Equity, Debt, and Sovereign Bonds

(The following article appeared on CNBCTV18 online on July 11, 2019, URL below:

https://www.cnbctv18.com/economy/equity-debt-or-sovereign-bonds-what-is-the-best-way-forward-3969741.htm )

Equity, Debt, and Sovereign Bonds

Consider this. You are the shareholder of a company that is growing nominally at 11-12% annually. The company can raise debt at 7% per annum. The company needs growth capital. Would you prefer that the company take in more of debt or equity?

This is the context that we - as shareholders of our nation – face. What is the ideal mix of debt and equity savings we should target from overseas, to fund our growth?

Mathematics, Value & Trust

The simplistic mathematical answer could be to take in as much debt as possible. Why would we dilute ownership, when we could borrow well below our expected growth rate? Would we not leverage as much as we could?

However, the real-world answer is, it depends. 

For one, if the equity infusion comes with additional value, such as access to technology, markets, processes, job creation etc., that will override math. We would usually welcome such Foreign Direct Investment (FDI) over any other form of capital.

Second, how confident are we of growing at 11-12% on a sustainable basis, while maintaining a stable economy and a manageable exchange rate? 

After all, foreign debt investors have to be paid back in full in hard currency, along with interest, irrespective of how we perform. 

In contrast, foreign equity investors take on the real risk of us not living up to our potential. There is no guarantee whatsoever – not on their earnings, not even on their principal.  

The more risk averse we are and the less we trust ourselves, the more we might deviate from the mathematical answer of taking in as much debt over equity as possible. 

The Story So Far

From the time India opened up to foreign savings, how have we done on the debt & equity mix? Let us consider the data. 

Foreign Portfolio Investments

As of today, we have USD 60 bn of Foreign Portfolio Investor (FPI) investments in debt. This is about 3.3% of our total outstanding debt across government & non-government paper. 

Against this, FPI investments in equity are worth USD 428 bn – seven times the outstanding in FPI debt. This is a breathtaking 41% of the total National Stock Exchange (NSE) Free-Float Market Capitalization (FFM-Cap). 

Beyond FPI 

Beyond FPI debt, we also have USD 154 bn of overseas loans, and USD 103 bn in overseas trade credits. Put together, this USD 316 bn of debt (across FPI, loans and trade credits) is 7.8% of our gross debt across banks, non-banks and debt capital markets. 

On equity, beyond FPI equity investments, we have had USD 220 bn of net FDI investments come in – which have grown substantially in value over time. The total equity investments across FPI and FDI is at least USD 648 bn, or 62% of NSE FFM-Cap. 

Foreigners practically own India Inc.

Summary – Across Debt & Equity 

Whichever way we cut, slice and compare the data, we have taken in more equity investments than debt – both in absolute and relative terms. 

We have also made foreign equity investments somewhat stable, by our inclusion into global equity indices such as MSCI. We are yet to include our debt into global debt indices, and that leaves foreign debt investments far more unstable.

In short, debt is the stepchild when it comes to attracting foreign capital. This has a bearing on the current debate around Sovereign Bonds (SBs) as well.

We appear to have overridden mathematics with other considerations – perhaps risk aversion and perhaps doubts about our ability to manage our economy. 

The Price of Saying “No”

Finance is replete with brutal examples of things going wrong when people say “Yes”, when they should have said “No”. 

Thus, examples of Latin American countries that said “Yes” to excessive foreign debt and paid the price are often quoted, and rightly so.

India has avoided this error, by saying “No” to foreign debt from early on. 

This stood us well during times of global deleverage – such as during the Asian crisis or the Global Financial Crisis.

However, there is also the much less documented price of saying “No”, when we should have said “Yes”. 

Having too little leverage implies that we enjoy much less growth and prosperity than we could – and that is not a small price to pay for a developing country. 

More directly, an excessive reliance on equity capital also means that we have sold our economic crown jewels cheap. As we argued earlier, foreigners now own India Inc., as a result of our conscious choice to prefer equity capital inflows over debt. 

Foreigners who perhaps had more faith in our abilities that we ourselves, have benefitted from that confidence – both with substantial ownership of the country’s economy and with double-digit dollar returns over time.

The Way Ahead

Perhaps our current balance is too risk averse. Perhaps there is a better Goldilocks mix across foreign debt and equity possible, going forward.

To rebalance the mix, however, we must instill confidence that we will manage our economy on a sustainable basis over time.

In this regard, it does not help if we cite “low cost” as the reason for a Sovereign Bond (SB) issuance. SB is not low cost now. On a currency hedged basis, it is 1% more expensive than local currency debt. And no, this is not altered even if the Rupee stayed stable over time. We would still be better off borrowing in Rupee and selling forward USD against Rupee instead. 

We could rather argue that we need to attract global savings in debt, that a prudent amount of SB is a cheap form in which the country can attract foreign currency debt, that such SBs would free up domestic savings for productive investments, set a benchmark for other Indian issuers, and perhaps help instill some policy discipline. 

Likewise, we would do well to shore up our policy credibility. As an example, local stakeholders may publicly applaud the fiscal balance and restrict any impolite remarks about it to gossip at the water cooler. Even foreigner investors may do the same, as long as it suits them. But at the first sign of trouble, those trading in India Credit Default Swaps (CDS) on the back of SBs would tear us apart on any perceived or real credibility gaps.

Conclusion

We could do with a better mix of debt and equity across the foreign savings that we attract. This should help us grow better, without selling our economic crown jewels cheap. To increase the quantum of debt inflows, we do need more confidence in our abilities, and we do need to fiercely protect policy credibility to instill such confidence.