return (as much as 8.5% for dollar-denominated India Millennium Deposits?IMD), that may set a benchmark for other Indian papers to be issued at a relatively high coupon rate.
Issue no 2: In the current volatile exchange rate environment, when the rupee is depreciating (on an average, the rupee depreciated by 6% in the last five years), the exchange rate risk may be a significant add-on, on the already high interest rate (add 6% to, say, 8.5%!). In this context, we must remember that when the IMD bonds were issued, the rupee was fairly stable. Hence, the question of exchange rate risk was not significantly important at that point. But it is relevant today? (For the record, the volatility index of the rupee was merely at 1.7% during 2000-05, lower than 3.2% during 2011-June 2013.)
Issue no 3: The launch of such a bond may result in substitution across NRI deposits and hence, on the whole, there may be limited gain.
Issue no 4: Let?s also not forget that the IMD was issued under an extraordinary situation in FY99, and we have proved to one of the more resilient economies during the crisis.
Issue no 5: Finally, the liquidity impact of such a bond issue also has to be carefully managed by the apex bank through concomitant OMOs. In a situation when the central bank is already grappling with inflation management, such liquidity management may be challenging. However, there could be potential benefits of increased liquidity also.
Issue no 6: Another issue worth noting regarding the issuance of sovereign bond is the composition of external debt. Two examples are worth citing. One is of Argentina and the other is of Japan. In December 2001, Argentina suffered a severe financial crisis, leading to the largest sovereign debt default in history. Argentina defaulted on part of its external debt. Foreign investment fled the country, and capital flow to Argentina ceased almost completely. The currency exchange rate (formerly a fixed 1-to-1 parity between the Argentine peso and the US dollar) was floated, and the peso devalued quickly, producing higher-than-average inflation. Finally, massive restructuring of debt worth $160 billion finally saved the country. This has happened as most of Argentina?s sovereign debt was held by foreign investors (around 61% of sovereign debt held by non-residents in 2001). Before the onset of the crisis, Argentina had public debt-to-GDP of 53.6% of GDP (2001), which shot up to 165% of GDP in 2002. Interestingly, Argentina had a current account surplus at the end of 2012, yet its currency had depreciated by an overwhelming 73% in the last five years.
Japan, on the other hand, has a debt-to-GDP ratio of more than 100% since 1997 (currently 238% of GDP) but has a stable macro-foundation and the reason again lies in the composition of debt. As on December 2012, non-resident investors held only 8.7% of outstanding government debt of Japan (84 trillion yen), rest 91.3% was held by residents. It may also be noted that for the 21 EU member countries, the debt share of the non-residents accounted for more than 31.5% of the general government debt.
We believe that the recent deterioration of CAD is a reflection of the structural bottlenecks facing the Indian economy. With the government (since September 2012) and RBI working in tandem with a cocktail of long-term structural reforms and short-term temporary measures, we have to be patient and perseverant for the rupee to stage a recovery. In economics terminology, we believe this combination is the Pareto optimal approach under the current dispensation.
The author is chief economic advisor, State Bank of India. Views are personal