The Union Budget has not been taken kindly by the equity markets, which fell as much as 1300 points in two days following its announcement. This is primarily owing to several proposals such as raising the minimum public shareholding limits in listed companies, increasing the income tax on the super rich, or taxing buybacks. The bond markets, on the other hand, seem to have celebrated. This was reflected in 10-year government bond yield, which fell from 6.72 per cent to 6.56 per cent.
But should the short-term bouts of financial markets, equity or debt, to the Union Budget proposals matter to the policymakers? The answer is yes.
For one, these reactions act as a signalling mechanism for the government. To the extent that the negative reaction of equity investors reflects their disappointment with budget proposals, the government must be concerned as it is these investors who could potentially help fund the government’s fiscal deficit. For instance, the government raised more than 50 per cent, or Rs 45000 crore, of its total disinvestment proceeds of Rs 85000 crore last year through two exchange traded funds – Bharat 22 and CPSE ETFs. Spooking equity investors could therefore inhibit the government’s revenue raising capacity.
The government’s plan to tap the overseas investor community, however, through issuing dollar-denominated sovereign bonds is a positive move but comes with its share of risks. The domestic debt markets are optimistic. This is owing to the fact that shifting a portion of sovereign borrowing from domestic to foreign markets could leave more room for India’s private sector to borrow domestically. In other words, there is less fear that the government borrowing plan of Rs 7.1 trillion would crowd out private investments because a part of this would be borrowed from foreign investors.
This could aid private capital formation, which has been missing for the past five years. This could also free up the conduct of monetary policy. To know how, consider the opposite: A higher domestic borrowing by the sovereign could firm up government bond yields, thereby blunting the impact of recent interest rate cuts by the central bank. This was the case, for instance, before the Fiscal Responsibility and Budget Management Act was enacted in 2003, and even more so before discontinuance of ad-hoc Treasury Bills issuances by the central bank in 1997.
In decades before 1997, the fiscal deficit was often monetised through the issuance of Treasury Bills by the RBI. This meant a continually high fiscal deficit and an upward bias on interest rates across the economy. This led to what was popularly called “fiscal dominance of monetary policy,” which compromised monetary policy independence.
The Union Budget proposal to shift a part of the sovereign’s borrowing plan to dollar bonds should be seen in this context. The Monetary Policy Committee could now be free to reduce rates further, unencumbered by the prospect of the negative impact of sovereign borrowing plan on domestic interest rates.
As per some reports, the government plans to finalise the overseas borrowing plan by September. The actual implications of this plan would depend on a few essential factors. One, the size of this borrowing. The government has indicated that they would keep it at 10 per cent of the total borrowing. This comes to roughly Rs 71000 crores. Given that the external sovereign debt in March 2019 was 3.8 per cent of GDP, there is room to borrow more.
But the investors would want to be confident that the government would be able to serve its debt obligations without significant adjustments to the fiscal policy in future. In this context, a strict adherence to a prudent fiscal policy backed by fiscal consolidation measures is imperative. Unfortunately, the present reduction in fiscal deficit target from 3.4 per cent to 3.3 per cent is driven by unrealistic tax revenue growth expectations (18 per cent) and an ambitious nominal GDP growth rate (11 per cent). Foreign investors may seek better assurance to ensure India’s debt sustainability.
Second, prudent debt management requires mitigating both risks as well as costs of borrowing. The risks of overseas sovereign borrowing, especially in the case of emerging market economies, are threefold: Refinance risks, exchange rate risks, and interest rate risks. Refinance risk arises out of the need to refinance a maturing debt obligation. Issuing short-term debt could increase this risk, especially for governments that are fiscally profligate. This is why fiscal rectitude is important.
Exchange rate risk is perhaps the most relevant to India. In a dollar-denominated sovereign bond issuance, this risk must be borne by the sovereign, and not by investors. Given that hedging this risk would be costly, the government would most likely not hedge. This could expose it to fluctuations in the exchange rate, especially if the rupee depreciates significantly between the issuance and maturity dates.
Third, the sovereign would also be exposed to interest rate risks if US Fed rate is higher at the time of the reset date. As an international example, consider the case of Mexico. In the 1970s, the rise in oil prices owing to OPEC embargo boosted the profits of Mexican state-owned oil companies. Encouraged by low real rates owing to high inflation, Mexico tapped the US bond markets to borrow at cheap rates. The situation, however, turned out of favour in 1980s when the US Fed began raising rates aggressively to contain inflation. Mexico’s funding soon dried up – exposing it to refinance risk – as US investors preferred to invest at home at higher interest rates. In 1982, Mexico’s finance minister informed the US and the IMF that it could not service obligations on $80 billion of debt.
The costs of borrowing could be mitigated by ensuring political and financial stability. India’s credit rating, which impacts borrowing cost, is presently one of the lowest at BBB- by Fitch and Baa2 by Moody’s. Against this backdrop, it becomes even more important to ensure fiscal prudence, political stability, and a comprehensive risk management framework that guards against the three aforementioned risks. If these risks are managed, then the plan to tap overseas foreign currency sovereign bond market could prove to a wise measure.
(Harsh Vora is a proprietary investor and trader based in Vadodara)
The views expressed above are the author’s own. They do not necessarily reflect the views of DH.
