INTRODUCTION TO EXTERNAL DEBT MANAGEMENT

table of contents

S.R.nocontent

1Introduction to External Debt Management

2External Debt and Macroeconomic Considerations

3Important Aspects Related To External debt Management

4External Debt Sustainability

5External Debt Development and Management Some Reflections on India

6External Debt Management Policy

7CONCLUSION

Introduction to External Debt Management

External debt (or foreign debt) is that part of the total debt in a country that is owed to creditors outside the country. The debtors can be the government, corporations or private households. The debt includes money owed to private commercial banks, other governments, or international financial institutions such as the IMF and World Bank.

Definition

IMF defines it as "Gross external debt, at any given time, is the outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy."

In this definition, IMF defines the key elements as follows:(a) Outstanding and Actual Current Liabilities: For this purpose, the decisive consideration is whether a creditor owns a claim on the debtor. Here debt liabilities include arrears of both principal and interest.

(b) Principal and Interest: When this cost is paid periodically, as commonly occurs, it is known as an interest payment. All other payments of economic value by the debtor to the creditor that reduce the principal amount outstanding are known as principal payments. However, the definition of external debt does not distinguish between whether the payments that are required are principal or interest, or both. Also, the definition does not specify that the timing of the future payments of principal and/or interest need be known for a liability to be classified as debt.

(c) Residence: To qualify as external debt, the debt liabilities must be owed by a resident to a nonresident. Residence is determined by where the debtor and creditor have their centers of economic interest - typically, where they are ordinarily located - and not by their nationality.

d) Current and Not Contingent: Contingent liabilities are not included in the definition of external debt. These are defined as arrangements under which one or more conditions must be fulfilled before a financial transaction takes place. However, from the viewpoint of understanding vulnerability, there is analytical interest in the potential impact of contingent liabilities on an economy and on particular institutional sectors, such as government.

Generally external debt is classified into four heads i.e. (1) public and publicly guaranteed debt, (2) private non-guaranteed credits, (3) central bank deposits, and (4) loans due to the IMF. However the exact treatment varies from country to country. For example, while Egypt maintains this four head classification, in India it is classified in seven heads i.e. (a) multilateral, (b) bilateral, (c) IMF loans, (d) Trade Credit, (e) Commercial Borrowings, (f) NRI Deposits, and (g) Rupee Debt.

External Debt and Macroeconomic Considerations

How foreign borrowing affects macroeconomic stability can be best understood in the context of production, consumption, savings, and investment. In a closed economy (no foreign trade), production comprises goods and services for personal consumption (consumer goods), capital goods (buildings, plant and equipment, inventories used by enterprises), and goods and services used by the government, which can be both for consumption (for current use) and for investment. Where there is foreign trade, production also includes goods for export; imports are a supplement to domestic consumption, for investment, for government use or for exports.

There is a relationship between production and income. Put simply production creates incomes equal to the value of output. The government in taxes takes some income; some is taxed; some is saved by the private sector; the balance is spent on consumption. Foreign borrowing is the excess of imports of goods and services over exports and net borrowing creates debt, which can be repaid if exports exceed imports. In the absence of foreign borrowing (exports and imports are equal), private sector investment plus government spending is limited by the level of private sector savings and taxation.

Economic growth, of course, could be accelerated with foreign borrowing, permitting imports to exceed exports and at the same time, investment plus government expenditures to exceed savings plus taxes. There are standard indicators for measuring the burden of external debt: the ratios of the stock of debt to exports and to gross national product, and the ratios of debt service to exports and to government revenue. Although there is widespread acceptance of these ratios as measures of creditworthiness, there are no firm critical levels, which, if exceeded, constitute a danger for the indebted country.

However, the World Bank Staff has proposed a set of parameters, which it uses to demarcate moderately and severely indebted countries. Countries with a rapid export growth can support higher debt relative to exports and output. Heavily indebted, however, are vulnerable to severe macroeconomics shocks-sharply higher interest rates in the lending countries, for instance, or simply lenders cutting back on their commitments. Faced with these pressures, countries must then adjust by cutting private investment, decreasing government expenditures and or increasing government revenues.

Important Aspects Related To External debt Management

A) Financing Techniques

Countries have a limited ability to support external borrowing. At the same time, the supply of finance is also limited. Consequently, borrowers must choose the best combination from the available sources of external finance to suit the needs of individual projects-and of the economy as a whole. The country wishes to minimize the problems in servicing new debt, while making maximum use of grants and foreign loans on concessional terms. These are clearly the cheapest from of financing, but their availability is generally restricted to the poorest developing countries; and even for those countries, they are inadequate to meet needs. A maximum leverage can be obtained from concessional financing by combining it with other types of financing. Other sources of credits are export financing and loans from international commercial banks.

Authorities should ensure that credits from financial markets are part of a package that provides the best possible external financing mix for the economy, as well for an individual project. For projects the best mix could mean one with: (1) maximum concessional loans or maximum market finance (2) the maximum capital that can be rolled over easily, or (3) the minimum debt service due in the years before returns materialize. Authorities must also ensure that the aggregate financing package meets national financing priorities, This involves an assessment of such aspects as: the sources of finance ,including the amounts that can be borrowed and the prospects for future supply; the currency composition of foreign borrowing that would minimize exposure to exchange rate fluctuations; the exposure to interest rate fluctuations over the life of the loan; and the impact of new borrowing on the structure of debt service obligations.B) How much to Borrow

The amount that any country ought to borrow is governed by two factors: how much foreign capital the economy can absorb efficiently, and how much debt it can service without risking external payment problems. Each factor will depend on the quality of economic management. Borrowings can be on different terms and in different currencies, which complicates the policy decision. There may be uncertainty too about evolving debt-servicing capacity. Interaction between debt servicing capacities, the type of finance, and the borrowing decision increases in complexity as the number of loans increases.

