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For years, we have been told it is a sin to increase our
foreign debt. Suddenly the sin has been declared a
virtue. Finance minister P Chidambaram had permitted
foreign institutional investors to invest 100 per cent if
their money in debt instruments, against the earlier
ceiling of 30 per cent. In this lies the seed of a future
debt crisis.
Today, Reliance Capital is offering 20 per cent interest
on fixed deposits, implying a yield of 12 per cent after
tax. But FIIs based in Mauritius escape all taxation,
and so will get a full 20 per cent yield. This amounts
to borrowing foreign money at extraordinarily high
interest rates. If the scheme attracts large sums, India
will enter a high interest debt trap.
It is barmy to first limit external commercial borrowings
to keep our debt low, and then allow foreign debt to FIIs
without any limit. Mr Manmohan Singh imposed the earlier
ceiling of 30 per cent on FII debt to stop them from
making easy money through arbitrage between high interest
rates in India and low ones abroad. FIIs enjoy
convertibility on capital account but Indians do not, and
this lets FIIs reap a windfall through arbitrage, free
from competition from Indians.
Now the finance ministry has performed a volte face. Its
reason for doing so are not convincing. Let us examine
the merits of each. The ministry says this is a step
towards full rupee convertibility, and that the inflow of
FII money will by itself bring down interest rates and
reduce the arbitrage differential between rates in India
and abroad.
Really? This will happen only if the inflow is very
large and if the RBI lets it increase the money supply.
However, a large inflow will stoke inflation, worsening
poverty and reducing the competitiveness of Indian
exports.
Why borrow at high interest rates for this? If the
government wants low interest rates so badly that it is
willing to let money supply shoot up, it can simply
monetise the budget deficit. This will give the same
result without increasing foreign debt. The ministry
says very few FIIs have invested even 30 per cent of
their money in debt. So raising the limit to 100 per
cent is a worthwhile experiment. If money suddenly
floods in, the government can ban further flows. .
Is it not paradoxical to introduce a scheme which must be
abandoned if it actually succeeds in attracting foreign
interest? Besides, if inflows are small they cannot
bring down interest rates, so the arbitrage differential
will stay high. In the new scheme, FIIs are not allowed
to invest in government securities - which is what they
are really interested in. They can invest only in
unguaranteed private sector debt. So the FIIs will have
to take on all the risks - country risk, company risk and
currency risk. Few will be willing, so inflows will be
very modest.
Here again, it is odd to hear a scheme justified on the
ground that it will probably fail. And it might not.
India's credit-rating is not high today, but is
improving.
Reliance recently succeeded in raising $100 million of
50-year bonds in the US market, at 10.68 per cent
interest. Merrill Lynch, which managed the issue,
projected rupee depreciation of 5 per cent per year as a
reasonable scenario and suggested that a comparable rupee
interest rate would be 15.95 per cent.
By this yardstick, FIIs should find today's 20 per cent
quite attractive. It will be unattractive only of rupee
depreciates by 9 per cent per year or more. And this will
not happen unless we have very high inflation. The
finance ministry can justify such high-interest borrowing
only on the ground that our inflation rate will soon
shoot into the stratosphere. Is this a confession?
India's debt market is woefully underdeveloped. Will the
new measure rectify this? Not at all. The first
requirement for a healthy debt market is liquidity for
girls, and that is possible only if FIIs and other
traders, including foreign banks, can deal in repos in
gilts. But the government persistently refuses to permit
his, because of the misuse of repos by Harshad Mehta.
Finally, some FIIs say that they typically have funds
devoted to pure debt or pure equity, and so have rarely
availed of 70:30 mixture allowed so far. The answer,
surely, is to let them float one equity fund and one debt
fund with a size ratio of 70:30. This cannot be a reason
for permitting unlimited debt.
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