## Thursday, February 26, 2009

### Fiscal crisis again

I have an article in Financial Express today about India's fiscal problem in the immediate context of the S&P rating downgrade.

1. " In March 2004, the foreign debt of the Indian private sector was $67 billion. By September 2008, this had risen to$166 billion. As a consequence, the views of credit analysts abroad, about Indian credit risk, now matter. When the cost of capital for the private sector goes up by 100 bps, this yields a direct hit of a higher interest cost to the tune of Rs.8,300 crore a year."

A. Two key assumptions:

1. All this debt stock has been contracted on a floating rate basis.
2. None of the interest rate risk has been hedged.

Strong assumptions.

I have not seen any data that would imply that. Please point me to the numbers you might have seen.

B. If both of us are looking at the same data, then this debt stock figure also includes NRI deposits. I am not sure how much of that is affected by country risk concerns.

C. Overall, I share your concerns about India's fiscal situation. Global investors are concerned about fiscal balances across the board - look at country CDS spreads and gold.

2. Under normal times, the typical rhythm of a corporate treasury is to rollover borrowings that are maturing. There's a continuous stream of old stuff maturing and new stuff being borrowed to take its place. I would hazard a guess that almost all the borrowing of 2006, 2007 and 2008 will mature in 2009, 2010 and 2011.

Under stressed times, there is a near-certainty of fresh borrowing being undertaken to make repayments, or even new borrowing being undertaken to bring money into the business.

So in short, India's fiscal deterioration is going to inflict significant damage on the private sector, and that's the first time this kind of relationship has been observed in India's history.

NRI deposits: I don't know where they're counted. RBI regularly modifies the interest rates for NRI borrowing so as to pull in more or less money. So it also responds to price factors. In 1991 there was quite some action in NRI deposits, as of course it should. "NRIs are not wood, NRIs are not stones, NRIs are men, and being men, they will respond to incentives".

3. A. NRI Deposits
"Ratings downgrades do not appear to discourage NRI deposits. The coefficient of the credit rating downgrade variable in the foreign currency deposit equation is positive and marginally significant, and negative, but insignificant, in the rupee deposit equations. This result is at odds with the finding in Gordon and Gupta (2003) that credit downgrades are associated with smaller portfolio flows into India. However, that foreign portfolio investors(FIIs) rely more on the views of foreign ratings agencies than do expatriate Indians (NRIs) is perhaps not surprising. The finding is also consistent with Kaul’s (2000) observation that India’ sovereign risk is something that worries institutional investors but not retail investors."

IMF Working Paper
Nonresident Deposits in India: In Search of Return?

http://imf.org/external/pubs/ft/wp/2004/wp0448.pdf

B. Role of Incentives

Too many people make the mistake of thinking that providing the right monetary incentive will achieve the goal. Unfortunately, that is only a part of the story. There is much more to it and I encourage you to read the following if you haven't already:

Douglas North's Nobel Lecture

http://nobelprize.org/nobel_prizes/economics/laureates/1993/north-lecture.html

3. I have more to say about your first point, but am running out of time. I shall certainly post later.

4. Ajay:
Agree with you corporates rollover debt when they mature....so the increase in spread will hit the corporates when they roll the debt over...They can change venue of borrowing to India, however, I doubt the rate in India will be as cheap
Ratings do matter a lot in terms of access to financing: 132 high grade issuance vs. 19 speculative grade issuance - YTD in US market

