The dollar debt chase

Among the slew of measures being experimented with to address the problem of a widening current account deficit and a collapsing rupee are various interventions to accelerate debt inflows.

In May, the Finance Ministry announced a major tax concession to investors in India’s debt market. The withholding tax on interest earned on investments by foreign institutional investors (FIIs) and qualified foreign investors (QFIs) in government securities and bonds issued by Indian companies was slashed from the prevailing 20 per cent to just 5 per cent.

This concession is to apply not just to investments made in the future but on all interest income on such investments accruing between June 1, 2013, and May 31, 2015, irrespective of when the investment has been made.

More recently, on completing the first year of his current term as Finance Minister, P. Chidambaram announced that public sector companies and banks will be allowed to raise funds overseas, and proposed liberalising the terms for inflow of longer term non-resident funds and external commercial borrowing.

The latter is clearly a signal of the way the Government intends to go in dealing with its current account financing needs.

These efforts to incentivise and attract foreign lenders and encourage foreign borrowing by domestic private and public sector players seems to be driven by two trends.

The first is the evidence that, despite the liberalisation of a host of FDI rules and relaxation of FDI caps, the inflow of foreign equity investment (direct and portfolio) would be inadequate to keep pace with the widening current account deficit.

Since the deficit has to be financed without running down reserves in order to shore up the tottering rupee, other sources of funds must be relied on. Foreign debt, which has been rising fast, seems to be the chosen option.

Reliance on foreign debt

Thus external commercial borrowing (ECB), which rose in 2007-08 touching $62.3 billion as compared with $41.4 billion the previous year but slowed over the next two years to settle at $70.7 billion at the end of 2009-10, has surged again to touch $88.4 billion at the end of March 2011, $104.8 billion at the end of March 2012 and $120.9 billion at the end of March 2013.

As a result, while ECB and NRI deposits were at more or less similar levels in March 2007, the former has raced ahead of the latter in recent times (Chart 1). This is what the Government wants to exploit.

The second factor favouring reliance on foreign debt as the means of current account financing is evidence of substantial investor interest in Asian bond markets. Even over the first three months of 2013, junk-rated borrowers in Asia, such as China’s property developers, had successfully issued $18.1 billion of debt as compared with the previous full-year record of $16.2 billion in 2010.

In April, Indonesia raised $1.5 billion in 10-year bonds at a yield of 3.5 per cent (176 basis points over US Treasuries), which was the lowest rate ever paid by the country for non-Islamic bonds. It raised an additional $1.5 billion in 30-year bonds at a yield of 4.75 per cent.

The two offers were oversubscribed, driven according to observers ( Financial Times , April 9) by US investors who accounted for half of the $12.5 billion of orders received. Easy liquidity in global markets and the need to mop up investment options before the effects of monetary easing by the Bank of Japan are felt, are the often-cited explanations for this boom.

Though markets seemed to be freezing immediately after April, affected possibly by fears of the withdrawal of quantitative easing and monetary policy tightening by the US Fed, the $1 billion raised by China’s Internet search engine company Baidu at the end of July points to persisting buoyancy.

It is in this background that the Indian Government decided to incentivise foreign lenders with the major tax concession to foreign financial investors in the debt market referred to earlier.

Moreover, now, public sector companies are being encouraged to join the borrowing spree. In his end-of-first-year announcement, Chidambaram reportedly said these entities had an advantage in debt markets both because of their strong balance sheets and the fact that they would be issuing ‘quasi sovereign bonds’. That is, being government-owned institutions, the bonds these entities issue would carry an implicit sovereign guarantee, though the interest cost would be borne by the entities themselves. That should be attractive to lenders.

This clever move addresses the problem that, if sovereign bonds are issued to attract the foreign exchange needed to finance the current account deficit, the Government’s fiscal deficit may rise and the Government’s debt position would be under investor scrutiny. The hope here is that moving sovereign borrowing off the Government’s balance sheet, by getting publicly-owned entities to borrow, would help avoid those difficulties.

