Three months ago, when the Finance Ministry released
its annual assessment of India's external debt position,
the scenario appeared comforting. On the one hand,
the external debt to GDP ratio, at 17.3 per cent at
the end of March 2011 (Chart 1), was well within limits
considered safe. It was lower than in many other countries,
much below where it had been during the 1991 crisis
and below its level in the previous two years. Combine
this with the fact that India has accumulated considerable
foreign exchange reserves to cover any bunching of
repayments and external debt does not appear to be
among the country's problem areas.
Chart
1 >> Click
to Enlarge
However,
a closer examination of recent trends suggests that
there may be some cause for concern on the external
debt front. To start with, in recent years the absolute
volume of external debt has been rising quite sharply,
except for stagnation in crisis-year 2009. The stock
of debt at the end of March rose by $33 billion and
$52 billion in 2007 and 2008 and by $37 billion and
$45 billion in 2010 and 2011 respectively (Chart 2).
Clearly, India's appetite for debt has been increasing.
Chart
2 >>
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to Enlarge
Secondly, as has been known for some time now, India
is being graduated out of official (bilateral and
multilateral) debt, so that the share of private sources
in total debt has been rising significantly. Third,
within these private sources, the share of deposits
from Non-resident Indians seeking to benefit from
differentials in interest rates between the Indian
and global markets has been falling, while that of
external borrowing by domestic entities has increased
from around 20 per cent in 2005 to almost 30 per cent
in 2011 (Chart 3).
Chart
3 >>
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to Enlarge
This increasing role for commercial borrowing has
essentially been because of an increase in borrowing
by India firms from international markets. The Reserve
Bank of India releases monthly figures on external
borrowing by Indian corporates through the ‘automatic'
and ‘approval' routes. The most recent figure is for
October 2011. Those figures show that despite month-to-month
fluctuations, external borrowing by these entities
has risen quite sharply from $8.6 billion between
April and October 2010 to $16.4 billion between November
2010 and May 2011, and to $18.7 billion between April
and October 2011 (Chart 4).
Chart
4 >>
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to Enlarge
Finally, there has been an increase in short-term
debt in total external borrowing from 13 per cent
to 21 per cent of the total. This may partly reflect
the unwillingness of lenders to increase only their
long-term exposures in a country with a rising appetite
for debt. It may also be because Indian borrowers
are also using the short-term channel to reduce financing
costs, in the belief that they can, if necessary,
roll-over that debt when due.
Thus, the growth in external debt has been substantially
because the Indian corporate sector has stepped up
its commercial borrowing from the international market.
This trend seems to have accelerated in recent times.
Underlying the month-to-month variations in the volume
of borrowing because of the presence or absence of
large individual borrowers, there is evidence of a
continuous rise. To add to this, Indian borrowers
have not shied away from short-term debt either.
Three factors explain this tendency. One is the increased
reliance of the corporate sector on debt (as opposed
to equity) to finance expenditures, and more so on
foreign debt because on average it tends to be much
cheaper. A second obvious cause is the sharp rise
in domestic interest rates. The Reserve Bank of India
has announced around a dozen increases in reference
rates since March last year, raising the cost of credit
provided to the banking system by more than 3 percentage
points. Since this is the rate at which banks can
borrow from the RBI, they in turn are charging higher
rates on loans to their clients. In the event, there
has been a widening of interest rates payable on borrowing
from the domestic and external markets, with the latter
being the cheaper source. When this happens, the normal
tendency would be for firms to borrow abroad to meet
even their domestic expenditures and finance their
expansion plans targeted at the domestic market.
Finally, this tendency has been encouraged by the
willingness of the government to permit such access.
In principle there is a ceiling on aggregate external
commercial borrowing (ECB) set by the government at
each point in time. But not only is that ceiling not
imposed strictly, but the government periodically
revises the ceiling to accommodate increases in private
borrowing. The most recent increase was a $5 billion
hike in the ceiling for both government and corporate
ECB to $15 billion and $45 billion respectively.
This lax attitude has been strengthened by the rise
in domestic interest rates. With evidence that GDP
growth and industrial growth are faltering, the government
and the RBI have been criticised for hurting growth
in an unsuccessful attempt to control inflation by
hiking rates. One way to mute that criticism is to
allow the bigger and more vocal firms to access cheap
resources from the international market by permitting
increased volumes of ECB. Moreover, any increased
inflow of foreign capital, even in the form of debt,
helps to shore up the rupee (which has depreciated
because of the global flight to safety to the dollar
and the recent tendency for foreign investors to exit
from India in the context of increasing trade and
current account deficits in India's balance of payments).
This effect on the rupee must also be motivating the
RBI to facilitate the increase in debt.
There are, however, two much-discussed dangers associated
with this tendency. First, there arises a mismatch
between the currency in which debt service commitments
on external loans must be met and the currency in
which revenues are garnered from the domestic market-oriented
activities that are financed by such loans. Hence,
a part of the foreign exchange earned or acquired
in other activities would have to be diverted to these
borrowers in the future so that they can meet their
debt service commitments. This could put some strain
on the balance of payments.
The second problem is that the borrowers themselves
are taking on substantial exchange rate risks. While
they may be obtaining finance at interest rates lower
than currently charged in the domestic market, their
debt service commitments in rupee terms can rise sharply
if there is a depreciation of the domestic currency.
This could more than neutralise the benefit of an
interest rate differential.
Besides these factors that call for exercise of caution,
another danger is a rise in in rates in international
markets. Those interest rates are low now because
central banks in the developed countries have pumped
large volumes of cheap liquidity into the market in
response to the crisis. But there is no guarantee
that the era of access to cheap liquidity for emerging
markets will continue, as illustrated by the difficulties
being faced by the peripheral countries in the Eurozone.
If international rates rise, efforts to refinance
maturing debt would require expensive borrowing. When
all of this is put together, the rise in external
borrowing, though still within limits, increases the
vulnerability of the corporate sector and the nation.
The government, therefore, would be well-advised to
continue with its policy of limiting external borrowing.
However, under pressure from the corporate sector,
it seems to be inclined towards loosening rules with
respect to external borrowing, to dampen corporate
criticism of the high interest rate regime. In response,
corporates are being offered an escape to cheap credit
through means that increase external vulnerability.
There are conspiracy theories doing the rounds. Rumour
has it that there is a standoff between the Ministry
of Finance and the Reserve Bank of India over interest
rate policy. Given the government's own failure, the
central bank has been forced to take on the burden
of combating inflation, leading to the sharp rise
in interest rates. But since the Finance Ministry
does not seem to like that, it is reportedly using
the ECB lever to counter the impact of the RBI's intervention
on the corporate sector. Whatever the drivers, the
process is increasing external vulnerability.
*
This article was originally published in the Business
Line on 12 December, 2011, and is available at
http://www.thehindubusinessline.com/opinion/columns/c-p-chandrasekhar/
article2709520.ece?homepage=true
