Sovereign bonds: Risks and Rewards

In the budget, the government has proposed to raise a part of its gross borrowing in external markets in external currencies by issuing sovereign bonds. Under the programme, both the initial loan amount and the final payment will be in either US dollars or some other comparable currency.

What are Sovereign Bonds?

The issuer of the bond promises to pay back a fixed amount of money every year until the expiry of the term, at which point the issuer returns the principal amount to the buyer. If such a bond is issued by the government it is called a sovereign bond. In the financial markets, more is the respect for the sovereign bond when the country is more strong financially.

Why the government is looking at External Borrowing?

• Often it is said that government’s domestic borrowing is crowding out private investment and preventing the interest rates from falling even when inflation has cooled off and the RBI is cutting policy rates. Hence the government plans to borrow from outside to allow space for private companies to borrow.
• India’s sovereign external debt to GDP at 5 per cent is among the lowest globally. This provides an opportunity for the Indian government to raise funds this way without worrying too much about the possible negative effects.
• Sovereign bond issue will provide a benchmark for Indian corporate entities who wish to raise loans in foreign markets. This will help Indian businesses that have increasingly looked towards foreign economies to borrow money.
• In the advanced economies where the government is likely to go to borrow, the interest rates are low and there are a lot of surplus funds waiting for a product that pays more.

Concerns against Sovereign Bonds

• Since both the initial loan and the repayment would be in foreign currency the economists believe that there could be depreciation of the rupee and the government would be forced to return more rupees to pay back the same amount in external currency.
• The volatility in India’s exchange rate is far more than the volatility in the yields of India’s G-secs. This would lead to a situation where the government would be borrowing at “cheaper” rates than domestically, the eventual rates (after incorporating the possible weakening of rupee against the dollar) might make the deal costlier.
• One of the big reasons for borrowing outside is to reduce the number of government bonds the domestic market will have to absorb. But this argument is questioned for the fact that RBI would be required to “neutralise” the fresh foreign currency by sucking the exact amount out of the money supply. As a result there RBI would be selling more bonds. Failure to do so will create inflation and push up the interest rates, thus disincentivising private investments.

India must not forget that the external borrowing could be a double-edged sword. Most probably the government will be tempted to dip into the foreign markets for more loans every time it runs out of money. At some point, if India tries to make any compromise on its fiscal health, the foreign investors will pull the plug on fresh investments, creating dire consequences for India.