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Budget 2019: Sovereign borrowing plan and its likely impact on local FX and interest rate market

Jamal Mecklai
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Union Budget 2019 India: With politics no longer the overriding consideration, the Modi government has delivered a visionary budget, with a target of creating a $5-trn economy in five years. While there are too many elements to discuss in detail, we will focus on the announced sovereign borrowing plan and the impact it is likely to have on the local FX and interest rate market.

There has been talk of a sovereign borrowing for many, many years, but the time has never been right partly because of the tension that prevailed between the government and the RBI. With that tension having eased, at whatever cost to the hallowed "central bank independence", this excellent initiative has come to life. The first such tranche is scheduled to hit the market as early as September.

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For FY20, the budgeted government borrowing is Rs 7.1 lakh crore (a little over Rs 100 bn). A prudent, if a bit aggressive, first-time borrower in FX would likely try and raise about 15-20% of its requirement in the global market. Given that this issue has been a long time coming to market, there will certainly be huge demand, which suggests each tranche should be at least $10 bn. It would be prudent then to have two issues during the rest of FY20-of about $10 bn each.

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As has been articulated by members of the finance team, global markets are flush with liquidity and India should be able to borrow at an attractive price. While that is doubtless true, market realities are that investment grade sovereign paper (AA South Korea bonds) currently yield about 1.5% for five and ten years. Thus, it is hard to see how India could borrow at much below 2.5%; with the 10-year forward hedging cost at 4.1%, this would make the fully-hedged cost about equal to the current 10-year G-Sec yield (6.69% at Friday’s close).

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So, while the sovereign borrowing will not be cheaper for the government, it will serve the critical purpose of reducing the government’s call on domestic savings, which should translate to lower domestic interest rates, which, in turn, would support all parts of the economy, particularly exports. This is significant in that the Economic Survey and all analyses thereof spoke of the need to support exports with "a competitive exchange rate."

Now, the impact on the spot exchange rate of a sovereign bond of, say, $10 bn would be to strengthen the rupee, since market would prepare for a large amount of fresh supply of dollars-indeed, the very announcement of the bond would have the same impact. On the other hand, some global investors may, at least initially, simply transfer their planned investments into Indian bonds to the sovereign issue. Nonetheless, the impact on the rupee is unlikely to be what would normally be considered export-supporting, and, indeed, exports, which did grow by 8+% in FY19, may take some time to take off, particularly given the relatively difficult global market conditions. Clearly, RBI will have to be fully engaged in preventing the rupee from appreciating too much.

The announcement of the sovereign bond also, perhaps, explains RBI’s recent requirement that banks not carry forward their long dollar positions beyond each quarter end, which surprised the market a few weeks ago and pushed the forward premia higher. Clearly, the forward premia will remain underpinned, since, certainly at the start of its program, the government would hedge the borrowing fully and market would prepare for this.

Companies will need to tailor their hedge programs to these new realities. Another critical impact of the sovereign bond issue will be to give a much-needed boost to the domestic bond market. The G-Sec yield curve will fall in line with the global market so the benchmark borrowing cost will be definitively fixed. Credit spreads will become that much more transparent and credit rating agencies will need to be much more effectively regulated.

Interest rates will become much more volatile, since global factors will now affect not just the exchange rate but also the benchmark borrowing cost. Managing rupee interest rate risk will become the new game in town for corporate treasuries. In short order, companies will issue more floating rate paper and investors will need to become even more circumspect about debt investments. A much wider array of hedging instruments from simple rupee interest rate swaps to credit default swaps to interest rate options and swaptions will become part of the market.

Banks will, of course, jump on these opportunities, particularly as the CCIL platform for spot FX will bite into their easy customer margins. RBI will need to quickly rationalise its criteria of who is allowed to do what to whom, and, of course, ensure a reasonably level playing field for market users.
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(The author is CEO, Mecklai Financial. Views are personal.)