Handle with care

Sovereign borrowing in foreign currency has inherent risk

One of the big departures from the past in the first Budget presented by Finance Minister Nirmala Sitharaman last week was the idea to fund the fiscal deficit partially by borrowing from international markets in foreign currency. The basic idea is that by shifting part of its borrowing aboard, the government will reduce the pressure on the domestic market, which will help keep interest rates at lower levels. Public-sector borrowing is putting significant pressure on market rates, along with liquidity in the system, which, among other things, is affecting monetary policy transmission.

As this newspaper argued last week, this is a good idea if it is done safely. The government can take advantage of low global interest rates, which are unlikely to rise significantly in the foreseeable future. However, it will have to be careful and should avoid going overboard because there are multiple inherent risks in the idea — the reason why the policy establishment avoided it so far. For one, the government will be taking currency risk. A depreciation in the rupee will increase the government’s liability. On the other hand, the overall increase in the import of foreign capital could put upward pressure on the rupee, which can affect exports and make currency management more difficult for the central bank.

Second, this will increase the government’s exposure to the vagaries of global financial markets. A shift in perception towards emerging markets and an upsurge in risk aversion — not necessarily because of a change in India’s fundamentals — could put pressure on Indian sovereign bonds. This would directly influence the view of foreign investors with positions in rupee-denominated government bonds and lead to higher volatility, both in the debt and currency markets.

Third, this could potentially discourage foreign investors from investing in rupee-denominated government bonds, because they will have the option of investing in hard-currency bonds and avoid the currency risk associated with the rupee. This can diminish the gains from accessing international markets. 

Fourth, the domestic bond market serves as a signalling mechanism for the government by making price adjustments in response to the supply of bonds. Large issuances in global markets can impede this process. In fact, the government will have an incentive to take more of its borrowing abroad because it will help keep domestic interest rates in check. Naturally, this will increase risks for financial stability. History shows that the accumulation of foreign-currency debt can lead to difficulties.

Therefore, it will be important for the government to explore and use this option carefully. In this context, the government would do well to constitute an independent fiscal council, as was also recommended by the N K Singh committee, which reviewed the Fiscal Responsibility and Budget Management rules. The council, which will evaluate fiscal management, can also advise the government on sustainable levels of foreign borrowing. Further, international experience shows that countries with an independent fiscal council have better fiscal outcomes. At a broader level, the council will instil more confidence in the market and, gradually, help reduce borrowing cost in the system.