India has hit on a not-so-novel idea to shield an economy made vulnerable by high international oil prices. The government has got State Bank of India, the country’s largest bank, to sell Five-year foreign currency deposits to expatriate Indians to help tackle a worsening balance of payments situation.
| Indian taxpayers: footing the bill for a costly way to cut trade deficit | ||||||
SBI, whose largest owner is the Indian central bank, is expected to collect between $2 billion and $4 billion from the sale of India Millennium Deposits (IMD). Just before the deposits went on sale, SBI Chairman GG Vaidya said his bank had commitments worth $5 billion for IMD.
India’s oil import bill is expected to double to about $18 billion this year. A widening trade deficit and a sell-off by foreign portfolio investors put the balance of payments in the red by about $1 billion in the quarter ended June, as compared with a surplus of $3.32 billion in the previous quarter. The rupee has lost around 6% of its value against the dollar since April.
The IMDs should plug the hole in India’s balance of payments and stem that slide. They will also add to India’s external debt of $98 billion, about 22% of its GDP. India’s coalition government has yet to pass on the full cost of the dearer oil to consumers (domestic prices are Fixed by government), leading to a ballooning of its deficit. The government must keep domestic interest rates down or risk a slowdown in the economy.
The Millennium deposits should keep interest rates down at home because the money will be lent in rupees. Nearly 40% of it will be invested in government bonds alone. The dollars will be sold by SBI to the central bank, and will add to foreign currency reserves, which have fallen by about $2.7 billion since April to $35 billion in October. Tarun Mahrotri, head of treasury and capital markets at HSBC, says: “IMDs will take the pressure off domestic interest rates and provide comfort to foreign investors over the health of India’s reserves.”
Critics, however, point to the cost. The deposits pay a Fixed dollar interest rate of 8.5% each year, or about 575 basis points over Five-year US treasury paper. AV Rajwade, a forex consultant, points out that this is higher than 5% or so India earned on foreign exchange reserves last year.
According to an SBI official, the deposits, repayable in foreign currency, will be sold to the central bank with an understanding that it will buy them back when the deposits mature at the current exchange rate of around Rs46 to a dollar. Assuming a $4 billion collection, Rajwade reckons the loss of holding this sum in the reserves over Five years will be $700 million.
Senior bankers also point out that the rupee should be allowed to slide and that the current situation does not warrant locking into high-cost foreign borrowing. “In 1998 when the government got SBI to sell $4.23 billion of similar Resurgent India Bonds (RIBs) to expatriate Indians, it faced the threat of economic sanctions from the west provoked by India’s nuclear tests,” says a former SBI official who helped sell the RIBs. “The Asian crisis followed and the rupee was under serious threat. That is not the case today. The government should let the rupee depreciate for now and work on economic reforms to attract larger Flows of foreign direct investment.”
SS Tarapore, a former deputy governor of the Reserve Bank of India, the central bank, argues that the reason such borrowings are costly is that the government guarantees the exchange risk. Most of the cost of the rupee’s depreciation over the term of RIB or now the IMD is borne by the government while the SBI bears the cost of just 1% of the annual depreciation of the rupee.
A depreciating rupee has added some 10% to the cost of RIBs repayable in 2003. If the rupee continues to lose about 5% of its value each year, the cost of IMD will work out to over 13%, higher than the government’s rupee borrowing cost. On October 23, Five-year bonds were trading at a yield of around 10.85%.
So why does the government just not borrow at home? Ashish Pitale, a debt analyst at JP Morgan, points out that by “shoring up the reserves to take the pressure off higher oil imports, the government has stemmed the slide in the rupee”. SBI also argues that a chunk of the deposits might be encashed in rupees as expats are allowed to transfer freely or gift them to family or relatives in India.
HSBC’s Mahrotri points out that IMD is a good investment for expatriate Indians. “A spread of 220 basis points over Libor is attractive, particularly when there is no exchange risk. Comparable Five-year Indian bonds of ICICI and Reliance listed overseas are trading at 200 basis points.”
The collecting banks, mainly foreign, are eagerly selling IMD, and with good reason. SBI will pay them a commission of 150bp and lends them half the sum they collect in rupees at a 10% interest rate. For foreign banks, which have limited access to low-cost deposits in India, this is cheap five-year money.
A former SBI official who helped organize the 1998 RIB issue points out that around $3 billion of the $4.23 billion was collected by foreign banks. Several advanced loans to expatriate Indians to buy the bonds. “These foreign banks went up to their full country exposure limit,” he says. “It was an easy way to bring in money to fund their Indian operations without having to bear exchange risk.”
This time also several foreign banks are hawking loans to high-net-worth Indians in the Middle East and Europe to buy IMDs. A banker from Citibank, which hopes to match the $822 million of RIBs it sold two years back, says: “We are lending at 75 to 100 basis points over Libor to customers to invest in IMDs. We use the funds we get from SBI for our consumer banking products such as car or home loans.”
Fat spreads will not be easy to come by. A former official of the SBI who led its effort to sell RIBs, says: “The spread between the rupee cost of RIB (around 9.5%) and domestic interest rates on rupee bonds was around 250 basis points then. Banks earned risk-free money by simply investing in gilts. Now, rupee bond rates are comparatively lower at 10.85%, giving a spread of just 50 to 75 basis points.”
There seems little chance that investors and banks will lose money or sleep over IMD. But there seems an even slimmer chance that the taxpayer can escape the cost of handing out an open-ended exchange rate guarantee to them. The mandarins in the Finance ministry seem to think it is well worth that cost. Indian taxpayers can only hope they are right.