C) Managing Risk

Countries are sometimes exposed to BOP shocks arising from unfavorable changes in the relative prices of exports and imports, suppose that a countrys exports earnings are in dollars and its foreign debts are repayable in yen deterioration in the exchange rate of the dollar vis-a-vis the yen will add to the debt servicing obligation of the borrowing country. Fluctuations in commodity prices, foreign exchange rates and world interest rates are largely beyond the control of countries. It is possible to hedge against this risk. Managing risk is an important part of public debt management.D) Knowing The Debt

Information on external debt and debt service payments is essential for the day-to-day management of foreign exchange transactions as well as managing debt and for planning foreign borrowing strategies, At the most detailed level, the information enables central authorities to ensure that individual creditors are paid promptly; at more aggregated levels; debt data are needed for assessing current foreign exchange needs, projecting future debt service obligations, evaluating the consequences of further future borrowing and the management of external risk The component of external debt statistics include details of each loan contract and its schedule of future service payments, figures on loan utilization, and the payments of debt service obligations. From these data elements summary figure on foreign borrowing, outstanding debt, and projected debt are assembled. The resulting statistics provide inputs for budget and BOP projections.

After this lets have a look at external debt sustainability in detail in Chapter 2.External Debt Sustainability

Sustainable debt is the level of debt which allows a debtor country to meet its current and future debt service obligations in full, without recourse to further debt relief or rescheduling, avoiding accumulation of arrears, while allowing an acceptable level of economic growth. (UNCTAD/UNDP, 1996)

External-debt-sustainability analysis is generally conducted in the context of medium-term scenarios. These scenarios are numerical evaluations that take account of expectations of the behavior of economic variables and other factors to determine the conditions under which debt and other indicators would stabilize at reasonable levels, the major risks to the economy, and the need and scope for policy adjustment.

In these analysis, macroeconomic uncertainties, such as the outlook for the current account, and policy uncertainties, such as for fiscal policy, tend to dominate the medium-term outlook.

World Bank and IMF hold that a country can be said to achieve external debt sustainability if it can meet its current and future external debt service obligations in full, without recourse to debt rescheduling or the accumulation of arrears and without compromising growth. According to these two institutions, external debt sustainability can be obtained by a country by bringing the net present value (NPV) of external public debt down to about 150 percent of a countrys exports or 250 percent of a countrys revenues.

Indicators of External Debt Sustainability

There are various indicators for determining a sustainable level of external debt. While each has its own advantage and peculiarity to deal with particular situations, there is no unanimous opinion amongst economists as to one sole indicator. These indicators are primarily in the nature of ratios i.e. comparison between two heads and the relation thereon and thus facilitate the policy makers in their external debt management exercise.

These indicators can be thought of as measures of the countrys solvency in that they consider the stock of debt at certain time in relation to the countrys ability to generate resources to repay the outstanding balance.

Examples of debt burden indicators include the (a) debt to GDP ratio, (b) foreign debt to exports ratio, (c) government debt to current fiscal revenue ratio etc. This set of indicators also covers the structure of the outstanding debt including the (d) share of foreign debt, (e) short-term debt, and (f) concessional debt in the total debt stock.

A second set of indicators focuses on the short-term liquidity requirements of the country with respect to its debt service obligations. These indicators are not only useful early-warning signs of debt service problems, but also highlight the impact of the inter-temporal trade-offs arising from past borrowing decisions. The final indicators are more forward looking as they point out how the debt burden will evolve over time, given the current stock of data and average interest rate. The dynamic ratios show how the debt burden ratios would change in the absence of repayments or new disbursements, indicating the stability of the debt burden. An example of a dynamic ratio is the ratio of the average interest rate on outstanding debt to the growth rate of nominal GDP.

These were certain aspects of external debt in the next chapter we will see how the external debt was managed by various countries of the world at the time of economic crisis.

Debt management strategy-a global overviewThe design of an adequate strategy for public debt management should include proper consideration of a number of questions. Among them, several come to mind: (a) how much public debt should be issued in domestic markets and how much in foreign capital markets? (b) What should be the currency denomination of new public debt issues? (c) What is the optimal maturity structure of public debt? (d) Should governments consider redeeming in advance some issues and refinance them on different terms? (e) Should public debt be issued at fixed or variable rates and (f) should public debt issues be directed to a particular segment of the market (financial institutions, other institutional investors, corporate sector, etc).Most of these choices entail a trade-off between the level and the variance of debt costs and are highly dependent on both the domestic macroeconomic context and conditions in international markets.

Nonetheless, the debt management strategy has important implications for the economy as a whole. Good liability management should result in lower borrowing costs and unobstructed access to international capital markets, while minimizing any crowding-out effects on private sector borrowing. The choice of the specific characteristics of the debt portfolio involves difficult decisions. While on a pure cost-based analysis it is tempting to choose short-term over long-term debt, the latter might Brady bond spreads for different emerging market economies have behaved similarly, though at different levels, in the midst of financial crises or increased uncertainty. Thus, the liquidity of emerging markets securities and the collective behavior of institutional investors make the financial authorities tasks more difficult, particularly since systemic risk may rise swiftly. Over the past decade, capital mobility has increased many times over and its main features have also changed, especially those related to the allocation between foreign investment and traditional lending. Mexico, as a recipient economy, has witnessed those events.

Total capital inflows to Mexico grew from a yearly average of US$ 2 billion in 198788 to $36 billion in 1993. In the latter year, foreign investment amounted to 920/0 of capital inflow.

The 1994 crisis caused an important reduction of these flows, to $23 billion in 1995. Given that foreign investment for that year turned out to be negative, loans from abroad represented more than 1000/0 of total capital inflows. For 199697 capital inflows were on average $10 billion per year. However, it should be emphasized that total foreign investment represented more than 2000/0 of that amount. That is, foreign investment more than compensated for the decline in indebtedness. For 199899 capital inflows are estimated to have averaged $16 billion per year, with total foreign investment amounting to 770/0 of the inflows. Foreign direct investment grew from $4 billion in 1993 to $11 billion in 1994 and has kept a stable level of around $10 billion per year since then. On the other hand, portfolio investment has shown more erratic behavior. Having reached a peak of $29 billion in 1993, it turned negative in 1995 ($10 billion) and for 199699 has averaged under $1 billion per year. The important reduction in the flows of foreign portfolio investment to Mexico since the crisis of 199495 is primarily explained by the adoption of a floating exchange rate regime.