From S&P LCD commentary:
"As of mid-February, the average yield at offer for investment-grade issues tracked by LCD was 6.7%, with an average spread-to-Treasuries of T+420. In contrast, the 19 speculative-grade bonds totaling $9 billion that have been issued until mid-February average an 11.46% yield at a spread of T+950. " 5. Apropos of your piece, Fiscal Crisis again, as I read it, India's major mistake is that it does not have a 200-year post-independence history. A good question to answer would be, how relevant is the fact that UK repaid its debt after the war with Napoleon for deciding sovereign rating of UK today? If Napoleonic times are relevant today, surely the fact that India prepaid its IMF debts in the 1990s should matter? Especially considering that the same person who piloted India out of troubled waters is still at the helm? Another good question is, was UK worth a downgrade when, in the era when they were plundering India of its riches, they built up such high debt-to-GDP ratios? I know that the US debt-to-GDP ratio was 44% in 2006, 48% in 2007 and expected to go to 51.6% according to the WEO. I am sure that following Obama's budget proposal, the 2009 estimate will have to be revised significantly upward. Does that not merit a rating downgrade? Indeed, it is commonly acknowledged that the US's economic excesses and handling of their economy over last 8 years has created this worldwide mess. Does this not deserve a downgrade as a punitive measure? Has the US not fecklessly run debts of over$10 trillion in good times? And when the fecal matter hit the fast-revolving overhead device, Paulson as Treasury Secretary asks in a 3-page note, Give me $700Bn -- and trust me blindly to use it well to clean off some of the stains. That is certainly not a professional way of proposing public debt management by no less a person than the Treasury Secretary -- and that proposal should itself have been enough to put US on a rating watch. That did not happen! By the way, I am not as well-informed as you or the other excellent economists and writers whom you point us to, so I'd like to know your estimate of what is India's debt-to-GDP ratio today? 250%? 150%? 40%? It is not in the WEO. You imply that the Indian Government is hiding it. Take your estimate, and then answer the following question. How does India's debt-to-GDP ratio compare with the US debt-to-GDP ratio? When you do that, please add to the US debt figure * the cost of the Iraq and Afghanistan wars that have been off-budget in the US (we now learn). * the estimated value of losses in off-balance sheet SIVs that need to hit the balance sheet of US-headquartered companies, and the US Government. * the estimated cost of TARP and of nationalizing a significant part of the entire banking sector, if it has not entered the debt calculations already. Why is the US not being considered for downgrade, with its eye-popping single-year deficit of$1.75 trillion proposed by Obama yesterday?

Another question I would like to know your views on is:

Why should the borrowing cost of all Indian companies go up because of a subjective view of a few rating analysts who haven't exactly covered themselves with glory in their ratings of US corporate debt in recent times? After all, over 90% of their AAA rated securities have been downgraded and they did not see it coming till the proverbial shoeshine boy did. So their eagerness to downgrade is seen to be pretty selective.

6. Econlogic,

On NRI deposits, what Poonam & Peter are doing is : explaining the _quantity_ of NRI inflows as a function of the price offered, India's rating and other explanators. They find that the rating doesn't matter much.

I'm focused on the price and not the quantity. I.e. I'm claiming that other things being equal, India's fiscal deterioration of 2007 and 2008 will demand higher prices for NRI deposits. So that's a different question from the one they address.

There are deeper problems that bedevil their regressions. When you do a regression like:

qty = a + b price + c rating + ...

we tend to slip into the illusion that the things on the right hand side are exogenous and the system is responding to these changes. But in the case of NRI deposits, the larger picture is that RBI controls the price with an aim to achieving the quantities which are most conducive with the exchange rate regime. So there has been a lot of adjustment of the price to get to the desired quantities.

After controlling for these things, it's not surprising that the rating doesn't affect the quantity. In a crude model where RBI stabilised the quantity, changes in the rating would generate offsetting changes in the price and so in the regression it would look like rating didn't matter while it was, in fact, inducing considerable offsetting responses from the price.

To zoom out of the NRI deposits question alone to the larger question of the damaging consequences of India's fiscal stress, I'm making a simple point. The global credit market has swung from trusting everything to trusting nothing. In such difficult times, India is offering a messy fiscal environment where even the experts don't agree on the data. Surely this will damage the prices at which India can borrow.

7. Anonymous,

You ask about what bonds would you trust. I, for one, have greater trust in US or UK institutional mechanisms as compared with what we have in India.

Let's think of one important dimension: inflationary fears. One way in which a sovereign can cheat on bondholders is by tolerating or engineering a little inflation. This is not like default but yet, in a deeper sense, it is. When the time comes to repay Rs.100, the government effectively pays back Rs.90 because there's been 10% unanticipated inflation between the issue date and the expiration date.

In the UK, the formal structures of the central bank - held at a safe distance from the treasury, held at a safe distance from the debt management office, tied down by a inflation target, endowed with accountability/transparency/independence - reassure the bondholder that 2% inflation will come about as promised over a 20 year horizon. This improves confidence in the 20 year bond.

