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What are sovereign bonds, and what are their risks and rewards?

Topics covered:

  1. Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

 

What are sovereign bonds, and what are their risks and rewards?

 

What to study?

For prelims and mains: Sovereign bonds- uses, need, significance and challenges?

 

Context: The government has announced its plans to raise a portion of its gross borrowing from overseas markets. With the help of Reserve Bank of India (RBI), the government will finalise the plans for the overseas issue of sovereign bonds by September.

 

What exactly are sovereign bonds?

A bond is like an IOU. 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.

 

Why is India borrowing in external markets in external currency?

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.

 

What is the controversial part?

  • The current controversy relates to India’s sovereign bonds that will be floated in foreign countries and will be denominated in foreign currencies.
  • 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 are so many cautioning against this move?

  1. The volatility in India’s exchange rate is far more than the volatility in the yields of India’s G-secs (the yields are the interest rate that the government pays when it borrows domestically). This means that although the government would be borrowing at “cheaper” rates than domestically, the eventual rates (after incorporating the possible weakening of rupee against the dollar) might make the deal costlier.
  2. Borrowing outside would not 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.
  3. Based on the unpleasant experience of other emerging economies, many argue that a small initial borrowing is the thin end of the wedge. It is quite likely that the government will be tempted to dip into the foreign markets for more loans every time it runs out of money. At some point, especially if India does not take care of its fiscal health, the foreign investors will pull the plug on fresh investments, creating dire consequences for India.

 

Sources: Indian Express.