This regime has proved to be extremely helpful in inhibiting short-term foreign investments by reducing their expected return, once adjustment is made for exchange rate risk. Without the implicit guarantee to portfolio investment provided by the semi-fixed exchange rate regime, foreign direct investment started to play a more dominant role in financing

Mexicos current account deficit blurred. The Exchange Stabilization Fund prevented the liquidity crisis from turning into a solvency crisis, whose repercussions would have been far more devastating.

Prior to 1994, both debtors and the banking system in general were in a fragile situation. Past due loans had increased substantially, and the lack of proper provisioning started to erode banks capital.

In addition, some commercial banks faced severe problems that were not revealed in their financial statements, and, in some instances, banks disregarded existing regulations and proper banking practices (Mancera (1997)). In this environment, the effect of the currency depreciation, rising inflation and higher interest rates on the credit service burden seriously jeopardized the Mexican financial system. At that time, the materialization of systemic risk and its impact on the economy were major concerns.

Faced with this situation, the government and the central bank implemented a comprehensive programme to deal with the banking sector crisis, without derailing monetary policy from its main task of procuring the reduction of inflation. The successful mix of policies ensured the consistency of Mexicos macroeconomic framework and allowed the economy to recover and rapidly return to international markets. An important element of the overall strategy was to provide liquidity to commercial banks to comply with their external obligations. To this end, a dollar facility was made available to them by the central bank. Thus, Banco de Mxico played the role of lender of last resort for commercial banks at a time of distress, making foreign exchange available to banks through a specially designed credit window. These dollar-denominated loans were channeled through the Fund for the Protection of Savings (FOBAPROA).At the beginning of April 1995, the dollar-denominated credits granted through FOBAPROA reached a maximum of US$ 3.8 billion. However, the high level of interest rates purposely charged on such credits induced a rapid amortization, as banks sought other sources of financing. By 6 September 1995, the 17 commercial banks that had participated in this scheme had already repaid their credits.

In this sense, the programme achieved its stated purpose, namely that of providing temporary assistance. Once international markets were reopened to Mexican agents (July 1995), the main objectives for the immediate future included the refinancing of the Exchange Stabilization Fund in the market, have a smaller refunding risk and thus be preferable in the end.

That is, a better schedule of amortizations lowers country risk and finance costs over the medium term, both for the government and for the private sector. Likewise, borrowing domestically may turn out to be more expensive than in external markets. Yet borrowing in domestic markets could trigger a rapid development of these markets and pave the way for a solid corporate domestic market in the future. In sum, a good liability management strategy is one that helps minimize the cost of borrowing over the medium and long term. The objective is certainly not to save the last basis point in each transaction, but rather to bring down the overall borrowing cost. Thus, a smooth debt amortization profile is crucial. There is no doubt that emerging economies have to work hard to ensure desirable characteristics in the debt profile, even if initially costly. At the end of 1994, Mexico faced a liquidity crisis accompanied by a very high refinancing risk.

This forced the country to seek support from the international community to confront the heavy short-term debt burden. Economic policy was oriented towards rapidly re-establishing macroeconomic stability. This was the only way to stop capital flight and gradually restore Mexicos access to international financial markets. To deal with the scenario just described, a comprehensive package of policy measures was put together. The stabilization programme was built upon restrictive fiscal and monetary policies and was reinforced by the financial package (Exchange Stabilization Fund) assembled by the US financial authorities and multilateral organizations. The rescue package amounted to more than US$ 52 billion: $17.8 billion committed by the IMF, $20 billion by the United States government, $10 billion by the Bank for International Settlements, $3 billion by commercial banks and $1.5 billion by the Bank of Canada. It is worth mentioning, however, that in 1995 Mexicos drawings amounted to only $24.9 billion. A solvent government might still face liquidity problems that limit its ability to service its debt. For instance, an overly pessimistic view about the future of the economy might lead lenders to curtail the amount of financing temporarily even if the country is in fact solvent. Eventually, liquidity problems might escalate, negatively affecting the governments access to international capital markets. At this particular stage, the distinction between liquidity and solvency problems for a country is.

At the same time; the private pension fund system has continued to grow, making long-term resources more widely available. Today, Mexicos foreign debt amortization schedule is light and well distributed over time. The overall debt burden, including domestic and external debt, diminished from levels above 450/0 of GDP in 1990 to approximately 280/0 in 1998. This trend is thought to have continued in 1999.The countrys solvency and liquidity indicators compare favorably to those of other countries: external debt as a share of GDP amounted to 170/0 in early 1999, while the ratio of total exports to external debt was 1.7. An example of Mexicos strategy to ensure external financing when conditions in international capital markets turn adverse is the credit line secured with international financial institutions in November 1997.

After having a look at the global scenario of external debt lets understand the debt management in India .External Debt Development and Management

Some Reflections on IndiaIntroduction

In 1990-91 when India got into a severe foreign exchange crisis her outstanding level of external debt was $ 83. 8 billion. The level of debt was about 40 per cent of Gross Domestic Product and the debt service payment was about 30 per cent of exports of goods and services. Several destabilizing forces acting on the Indian foreign exchange markets were a downgrade of Indias sovereign credit ratings to non-investment grade, reversal of capital flows, exacerbated the foreign exchange crisis and withdrawal of the foreign currency deposits held by non-resident Indians. One can best describe the severity of the situation by quoting from the then Finance Minister of India Dr Manmohan Singhs Budget 1992-93 speech to the Parliament:

"When the new Government assumed office (June 1991) we inherited an economy on the verge of collapse. Inflation was accelerating rapidly. The balance of payments was in serious trouble. The foreign exchange reserves were barely enough for two weeks of imports. Foreign commercial banks had stopped lending to India. Non-resident Indians were withdrawing their deposits. Shortages of foreign exchange had forced a massive import squeeze, which had halted the rapid industrial growth of earlier years and had produced negative growth rates from May 1991 onwards".With this background a study on Indias external debt would obviously raise certain questions such as: how did India manage historically with a very low volume of external capital inflows; how is that the third world debt crisis of early 80s had a little impact; how is it then that India got into a massive foreign exchange crisis in 1990-91; how was India spared from the contagious currency crisis of 1997; and how did India managed to improve her rank from what was third debtor after Brazil and Mexico in 1991 to eighth in 2002 in the list of the top fifteen debtor countries(as per the Global Development Finance report 2004 published by the World Bank). Still more notable is the fact that India never defaulted to international lenders in her entire credit history (except one or two instances of corporate rescheduling).

