Vijay Kumar Gaba

 The issue of high and rising US public debt is a subject matter of public discussion in Indian streets. Using a common Dalal Street phrase I can say that every paanwalla, taxi driver, and barber is now discussing how unsustainable US public debt is. For example, listen to this boy .

From top economists, analysts, and global strategists to a common man on the street, all are worried about an imminent US default and its impact on the global financial system, especially the developing and underdeveloped countries.

Currently, the US public debt is close to US$35trn (Appx 125% of annual GDP) and is projected to double in the next eight years. The current US government's annual interest payments are more than US$1trn (Appx 20% of annual federal revenue; 14% of annual federal spending and 4% of GDP). The average interest rate on the entire debt is less than 3% p.a.

As of June 2023, 43% of this debt was owned by the Federal Reserve System and State and Local Governments. 32% of the debt was owned by various domestic institutions (MF, Insurance, Pension, and Depositories, etc.) The balance 26% was owned by other institutions including foreign governments. Almost the entire debt is denominated in USD.

This debt level is a matter of concern but does not prima facie appear to be at a disaster level. The worrisome part is that about one-third of US public debt is short-term (12 months or less maturity). However, considering that a large part of this debt could be owned by the government institution and the Federal Reserve System, refinancing of this debt should not pose a significant problem. In my view, US debt could be sustained with 3-4% inflation, 20% USD devaluation, 5% revenue growth (higher taxes), and rationalization/reimbursement of various war funding expenses, this debt could be sustained, reduced, and serviced. It is of course going to be hard for US savers and middle classes for a decade or so. USD losing its reserve currency status may be collateral damage.

For context, as per the interim budget for FY25, India’s central government debt was ~Rs172trn as of 31^st March 2024. This is approximately 58% of GDP. 3% of this debt is held by foreign entities. However, using the standard IMF definition India’s Debt to GDP ratio is ~82%. Since most of this debt is INR-denominated and RBI is holding a strong US$650bn forex chest, servicing is not an issue.

However, as per FY24BE, interest expense would account for 25% of total government expenditure, after material cuts in subsidies. For a developing economy, this interest expense to government revenue expenditure is considered worrisome, as it hampers investments, keeps fiscal deficit high, makes interest rate cuts difficult, leads to lower social expenditure affecting the quality of life, and hampers further market borrowing capability of the government.

The small point is that investors in Indian securities should be more concerned about seemingly unsustainable public debt in India rather than the high debt levels of developed countries.

As a small investor with zero risk appetite, I keep a cushion for lower subsidies, late payments of government dues, higher effective taxes, small probability of higher rates in my investment strategy.

 One of the elementary principles of economics is that the price of anything is determined by the equilibrium of demand and supply. Though sometimes, in the short term, a state of inequilibrium may exist leading to higher volatility in prices; the equilibrium is usually restored by operation of a variety of factors. This principle usually applies to all things having an economic value, including currencies, gold and money (capital). The traits of human behavior like "greed", "fear", "complacence", "renunciation", and "aspirations" are usually accounted for as the balancing factors for demand and supply and not considered as determinants of price as such.

However, the case of currencies and capital is slightly complex given currency’s dual role as a medium of exchange and a store of value; and use of money as a policy tool to achieve the objectives of price stability, financial inclusion, poverty alleviation, social justice etc.

As a medium of exchange, price of currency is mostly a function of demand and supply of that currency at any given point in time. Higher supply should normally lead to lower exchange value and vice versa. The demand of the currency as medium of exchange is determined by the factors like relative real rate of return (interest), terms of trade (Trade Balance etc.), and inflation, etc. in the parent jurisdiction.

As a store of value, the price of a currency is, however, materially influenced by the faith of the receiver in the authority issuing such currency. For example, to the transacting parties, promise (since the currency is nothing but a promissory note) of the US Federal Reserve may hold much more value than the promise of, say, the Reserve Bank of Australia; regardless of the fact that the Australia runs a current account surplus, has lower interest rate, a similar inflation profile and a much stronger central bank balance sheet (as compared to the US Federal Reserve) and public debt profile. (1.50AUD=1USD)

Similarly, price of money (Interest rates) is usually a function of demand and supply of the money in the financial system. Demand for money is usually impacted by the factors like level of economic activity and outlook in the foreseeable future; whereas supply of money is mostly a function of risk perception; relative returns and policy objectives.

In Indian context, exchange value of INR, 10yr benchmark yield and crude oil prices evoke much interest. Interestingly most economic growth forecasts appear predicated on these, whereas logically it should be the other way round. Politically also, the USD-INR exchange rate is a popular rhetoric of the politicians on all sides of the Indian political spectrum. Recently, the rise in the international acceptability of INR has become a popular plank of the incumbent government; though there is little evidence of this happening as yet. The politicians refuse to acknowledge that INR depreciation is a normal economic phenomenon, and there is nothing at present that can reverse it.

To further emphasize my point, I may reiterate the following narration from one of my earlier posts.

“In the summer of 2007, I had just moved to the financial capital Mumbai from the political capital Delhi. The mood was as buoyant as it could be. Everyday plane loads of foreign investors and NRIs would alight at Mumbai airport with a bagful of Dollars. They would spend two hours in sweltering heat to reach the then CBD Nariman point (Worli Sea link was not there and BKC was still underdeveloped), and virtually stand in queue to get a deal where they can burn those greenbacks.

