Bond Indices, Public Debt and Impossible Trinity

The piece Prime Minister Modi’s Foreign Journeys and Forex Reserves  argues an association between foreign capital and geopolitics in formulating a geostrategic doctrine.  What is striking, however, is the fact that a quarter of century of post-cold war and post non-alignment, suspicions about the West have not been erased from the Indian psyche.  However, it would be imprudent to discount overt or covert linkages between aggressive investor wooing with the need to shore up foreign exchange (forex) reserves. Besides accretion to forex reserves, there is added objective to ease access to foreign capital.

Domestic investment is financed through a combination of domestic savings, government savings and savings of the rest of the world. Domestic savings are usually constant. The increased level of government dissaving (increasing fiscal deficit) leads to increased current account deficit (savings from the rest of the world). The twin deficit paradox has implications for domestic economy as reflected in the economic crisis of 1991. Current account deficit has to be bridged by capital account surplus thereby opening doors for foreign direct investment and foreign portfolio investment. The low foreign exchange reserves in 1991 necessitated seeking of funds from IMF to tide over the balance of payment crisis. The price to be paid was liberalization of Indian economy. Therefore, to borrow from Shankar Aiyar’s book, the liberalization and consequent positive externalities were the accidental byproduct of the economic crisis of 1991.

Volatility induced by forex movements naturally impact exchange rates. Exchange rates are determined either by market forces or through the Central Bank. The Central Bank (RBI in India) can set a fixed exchange rate to eliminate volatility at the front end but the price would be a limit on the foreign exchange being purchased. Alternatively, the RBI could opt for floating rates, of which many different variations exist. From 1993, India has adopted a floating exchange rate. In floating rate mechanism, it is the market forces at work on paper, but in practice, the Central Bank usually keeps an eye on the movements. If there exists a feeling of increased unusual volatility, the Central Bank at times, will intervene albeit implicitly to restore stabilit. The currency could be current account convertible- free exchange of forex for current account purposes or capital account convertible- free exchange of forex even for capital account purposes. While India is current account convertible for 1994 onwards, it is not yet completely capital account convertible.  

In case of capital account convertible currencies, RBI interventions in forex markets can lead to increased overseas capital flight in case sufficient reserves don’t exist. These risks were manifested in outflow of hot money during the South East Asian crisis of 1998. For a freely convertible currency, the investors can invest or withdraw money denominated in foreign exchange at will. In case of crisis, huge outflow of forex can exacerbate the economic situation.

In forex parlance, each country faces an impossible trinity. Any country cannot simultaneously pursue a policies of fixed exchange rate, capital account convertibility and independent monetary policy. There is an inherent trade off as a country seeks to pursue one or more of these objectives. Therefore as India seeks to expand its capital and money markets, it is faced with this trilemma. Inviting greater foreign capital in debt market would expose India to greater risks of hot money outflows during a prospective crisis. Currently, there is limit of 6% on foreign portfolio holdings in the Indian debt market. Removal of this cap or increasing the cap can be good options. Yet to be meaningful, it needs to be accompanied by capital account convertibility. This could call into question the reliability of independent monetary policy or induce in worst cases the volatility in fixed exchange rates. It must be noted, while exchange rate is not fixed, managed float ensures the currency moves within a given band with implicit interventions by the RBI to keep the rate in preferred bandwidth.

In seeking access to global capital, Indian financial instruments need to be linked to global indices that are operated by Bloomberg etc. Recent discussions with Bloomberg by Prime Minister Modi in New York underscored the need for Indian debt instruments to be listed in these indices. In fact, Chinese instruments were listed in these indices only in early 2019 and currently have a weight around 6%. To most foreign portfolio investors, these indices are trackers for their portfolio constructions. Indian instruments even with weightage of 2-3% might lead to significant inflow of foreign debt capital. Further, as weightages improve, the cost of capital also begins to decline. The indices however desire a free entry and exit. Removal of 6% cap would lead to a quasi capital account convertibility scenario thereby an increased exposure to possible vagaries of impossible trinity.

The government in Budget 2020-21, have come up with a solution to sidestep these hurdles. Since the indices include only individual bonds, the government can issue a special class of government securities to circumvent 6% limit. These special class of G-Secs will not be subject to 6% FPI limit and allow free entry and exit conditions. Investment in these securities is equivalent to investment in capital account convertible securities. In a budget dominated by negative headlines, this is an interesting piece of a reform underneath the radar. This measure, if followed with subsequent measures potentially might transform the Indian debt market significantly in the mid to long run. Resolution of the domestic crowding out effect might be facilitated through this approach bringing down the interest rates and increasing the loanable funds for capital accumulation. There however, arises an increased risk of exposure of G-Secs to forex volatility besides prospective increase in the cost of capital during times of crisis.

There is without doubt, India has to open up the debt market and move towards fully convertible currency. Moreover, the Indian debt market is largely illiquid. The journey is a continuum and the step must be followed up by allowing state government and corporates to issue securities that could be freely convertible. Of course any instrument that seeks an inclusion in the indices would need to meet the criteria of size and liquidity. Therefore, in all likelihood, when permitted, corporate issuance would be less. Since they are permitted to be issued in rupee currency also, this might be a step of building rupee based global debt and currency market. In the past rupee based Masala Bonds issued by Railways have been a success. The development of rupee based global market linked to indices would not merely reduce the capital pressures but lower the volatility in foreign exchange market.

In some ways, this step represents a movement towards corporate accountability by stealth. For a government that is often criticised as ‘suit-boot sarkar’, open movement towards forex liberalization might be politically costly. The movements beneath the radar movements might achieve multiple objectives and hit many birds with a single stone.