Although the level of debt has increased to $ 112.1 billion by end-December 2003, the magnitude of debt is no longer an issue at present. The economic reforms and debt management policies pursued since 1991 have helped to bring down the share of external debt in GDP to 20.2 per cent and the debt service ratio to 15.8 percent by end-December 2003. The reforms involving trade and capital account liberalization have changed the nature and composition of capital flows into Indian economy. The gradual opening of the capital account and improved credit standing internationally, supported by the prudent macroeconomic policies, have established investors confidence.

The above scenario although presupposes several accomplishments underlying the countrys external debt management history, the Indian economy nevertheless displayed several episodes of imbalances in her debt, capital flows and external sector. Indias external debt management in the light of the development in her overall macroeconomic policies and draws lessons for countries in the region. It needs to be mentioned here that the trends in debt need to be reviewed along with the developments in external sector and capital flows, because the overall trade regime, involving trade restrictions, export subsidisation and exchange controls would govern to a large extent the behaviour of external debt.

Burden of External Debt In India

It is a source of some comfort that India's external debt continues to be at a stable level. According to the status paper prepared by the Union Finance Ministry, the stock of foreign debt stood at $98.4 billion at the end of December 2001. After a substantial increase of $16 billion between 1991 and 1995, partly on account of fresh loans and partly on account of exchange rate movements, the total debt has fluctuated between $93 billion and $99 billion since 1995. Going by a number of indicators, India's external debt situation is far better today than it was during the balance of payments (Bop) crisis of 1991.

While the absolute size of foreign debt is important, more relevant is the weight this debt imposes on the economy. And, on that count, the burden has become lighter and lighter, even as the stock of outstanding has remained more or less constant. Annual repayments of loans and interest as a percentage of current receipts the debt service ratio, which was as high as 35 per cent in 1990-91, has fallen to 13 per cent today. Debt as a percentage of the gross domestic product has nearly halved since the early 1990s. And the short-term debt to GDP ratio, which crossed 10 per cent in 1990-91 and precipitated the Bop crisis of that year, has been held under 3 per cent. Overall, India is now classified by the World Bank as a "less" indebted country, which is two rungs below the extreme category of "severely" indebted countries, which is where Brazil, Argentina and Indonesia now belong. In absolute terms as well, India's position has improved globally. In the mid-1990s, India was the third largest debtor in the world; today it is ranked ninth. All this has taken place in spite of the fact that new loans are increasingly being raised on commercial rather than concessional terms, as was the practice for decades.

External Debt Management Policy

Indias Debt-GDP ratio which shows the magnitude of external debt to domestic output had declined from 38.7 % at the end of March 1992 to 22.3% at end March 2001.Similarly the debt service ratio that measures the ability to serve debt obligations has declined from 35.3% of current receipts in 1990-91 to 16.3% in 2000-01.

This improvement in external debt should be attributed both to a cautious policy on foreign borrowings (which includes annual caps on commercial loans which would not have been possible if the rupee was fully convertible) and to the steady growth in current receipts in the Bop. There are, however, enough areas of concern, which should prevent complacency and persuade the Government to go slow on capital account convertibility. The first is that while the short-term debt to GDP ratio was only 2.8 per cent at the end of 2001, the more accurate measure of immediate repayments total debt of a residual maturity of one year was 9 per cent of GDP in December 2001. This is still not a very heavy burden, but it is not something to be taken lightly.

The second concern should be that the estimate of debt servicing in the years ahead (based on past borrowings) shows that there are going to be two major humps round the corner. In 2003-04 and 2005-06, repayments of the expensive Resurgent India Bonds and India Millennium Deposits fall due. Debt service in both years will then cross $12 billion. This will be the largest since 1995-96, though the Government hopes that not all the repayments will be repatriated. The third concern should be the impact of the Government's decision to make even the existing non-repatriable bank deposits by non-resident Indians fully payable in foreign exchange. As a consequence, two such schemes were discontinued last April and outstandings transferred to repatriable accounts where they will be held till maturity. The stock of deposits in one of these schemes was itself over $7 billion. This means that if these deposits are taken out of the country when they mature they will add to India's debt service burden. And if they are renewed they will add substantially to India's external debt burden. Either way, the Government's decision is going to have a negative impact on the Bop.

Problems Of External Debt Management In India

Borrowing costs are not limited to interest costs. First, there is the dependency syndrome, which leads to the development of constituencies at the various levels of government to keep the borrowing momentum in full swing, actively supported by the multilateral development agencies. Second, there is an element of uncertainty in regard to whether the loans will be available when most needed, with the uncertainty increasing in the event of any demonstration of national self-reliance in area unacceptable to the stockholders of the lending agencies. Third, neither the civil servants negotiating the loans nor their political bosses have a direct responsibility for loan repayment, with the result that there is bound to be a relatively high degree of laxity in ensuring the best and most productive use of the borrowed funds. Fourth, there is hardly any evidence to indicate that countries with heavy indebtedness really can ever develop to such an extent that they will be free from such indebtedness.

1997 Asian Crisis and Its Impact

The Southeast Asian crises had several common elements: speculative attack on the currencies (with sharp depreciation); the authorities being forced to defend the plummeting currency by depleting large volumes of international reserves; banking crisis compelling the governments to extend massive financial assistance to banks through budgetary support to prevent a collapse.

