Mr Reddy looks at external debt policies in emerging economies
Speech by the Deputy Governor of the Reserve Bank of India, Dr Y V Reddy, at the Seminar
on Corporate External Debt Management in Kathmandu, Nepal, on 11 June 1999.
Mr Chairman and friends,
At the outset, I would like to express my gratitude to Dr Shanker Acharya, Mr Ravi Mohan
and Mr Sanjay Kathuria, who gave me an opportunity to attend this seminar on "Corporate
External Debt Management". The deliberations have indeed been a feast and there is nothing
but admiration for the outstanding organisational abilities of all concerned. There has been an
ideal mix of participants and subjects. In the previous seminar on external debt at Trivandrum
last year, we had flagged the corporate angle to external debt as a priority item. We should all
be happy that the suggestion has been acted upon now. Like the proceedings of the earlier
seminar which have been published by the RBI, I hope CRISIL would arrange to get the
papers and proceedings published soon.
A number of valuable suggestions have been made in the seminar and some of them are
particularly relevant to the RBI. Some of them require clarifications as to the rationale of
current policies and procedures. A few of them need immediate attention while others have to
be pursued in the medium term. They require careful examination. I assure you that we in the
RBI will consider all of them seriously and seek your advice and cooperation.
Let me not try to either summarise the highlights of this seminar or respond to the valuable
insights. I intend sharing with you some thoughts on new dimensions in external debt policies
of emerging economies, consequent upon the recent crises in East Asia, Latin America and
Russia. New approaches are being advocated in the context of discussions on the new
international financial architecture.
The responses to the recent crises, the follow-up consideration of measures to prevent similar
crises, and possible actions to meet them when they occur, have covered a wide spectrum of
policies. The debate covered many policy issues: domestic and external, macro and micro,
financial and regulatory, national and multilateral, relating to both developed and emerging
economies. Eminent academics have also contributed to the debate. At policy level, there have
been discussions in G-7, G-24, and the newly founded G-22, G-33 and Financial Stability
Forum, not to speak of the Commonwealth Secretariat, UN, IMF, World Bank and BIS. India
has been invited to participate in most of these. In all these deliberations, external debt
policies were a crucial part. Perhaps this is an ideal forum to describe these new dimensions
briefly and narrate the Indian position.
The new dimensions relating to external debt policies can be analysed under five broad heads,
viz.: level of reserves and external debt; maturity pattern; issues relating to short-term debt;
policies relating to transparency and standards; and involving the private sector in forestalling
a debt crisis.
Level of Reserves and External Debt
There has always been a continuous but inconclusive discussion on the optimum level of
reserves. Traditionally, however, the adequacy of reserves has been mainly linked to import
requirements. Incidentally, recent experience has shown that countries which were holding
large levels of reserves did not necessarily escape the crisis. This shows the importance of
appropriate policies and avoidance of excessive comfort from level of reserves. Nevertheless,
the level of reserves continues to be an important source of comfort on matters relating to
stability in the external sector, and consequently on the domestic economy. Because of the
importance of showing the real level of reserves in a transparent manner, there are increasing
efforts to measure unencumbered reserves. The emphasis has also shifted from measuring the
adequacy of reserves only in relation to imports to measuring in terms of short-term liabilities,
in particular short-term debt.
Two notable suggestions in this regard have emanated - one from Pablo Guidotti, Deputy
Finance Minister of Argentina, and the second from the Bank for International Settlements.
Mr Pablo Guidotti proposed a simple guideline for policy makers in emerging market
economies. He suggested that countries should manage their external assets and liabilities in
such a way that they are always able to live without new foreign borrowing for up to one year.
In other words, usable foreign exchange reserves should exceed the scheduled amortisation of
foreign currency debts (assuming no rollovers) during the following year. In terms of debt
management, this implies a limit on the size of the debt, in particular short-term debt and debt
that is falling due for repayment.
The BIS, in its latest Annual Report, recognises the importance of countries preparing
themselves for the possibility of sudden outflows, and identifies ways in which reserves can
be built up. One way of doing this is to run trade surpluses and what the BIS terms as a less
disruptive solution is the Argentine proposal, namely to borrow reserves and arrange
contingent lending facilities with the private sector. In the view of the BIS, "Given the swings
of mood in these markets, the authorities might at certain times find it relatively easy and
inexpensive to lock in longer-term foreign currency loans for later use. Finally, countries
might then make use of the recently announced Contingent Credit Lines offered by the IMF.
In conjunction with similar private sector arrangements, this would be a joint testimonial to
the soundness of the country in question and could contribute materially to the avoidance of
contagion problems".
In a somewhat similar vein, Chairman Greenspan expressed a view that countries could adopt
a "liquidity-at-risk" standard to manage their exposure to financial risks. This standard would
give the ex ante probability that a country would avoid new borrowing for one year, based on
the level of reserves.
