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Economy May 8, 2012

Sovereign bonds issue, Yes; sovereign fund, a big No

By R Jagannathan

It speaks much for the kind of policy confusion in Delhi that we now are talking simultaneously about creating a sovereign fund to invest in assets abroad and a sovereign bond issue to borrow money abroad.

So we want to borrow to invest - which is not a great idea at any time.

A PTI report says that a meeting of secretaries is to be held on Wednesday (9 May) to mull over the idea of creating a sovereign fund to buy overseas assets for state-owned companies. The reference is obviously to companies like Coal India or ONGC to buy energy assets abroad. If the idea finds favour, it will go to the cabinet or an empowered group of ministers for final approval.

An Indian Express report talks of a sovereign bond issue to raise more foreign exchange reserves. India is facing a serious current account deficit - the gap between external income and expenditures which has to be financed by capital flows - of close to 4 percent of GDP and our foreign exchange reserves are slowly draining out. The rupee has been weakening because demand for dollars outweighs demand for rupees.

The proposal to create a sovereign fund is at odds with the panicky moves being orchestrated by the finance ministry to shore up our foreign inflows and reserves. Reuters

The proposal to create a sovereign fund is at odds with the panicky moves being orchestrated by the finance ministry to shore up our foreign inflows and reserves. Over the last one year, the country's foreign exchange assets (excluding gold and SDRs) have dropped by nearly $21 billion to around $260 billion - at a time when the current account deficit (CAD) could be in the range of $80-90 billion in 2011-12. In other words, we need these kinds of capital inflows to keep our forex reserves where they are.

It is to foot this CAD bill that the government has done the following:

• Withheld the General Anti Avoidance Rules for this year to build confidence among foreign investors.

• Liberalised the foreign currency non-residents (FCNR-B) deposits scheme to pay interest at 2-3 percent above the London Inter-Bank Offered Rate (Libor).

• Reduced the withholding tax on profits earned by banks or lenders abroad from 20 percent to 5 percent, to invite more short-term dollar borrowings.

And all this is only in the last few days. Earlier, rules were liberalised for foreign investment in government bonds, corporate debt, et al.

So one wonders why when the government is borrowing feverishly to bring in capital it should simultaneously be thinking of creating a sovereign fund to invest abroad?

Of course, companies like Coal India can always seek foreign exchange for specific purchases of assets abroad. But a permanent fund for doing the same seems like a needless indulgence.

However, the idea of floating a sovereign bond issue is relevant for now, given that the international climate for capital flows is deteriorating in the wake of the unending eurozone crisis.

Also, given that fact that we could be facing a further rating downgrade, it makes sense to fast-forward the sovereign bond issue when the country's rating is still investment grade.

India has floated sovereign bonds/debt in the late 1990s and the turn of the 2000s - in the form of Resurgent Indian Bonds and India Millennium Deposits - to tide over foreign exchange costs. Those bonds/deposits were floated in worse circumstances - after the Pokharan 2 blasts which earned us the wrath of the US - when the country's external front was far from rosy.

Today, the balance of debt has shifted towards domestic currency, and external debt as a percentage of government borrowing is probably less than 10 percent (it was 7.9 percent in 2010-11).

This is why the recent budget broached the idea of selling sovereign debt abroad. The Fiscal Policy Strategy Statement that was issued along with the 16 March budget has this to say: "With a gradual decline in net inflow from multilateral institutions in the coming years, government would have the option of exploring other sources of external debt in the form of sovereign bond issuance."

Now is as a good a time as any to float these bonds. On the assumption that the rupee will decline in the near term but can only gain strength over the medium term as India returns to the growth path with lower inflation - probably beyond 2014 - these bonds may be easier to repay in appreciated rupee terms after five years.

The idea of floating a sovereign wealth fund, however, is a loser. Borrowers should not pretend to be investors.

by R Jagannathan

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