Another distinguishing feature of the crisis was the effect of contagion; crisis in one country spreading into several others in the region. The contagion impact depended on the degree of financial markets integration as well as the existing state of the economy.

The speculative attacks were on those countries currencies that were competing in the same world markets for goods and capital.

The Asian crisis had only a marginal impact on India, with negligible impact on her foreign exchange markets, the level of reserves and the banking system. It has been observed that the macroeconomic fundamentals prevailing at the time coupled with the flexible exchange rate management and control on short-term capital flows helped India to withstand the currency crisis.

The crises demonstrated that the major objective of sound debt management policy could be to achieve or maintain debt sustainability, while meeting key economic macroeconomic goals.

At the time of currency crisis Indias balance of payments situation had become sustainable due both to a reduction in the current account deficit and to a substantial increase in net capital inflows. The current account deficit had fallen from its peak level of $ 9.8 billion in 1990- 91 to US $3.7 billion in 1997-98; the later was estimated at 1.5% of the GDP.

The 1997 level of current account deficit as per cent of GDP was 7.9% in Thailand, 4.9% in Korea and Malaysia, 3.3% in Indonesia and 4.7% in Philippines. Indias external debt at the end of 1997-98 was $92.9 billion or 23.8 per cent of GDP. The debt-GDP ratio was very high for the affected Southeast Asian countries: Thailand (56.8%), Indonesia (67%), Philippines (54%) and Malaysia (49%).

Table 2: Selected Indicators of Indias External Sector (% growth unless noted)

Item/Year

91-9292-9393-9494-9595-9696-9797-98

1. Growth of Exports -1.13.320.218.420.34.52.6

2. Growth of Imports -24.515.410.034.321.610.15.8

3. Exports/Imports 86.777.684.874.874.070.283.3

4. Reserves to Imports 5.34.98.68.46.06.67.0

5. Short-term debt/Reserves76.764.518.816.923.225.519.8

6. Debt service Ratio 30.227.525.626.224.321.418.3

7. Current account balance* -0.4-1.8-0.4-1.1-1.8-1.0-1.5

8. External Debt*

41.039.835.832.328.225.923.8

9. Debt service payments* 3.33.33.33.63.63.32.8

* As % of GDP Source: Economic Surve

The level of international reserves, which was just $ 5.5 billion in 1991-92, increased to $29.4 billion 1997-98, providing about 7 months of imports cover. Nevertheless, exports continued to finance over 80% of India imports, thus making the trade account near self-sustaining. By the end of March 1998, the combined level of portfolio flows and short-term debt constituted about 75 per cent of the countrys foreign exchange reserves.

Indeed, the entire volatile inflows were said to have been added to reserves that had given sufficient leeway for stabilizing speculations in the foreign exchange markets.The net capital inflows into India increased from $4.7 billion in 1991-92 to $9.5 billion in 1996-97, which came down marginally to $8.2 billion in 1997-98, because of the uncertain domestic and international environment (mainly arising out of sanctions from the US). In the aggregate, there was already a shift towards non-debt creating flows, by way of foreign institutional investors (FII) into Indias debt and equity markets, euro equity issues by Indian companies, which had reached at $5.5 billion in 1997-98.

Debt flows (to cover aid, commercial borrowings, NRI deposits, drawings from IMF) in contrast was actually coming down significantly, reaching about $3.0 billion in 1997-98.

Short-term debt was repeatedly considered as an important risk factor in the precipitation of foreign exchange crisis, especially when coupled with high or unsustainable current account deficits. The share of short-term debt in the total debt was just 6% in India at the time of crisis, which compares with 41% in Thailand, 25% in Indonesia, 28% in Malaysia and 19% in Philippines. By the end of March 1998, the combined level of portfolio flows and short-term debt constituted about 75 per cent of the countrys foreign exchange reserves. Indeed, the entire volatile inflows was said to have been added to reserves that had given sufficient leeway for stabilizing speculations in the foreign exchange markets.

It needs to be recognized that the short term flows also have provided the necessarily liquidity to an otherwise thin currency market in India.

The Asian crisis had therefore important policy lessons, and particularly in the context of external debt management and capital flows. It is by now abundantly clear that the crisis was not just because of the high current account deficit but much to do with the way the current account deficit was financed, the nature of capital flows (such as debt vs non-debt creating flows), and finally the way external capital being used for (such as financing investment as opposed to consumption or non tradable). The relative immunity to the crisis had also much to do with the structure of capital flows.

Although the Indian rupee was fully convertible on the current account, convertibility on the capital account front was rather asymmetric, with somewhat more restrictions on capital outflows than on inflows. With controls on trade, foreign exchange transactions and short-term capital flows, it was therefore possible to insulate the Indian economy from external shocks.

Exchange rate was considered the most important variable affecting the currency crisis. After a devaluation of about 22% in July 1991 India shifted to a system flexible exchange rate management based on partial convertibility in March 1992 and finally to market determined exchange rate system in March 1993. The market driven exchange rate also had obliged the policy makers to have lower inflation, disciplined fiscal and monetary policies, and stable real exchange rate for attaining sustainable balance of payments.

Under the circumstances the Reserve Bank retained the necessary flexibility in managing the currency, by quoting its own reference rate and actively intervening at that rate from time to time. In addition the market driven exchange rate also prevented excessive risk-taking by agents that would have occurred a fixed or a pegged exchange rate regime.In fact, the existence of exchange risks have discouraged some of the more speculative short-term capital flows in to India, thereby reducing the need for policy interventions.

The conduct of exchange rate policy had also stabilizing impact on the currency and capital flows pursued with appropriate mechanisms of intervention and sterilization. Looking from the experience, one noticed some kind of self-balancing mechanisms to have worked in the Indian foreign exchange markets. At a time of exchange market pressure, the policy seemed to have been not to defend the currency fully by spending reserves and, thereby, offering the speculators an easy target. In addition the market driven exchange rate also prevented excessive risk-taking by agents that would have occurred a fixed or a pegged exchange rate regime. In fact, the existence of exchange risks have discouraged some of the more speculative short-term capital flows into India, thereby reducing the need for policy interventions.

