Foreign sovereign bonds

Foreign sovereign bonds

Foreign sovereign bonds

There has been a lot of noise around foreign sovereign bonds ever since the Finance Minister proposed to raise part of the Indian government’s borrowings in the external markets in other currencies. 

What is it?

They are government securities issued in order to finance the fiscal deficit and manage the temporary cash mismatches of the government. There is always a ready market for government securities. Apart from a fixed return, they offer maximum safety and are also actively traded in the secondary market. 

That is, the issuer of a 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. When a government issues such a bond it is called a sovereign bond. Typically, the more financially strong a country, the more well respected is its sovereign bond. Some of the best known sovereign bonds are the Treasuries (of the United States), the Gilts (of Britain), the OATS (of France), the Bundesanleihen or Bunds (of Germany) and the JGBs (of Japan).

Now, central government securities can be denominated in either foreign or domestic currency. In India, the government has only issued sovereign bonds in local currency in the domestic market. Foreign portfolio investors have evinced interest in Indian government bonds traded locally in recent years., as the real interest rate on Indian bonds is attractive compared to other developed countries. But currency stability is vital for such investors, as they take the currency risk investing in rupee-denominated government bonds.

This is where a foreign sovereign bond makes a big difference. A government bond issued in foreign currency (mostly in US dollars) shifts the currency risk from investor to the issuer (in this case, the government). Such bonds can be settled on Euroclear, the world’s largest securities settlements system, simplifying ease of investing for foreign investors.

Why is it important?

The issue of international sovereign bonds will have several long-term implications. It may facilitate the inclusion of India’s government bonds in the global debt indices. India’s representation in the global debt market indices is small compared to other emerging markets. This may lead to higher foreign inflows into India.

Two, inclusion in global benchmarks would also improve the attractiveness of rupee-denominated sovereign bonds. Three, the rates at which the government borrows overseas will act as a yardstick for pricing of other corporate bonds, helping India Inc raise money overseas. While some commentators think that the government can borrow at very low costs overseas, this argument is weak, as it will have to hedge against forex risks.

Why has there been no issue of such bonds so far?

That’s because there are risks too. Dollar-denominated bonds are more sensitive to global interest rates. Global shocks, as seen in the 2013 fed taper tantrums, can lead to heightened selling pressure on Indian bonds. For now, foreign investors’ holdings in Indian debt has been low, at about 3.6 per cent of outstanding government securities. In the Indonesian bond market, it is 38 per cent, while in Malaysia it is about 24 per cent. The RBI has been taking baby steps in opening up the limits for foreign investors, to ensure that we are not as vulnerable to an exodus of funds. So if the government does issue foreign sovereign bonds, it must exercise caution.

In other words, both the initial loan amount and the final payment will be in either US dollars or some other comparable currency. This would differentiate these proposed bonds from either government securities (or G-secs, wherein the Indian government raises loans within India and in Indian rupee) or Masala bonds (wherein Indian entities — not the government — raise money overseas in rupee terms).

The difference between issuing a bond denominated in rupees and issuing it in a foreign currency (say US dollar) is the incidence of exchange rate risk. If the loan is in terms of dollars, and the rupee weakens against the dollar during the bond’s tenure, the government would have to return more rupees to pay back the same amount of dollars. If, however, the initial loan is denominated in rupee terms, then the negative fallout would be on the foreign investor.

Why is India borrowing in external markets in external currency?

There are many reasons why. Possibly the biggest of these is that the Indian 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. If the government was to borrow some of its loans from outside India, there will be investable money left for private companies to borrow; not to mention that interest rates could start coming down. In fact, the significant decline in 10-year G-sec yields in the recent past is partially a result of this announcement.

Moreover, at less than 5%, India’s sovereign external debt to GDP is among the lowest globally. In other words, there is scope for the Indian government to raise funds this way without worrying too much about the possible negative effects.

Thirdly, a sovereign bond issue will provide a yield curve — a benchmark — for Indian corporates who wish to raise loans in foreign markets. This will help Indian businesses that have increasingly looked towards foreign economies to borrow money.

Lastly, the timing is great. Globally, and especially in the advanced economies where the government is likely to go to borrow, the interest rates are low and, thanks to the easy monetary policies of foreign central banks, there are a lot of surplus funds waiting for a product that pays more.

In an ideal scenario, it could be win-win for all: Indian government raises loans at interest rates much cheaper than domestic interest rates, while foreign investors get a much higher return than is available in their own markets.

Why should I care?

How does all this impact you? For one, such a move can lower yields on government bonds in the domestic market. For the current fiscal, the Centre’s gross market borrowings are at Rs 7.1 lakh crore. Raising part of this overseas can ease the oversupply of government bonds in the domestic market. Since interest rates on financial products track the movement in G-Sec yields, this can reduce interest rates on loans and savings.

Interest rates offered on post office savings or bank fixed deposit rates can move lower if the yields on government bonds fall. Banks can also lower their lending rates. Remember though, the increased vulnerability of Indian bond markets to foreign flows can pinch you too, with more volatile returns from debt funds.

We should also question the assumption that borrowing outside would necessarily reduce the number of government bonds the domestic market will have to absorb. That’s because if fresh foreign currency comes into the economy, the RBI would have to “neutralise” it by sucking the exact amount out of the money supply. This, in turn, will require selling more bonds. If the RBI doesn’t do it then the excess money supply will create inflation and push up the interest rates, thus disincentivising private investments.