Sovereign borrowing from/in foreign countries is not a new phenomenon. Documented history since the 15th century shows large-scale sovereign borrowings and a regular history of sovereign defaults too.
Over the last 300 years, this history shows many ups and downs. However, we will focus only on the period following the Second World War when most of today’s rules governing sovereign borrowings came into being.
After the Second World War, the evolving monetary arrangement paved the way for more government lending and radically changed the sovereign debt market. The three decades following the War, most lending to developing countries, came from either governments or international institutions such as the World Bank or the International Monetary Fund (IMF). The Paris Club was created in the 1950s to deal with debts (defaults and renegotiation) owed to government agencies or wealthy sovereigns.
However, starting with the 1970s, banks or the London Club began to lend massively to developing countries. The reforms that took shape in Chile had a significant demonstration effect on the less developed countries (LDC) and there was considerable buildup of sovereign debt in foreign currency in many LDCs.
The Polish and Mexican defaults in 1981 and 1982 temporarily reversed the lending trend, leading to defaults by other countries. But lending resumed and it was not until 1990 that LDCs’ sovereign borrowings became the focus point for financial stability.
The issue in 1990s in respect of sovereign borrowing was that sovereign risk had become concentrated in the hands of a few banks. To avoid a crisis, the US treasury secretary, Nicholas Brady, announced in 1989 a plan wherein bank debts were exchanged for marketable sovereign bonds with a lower present value but with 30-year US treasury bonds as collateral. Since the peak was attained in 1990, sovereign defaults had a declining trend which ended with the Greece sovereign bond crisis.
Surprisingly, in this long history of sovereign foreign currency borrowings and defaults, India did not feature anywhere. Perhaps India’s outlook was shaped by the balance of payments (BoP) crisis of 1991 at home and the unfolding LDCs' sovereign bond crisis outside. As a result, sovereign foreign currency borrowings have never made it to the list of policy options, almost never to finance the fiscal deficit. Even the IMF loan, negotiated by India in 1991 during prime minister (PM) Chandrasekhar’s tenure had minimal conditions. Thus, the decision to borrow in foreign currency on commercial terms is a major departure from the stated policy and needs some careful consideration.
The most recent official publication that talks about borrowing in foreign currency to finance fiscal deficit is the Fiscal Responsibility and Budget Management (FRBM) review committee report (Chairperson: NK Singh). Largely unnoticed by most economists, it was in this report (pg 59) that the seed of the proposal to finance fiscal deficit using foreign borrowings were sown.
However, neither the final recommendations mentioned this aspect nor was it taken into account in debt sustainability calculations which gave the target debt-GDP ratio of 60% (40% for the Centre).
The reasoning goes as follows: “Based on the latest data from the Central Statistics Office (CSO) and the Reserve bank of India (RBI), net household financial savings were reported at 7.6% of GDP for FY15. Further, India’s external borrowing needs can be proxied by its sustainable current deficit India in the medium-term, which is estimated at around 2.3% of GDP. Therefore, a total of 10% of GDP of household savings and external borrowing would be available, which can be assumed to be allocated equally between the public and private sectors. This would lead to a combined fiscal deficit of the Centre and the States of 5% of GDP, and at the same time ensure an investment of 5% of GDP. ”
The above reasoning is problematic on many counts. Notably, the report did not specify why a drastic change in policy was warranted when the finance commission earlier had recommended only domestic borrowing. Then, in what currency should the government borrow, what should be the end use of the foreign funds, who will bear the cost of exchange rate risk? If the exchange rate risk is left unhedged, how will debt sustainability be impacted? These questions have all been left unanswered. Thus, everything appears to be on soft ground.
Then the issue of sovereign guarantees already extended in foreign currency has not been discussed at all. It was reported in April that the government of India, in 2009, had issued a sovereign guarantee on behalf of Infrastructure Leasing & Financial Services (IL&FS). Following the crisis in IL&FS, approximately $2 million was paid to the Asian Development Bank (ADB), and about €600,000 to €700,000 have been paid to KfW.
As per the receipts budget 2019-20, the total contingent liability of government of India as of 2017-18 was Rs380,172.80 crore. Of this, Rs304,398.05 crore is towards guarantees given in pursuance of agreements entered into by the government of India with international financial institutions, foreign lending agencies, and foreign governments.
Thus 80% of the contingent liability has foreign currency risk. Since detailed data on foreign guarantees is not available it is difficult to gauge how much can crystalise in the near future. But a sovereign guarantee in foreign currency can be imagined as a put option on two risky variables—GDP and exchange rate. Given the trends in both, for the holders, this option is gaining in value.
In conclusion, the decision to tap international markets to finance fiscal deficit is in line with general trends observed across many emerging market economies (EME) since 2013. However, the reasons to change the currency composition have been unique in each case. They range from de-dollarisation to geopolitical calculations, to take the advantage of negative cross-currency swap basis. However in each of these cases there is also a strong cost-risk analysis.
Surprisingly, the origins of the decision to change currency composition of public debt in India are not very clear. FRBM review committee reports appear to be the most recent source; but the logic used to justify sovereign borrowings is rather convoluted and devoid of any cost-risk analysis.
(The writer is an economist in the banking sector. Views are personal.)