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From THE HINDU group of publications
Sunday, July 08, 2001













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Implicit sovereign guarantees

Suresh Krishnamurthy

IN THE case of sovereign ratings, the domestic debt of a country is rated higher than the debt denominated in foreign currency.

This is mainly because of the assumption that any country can print fresh money to honour its domestic currency debt obligations. The same logic has been behind the investment decisions of many retail investors in India.

One would suppose that it is logical for investors to seek out government securities and government guaranteed debt programmes. However, retail investors in India have gone a step further. They also sought out fund mobilisation programmes of government companies.

The logic behind this phenomenon was the assumption that sovereign guarantee was implicit in the case of these schemes. Thus, we fund huge inflows into the schemes of the UTI such as US-64 and monthly income plans, fixed deposit programmes of companies such as Steel Authority of India, fund mobilisation programmes of the three development financial institutions.

In fact, in most of these cases, investors have been willing to accept lower rates for the perception of safety. Take SAIL, for example. At end-March 2001, its fixed deposit base of around Rs 2,000 crore was more than 40 per cent of its networth. The company continues to incur huge losses and still the coupon rates are significantly lower than what a company in such a perilous situation would pay.

The logic behind their investment decision was vindicated in 1998 when the US-64 crisis broke out. The government infused cash of Rs 3,300 crore then to help UTI manage the crisis. Now, however, with the break out of another such crisis in US-64, such an assumption appears to rest on shaky grounds. Will the Government come out with a bailout package this time around too?

The Government's response this time is likely to be watched closely. Any bailout package will reinforce the view that investors in beleaguered government companies such as SAIL and IFCI are safe, and they need not withdraw their funds immediately. At a time when there are very few quality investment options, it would also motivate investors to invest in government companies irrespective of their financial health.

On the other hand, investor response would be different if the government restricts providing liquidity to small investors in US-64. If that were the case, we can expect investors to exhibit more informed behaviour with respect to investing in government companies going forward.

Overall, this crisis still needs to be viewed as a warning bell for investors to diversify their portfolio. At any point in time, the debt portfolio of an investor cannot contain only investment in government securities, small-savings schemes, bonds of financial institutions and schemes of UTI. Diversifying into non-government schemes such as private sector fixed deposit programmes and private sector mutual funds is essential.


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