03 August 2019
Sovereign borrowing in dollars could prove addictive
Source: By Vivek Dehejia: Mint
If you’re a non-smoker, and someone tells you that smoking one cigarette a day for the rest of your life will not be so harmful for you, and may be enjoyable, would you walk to the nearest paanwala and buy your first smoke? Probably not, you will likely reason that, if you enjoy that first cigarette, you will be tempted to increase your intake, and, if you are not disciplined, you might end up being a pack-a-day smoker, which would most certainly be harmful to your health.
As it turns out, this is the best analogy I can find for the ongoing debate in India on whether there should be government debt issued that is denominated in foreign exchange, which is one of the most adventurous proposals in the Union budget for 2019-20. As Union finance minister Nirmala Sitharaman said in her budget speech on 5 July: “India’s sovereign external debt to gross domestic product (GDP) is among the lowest globally at less than 5%. The government would start raising a part of its gross borrowing programme in external markets in external currencies. This will also have a beneficial impact on demand situation for the government securities in the domestic market."
This proposal has been much debated since then, with a surprisingly broad range of critics, from right-of-centre economists such as former Reserve Bank of India governor Raghuram Rajan, to left-of-centre nativists allied to the current governing party. As it happens, the critics are right, and it would be a very bad idea for India to indulge in the “original sin" of borrowing in dollars (or euros, or yen, or any currency other than the rupee).
This is where the smoking analogy comes in. Sovereign borrowing in foreign currency is similar. Issuing a small amount of debt denominated in a foreign currency may be relatively innocuous, but, if it tempts the government to increase its foreign currency borrowing, the consequences could be disastrous in the long run.
Let us recall that almost all macroeconomic crises in emerging economies emanated from issues relating to foreign exchange—be it the exchange rate itself or the level of indebtedness in foreign currencies. Thus, the Asian crisis of the late 1990s originated with unsustainable foreign currency debts, as have most macroeconomic crises in Latin America and Africa.
Apart from 1991, which was a singular episode, triggered by the spike in oil prices and the collapse of remittances from workers abroad following the first Gulf War, India has been largely immune from major macroeconomic disturbances emanating from overseas. A key reason is that we did not borrow abroad in foreign currencies. The closest we came, and it should provide a salutary warning, was in the waning days of the previous government’s term, when an excessive inflow of “hot" money in the form of foreign portfolio investment in Indian equities caused India to be added to the club of emerging economies known as the “Fragile Five" in the aftermath of the “taper tantrum" of 2013.
Think about it. India became a member of this dubious club though all the monies that had flown in and were at risk of flowing out were invested in rupees. This was destabilizing enough. Imagine, instead, if at that time India had a large sovereign debt denominated in dollars and there was a sharp depreciation of the rupee as foreign portfolio investors fled to put their monies back in the safe harbour of US treasury securities? The bloodletting would have been much worse and could have led to a genuine, full-blown macroeconomic crisis reminiscent of 1991.
In short, the prospect of foreign borrowing creates considerable downside risks without much in the way of attendant upside gains. It would be unwise to commit this original sin, as all previous governments of all political stripes have understood.
So why then does the government at present wish to open this Pandora’s Box? It is a matter of speculation, but it seems very likely that treasury and central bank officials have succumbed to lobbying efforts by honey-tongued Wall Street investment bankers and fund managers who never met a novice investor that they didn’t attempt to solicit business from. Such folks usually promise the world—in this case, cheap borrowing in dollars—and then make a fortune on the sovereign foreign bond issues while the hapless sovereign bears all of the exchange-rate risk.
If you think such an argument makes me a protectionist, think again. Many years ago, my great guru, economist Jagdish Bhagwati, wisely distinguished between free trade in goods and services, on the one hand, and free trade in capital, especially financial capital, on the other. He argued, correctly, that the former is analytically distinct from the latter, as the latter carries considerable risk of destabilizing an economy. In having made this case, Bhagwati, ironically, is on the same side of the debate as the distinctly left-of-centre economist and his Columbia colleague, Nobel laureate Joseph Stiglitz, and on the opposite side from folks like Lawrence Summers, who has been among the most aggressive and shrill exponents of the “Washington consensus" over the several US administrations he has worked for.
Bhagwati and Stiglitz are right, and summers is wrong. India should resist the entreaties of Wall Street and its acolytes in India, and must stay away from the addiction of foreign borrowing.