Evolving Debt and Capital Flows Scenario Towards 2003

Indias external $ 112.1 billion stood at the end of December 2003, which increased from $ 83.8 billion in March 1991(Table 3). The growth rate during the period was at an annual average rate of 2 per cent per annum. Some of the increase has been due to valuation changes, resulting from the weakening of US dollar vis -a- vis other currencies (for example, $ 5.7 billion out of $6.8 billion increase in external debt during 2002-03 was due to such valuation changes).

In terms of the level of outstanding debt India ranked as eighth in 2002 from among the top fifteen debtor countries in the world, coming after Brazil, China, Russian Federation, Mexico, Argentina, Indonesia and Turkey. This implied a marked improvement in her debtor position since 1991 foreign exchange crisis, when her rank was third from among the top fifteen debtor countries, i.e. coming after the two most heavily indebted countries such as Brazil and Mexico.

Table 3: India's External DebtEnd-March 1991(US $ mn.)Share in total External DebtEnd-March 1996(US $ mn.)Share in total External DebtEnd-March 2001(US $ mn.)Share in total External DebtEnd-Dec 2003(US $ mn.)Share in total External Debt

Multilateral2090025286163131898323055827

Bilateral1416817192132015323161794216

IMF26233237430000

Export Credit43015537665368547734

Commercial Borrowing1020912138731523227242058218

NRI Deposits*1020912110111217154172986727

Rupee Debt1284715823393042326352

Short-term Debt854410503452745357735

Total External debt838011009373010098757100112130100

Share of Concessional Debt to Total Debt44.842.336.036.4

Source: Indias External Debt: A Status Report, Government of India, 2003.

An important aspect of Indias external debt has been its concessionality. As of December 2003 about 36. 4 per cent of the overall debt portfolio was characterized by concessional debt, contracted mainly from multilateral and bilateral institutions. Due to the concessional nature of indebtedness the present value concept becomes the appropriate measure, obtained by discounting the future debt service payments for individual loans by appropriate discount rates and aggregating such present values.The present values Indias external debt stood at $ 82.9 billion in the year 2002 which is 80 per cent of the total outstanding debt. According to Global development Finance, the present value of external debt in the year 2002 was 17 per cent of GNP, lowest within the top fifteen debtor countries except China (with 14 per cent in 2002).

The effectiveness of debt management policy should be judged in terms of the debt serving capacity, which can be gauged by indicators measuring solvency as well as liquidity. In Table 4 we analyze the most commonly used indicators debt sustainability: debt service ratio, interest service ratio, debt to gross domestic product ratio, short-term debt to total debt and short term debt to foreign exchange reserves. As seen from Table there is remarkable improvement in all the ratios during 1990-2003. The stock of external debt to GDP ratio declined from its peak of 38.7 per cent in 1991-91 to 20 percent in 2002-03. The debt service ratio which reached a record level of over 35 per cent in 1990-91, declined steadily to 14.7 per cent in 2002-03.

The most notable outcome of external debt management during 1990s has been the control over short-term debt. The level of short-term debt amounted to only US $5.0 billion by December 2003. The share of short term debt to total debt declined significantly from over 10 per cent in 1990-91 to 4.4 per cent in 2002-03, which actually was the lowest for India from among the top 15 debtor countries.

The volume of short-term debt, which was 146 per cent of foreign exchange reserves in 1990-91, declined to just 6 per cent in 2002-03. By taking into account the residual/remaining maturity within the component of short-term debt, it still remains modest at $ 12. 7 billion or 11.7 per cent of total external debt by end-December 2003(Table 5).

Special Purpose External Commercial Borrowing

The Indian Government had obtained external borrowing using special provisions three times since 1991: India Development Bonds (IDBs), 1991; Resurgent India Bonds (RIBs), 1998; and, India Millennium Deposits (IMDs), 2000. These borrowings were used only to meet the unfavorable external circumstances, and served as alternative to sovereign borrowings. The maturity of these issuances were about five years, mostly subscribed by non-resident Indians, with redemption only at maturity and offering reasonable spread over comparable government bond yields. These instruments were considered as substitutes for foreign currency deposits, which extended the duration of the countrys debt profile.

Table 11: Special Borrowings by India since 1991

Type of BorrowingsAmount(US $ Million)Interest Rate (%)5-Year Government Bond YieldSpread

(Col 3-4)

India Millennium Deposits, 20005,520

Mobilization in US Dollar5,1828.505.572.93

Mobilization in Pound Sterling2587.854.633.22

Mobilization in Euro806.85

Resurgent India Bonds, 19984,230

Mobilization in US Dollar3,9877.755.262.49

Mobilization in Pound Sterling1808.005.452.55

Mobilization in Euro636.25

India Development Bonds, 19911,627

Mobilization in US Dollar1,3079.507.861.64

Mobilization in Pound Sterling32013.259.923.33

Source: Indias External Debt: A Status Report, Government of India, October 2001.

Foreign Currency Deposits

Many countries allow foreign currency deposits from expatriates as a source for balance of payments financing. Such schemes were introduced in India in 1970 allowing non-Resident Indians/Overseas Corporate Bodies to place deposits denominated in foreign currency as well as local currency with the Indian banks, with interest rate fixed and exchange rate guaranteed by the Reserve Bank of India. The two oil shocks of 1970s brought substantial amount of US dollar deposits from the gulf countries. By the end of March 1990, the total NRI deposits were to the extent of $ 12 billion. However these short-term deposits have proved to be very volatile, responding to macroeconomic instability as well as political risks. The external payments difficulties of 1990-91 demonstrated the vulnerability associated with these deposits.

Considering the huge fiscal costs of exchange guarantee and higher interest rates offered on such deposits as compared to international rates, the policy later years withdrew the exchange rate guarantee and reduced considerably the interest rate spread. A scheme called Non-resident Non-repatriable Rupee Deposit (NRNRRD) was also introduced in order to avoid the reversibility character of the deposits, but was later withdrawn in April 2002.