There are a set of related explanations why the Government needs to show this remarkable generosity of both subsidising foreign borrowing with tax concessions as well as implicitly guaranteeing debt that it does not want to incur. The first is that, as the current account widens, the rupee slumps and the rating agencies turn aggressive, the thirst for foreign capital in post-liberalisation India is turning insatiable.

Reason for generosity

No more is it adequate to incentivise foreign investment in crucial high technology or infrastructural sectors. Liberalisation is forcing the Government to reward any kind of foreign investment so long as it brings foreign currency into the country.

The second is that it no more seems adequate to incentivise only foreign investments in equity capital, through, for example, the abolition of long-term capital gains in 2003.

Even though there has been a surge in foreign institutional investment in emerging markets including India, the Government is fearful that inflows into the equity market would be inadequate to quench its thirst for foreign capital. So debt flows need to be incentivised too.

Finally, there is the evidence that foreign investors are showing an appetite for concessions. As the Government has liberalised rules relating to foreign investment in the debt market, debt flows through the FII route into India have indeed increased. As Chart 2 shows, net cumulative FII investments in debt instruments that were negligible at the turn of the century, and touched just $5 billion at the end of May 2009, had risen to close to $40 billion by the end of May 2013 (figure for 2013 refers to May 22).

As a result the share of debt in cumulative net FII inflows estimated by the Securities and Exchange Board of India (SEBI) rose from just 0.1 per cent at the end of May 2001, to 8 per cent in 2009, and 21 per cent in 2012, only to decline marginally to 18 per cent by late May 2013.

Substantial expectations

Expectations are that overseas borrowing by Indian corporates would be substantial this financial year as well. According to reports, a host of leading Indian corporates have declared their intention to tap the ECB market.

This includes plans of Reliance Industries to raise about $1.75 billion, of Adani Enterprises and Essar Steel looking to raise $2 billion, and of JSW Steel wanting to raise $900 million.

In this chase after foreign exchange, the many dangers associated with foreign borrowing are being underplayed.

Unlike the case with investments in equity, where returns are linked to performance, interest and amortisation commitments on debt have to be met irrespective of the returns obtained in or foreign exchange earned by the investments they finance. The debt being in foreign currency, these binding commitments have to be met in foreign currency as well.

So if the concessions being offered result in an intensified surge in debt inflows, payments on the current account on account of interest would rise as well.

It would rise even faster if the interest rate that has to be offered to foreign financial investors in India’s increasingly uncertain environment also increases.

The result would be larger outflows on the current account. Financing a widening current account deficit with debt may be self-defeating.

The point is that the withholding tax concession is not being limited to investments in long-term bonds such as those used to fund infrastructure, for example.

Investors in all kinds of bonds would benefit. With economic uncertainty encouraging investments that can exit quickly, there is likely to be an increase in interest in and the issue of short-term bonds.

Already, India’s short term external debt that was fluctuating in the $45-52 billion range between end-March 2008 and end-March 2010, has since shot up to $96.7 billion at the end of March 2013 (Chart 3).

Incentivising short-term debt inflows is a sure way of increasing vulnerability to sudden capital outflow that can precipitate a balance of payments crisis, as India’s experience in 1991 and Southeast Asia’s in 1997 illustrated.

The measure could, therefore, increase balance of payments vulnerability.

Finally, relying on foreign currency debt to finance domestic expenditures when the rupee is depreciating has implications for the viability of borrowers.

Rupee depreciation increases the local currency or rupee cost of servicing foreign debt, imposing an additional and undefined burden on the borrower. This is proving a problem because many borrowers have not hedged against rupee depreciation.

Firms exploiting increased foreign investor interest can in difficult times, such as now, find themselves unable to service foreign debt without courting losses and even bankruptcy.

For these and other reasons the Government would do well to stop celebrating its ability to finance the current account deficit without drawing down reserves by attracting foreign capital and focus on finding ways to reduce that deficit.

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