Sovereign bonds: The big picture

India must work on a road map towards capital account openness, in which sovereign bond is back-loaded, not front-loaded

A lot has been said about the case for and against the Budget proposal to issue sovereign foreign currency denominated bonds. It is difficult to add much to the debate by way of arguments. Yet, there is a big picture consisting of bits and pieces that may help in finding a wise way forward.

In global financial markets, sovereign debt is very different from non-sovereign debt. Crucially, the sovereign is not a limited liability entity. It exists in perpetuity and its assets are somewhat indeterminate. Its liabilities to non-residents in global financial markets are, in most cases, governed by laws other than those in its own jurisdiction. (While issuing bonds, the jurisdiction is defined.)  Voluntary agreements with debtors are not legally binding on all.  As a debtor, the sovereign is vulnerable to hostile creditor legal action. 

In short, there is no legally binding debt restructuring mechanism in respect of sovereign debt. Efforts by the International Monetary Fund (IMF) to evolve one have not succeeded.

Sovereign debt is good as long as good times last. When they cease, a sovereign workout in the existing non-system can be extremely painful for the debtor country and its citizens. It makes no difference whether the country happens to be middle-income or not, as examples of Greece, Turkey or Argentina show. 

Incidentally, international law does not recognise the doctrine of odious debt, also known as illegitimate debt— that is, national debt incurred by a despotic regime. Both, international law and the IMF, hold governments strictly liable for all debt incurred by their predecessors.

Global finance needs some “safe assets” in its portfolio. Financial conglomerates are willing to subscribe to a sovereign bond of a country even if it borrows for day-to-day expenses (revenue deficit) and has to borrow externally to pay for its imports (current account deficit). History is replete with precedents.  The reason is simple: Those subscribing to sovereign bonds are privileged creditors relative to others. 

Experience shows that a sovereign debt crisis does not happen in isolation.  It is accompanied by others, such as, banking, political and external sector crisis. Policy-makers’ freedom to manage a crisis is severely constrained if the sovereign has debt obligations to non-residents, especially in foreign currencies.  History also shows that recourse to sovereign foreign currency debt is seldom constrained by prudence; especially if political economy tilts in favour of profligacy. 

illustration: Binay Sinha

Sovereign debt typically starts with small doses and then becomes a dangerous addiction and often results in repeated approaches to the IMF for succour. The record of developing countries being disciplined by sovereign debt markets is poor and India’s record in being disciplined by financial markets in general is in the public domain.  The size of the economy of India and geopolitical setting in which India is placed makes it difficult to assume that we will get adequate support in case risks on sovereign debt materialise. 

From a macro-economic point of view, there are some basic features of our economy that we should not ignore while considering the issue.  First, we have been financing our investments predominantly (well over 90 per cent) through domestic savings. Our basic approach to the external sector has been to access foreign savings to supplement and not to substitute domestic savings.  It is inconceivable that sovereign bonds can make up for the shortfalls. 

Second, there is a limit to our dependence on foreign savings.  The aggregate level of a sustainable current account deficit of 2 per cent represents the acceptable level of aggregate foreign savings.  If this limit is accepted, sovereign borrowings by way of bonds can only be a substitute to some other form of foreign savings — say external commercial borrowings.  Similarly, if the fiscal deficit is pre-determined, there is a substitution of funding from domestic sources with foreign savings to the extent of issue of sovereign bonds.   

Third, there is a hierarchy of desirable sources of foreign savings that has served us well. The most preferred is the green field foreign direct investments. A second source is foreign direct investment in the existing enterprises. Another is portfolio flows in equities.  The fourth is external commercial borrowings by non-financial corporate sector for financing their investments. The fifth is external commercial borrowings by the financial sector. Sixth, there is surrogate sovereign borrowings—that is, borrowings by public sector financial and non-financial enterprises which involve an implicit sovereign guarantee. They also help establish implicit sovereign rating for India. 

Since until now sovereign bonds do not find a place in this scheme, how will they fit into this hierarchy?  In brief, the decision on sovereign bonds in many ways, amounts to a basic change in policy towards a more open capital account. 

The way forward

We should aim for a day when foreigners can freely buy our sovereign paper and simultaneously our citizens can freely buy other country’s sovereign bonds. But that needs a road map which captures the evolving state of global financial system and our domestic strengths as well as vulnerabilities in fiscal, finance, and external sectors.  It may be wise to start work on a road map towards capital account openness, in which sovereign bond is back-loaded and not front-loaded. 

The writer is former governor, Reserve Bank of India