12: Outstanding Balances NRI Deposit Schemes (US $ million)

End-MarchNR(E)RAFCNR(A)*FCNR(B)NR(NR)RD**FC(O)NTotal

19754040

19808561881,044

19852,3047703,074

19903,7778,63812,415

19954,5567,0513,0632,4861017,166

19963,9164,2555,7203,5421317,446

19974,9832,3067,4965,604420,393

19985,63718,4676,262220,369

19996,0457,8356,61820,498

20006,7588,1726,75421,684

20017,1479,0766,84923,072

20028,4499,6737,05225,174

200314,92310,1993,40728,529

*:Withdrawn effective August 1994.

**:Withdrawn effective April 2002.

Source: Reserve Bank of India.

Let us view the financial highlights of the fiscal 2005-06 in form of charts and tables in the next chapter. Indias External Debt as at the end of March 2006

CURRENT SCENARIO

Indias total external debt is placed at US $ 125.2 billion at the end of March 2006. At this level, the external debt stock increased by about US $ 2 billion over the end-March 2005 level (Chart 1).

The valuation effect, on account of appreciation of the US dollar against other major international currencies, has had a moderating impact on the stock of external debt.

Among the various components of debt, NRI deposit, trade credit and multilateral debt have risen during the year (Table 2).

External commercial borrowings (ECBs), bilateral and rupee debt declined during the year. External commercial borrowings recorded net outflows due to one-off effect of principal repayment of India Millennium Deposits (IMDs) (US $ 5.5 billion) (Table 2) (Chart 2). Table 2: Variation in External Debt by Components

Item At the end-of Variation during 2005-06 March 06 March 05 Amount Amount Absolute variation Percentage variation (US $ million) (US $ million) (US $ million) (Per cent) (1)

(2)

(3)

(4)

(5)

1. Multilateral 32,558(26.0)

31,702(25.7)

856

2.7

2. Bilateral 15,784(12.6)

16,930(13.7)

-1,146

-6.8

3. IMF 0(0.0)

0(0.0)

0

0.0

4. Trade Credit

a. Above 1 year 5,326(4.3)

4,980(4.1)

346

6.9

b. Upto 1 year* 8,788(7.0)

7,524(6.1)

1,264

16.8

5. Commercial Borrowings 25,560(20.4)

27,024(21.9)

-1,464

-5.4

6. NRI Deposits (long-term) 35,134(28.1)

32,743(26.6)

2,391

7.3

7. Rupee Debt 2,031(1.6)

2,301(1.9)

-270

-11.7

8.Total Debt 1,25,181(100.0)

1,23,204(100.0)

1,977

1.6

Memo Items A. Long-Term Debt 1,16,393(93.0)

1,15,680(93.9)

713

0.6

B. Short-Term Debt 8,788(7.0)

7,524(6.1)

1,264

16.8

The US dollar was the most important currency in the currency composition of Indias external debt at end-March 2006, accounting for 45.1 per cent of total external debt stock (Chart 3).

Indicators of Debt Sustainability

There has been a perceptible improvement in external debt indicators over the years reflecting the growing sustainability of external debt of India.

External debt to GDP has dropped to 15.8 per cent at end-March 2006 from 17.3 per cent at end-March 2005 and 30.8 per cent at end-March 1995.

The debt service ratio has risen to 10.2 per cent during 2005-06 from 6.1 per cent during 2004-05 largely due to IMD repayments. It may be indicated that debt service ratio was 17.1 per cent in 1999-2000.

Reflecting the rise in short term debt during 2005-06, the ratio of short-term to total debt and short term debt to reserves rose to 7.0 per cent and 5.8 per cent, respectively (Table 3).Table 3: Indicators of Debt Sustainability (in per cent)Indicators

End-March 06

End-March 05

(1)

(2)

(3)

Total debt /GDP

15.8

17.3

Short-term/Total debt

7.0

6.1

Short-term debt/Reserves

5.8

5.3

Concessional debt/Total debt

31.5

33.3

Reserves/ Total debt

121.1

114.9

Debt Service Ratio*

10.2

6.1

* relates to fiscal year 2005-06 and 2004-05

The share of concessional debt in total external debt declined to 31.5 per cent at end-March 2006 from 33.3 per cent at end-March 2005 (Table 3). It may be recalled that this ratio was around 45.9 per cent at end-March 1991. This development indicates a gradual increase in non-concessional private debt in India's external debt stock. At this level, however, concessional debt continues to be a significant proportion of the total external debt, especially by international comparison.

Indias foreign exchange reserves exceeded the external debt by US $ 26.4 billion providing a cover of 121.1 per cent to the external debt stock at the end of March 2006 (Chart 4).

CONCLUSIONManagement of external debt is closely related to themanagement of domestic debt, which in turn depends on the management of overall fiscal deficit. Debtmanagement strategy isanintegralpartofthe wider macroeconomicpolicies that act as the first line of defense against any external financial shocks. For an emerging economy, it is better to adopt a policy of cautious and gradual movement towards capital accountconvertibility. At the initial stage, it may be prudent to encourage non-debt creating financialflows (Foreign Direct Investment and Equity Portfolio) followed by liberalizationof long-term and medium-term external debt. Big bullet loans are bad for small economies, as these can create refinancing riskthat many countries would be well advisedto avoid. It is not enough to manage the government balance sheet well; it is also necessary to monitor and make an integrated assessment of national balance sheet and to put more attentionon surveillance ofoveralldebt- internaland external, private andpublic.Ineachofthemajor Asiancrisis economies-Indonesia,Koreaand Thailand- weakness in the government balance sheet was not the source ofvulnerability, rather vulnerability stemmed from the un-hedged sort-term foreign currency debt of banks, finance companies and corporate sector. It is not sufficient to manage the balance sheet exposures, it is equally important manage off balance sheet and contingent liabilities. Emerging as well as advancedeconomieshaveexperiencedhowbadbankscanleadtolargecoststotheeconomyandanunexpectedweakeningofthegovernmentsbalancesheet.Government guarantees of private debt canalso have similar adverse impact. It is necessary to adopt suitable policies for enhancing exports and other current account receipts that provide the meansfor financing imports and debt services

