## Wednesday, April 05, 2006

### Doing everything wrong on debt inflows

In India, there is a deeply held belief that debt inflows are bad, that all policy levers should be used to block debt inflows. In my column in Business Standard titled Doing everything wrong on debt inflows on Wednesday, I argue that a more nuanced understanding of the problems of debt inflows throws up difficulties with every aspect of existing policies.

I offer a five-part design of a sensible framework on handling debt inflows within a framework of capital controls. We could be moving towards convertibility, which would put wonks like me out of job on these kinds of questions. :-) But this five-part strategy could be put into use immediately, pending full convertibility.

I asked Joydeep Mukherji about what is going on with local currency debt issuance in Latin America. He said: Latin governments are trying seriously to get foreigners to invest in their long-term local currency debt. The Mexican government issued 20 year bonds 2 years ago and is thinking of issuing 30 year bonds now in Pesos, with fixed nominal interest rates. Most of these bonds are bought by foreigners, who have the choice of hedging currency risk if they so desire. Colombia is doing the same, but issuing in Pesos but in the foreign market (due to imperfections in its own markets). Brazil, as you cite, is trying to get FII money into its own debt market to lengthen the yield curve. These sovereigns have been trying to take advantage of the currently liquid state of global capital markets by rapidly reducing their dollar exposure, reducing a major source of vulnerability to their finances.

Update (17/6/2006): in a speech two days ago, Randall Kroszner said:

Since 2000, ten-year nominal fixed-coupon bonds in local currency have been introduced in Brazil, Colombia, Indonesia, Mexico, and Russia, while Korea issued a ten-year fixed coupon bond in 1995. To illustrate in more detail, the governments of Mexico and Korea have been able extend the average maturity of their local-currency debt significantly in just the past few years. The Mexican government issued ten-year maturities in 2001 and then 20-year maturities in 2003. The proportion of local-currency debt in Mexico maturing within one year was nearly 90 percent in 2002 and is now below 75 percent. (I have included floating rate debt in the one-year maturity category.) The Korean government continues to increase the proportion of its domestic currency debt in longer maturities, with the one-year-and-under segment falling from roughly one-half in 1999 to one-quarter by the end of last year.

Two, bond yields in local currencies of emerging-market countries have also declined. It is perhaps not surprising that, given their high rates of saving and generally high level of economic development, the governments of Hong Kong and Korea can borrow at close to industrial-country levels. More notable, however, is that the Mexican government can borrow in pesos at a ten-year maturity at rates that have averaged roughly 9 percent. And Mexico is not unique in this regard. Other middle-income emerging markets with ten-year local-currency fixed rate bond yields in the single digits include Chile, Malaysia, Russia, and Thailand, to name but a few. For countries with longer maturities, implied short-term interest rates five years ahead also have been declining and have reached very low levels, although there have been some increases in the past few months.

I got lots of comments on these issues. Here are some comments, and my responses:

Comment: But the FII limit is not binding and hence it's not really a limit. My response would be in two parts. First, my article was about the structure of capital controls, pointing out that it's just wrong to limit FII investments into INR debt (both GOI and firms) while supporting liability dollarisation by both the State and by firms. So whether the limit binds or not, the policies are wrong. The policies claim to keep India safe but are actually in the opposite direction. Second, I think that when India advertises tiny limits to the world, the biggest institutional investors get turned off. If India said that our FII framework for debt is the same as our FII framework for equity, then the big institutional investors would get going setting up offices in India to learn and trade Indian bonds.