Public Finance and Policy (NIPFP), New Delhi. He can be reached at [email protected].]
released the draft
framework for External Commercial Borrowing (ECB) for public comments on or
before October 11, 2015. For the benefit of those who may be interested in
providing comments, this post situates this development in the appropriate
Finance constituted a committee under the chairmanship of Mr. M. S. Sahoo to
review the framework relating to ECBs. The Sahoo Committee submitted a detailed
report in February 2015. The Committee argued that the purpose of any
financial regulation is to address market failure. With regards to ECB, the
only potential market failure arises from currency exposure.
(X) borrows $1 million from a US lender (Y) at an exchange rate of $1 = Rs. 60,
X effectively has to repay Y a principal amount of Rs. 6 crores + interest; but
if the exchange rate immediately depreciates to $1 = Rs. 70, then X effectively
has to repay Y a principal amount of Rs. 7 crores + interest. Therefore, the
exchange rate exposure will cost X Rs. 1 crore extra (without interest
differential) unless X had hedged (insured) against the risk. X can hedge
currency exposure by using INR-USD currency derivatives.
hedge its currency risk? Not really, because of two
reasons. First, if X believes that the Indian Government and RBI will
manage the exchange rate (and prevent depreciation), it will not waste money
trying to hedge the risk. Research
shows that Indian companies carried higher currency exposure when the
currency was less flexible. This moral hazard problem can be solved only if
there is no explicit or implicit state guarantee of exchange rate management.
The second reason why X may not hedge is because currency derivatives market is
not well developed in India and is consequently illiquid. Illiquid markets
raise the cost of hedging through currency derivatives, which may keep X away.
Therefore, there are good reasons for X to not hedge its currency exposure.
exposure and consequently ends up losing Rs 1 crore, is this in itself a market
failure? No. Everyone has a fundamental right to do business and take business
decisions. Good decisions result in gains. Bad decisions may lead to
bankruptcy. This is the normal rhythm of market economy. Inefficient companies
wind up releasing labour and capital, which find better use in more efficient
companies. Failure of individual companies does not cause the market to fail.
The state has nothing to worry about (assuming it has provided for adequate
companies have unhedged foreign currency exposure, there is a possibility of a simultaneous
correlated credit distress of numerous companies (especially in the same or
co-related sectors) due to a large exchange rate fluctuation. Many of them may
not be able to absorb the distress and may go bankrupt. Even if they don’t go
bankrupt, distressed companies may have reduced ability to finance investment
leading to macroeconomic issues. This can have a domino effect of negative
externalities. For example, if vast number of companies in a sector goes
bankrupt, domestic banks with exposure to that sector will now suddenly end up
with a large volume of non-performing assets in their books, transferring the
exchange rate shock from the real economy to the Indian financial sector. These
may give rise to systemic risk concerns, which justify regulation of ECBs in
the first place. Accordingly, the Sahoo Committee concluded that any regulation
on ECB should be to address this one and only one potential market failure –
company taking ECB may be required to mandatorily hedge against the currency
risk. However, currency risk may differ across companies depending on their
export volumes and natural hedges. In other words, an IT company, which is in
the outsourcing business and has dollar income, has a ‘natural hedge’. In
contrast, a domestic real estate development company, which has only rupee
cashflow, is fully exposed to exchange rate fluctuations. This variation across
firms across sectors makes hedging a difficult tool to implement in practice.
company will borrow from a foreign lender if the interest rates are lesser than
that provided by domestic lenders. A tax can neutralise this interest rate
differential and therefore kill the very incentive that motivates an Indian
firm to borrow in foreign exchange. The Financial Transaction Tax (IoF) in
Brazil is an example. However, this measure does not address the basic problem
of unhedged currency exposure. It is more of a preventive measure than a
to auction the interest rate differential that motivates ECB. To illustrate, if
the interest rate differential between foreign and domestic lending rates is
200 basis points (2%), the company that pays the most to raise ECB sacrifices
the maximum volume out of this 200 basis points. In other words, the one who
takes the least arbitrage benefit wins the bid. This acts like the tax in
checking the volume of ECB flow but does not address the unhedged currency
is the curative measure, the Sahoo Committee preferred mandatory hedging over
tax or auction of ECBs, in spite of the difficulties in implementing it. The
idea was that the entire ECB framework could be liberalised provided the
currency risk is mandatorily hedged by the domestic borrower.
implementation of mandatory hedging naturally led to disagreements among policy
makers regarding the feasibility of such norms. In spite of this, the Sahoo
Committee report permanently shifted the ECB policy discourse on at least three
present ECB policy is full of micro-distortions, carve-outs for various sectors
etc. which made the entire framework unnecessarily complicated and many a times
lacking any intelligible policy rationale. Consequently, on August 7, 2015, the
Ministry asked RBI to come up with a new simple and transparent ECB policy.
The present draft ECB policy released by RBI is a consequence of this chain of
debate by focusing on currency risk as the potential reason for market failure
due to ECBs. This nudged the policy-makers to re-think the policy behind INR
denominated borrowings, where the currency risk is completely borne by the lender
thereby alleviating the systemic risk concern. The RBI in its First
Bi-Monthly Policy Statement (paragraph 31) announced on April 7, 2015
proposed to allow Indian corporates eligible to raise ECB to issue rupee
denominated bonds in overseas market. Accordingly, RBI proposed a Draft
Framework on Issuance of Rupee linked Bonds Overseas on June 9, 2015.
the reporting framework for disclosing information on hedging. The format ECB-2
Return (the form for monthly reporting by companies taking ECB) has been
modified. A new part has been added which requires firms to disclose details of
financial hedging contracted if any. The reporting firms are also required to
provide details of average annual foreign exchange earnings and expenditure for
the last three financial years.
regulators in India is slowly becoming more open and consultative in nature.
The nudge has been provided by the FSLRC Handbook,
which was adopted by all the financial regulators pursuant to a resolution of
the Financial Stability and Development Council (FSDC) dated October 24, 2013.
Now, public comments are not only required to be invited but must also be ‘considered’
by the Board of the regulator before finalising regulations. The ball is now in
the court of the legal community to be more active in providing substantive
comments and play a meaningful role at the stage of policy formulation itself.