EMBED Excel.Chart.8 \s

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_1250856308.xlsChart2

28.7

38.7

37.5

33.8

30.8

27

24.5

24.3

23.6

22.1

22.6

21.1

20.2

Percent

External Debt - GDP Ratio*

Chart1

0.051

0.273

0.16

0.043

0.184

0.266

0.023

Composition of External Debt as at End Dec 2003 (Share in %)

Sheet1

Composition of External Debt as at End Dec 2003 (Share in Percent)

Short term Debt5.1%

Multilateral27.3%

Bilateral16.0%

Export Credit4.3%

Commercial Debt18.4%

NRI Deposit26.6%

Rupee Debt2.3%

Sheet2

External Debt - GDP Ratio

Mar-9128.7

Mar-9238.7

Mar-9337.5

Mar-9433.8

Mar-9530.8

Mar-9627

Mar-9724.5

Mar-9824.3

Mar-9923.6

Mar-0022.1

Mar-0122.6

Mar-0221.1

Mar-0320.2

Chart3

83.82.2

85.35.6

906.4

92.715.1

9920.8

93.717

93.522.4

93.526

96.929.5

98.335.1

101.139.6

98.851

105.367

104.971.9

112.197.6

Total External Debt

Foreign Currency Assets

US $ Billion

Total External Debt and Foreign Currency Assets

Sheet3

Total External Debt and Foreign Currency Assets (US $ Billion)

Total External DebtForeign Currency Assets

End Mar-9183.82.2

End Mar-9285.35.6

End Mar-93906.4

End Mar-9492.715.1

End Mar-959920.8

End Mar 9693.717

End Mar 9793.522.4

End Mar 9893.526

End Mar 9996.929.5

End Mar 0098.335.1

End Mar 01101.139.6

End Mar 0298.851

End Dec 02105.367

End Mar 03104.971.9

End Dec 03112.197.6

Chart4

4.4

7

9

9.4

10.3

11.1

11.2

11.2

11.5

12.8

16.2

17.2

17.6

20.1

28.5

Countries

Percent

International Comparison-Proportion of Short Term Debt to Total External Debt, 2002

Sheet4

International Comparison - Proportion of Short term Debt to Total External Debt

India4.4

Mexico7.0

Chile9.0

Phillipines9.4

Brazil10.3

Russian Fed11.1

Columbia11.2

Argentina11.2

Turkey11.5

Poland12.8

Hungary16.2

Malaysia17.2

Indonesia17.6

Thailand20.1

China28.5

Chart5

141.4

72.8

51.8

54.6

53.6

35

34.4

33.8

30.6

29.8

24.5

24.2

19.5

16.1

6.4

Countries

Percent

International Comparison-Proportion of Short Term External Debt to Total Foreign Exchange Reserves, 2002

Sheet5

International Comparison-Proportion of Short Term External Debt to Total Foreign Exchange Reserves, 2002

Argentina141.4

Indonesia72.8

Brazil51.8

Hungary54.6

Turkey53.6

Columbia35

Philipines34.4

Russian Fed33.8

Thailand30.6

Poland29.8

Chile24.5

Malaysia24.2

Mexico19.5

China16.1

India6.4

Chart6

0.3

0.4

0.7

0.9

0.9

1.4

2.7

3.5

6.6

9.5

16.6

17.8

21.1

24

38.4

Percent

Countries

International Comparison-Proportion of Concessional Debt to Total External Debt 2002

Sheet6

International Comparison-Proportion of Concessional Debt to Total External Debt 2002

Hungary0.3

Russian Fed.0.4

Chile0.7

Argentina0.9

Mexico0.9

Brazil1.4

Columbia2.7

Turkey3.5

Malaysia6.6

Poland9.5

Thailand16.6

China17.8

Philipines21.1

Indonesia24

India38.4

Chart7

0.416

0.156

0.214

0.113

0.064

0.031

0.006

Currency Composition of External Debt as at End-December 2003

Sheet7

Currency Composition of External Debt as at End-December 2003

U S Dollar41.6%

SDR15.6%

Indian Rupee21.4%

Japanese Yen11.3%

Euro6.4%

Pound Sterling3.1%

Others0.6%

Chart8

7.3

8.2

11.3

14.9

18.3

20.2

22.5

23.1

23.2

25

32.8

33.9

40.2

40.8

68.9

Countries

Percentage

International Comparison of Debt Service Ratio, 2002

Sheet8

International Comparison of Debt Service Ratio, 2002

Malaysia7.3

China8.2

Russian Fed.11.3

India14.9

Argentina18.3

Philipines20.2

Poland22.5

Thailand23.1

Mexico23.2

Indonesia25

Chile32.8

Hungary33.9

Columbia40.2

Turkey40.8

Brazil68.9

Chart9

10.57

10.73

8.17

7.27

7.17

6.98

6.32

7.02

6.46

6.53

6.85

US $ Billion

Government Guaranteed External Debt

Sheet9

Government Guaranteed External Debt

End Mar 9410.57

End Mar 9510.73

End Mar 978.17

End Mar 987.27

End Mar 997.17

End Mar 006.98

End Mar 016.32

End Mar 027.02

End Mar 036.46

Dec 31, 026.53

Dec 31, 036.85

_1250858299.xlsChart1

100100

9288.5

85.581.8

82.176.9

77.672.1

74.568.3

64.5555.08

60.5347.2

57.8643.3

61.8242.88

60.7839.78

59.4537.72

63.4539.05

63.4436.34

63.2935.46

66.5335.52

68.4335.75

72.8237.05

REER

NEER

Figure 4 : NEER & REER of the rupee

Sheet1

1986100100

19879288.5

198885.581.8

198982.176.9

199077.672.1

199174.568.3

199264.5555.08

199360.5347.2

199457.8643.3

199561.8242.88

199660.7839.78

199759.4537.72

199863.4539.05

199963.4436.34

200063.2935.46

200166.5335.52

200268.4335.75

200372.8237.05