In India, every single element of the above paragraph is wrong. The buyer of a 20 year bond in India has to contend with serious inflation risk when fiscal deficits are large. In this fashion, placing debt management within RBI, and not structuring monetary policy properly, generates a mechanism for fiscal stress to spillover into inflation.

I could go on. The basic point is clear: there is such a thing as properly designed institutional mechanisms, which inspire confidence. We in India have just not done a good job of the institutional framework.

You talk about the ability of the US to do dangerous things like fighting two wars etc. I would say that such luxuries are what you get when you build good institutions.

8. So would you include the Glorious Revolution of 1688 in England part of that "the slow, long, arduous path of building up trust and credibility in the eyes of the private sector, much like the UK did ever since the 17th century"?

Just checking. Because if you do, then what you have said amounts to a call for an upper-class coup, albeit one staged against a democratically-elected government this time.

And do try to give your readers a somewhat rounded version of the history. When you say "the UK has unmatched institutional credibility that comes from a multi-century track record of repaying on debt" and cite the Napoleonic Wars, please be sure to mention the "Bank Restriction Act of 1797":

"The Bank Restriction Act of 1797 was an Act of the Parliament of Great Britain allowing for Bank of England NOT to have to convert banknotes into gold."

http://en.wikipedia.org/wiki/Bank_Restriction_Act_of_1797

That sounds like repudiation to me. Of course, by then the upper classes were well in charge and the sovereign in retreat, so it's understandable if someone of your sympathies doesn't count this as a repudiation.

9. Hi Ajay,

Why on earth should we jump when credit ratings agencies change their minds? In any case--these downgrades are worldwide,and I'm wondering what happens when the general quality of assets appears to be falling across the world. If the US and the UK were not ring fencing everything, would capital still be flowing?

http://www.truthout.org/011709Y

10. 1. Nobody is saying that there will be no impact. The key question is how much. Just that I do not subscribe to your 8300 cr number. Just too many assumptions which I do not agree with.

i. I agree with your rollover logic. Yet, it is not clear to me as to why would corporate India rollover only by borrowing overseas?

During the last five years it made sense to borrow in USD either hedged or un-hedged.

A. The dollar was weakening, one could argue that uncovered US\$ borrowing made sense compared to INR.

B. MIFOR had crashed. Libor flat was swapping for well below OIS. All in fully hedged INR cost for a AA bank was lower than INR funding.

On both counts, it made sense to borrow overseas.

Today, 5-year OIS is almost in line with 5-year MIFOR and the dollar is gaining.

ii. Yes, spreads are significantly wider, but base rates are much lower as well.

iii. Indian numbers are dicey. So is everything else out there. Think of people who bought SS tranches of CDOs rated AAA by Moody's and S&P. What about bank balance sheets? What about Eastern Europe? What about Russia?

My concerns are different. Will credit be available at any price?

2. I agree that if you target the quantum, rates will become endogenous. I can see how that can be a problem in the regression.

On deeper thought, my issue with the argument is the following:

To target anything, one curve has to be perfectly elastic. For instance, when the central bank targets short rates, it has to deliver whatever money is demanded at that rate.

I am not sure that is the case here. Banks' demand curve for NRI deposits should be standard downward sloping. Supply curve should be upward sloping with ratings as the shift variable. The RBI can set rates, but at that rate the short side of the market (d or s)determines the quantum. In this case, complete offset is not possible.

11. Hi Ajai,
I have just gone through your article after reaching on your blog through Nandan's blog...I have no qualms in accepting whatever you say from the viewpoint of an economist....however what do we say about following:
1. Where were the rating agencies at the time of AIG/Lehman....
2. I still can't fathom the dichotmy that exists in Economist's criticism of India's handling of US-64 or If i am not wrong, most of the so called US educated economists and US itself argued against bailing out battered Indonesian and Thai banks; suddenly what changed at the time of US crisis.....

I dont have an authority on the subject as you guys do and I respect your judgement; but still my take on this entire downgrade thing is "not to look at the problem just because S&P has downgraded us....we know the problem and we are aware of it...their downgrade is just a whimsical act- yes it has a cost to it.....and our effort should always be to offset that cost not to loose our sleep over these downgrades;

Thanks
Alok
http://myheartfeltmusings.blogspot.com/

12. this is really a great achievement.it will help a lot...
it help to get the investor back in the firm .thanks for such info.

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