In the past, India has undertaken expensive foreign currency-denominated borrowing from NRIs through Resurgent India Bonds, India Millennium Deposit bonds and dollar-denominated deposits. This time, the government is proposing to issue a small sovereign bond.
The risk is small, considering the size of the borrowing, the inflation-targeting monetary policy framework and the fiscal responsibility law. The government and the Reserve Bank of India need to primarily manage risk through sticking to the Fiscal Responsibility and Budget Management Act and inflation-targeting frameworks.
In addition, the government should set up a Public Debt Management Agency (PDMA), which takes a comprehensive view of the government’s debt, its costs, currency denomination, tenor and time of issuance.
Why foreign currency borrowing is risky
The main difference between a dollar-denominated loan, as proposed in the Union Budget speech, and a rupee-denominated loan, is in who holds the risk of rupee depreciation. When an Indian borrower takes a loan in dollars, she has to pay back in dollars. If, in the meantime, the value of the dollar versus the rupee changes, the loss or gain accrues to the borrower. In addition to the interest rate, the borrower needs to pay back more if the rupee weakens. The borrower is ‘exposed’ to currency risk. For this reason, borrowing in domestic currency is expected to be safer than borrowing in foreign currency.
But risks can be managed. For example, foreign currency borrowing of private borrowers can be made safer by ‘hedging’ one’s exposure. It is possible there is a natural hedge. If one is an exporter who earns in dollars, then even when the exporter borrows in dollars, she is not putting her balance sheet at risk. On the other hand, if the borrower is a domestic builder, her earnings are in rupees, and if the rupee depreciates sharply, she may not be able to pay back the loan.
Another way of hedging currency exposure is to buy derivatives. There may be someone who may be willing to enter into a contract with you, at a price, to supply you dollars at today’s exchange rate. The cost for the loan is now the interest rate and the cost of hedging.
If the government of India were to borrow from international markets, it will have currency risk. So, for example, if it borrows at 2 per cent per annum in dollar terms in international markets, and if the rupee weakens by 2 percent per annum, then in rupee terms, it will pay back 4 per cent in rupee terms.