The East Asian currency crisis of the late 90s saw Russia defaulting on its sovereign obligations. A few years later, in 2001, Argentina shook the financial world when it defaulted on its external debt. In 2002, Peru and Uruguay failed to pay off their sovereign obligations. Post the global financial crisis of 2008, Greece's credit profile weakened, leading to a default.
Every crisis has its victims, but common threads in sovereign defaults are high government debt, dependence on foreign capital and low foreign exchange reserves.
This time, too, a likely collapse of global economies post the Covid-19 outbreak will have its victims. The alarm bells are already ringing. Global rating agency Fitch has predicted record sovereign defaults in the current year.
Much before the Russian sovereign default in 1997, India had narrowly escaped a crisis in the early 90s when its foreign exchange reserves were enough to cover just a few days of imports. At present, however, foreign exchange reserves are at a much comfortable level of $500 billion, which can easily cover over 10 months of imports.
But, India's vulnerability stems from growing government debt, both at central and state levels. "Growing debt creates refinancing risks. Debt management has generally veered towards fiscal restraint or responsibility. As you go ahead, fiscal dependence should drop and debt should become sustainable for refinancing," says Chandan Sinha, Interim Director at RBI's CAFRAL, an independent body set up by the central bank.
Story so Far
In the early 90s, when reforms were initiated, government debt was at its peak at 77 per cent of gross domestic product (GDP). It, however, started falling soon. By 1996, it touched a low of 66 per cent and again rose to an all-time high of 83 per cent in FY04. Subsequent high growth (high denominator) partly resulted in fall to 66 per cent in the next decade. The ratio has remained largely range-bound at 66-68 per cent between 2011 and 2019. The question is, will there be a spike now?
India has entered the crisis with estimated GDP growth of 4 per cent in FY20. In an already slowing economy, which is expected to shrink further due to high fiscal deficit and higher budget expenditure, the debt-to-GDP ratio is expected to go up substantially. The estimates from domestic rating agencies suggest that the ratio will jump to 84 per cent in FY21. This means outstanding debt of `168 lakh crore, which is close to the GDP of `200 crore, assuming zero growth in the current year. The 84 per cent debt-to-GDP ratio will be the highest in the last two decades. Global rating agencies Moody's and S&P have estimated debt figures of 83.7 per cent and 82.7 per cent, respectively, for FY22.
The implications for the economy are plenty - risk of a rating downgrade, cascading impact on ratings of banks and companies, and the danger of high inflation and currency depreciation. Eventually, banks and insurance companies will end up hosting this high government debt.
"It is a huge risk," says a dealer who deals in government debt.
Any crisis that banks face will ultimately end up being a problem for the government since it has to safeguard the interests of depositors and their trust in the banking system.
Recently, State Bank of India (SBI), along with other banks and Life Insurance Corporation (LIC), came to the rescue of private sector Yes Bank and the ailing IDBI Bank. The government, therefore, has to manage its finances more prudently since the responsibility of protecting a public institution ultimately falls on the Centre. In addition, banks with investments in government debt fear a likely haircut in interest or principal if the country's situation deteriorates severely. (See Box/The Baggage).
The Fiscal Extravagance
The Centre managed to control its fiscal deficit at 2.5 per cent of GDP just before the global financial crisis, but fiscal stimulus pushed it to 6.0 per cent in FY09, and to 6.5 per cent the next year. Though state governments managed to keep the deficit at 2.5 per cent in FY20, the Centre recorded a deficit of 4.6 per cent, higher than the budgeted 3.5 per cent. The return to the lower fiscal deficit of pre-2008 hasn't happened in more than a decade. Fiscal deficit is funded largely by domestic borrowings from banks, insurance companies, pension funds, etc. The combined borrowings of the Centre and states are likely to increase from `13 lakh crore plus in FY20 to close to `22 lakh crore plus in FY21.
States, with budgeted borrowings of `6.42 lakh crore in the current fiscal, now have the flexibility to borrow an additional `4.28 lakh crore at the upper end. Post Covid-19, the Central government has increased states' borrowing limit from 3 per cent of state gross domestic product to 5 per cent.
A Deutsche Bank report has pegged the Centre's debt-to-GDP ratio at 84 per cent in FY21. This is expected to move up rapidly as the economy will most likely shrink in the current year. "The denominator effect will also kick in as debt will grow faster than the nominal GDP rate," says a banking sector expert. "The government may have to borrow more either directly from the market or by monetising debt," adds another banker.
Sovereign Rating Risks
Global rating agency Moody's was the first to cut India's sovereign rating from Baa2 to Baa3, the lowest investment grade. The US-based agency highlighted risks from India's low growth, deterioration in fiscal position and the stress in the financial sector. Its last revision was in November 2017, when it upgraded India's rating from Baa3 to Baa2. Within days, S&P cautioned India of delayed recovery in growth, but retained India's rating at BBB-, which is also the lowest investment grade. S&P's last rating revision was in January 2007 when it downgraded the rating from BB+ to BBB-. On June 17, Fitch Ratings also revised the outlook for India to negative from stable, but retained its sovereign rating at BBB-. The agency had revised India's rating from BB+ to BBB- in August 2006.
