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Let Foreigners Buy Our Debt


Dheeraj Singh and I write at the Business Standard:

It’s time the government opened up to foreigners for its funding. Government of India securities, or G-Secs, are issued by the government, and primarily owned by Indian resident entities. Banks, the Life Insurance Corporation of India and Provident Funds hold about 80 per cent of government securities, which have about $800 billion (Rs 42 trillion) outstanding. A significant chunk is also held by RBI (12.5 per cent in September 2011 — though this would have risen significantly by now due to open market purchases).

Currently, foreign institutional investors are allowed to hold a maximum of $15 billion (out of which $5 bn has to be invested in securities maturing beyond five years) in government debt and $20 bn in corporate debt. An additional amount of $25 bn is allowed for investment in the infrastructure sector.

Since the limits are relatively small and demand far higher than supply, the limits of both government bonds and corporate debt are exhausted quickly. About half the limits are allocated on a first-come, first-served basis, while the remaining half is auctioned off to the highest bidder. Not only are investors willing to invest, they are also made to pay a fee to be allowed this privilege of investing. Further, once the limits have been exhausted, any new prospective investor has to get in line and wait.

It is simple economics that drives this demand, not any special love for the Indian government. Net of hedging costs of the currency, it is still possible to make a clear 2 to 3 per cent income on capital deployed. There’s nearly no risk of the Indian government defaulting on rupee debt (we won’t even let an Air India fail). Not many avenues around the world give such an opportunity to make money while taking the sovereign credit risk of a large and growing country like India.

We need to expand, or indeed abolish these foreign investor limits. Why are we averse to such foreign ownership? We often hear of the Asian crisis of the 1990s, when Asian governments saw rapid currency devaluation and foreign investors withdrew their investments in their debt. But that situation was different; much of that debt was denominated in dollars (so you had to pay more of the local currency back if it depreciated). Plus, we have seen a currency fall of 20 per cent in a year, even with these limits, simply because we have a free arrangement for investment in equities — on the flawed thought process that foreigners won’t really want their equity investment back.

Having foreign investors buy rupee-denominated bonds (or Treasury bills) will significantly reduce yields and thus, the cost of funding for the government — indeed, in 2012-13, more than 20 per cent of government expenditure will be on interest payments (Rs 3.2 trillion). Assuming that the weighted costs of borrowing comes down by 1 per cent over time, the government will save around Rs 450 bn in interest costs.

Secondly, if foreigners buy government bonds, it leaves our banks with the ability to lend to the rest of India. Banks currently have to buy government bonds with 24 per cent of their Net Demand and Time Liabilities (which is largely deposits) as part of the Statutory Liquidity Ratio (SLR) maintenance. A fourth of your money in the bank goes to the government — while foreigners wait in line, and people don’t get the loans they want. And, as the government borrows more and more, it crowds out other domestic borrowers. With foreigners buying government debt, SLR limits can be relaxed and there will be no crowding out.

Additionally, the inflow of dollars that will come in will help stabilise the currency. India maintains a massive current account deficit, of nearly $60 billion. This would, in general, result in the rupee falling; but foreign investment in equities and FDI has stemmed the fall till 2011. Last year, as the government’s policy paralysis and corruption gained visibility, investment dried up and the current account deficit took the rupee down by 20 per cent. If foreign investors were allowed to buy our debt, they would bring in more dollars and stem that fall as well.

If foreign entities hold a majority of Indian rupee debt, some might claim it could cause a crisis. If unfettered access is unacceptable, we should at least revise the current limits. The limit of $15 bn is just 2 per cent of the total Central government debt. In fact, the government will borrow an additional $85 bn this year. We should, at the very least, increase the limit to 20 per cent of all government debt, which translates to $150 bn. Remember, we actually borrow in rupees, and that figure is just a dollar equivalent. And then, we should allow foreign holders hedging measures of this magnitude, since current hedging limits prevent an entity from being able to protect a large investment.

In the medium- to longer-term, there would be other concomitant benefits too. The need for investors to hedge their exchange rate risk would help the market for foreign-exchange derivatives. And banks would be forced to shore up their skills in this area. Over time this could also help kick start the moribund market for interest rate derivatives. Indian residents could also be allowed to borrow abroad and invest in government bonds, to introduce competition.

Enthusiasm for G-Secs may wane if India keeps withholding 20 per cent tax on interest payments to foreign entities. We would argue for a removal of such taxation entirely as followed in most OECD countries, as the loss on a $100 bn portfolio in terms of taxes (Rs 70 bn a year) will be overshadowed by the saving in interest costs.

Current economic and monetary conditions seem to be conducive, as worldwide interest rates are low. Global investors are increasingly looking for options to enhance yields on their investments. And such a move would enable us lay the foundation for full capital account convertibility.

The present mini crisis provides a great opportunity for the government to welcome foreign investment into the Indian debt market, especially the market for government bonds.


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