Mumbai properties were selling like hot cakes. NRIs from the Middle East, Europe and US were buying properties without even bothering to have a look at them. Bank were hiring jokers for USD 100 to 500k salary for doing nothing. I was of course one of these jokers!

That was the time, when sub-prime crisis has just started to grab headlines. Indian economic cycle started turning down in spring of 2007, with inflation raising its head. RBI had already started tightening. Bubble was already blown and waiting for the pin that would burst it.

INR had appreciated more than 10% vs. USD in the first six months of 2007. However, since January 2008 (INR39=1USD) INR has depreciated over 112% till now (INR82.6=1USD). In the meantime, the Fed has printed USD at an unprecedented rate; and there has been no shortage of supplies of EUR, GBP and JPY either.

The point I am making is that in the present times when the balance sheets of most globally relevant central bankers are running out of space to accommodate additional zeros and their governments are still running fiscal deficits are with impunity to service the mountains of their debts and profligate policies, the value of currency is definitely not a function of demand and supply alone. Regardless of economic theory, it is the faith of people in a particular currency that is the primary determinant of its relative exchange value.

2005-2007 was the time when the Indians had developed good faith in their currency, due to high economic growth. Local people were happy retaining their wealth in INR assets, despite liberal remittance regulations and NRIs were eager to convert a part of their USD holding in INR assets. The situation changed in 2010 onwards. There is no sign of reversal yet. Despite the huge popularity of the incumbent prime minister amongst overseas Indians, we have not seen any material change in remittance patterns in the past six years. Despite tighter regulations, local people appear keen to diversify their INR assets. Most of the USD inflows have come from "professional investors" who invest others' money to earn their salaries and bonuses. These flows are bound to chase the flavor of the day, not necessarily the best investment. Whereas the outflows are mostly personal, or by corporates with material promoters' stakes. Even FDI flows have reportedly slowed down in the past one year.

In my view, no amount of FII/FDI money can strengthen INR if Indians do not have faith in their own currency. Yield and inflation have become secondary considerations.

Recently, the Reserve Bank of India released the “Report of Inter Departmental Group on Internationalisation of INR”. The IDG recommended a pathway to be followed for inclusion of INR in IMF’s SDR basket in the “long run”. Tomorrow, I shall discuss the recommendations of IDG tomorrow, in light of my assumptions.

All three major global credit rating agencies have assigned the lowest possible investment grade rating to India’s sovereign credit, placing India just one notch above the junk grade. For example, Moody’s Investors Services has assigned Baa3 (stable) rating to India’s sovereign credit, just one notch above the junk rating - C.

The Government of India is making a strong pitch to the rating agencies for upgrade of sovereign credit, arguing that India’s economy is the fastest growing major economy in the world, with strong macroeconomic fundamentals. Many government officials, politicians and market participants have challenged the assessment of these ratings agencies often terming it as unfair.

On the other hand, Moody’s Investors Services has recently flagged high public debt and risks of fiscal slippages ahead of general elections in 2024 to support their rating stance.

Moody’s reportedly said, “As the government balances the commitment to longer-term fiscal sustainability against its more immediate priority of supporting the economy amid high inflation and weak global demand, and ahead of general elections due by May, we expect some risks of fiscal slippage arising from possibly weaker-than expected government revenues”.

Moody’s argued that “India had a relatively high level of general government debt—estimated at around 81.8% of GDP for 2022-23, compared with the Baa-rated median of around 56%—and low debt affordability. India’s debt affordability, in terms of general government interest payments as a percentage of revenues, is estimated at 26% for fiscal 2022-23, compared with the Baa median of around 8.4%.

In social interactions, it is common to hear that many advanced economies with GDP growth of 1-3%, are running public debt much in excess of 100% of GDP. Most notably, Japan’s sovereign credit is rated AAA despite having public debt in excess of 220% of GDP. USA with its economy on the verge of a recession and public debt over 115% of GDP has AAA rating for its sovereign credit.

Recently, a report by the brokerage Morgan Stanley’s India unit, titled “How India has Transformed in Less than a Decade”, was also viral on social media. Thousands of enthusiastic market participants and political campaigners forwarded this 37-page report containing some selective charts & statistics and random hypothetical projections, without actually bothering to read it; leave alone verifying the data with alternative sources, correlating it with related socio-economic parameters or making any comparative analysis with peer groups.

My point is simple, at present the market participants, especially non institutional investors, are extremely positive about the markets. As I had mentioned a couple of weeks ago also, “sentiment of greed is dominating the sentiment of fear” (see here). In their fear of missing out (FOMO), small investors and traders are latching on anything that would support their positioning. Obviously, all bad news is getting ignored while good news is getting amplified.

If you feel that I am being unduly cautious and taking a risk to miss out on the structural bull market in India; you might be wrong. What I am suggesting here is to stay calm and not get carried away by the gravity defying moves in the market. I am religiously abiding by my asset allocation and return targets, disregarding the noise in the market. I shall review my asset allocation at the scheduled date, i.e., end of 1HCY2023 and decide if any changes are required. More on this tomorrow…