Global agencies have not upgraded India's rating for over a decade despite one of the highest growth rates in the world. Commitment to reduce the fiscal deficit in a time-bound manner, cut public debt and initiate structural reforms in land and labour have been India's pain points. "The rating model has a significant weightage for public debt and fiscal deficit. In the current environment, every country is going to see deterioration in their finances," says Arun Singh, Chief Economist, Dun & Bradstreet. Others talk of global rating agencies taking cognisance of India's resilience in managing the 90s economic crisis, building foreign exchange buffers and initiating regulatory reforms in the financial sector.
"We are of the view that the current economic scenario has set the stage for robust economic reforms, which will help India weather the crisis and put it on the earlier growth trajectory in another two to three years," says Sankar Chakraborti, Chief Executive Officer, Acuite Ratings & Research.
Debt Management Strategy
The next two to three years are going to be difficult since Covid-19 is yet to peak in India. The exact damage to corporate India, especially micro, small and medium enterprises and balance sheets of banks, would be known only when full exit from the lockdown happens.
The RBI now has the big task of raising `22 lakh-crore debt for the government and states at the lowest possible cost. Inflation is currently down and interest rates are also low, but it could change since food inflation is going up. Yields on 10-year government securities are around 6 per cent, which is a good rate for the central bank to borrow. Risk-averse banks are already returning over `7 lakh crore of daily liquidity through the RBI's reverse repo window.
Expert suggest that the increased supply of government securities (G-secs) is expected to push up yields since the savings available in the economy are limited. This is where the RBI's yield management will come into play. In the past, the RBI had used the open market operation (OMO) route to buy long-term securities and sell short-term papers to keep yields low in long-term papers. "OMO would continue," says the debt dealer quoted above. The RBI can also create room for banks to acquire additional G-secs. This can be done by hiking the limits of the held-to-maturity (HTM) bucket. This will help banks since HTM securities are not only eligible for meeting the statutory liquidity ratio but also don't attract mark-to-market losses for any fall in prices of securities as well.
The government and the RBI will also have to deal with the crowding-out effect in the market since the Centre is likely to sweep away all lendable resources. The private sector could face challenges to get money from banks, which are still the primary source of funds. This, in turn, would impact growth.
Though the credit offtake is low today and a situation of crowding out does not arise, credit demand could revive in sectors such as steel, cement, roads and infrastructure. "One of the reasons for a shallow corporate debt market is the supply of government paper. It's an easy pick for banks and other investors since every month there is either a Central or state paper in the market," says Sinha of RBIs CAFRAL.
"The total borrowings of the Centre, states and the public sector are over 15 per cent of the GDP, whereas household financial savings are just about 7 per cent," says Govinda Rao, Member, 14th Finance Commission. This will make fund-raising difficult.
In fact, there are some who suggest that the government is better placed to mobilise a part of its resources abroad, whereas a medium or even large private sector won't get money at good rates or able to manage its risk. Experts suggest one of the options could be overseas masala bonds, which are denominated in Indian rupees. HDFC Ltd was the first to raise `3,000 crore from masala bonds. NTPC followed with a `2,000 crore issue. "It is a good option if there is demand overseas," says Ashutosh Khajuria, Executive Director at Federal Bank. The Centre could encourage NRIs to invest in such bonds. However, some suggest such a window could generate only a limited amount of, say, `50,000 crore to `1 lakh crore, to start with.
The other option could be a sovereign bond issue abroad. Interest rates are low globally. But there is a currency risk if the rupee depreciates. Experts flag other dangers as well. Firstly, the government borrowing rate outside will act as a benchmark for all future borrowings for banks and the corporate sector. Secondly, investors would track India more closely, especially on current account deficit, fiscal deficit and foreign exchange reserves.
There are also suggestions for tax-free bonds as investors are withholding cash rarher than depositing in banks. "There is a huge load on institutional investors. Why is the government not passing it on to the public? Let it (securities) be open to the public in a different format. People have money in hand," says Gopalkrishna Tadas, Former Executive Director at IDBI Bank.
The last expensive option could be debt monetisation, in case the debt requirement goes beyond the absorption limit of the market. Experts suggest that market borrowing is not a solution since investor appetite would be low. If the supply of debt increases, yields will also shoot up. "The whole issue in monetisation of debt is how long (it will continue)," says Barendra Kumar Bhoi, career central banker and economist.
Clearly, all eyes are now on the country's fiscal and debt position. Given the long-term implications, the government should come out with a white paper on total liabilities, off-balance sheet borrowings, etc. There is an urgent need to adhere to a fiscal consolidation path in the next two to three years. Borrowings are mostly used for revenue expenditure, which is a big concern for global investors. Efficiency of domestic debt is also of utmost importance.
"It is also about the efficiency of where you are putting the additional borrowings. If the borrowings are used for productive purposes or specific projects where we are creating assets, they would yield returns. Even the private sector can leverage it down the line. Then it is credible," says RBIs Sinha.
High domestic debt with low interest won't do much damage in terms of high inflation, but a high debt and high interest together can spell trouble for any economy. India has seen very high levels of inflation in the past, and if the cycle repeats itself, there will be severe consequences.