Debt as burden

As the rupee’s slide continues, an issue that is likely to bother corporate India is it debt service commitments. This is because of the sharp build up of foreign currency debt in corporate balance sheets, leading to a rise in India’s debt burden in recent times. Having risen at a slow pace from $83.8 billion on 1990-91 to $104.9 billion in 2002-03, the magnitude of outstanding external debt owed by India has more than tripled to $316.9 billion at the end of June 2011. That is, as compared to an average annual absolute increase of $1.8 billion during the 12 years following the 1991 balance-of-payments crisis, the average annual increase has risen to more than $25 billion in the subsequent 8 years. Over the five years ending 2010-11, the annual average absolute increase in debt had risen to $33.5 billion. And, during 2009-10 and 2010-11, outstanding external debt rose by $36.5 billion and $45.5 billion respectively. This does point to a substantial acceleration in the rate of accretion of external debt.

A feature of this trend worth noting is that borrowing by the corporate sector has contributed substantially to the surge. Indian firms have in recent times chosen to borrow from international markets, since they could obtain credit from abroad at rates much lower than available in the domestic market. Many firms even chose to pay-off past debt mobilised in the domestic market and replace it with borrowing from abroad.

Five factors have encouraged this tendency to resort to external commercial borrowing. The first is that the period since 2003-04 has been one in which there has been a supply-side driven surge in capital flows to emerging markets worldwide, and India has been one of the beneficiaries. A part of that flow has been in the form of debt, as opposed to portfolio and direct investment, since banks and financial institutions have put behind them their experience with the debt crises of the 1980s and 1990s. Second, during this time the government has been periodically raising the ceiling on the volume of external commercial borrowing the country can resort to in a year. Moreover, the extent to which any single corporate entity can resort to external commercial borrowing has also been raised over time. Third, on average the rate of interest in India has been significantly higher than in the international market, encouraging “carry-trade” investments, or borrowing in foreign markets where rates are lower and lending in India were the rates are higher to benefit from the differential. Fourth, with the onset of the financial crisis, international banks and financial institutions obtained access to large volumes of cheap liquidity at near-zero interest rates. These were the funds that were pumped into the system by the Federal Reserve of the US and other central banks to bail out the financial system. A part of this liquidity was used by financial firms to indulge in carry trades in emerging markets. Finally, in India, this period of global excess liquidity was one in which inflation was ruling high, forcing the Reserve Bank of India to hike interest rates 13 times in a little more than a year. This made India an attractive destination for such flows looking to carry-trade opportunities for easy profits.

At the economy-wide level the borrowing surge spurred by these factors went unnoticed partly because the rapid growth in GDP was keeping the external debt to GDP ratio at comfortable levels. Thus over the period starting 2002-03, the external debt to GDP ratio fluctuated in the 17-20 per cent range, which would be considered acceptable. The absolute increase in external debt went unnoticed also because the exchange rate risk associated with external borrowing was concealed by the strength of the rupee. The large volume of external capital inflows into the economy during this period was strengthening the rupee to an extent where the central bank had to prevent the rupee from appreciating by resorting to purchases of the excess foreign currency in the market.

That scenario has now been reversed and the rupee has lost almost a quarter of its value relative to the dollar since early August. This must mean a huge increase in the debt-servicing burden for firms that borrowed from abroad when the times were good. What is more, this increase in the debt service burden occurs at a time when the demand for industrial goods has fallen and industrial growth has decelerated. Firms also do not have the option of substituting now-expensive external debt with cheaper domestic credit, since domestic interest rates are ruling high. Thus the enhanced debt servicing cost is bound to affect the bottom lines of many firms quite adversely.

According to one estimate (Business Standard, October 10, 2011) even two months ago, the fall in the value of the rupee since August had increased the redemption cost on foreign currency convertible bonds issued by 30 companies that were maturing over the subsequent 12 months by as much as Rs. 500 crore, from around Rs.1500 crore to Rs. 2000 crore. The rupee has only depreciated further since. Thus the sudden increase in the quantum of exposure to external debt can render corporations vulnerable, even if the economy as a whole is not.

But the debt burden is not a problem for corporate India alone. It also increases the external vulnerability of the country as a whole, especially because new debt is increasingly of the short-term variety. In 1991, when India was hit by a balance of payments crisis, the run up to the crisis was characterised by a rise in the share of short-term debt in aggregate external debt. It was the inability to refinance a significant volume of this short-term debt that precipitated a collapse in reserves and led to the crisis. Having burnt its fingers, the government made an effort to reduce dependence on such debt, so that its share came down to as low as 2.8 per cent at the end of March 2002. Since then however dependence on short-term debt has risen sharply. The share of short-term debt to aggregate debt stood at 21.6 per cent at the end of June 2011. This is close to the mid-1990s level from which it had subsequently collapsed. India is, therefore, vulnerable if international lenders choose not to rollover debt or provide new funding.

The official understanding seems to be that this is unlikely to happen and even if it does, the situation can be managed given the large reserves available with the RBI. But that too can change. After having risen from 42 to138 per cent between 2001 and 2008, the ratio of foreign reserves to external debt has fallen and stands currently at close to unity. Since these foreign reserves were accumulated during a period when India was running deficits on its balance of payments, it is widely known that our reserves have not been “earned” through net exports, as China’s reserves have been, but “borrowed”. They are the counterparts of some of the liabilities in foreign currency terms the country has accumulated. What emerges now is that all of the reserves are adequate only to cover one component of these liabilities, consisting of debt. Liabilities in the form of direct and portfolio investment, especially the latter, have to be serviced with earnings from net exports of goods and services or with receipts from remittances. At the end of June 2011, India’s outstanding net portfolio investment liabilities stood at $175 billion, or about 55 per cent of accumulated reserves. Together with accumulated portfolio liabilities short-term debt amounts to three-fourths of available reserves. Since both short-term debt and portfolio flows can dry up and quickly reverse themselves, our foreign reserves may not be as high or as adequate as they appear to be. Reining in the rise in external debt is, therefore, advisable.