In India, we have been steadily building up reserves by encouraging non-debt-creating flows
and de-emphasizing debt-creating flows. India's foreign exchange reserves have been steadily
increasing over the years. For instance, the last three years saw increases in reserves in the
range of $4.7 billion in 1996/97, $2.9 billion in 1997/98 and $3.1 billion in 1998/99, i.e. a
cumulative $10 billion. However, between end-March 1996 and December 1998, India's total
external debt increased by a mere $2 billion.
Our policy of building and maintaining an adequate level of reserves while at the same time
constraining debt, especially short-term debt, will continue though we would continuously
monitor the international debate in this regard.
Maturity Pattern
In many emerging countries, with deregulation and liberalisation, adequate attention has not
been paid to the maturity profile of the external debt portfolio. In fact, in some cases, even
information gathering on this subject was dispensed with as part of deregulation. Determining
the maturity was a micro decision left to the final borrowers, whose main consideration was
cost. Thus, borrowers in many emerging market economies have tended to borrow short with
a view to minimising cost. Creditors lent short-term since they expected their claims to mature
quickly. The recent crises showed that this could be risky. The policy dimension relating to an
appropriate maturity structure, which was earlier viewed as a micro decision, is now being
recognised as a macro aspect and a stability issue.
Elongation of the average maturity ensures a sort of private sector burden sharing in times of
crisis. It is important to recognise that the insurance embedded in long-term debt often
outweighs the cost.
These issues have direct relevance to corporates' access to external funds, both in terms of
cost and the period of borrowing. The cost of borrowing may increase on account of longer
maturities, but they will have the comfort of stable flows. In times of crisis, the costs of
disruption on account of destabilising flows may far exceed the cost of raising longer-term
debt.
There are issues on how the policy makers could promote or ensure an optimal maturity
structure. There can be several views on what an optimal maturity itself is. There is one
influential view that the average maturity of a country's external liabilities should exceed a
certain threshold, say three years.
In India, from 1992, emphasis has been laid not only on the cost and size of debt, but also on
the maturity. The desired maturity profile is taken into account in policy articulation and
clearance of individual cases. The average maturity of our ECB, as you may be aware, is five
years. Basically, considerations of the size, cost and maturity are embedded in the clearance
mechanism for ECB.
Thus, the ECB policy, though it is being liberalised gradually, will ensure built-in measures
towards an optimal maturity. The instruments by which this objective is achieved will
continue to be refined from time to time, taking account of international developments also.
Short-Term Debt
A major source of vulnerability in the Asian crisis was the large stock of short-term liabilities
of banks and corporates. In the short-term liabilities, debt constitutes a contractual obligation
and is thus on a different footing. As mentioned, the link between short-term debt and
reserves has come to the fore in these deliberations. There is a cost to building up reserves
through large debt flows since the cost of debt would generally be higher than the return on
reserves. However, not all short-term flows are bad and some short-term finance is essential to
finance transactions. In fact, it is recognised that trade-related short-term credit is not as
volatile as non-trade-related credit.
Overall, there appears to be a consensus now in favour of restraining the inflow of short-term
capital until markets, institutions and regulatory frameworks have been sufficiently
strengthened.
There is, however, a growing debate on the means by which short-term flows can be
controlled. Major suggestions relate to effective monitoring, tax on spot transactions, varied
reserve requirements, increased capital requirements on interbank transactions, changes in
capital adequacy requirements of lending banks to non-OECD countries, and discouraging
local firms from undertaking external borrowing by imposing taxes. Quantitative controls
have also been recognised as effective.
The oft-quoted measure relates to reserve requirements imposed on short-term flows. Chile
and Colombia imposed unremunerated reserve requirements of 30 per cent on short-term
flows, subsequently reduced to 10 per cent. This represented a tax on short-term holdings. The
empirical evidence on its effectiveness is inconclusive.
A favourite for economists has been the never-tried Tobin Tax, though it has often been
seriously considered by policy makers. The Tobin Tax proposal envisages a levy of uniform
tax on all spot transactions in foreign exchange. The objective is to discourage a one-night
stand by speculators in the foreign exchange market as the tax burden will be inversely
proportional to the maturity of flows. Another economist, Dornbusch, seeks a variant of the
Tobin tax, viz., to impose a tax on all cross-border flows. This is also on the drawing table so
far.
Paul Krugman has recently suggested that emerging nations should consider using taxes to
discourage local firms from borrowing in foreign currencies. Tax at uniform rate will have a
larger impact on short-term borrowing, and will thus operate in a somewhat similar way to the
Tobin tax.
The role of financial intermediaries, especially banks, in short-term flows has figured
predominantly in these deliberations. Alan Greenspan has also proposed imposing increased
capital requirements on borrowing banks to bring greater discipline to cross-border interbank
markets.
It is now accepted that just as there is no irresponsible borrowing without irresponsible
lending, there is no short-term borrowing without short-term lending. Hence, it is argued that
capital requirements in the banking system should be so prescribed as to discourage lending
banks also. In fact, the current policy is biased in favour of short-term lending. The current
Basle Accord provides that all claims on banks incorporated in OECD countries and
shortterm claims (i.e. up to one year) on banks incorporated in non-OECD countries carries a risk
weight of only 20 per cent, whereas long-term claims on banks in non-OECD countries carry
a risk weight of 100 per cent. The new Capital Adequacy Framework, which has just been
issued by the BIS as a consultative paper for comments, is reviewing this norm.
