Few would deny that the uncertainty that currently grips the global financial system is exceptional. Defining that exceptionalism is an unprecedented “backlash” on the part of Big Finance against developed country public debt that ballooned after 2007. Sovereign debt was earlier suspect only in the poorer developing countries, whereas the debts of developed country governments were considered riskless and subject to a zero per cent or negligible weight when regulatory capital requirements were computed under Basel norms. But that has changed substantially if the current attitude to U.S. and European public debt is any indication.

Government borrowing in the developed countries rose sharply after 2007 to finance emergency public expenditures aimed at stalling the recession triggered by the financial crisis and restoring the solvency of banks that had speculated their way to crisis. While the financial system benefited from such borrowing, it is now increasingly intolerant of the resulting accumulation of debt. As a result, the sovereign debts of developed-country governments are either subject to downgrade (as in the Greece and even the US) or have been put on watch for a potential downgrade (as in the case of Spain, Italy and France). The earlier idea that governments that can tax to mobilise resources to meet their commitments are unlikely to default on their debt is under challenge, even if for reasons that are not clearly spelt out.

This change in perception is based on the presumption that taxes cannot (or should not) be raised, so that expenditures need to be cut to release money to meet debt service commitments. Since that would slow growth and adversely affect tax revenues (as has happened in Greece), governments are seen as being caught in a debt trap of sorts. In the event, public debt in most developed countries is seen as excessive, and what was earlier considered a riskless asset has now been deemed risky. Right or wrong, this tends to discount the value of public debt.

Is India likely to be adversely affected by this new source of uncertainty in global financial markets? It is true that India’s exposure in the form of holdings of portfolio investments in international markets by private players is small.

Reserve Bank of India’s data on India’s gross international asset position (as on March 31, 2011) indicates that outstanding portfolio investments abroad account for an almost negligible $1.5 billion. International credit and other assets are more important at $20 billion, but as a stock that is by no means large. The two important forms that India’s international asset holdings take are direct investment ($98.2 billion) and accumulated reserve assets ($304.8 billion). Since private players largely hold direct investment assets, the squeeze in global demand would affect the overseas revenues of these firms, but possibly not do too much damage to the Indian economy.

What is more of an issue is the fate of the $274 billion of foreign currency assets (out of a total of $305 billion of reserve assets) held by India. While $127 billion of these are held as deposits with central banks, the Bank of International Settlements (BIS) and the IMF, as much as $142.1 billion is invested in securities, consisting largely of government securities. With the uncertainty surrounding the value and soundness of public debt, the danger of the erosion of the value of those assets is now significant. For example, India holds $41 billion of U.S. Treasury securities that have been downgraded recently by S&P. The balance is likely to be in the public debt of European governments.

It is this debt that is prone to a loss in value as a result of the new tendency to discount sovereign debt on grounds that seem whimsical. While the sums involved may be small (relative to the $1.2 trillion held by China in US Treasury bonds, for example) they are of significance because of the nature of India’s reserves. Unlike in the case of China, the reserves that insure India against adverse global responses are not earned through current account surpluses, but are drawn from what foreign investors have delivered in the past. They represent liabilities that are being held as assets that on average yielded returns as low as 2.09 per cent over the year ended June 201 (down from 4.16 during 2008-09). If the value of those assets is eroded, other things constant, India’s ability to cover its liabilities is eroded as well.

In addition to this, banks in India reporting to the BIS have disclosed holdings of claims amounting to $31.3 billion abroad. Of these, $14.9 billion are the external positions of banks in foreign currencies vis-à-vis the non-bank sector abroad. These exposures too are vulnerable given the volatility in financial markets in the OECD countries. Besides this there is the fact that because of the presence of legacy capital in the country (consisting, as of March 2011, of $204 billion of direct investment, $174 billion of portfolio investment and $265 billion of debt and other investments) India is vulnerable to global investor sentiment. Since that sentiment rules low and financial firms are registering losses in global markets, the flight of some of that capital is a real possibility.

Put all of this together and India does seem to be vulnerable to the uncertainty that pervades global markets. Finding ways to fortify its economic borders before a crisis hits is, therefore, a priority. Accelerating financial sector reform, as the Planning Commission seems to have decided is not.


Gillard hopeful on Europe solving debt crisis October 25, 2011