A V Rajwade: A financial engineering solution

WORLD MONEY

Can it be a solution to the problems of the fiscal deficit and infrastructure investment?

The Planning Commission's proposal to use reserves of foreign exchange to step up the pace of investment in infrastructure continues to attract media comment.

The proposal amounts to arguing that a higher fiscal deficit through the monetisation route (that is, purchase of extra debt by the central bank) is affordable, provided the extra resources so created are invested in infrastructure projects that would give fast returns to the economy, and measures like lowering duties are taken to increase imports.

I intend to look at the proverbial problem of squaring the circle (finding the resources for investment without either cutting expenditure, increasing taxes, the fiscal deficit, or, horror of horrors, privatising PSUs), from a financial, distinct from an economic, perspective.88

In recent years, in international markets, there have been several instances of the use of financial engineering to reduce fiscal deficits. The two that readily come to mind are:

In the second half of the 1990s, Italy swapped its lira debt into yen to reduce its fiscal deficit and qualify for the single European currency. Coupons on the government's lira debt were in double digits.

By swapping the debt into the low interest rate Japanese currency, interest payments were brought down drastically and Italy managed to meet the deficit criterion;

More recently, the German government "" once the paragon of fiscal rectitude "" securitised and sold its loans to Russia in the market, to bring down the fiscal deficit (it is another matter that even after that Germany exceeds the Stability Pact's ceiling on the fiscal deficit).

Can financial engineering provide a solution to the problem of fiscal deficit and infrastructure investment? The Indian government has a huge amount of "value" locked up in a large outstanding external debt at concessional rates of interest.

According to India's External Debt: A Status Report (June 2004) issued by the Ministry of Finance, the present value of India's external debt is lower by as much as $ 20 billion compared to the gross amount.

If a way can be found to use this hidden value, significant amount of resources would become available without an increase in the gross value of the government's liabilities.

The mechanics could be somewhat as follows ($100 as the gross amount of foreign currency debt at concessional rates of interest, with a present value of $60):

The government will issue rupee bonds for Rs 4,500 (an exchange rate of Rs 45) to RBI;

The RBI would use Rs 2,700 worth of bonds to "sell" $60 to the government. The balance amount of Rs 1,800 would be available for infrastructure investment;

The amount of $60 sold to the government will be invested as a separate fund outside the reserves, in zero-coupon sovereign bonds (with a face value of $100), earmarked for repaying the external debt in course of time;

A special-purpose vehicle could be used to hold the investment in sovereign bonds and service the external debt.

To my mind, the proposal has several attractive features:

Apart from releasing significant funds to the government, what I find attractive is that the proposal eliminates the government's exchange risk on the debt. The reserves, whose size seems to be unnecessarily worrying many commentators, will be reduced.

Rather than foolishly prepaying aid as the previous government did, this proposal will encash the value for better purposes.

The government's interest bill will go up to the extent of the coupon on the rupee debt, but the amount will come back as RBI profits to the government; the aggregate liabilities would remain unchanged.

Of course, it can be argued that this is merely a bookkeeping gimmick and the substance is an increase of Rs 1,800 in the fiscal deficit, bringing the argument back from the financial area to the economic pundits.

In a way of course, unlocking future values is a part of the financial market scene. Take the parallel of the banking system and the way it earned significant "profits" by selling old, higher coupon securities when interest rates were falling in the past three years.

It could be argued that these are paper profits, but they have enabled the banking system to provide for its non-performing assets (NPAs) and bring the ratio of net NPAs down to far more manageable levels.

The capital gains were, in effect, front-ending of the higher future income from the existing bonds, when this is more beneficial. What I am suggesting the government should do is not entirely different.

Incidentally, the rating agencies have threatened that the use of reserves and higher fiscal deficits would be a negative factor for India's rating.

The same agencies have not hesitated to bring Russia back to investment grade within six years of a sovereign default, while they continue to be cautious about India, despite the strong external position and a record of never having defaulted. A case of double standards?

Tailpiece: Even as the United Progressive Alliance government continues to dither with the idea of job reservations in the private sector, Abdullah Badawi, the Malaysian prime minister has signalled an unwinding of the affirmative action programme.

He has argued that ethnic Malays must improve their knowledge and skills to compete in a global economy as "a continuing reliance on crutches will further enfeeble [them]".

Email: avrco@vsnl.com