Most of the above proposals have the effect of increasing the cost of short-term debt. Hence,
these developments would be of interest to the corporate sector.
In India, we carefully monitor short-term debt. We maintain a difference in treatment between
trade- and non-trade-related debt. The authorities sanction short-term debt over six months on
a case-by-case approval of purpose, amount and terms, within a sub-ceiling of the total
external commercial borrowings ceiling. NRI deposits are controlled through specification of
interest rates or interest rate ceilings for different maturities in respect of deposits in select
schemes. According to the latest Status Report on External Debt circulated by the Ministry of
Finance, our short-term debt is very modest by all criteria.
The international consensus on the need for controlling short-term debt vindicates our policy
thrust with regard to discouraging short-term flows. We will have to continue with the
objective of restricting short-term flows, though the means of doing it could be refined from
time to time in consonance with domestic and, to some extent, global developments.
Policies Relating to Transparency and Standards
A major area of concern has been lack of transparency in regard to macroeconomic and
financial health. The issue of transparency has generated some debate. Transparency cannot be
one-sided - say only by public systems and not the corporate sector. Transparency provides
information and inference is a matter of interpretation or judgement. There are country-
specific circumstances also that govern the degree of transparency, which include the timing
of some disclosures.
India is one of the earliest members of the SDDS of the IMF. The RBI provides up-to-date
weekly data on all relevant macroeconomic and financial indicators through the Weekly
Statistical Supplement to the RBI Bulletin, which is available on the RBI website. In addition,
the RBI and Government disseminates as much information as possible through monthly,
quarterly and annual publications.
The World Bank, IMF, BIS, OECD and other international institutions are active in the
evolution of standards relevant for the functioning of domestic and international financial
systems. These cover a wide range of areas including data dissemination, fiscal, monetary and
financial policy transparency (IMF), banking regulation and supervision (BIS), securities
market regulation (International Organization of Securities Commissions), insurance
regulation (International Association of Insurance Supervisors), accounting (International
Accounting Standards Committee), Auditing (International Federation of Accountants),
Bankruptcy (United Nations Commission on International Trade Law) and Corporate
Governance (OECD, World Bank and Basle Committee). In addition, work relating to
improving the robustness of payments systems, general principles of good practices in social
policies, identifying practices and structures that support deep and liquid forward markets is in
progress.
It would be interesting to see how these standards evolve. While it may not be possible for all
countries to adopt these standards completely and promptly, countries will have to take
account of these standards, depending on individual country circumstances.
Increasingly, these international standards will have to be adapted to suit local requirements.
These will have an impact on our corporates trying to access international markets in terms of
costs and regulatory compliance. Corporates will need to impute these into their debt
management strategies.
Role of the Private Sector in Forestalling a Crisis
The efforts to involve the private sector in debt management have many objectives, viz., bring
about a more orderly adjustment process, limit moral hazard, strengthen market discipline,
help protect countries against volatility and contagion. The idea is to have mechanisms in
place before any crisis takes place - so that resolution of the crisis is more orderly.
While there is consensus regarding the need for the private sector to share the burden,
discussions in the various fora have centred on the mode of burden sharing. Ideas that are
being considered include contingent credit lines, embedded call options, debt-service
insurance, bond covenants, bankruptcy procedures, debt standstill and creditor-debtor
councils.
Basically, these mechanisms bind private sector participants to either provide additional
funds, or reduce debt service burdens in times of crisis without creating moral hazard or
disrupting the normal market conditions. For instance, countries could contract market-based
Contingent Credit Lines with commercial banks to trigger liquidity support in times of crisis.
If the credit lines are fairly priced, they could provide effective insurance against adverse
market developments. Call options on interbank credit lines would provide the basis for the
extension of maturities during times of trouble. Standstill arrangements will allow the private
sector to give additional borrowing when there has been a default on existing debt.
Creditordebtor councils could serve to improve the flow of information. Bond and debt covenants
could introduce sharing clauses, provisions for the modification of terms by qualified
majorities will speed up the negotiation process. There is also a suggestion that the G-10
countries could start including these new contractual terms in their fresh sovereign bond
issues in order to initiate the demonstration effect.
Another proposal relates to a universal debt rollover option with a penalty. The idea is that all
foreign currency debt should have attached to it an option, exercisable at the discretion of the
borrower, to roll over the liability at a penalty rate.
It is too early to comment on how these suggestions would evolve. These deliberations and
their outcomes are of interest not only to the Government of India and the RBI, but to the
corporates, since these would impinge on their operations. I trust that financial intermediaries
are closely following these developments. The RBI would welcome and indeed invite
suggestions in these matters.
When I started this address, I expressed happiness over the focus on the corporate angle to
external debt in this seminar. Encouraged by the response, I have a suggestion for the next
seminar. It would be worthwhile if the next seminar focuses on external debt management by
financial intermediaries, viz., banks, financial development institutions and non-bank
financial companies. The discussions could include risk management systems.