Beware the bond lure

Don't just buy time, address the imbalances

It has been reported that the government is seriously considering a sovereign bond issuance, with the obvious motivation of generating the quick dollar inflows sorely needed when the current account deficit is so large. This has been seen as an option by many people over the past couple of years, as the traditional sources of capital, direct investment and portfolio investment into equities, have either shrunk or become more volatile. Of course, during this period, the limits on the amount of money that foreigners could invest into Indian government (and corporate) securities were steadily increased and, alongside, restrictions on lock-in periods and residual maturity of the instruments were also eased. These measures have contributed to some inflows; but since the investments are rupee-denominated, their attractiveness is directly related to expectations about the movement of the rupee. Since these overwhelmingly point to further depreciation, with only the magnitude being a matter of debate, it would be naive to expect sustained inflows through this channel. This is particularly so after the release of the current account deficit numbers. Even if the latest numbers were an aberration, the extent of reversal in the coming quarters is hardly likely to be dramatic.

So, if rupee-denominated securities are not a very promising source of capital inflows, will dollar-denominated sovereign bonds do the trick? After all, they protect the investor from currency risk, which should immediately bring in a class of investors who are currently avoiding India because of risk perception. Also, with global interest rates at historic lows, courtesy the monetary stances of central banks in advanced economies and likely to remain there for a while, borrowing costs would be very attractive. Despite all the talk of a potential ratings downgrade, India is still in the investment grade, again making it accessible to a wide range of fixed-income investors.

But there are compelling arguments against such an issuance at this stage. Even devoid of currency risk, investors will wonder where the dollars needed to redeem their debt three or five years from issuance will come from. Either the current account deficit has to go down sharply, which will depend significantly on domestic policy actions, or other capital flows have to increase. If the medium-term prospects for both these outcomes are not very bright, investors will demand a significant default risk premium, which will take costs above what is predicted by the rating. Worse, if domestic macroeconomic conditions worsen, a "better safe than sorry" attitude on the part of investors can result in a surge of outflows, which will only compound the other problems. These may seem like low-probability outcomes, but the risks should not be underestimated, in terms of either likelihood or, more importantly, impact. Essentially, what the economy needs is not more time being bought through a bond issuance, but some quick and concrete measures to address the serious macroeconomic imbalances. To the extent that these measures can be more effectively implemented when there is some assurance of foreign currency liquidity, approaching the International Monetary Fund through one of its early-stage arrangements is a far more pragmatic option. This move was recommended by this newspaper last week; it gains significance in the context of the renewed debate on a sovereign bond issue.