RBI’s Proposal for a Major Recast of ECB Norms

[The
following guest post is contributed by Vinod Kothari of Vinod Kothari
 & Co. It deals with the details of the proposals announced by
the RBI.
In
an earlier
post
, Pratik Datta sets out the background to RBI’s proposals]
The
Reserve Bank of India (RBI) has proposed a
major recast of the norms for external commercial borrowings (ECBs). While
India is still far from capital account convertibility, the RBI has proposed
two new options for borrowings, which, in terms of end-use restrictions, will
almost be at par with foreign direct investment (FDI). These two are: long-term
foreign borrowings, and rupee-denominated foreign borrowings.
These
proposed reforms seem to be a part of a larger exercise to ease the existing
regime for ECBs. Recently,
the RBI allowed rupee-denominated trade credit.[1] It
has also proposed permitting rupee-denominated
offshore bonds
, for which draft guidelines were circulated earlier, and
now, in view of the already liberalised approach towards long-term ECBs, it
seems that the end-use restrictions in case of rupee-denominated overseas bonds
may be linked with their tenure.
Reforms
to the ECB framework were suggested by a Committee headed by Mr M S Sahoo,
which, in an elaborate and highly readable report, made
several far reaching recommendations.
Long-term ECBs
The
key stance of the proposed new ECB framework, set out in the press release of
23 September 2015, is the creation of a new class of ECBs, long-term ECBs
(LTECBs). An LTECB is one that has a minimum maturity of 10 years. The maturity
will be 10 years average maturity in case of loans, and 10 years tenure in case
of bonds, assuming, perhaps, that the bonds are bullet-repaying bonds. In case
of LTECBs, the new framework will only lay a minimalistic negative list, and
therefore, practically, the end-use restrictions will be bare minimum.
For
the sake of context, it is notable that the primary differentiator between ECBs
and FDI is the end-use restrictions. ECB is a debt; it has a repayment
obligation – hence the RBI allows ECBs to be used with strict end-use
restrictions. FDI, on the other hand, is contribution to capital, and hence,
does not involve any repayment obligation on the investee. Therefore, there are
no end-use restrictions in case of FDI. The most common end-use restriction on
ECBs is that ECBs are allowed to be used only for capital expenditure. A very
limited window exists in case of ECBs provided by a foreign direct equity
holder, subject to limits and conditionalities, where the ECB may be used for
working capital as well. ECBs may also be used, subject to limits, for repaying
rupee loans taken for working capital.
The
negative list in case of LTECBs is proposed with the following items:
i. Real estate activities
other than development of integrated township / affordable housing projects;

ii.
Investing in capital market and using the proceeds for equity investment
domestically;

iii.
Activities prohibited as per FDI guidelines;

iv.
On-lending to other entities with any of the above objectives;

v.
Purchase of land
Notably,
this negative list is almost similar to that in case of FDI.
Interestingly,
the restriction on on-lending to other entities seems to be applicable only if
the downstream borrower entity is engaged in one of the restricted activities
mentioned above. In this respect too, the restriction is similar to that in
case of FDI, where downstream investment by FDI recipient companies is
applicable if the end-recipient is engaged is one of the activities in which
FDI is either prohibited, or is subject to sectoral caps.
Rupee-denominated ECBs
The
other instrument that RBI proposes to allow, once again with minimum end-use
restrictions, is rupee-denominated ECBs. While in this case, the end-use
restrictions are similar to those for LTECBs, the added feature is that real
estate investment trusts (REITs) and infrastructure investment trusts (InvITs)
are also allowed to avail of such ECBs. It is notable that SEBI regulations permit
REITs and InvITs to leverage up to 49 per cent of their asset value.[2]
Rupee-denominated
ECBs leave the Indian borrower free from any foreign exchange risk. Therefore,
the cost of these borrowings is intended to be completely left to the
discretion of the borrower – they will be commensurate with domestic borrowing
costs. However, the lender here takes the risk of INR. Therefore, the lender
will be “allowed”[3]
to hedge INR exposure by on-shore hedging. It is common knowledge that a
foreign investor or entity having exposure in INR may either hedge himself in
India, using deliverable forward contracts, or may hedge outside India, using the
so-called no deliverable forward market, or may leave the exposure unhedged.
Some further
liberalisations in the existing ECB framework
In
addition to the above proposals, there are several liberalisations in the
existing ECB framework, that is, 3 years minimum average maturity.
First
of all, the end-use list is proposed to be expanded to include the following:
1.
To repay trade credit taken for period up to 3 years for capital expenditure;
2.
For payment towards capital goods already shipped / imported but not paid;
3.
Purchase of second hand domestic capital goods / plant / machinery;
4.
On-lending to infra-Special Purpose Vehicles;
5.
Overseas direct investment in Joint Venture/ Wholly Owned Subsidiaries by Core
Investment Companies coming under the regulatory framework of RBI;
6.
For on-lending to infrastructure sector and for import and/or domestic purchase
of equipment for the purpose of giving the same on hire purchase, as loans
against hypothecation or leasing to infrastructure sector by all NBFCs (subject
to minimum 75% hedging). Note that the existing policy allowed only for
infrastructure leasing.
The
list of eligible lenders is also proposed to be expanded to include the
following:
1.
Overseas regulated financial entities: this generalised term will mean any
entity which is regulated by the regulator of the jurisdiction. Thus, offshore
funds, if regulated, will also be eligible. Offshore leasing entities will be
eligible to provide financial leases, and so on.
2.
Pension funds;
3.
Insurance funds;
4.
Sovereign wealth funds and similar long term investors.
Conclusion
The
proposed changes in the ECB framework are welcome. Hopefully, these will help
the cost of domestic borrowings to come down, by establishing a benchmark yield
curve of rupee borrowings overseas. IFC’s Masala
Bonds
and other similar offshore rupee-denominated issuances have created
quite an interest in the market, and practitioners are now eagerly awaiting the
final regulatory framework for rupee denominated bonds as well. It is important
for the Central Board of Direct Taxes to also come up with necessary changes in
the rules for withholding taxes – otherwise, the current disparity between
withholding tax applicable to a foreign portfolio investor registered in India,
and a foreign investor investing without an FPI registration, will continue to
remain.

Vinod Kothari



[1]
Trade credit includes short-term borrowings, that is, for a weighted maturity up
to 3 years, for financing imports.
[2]
For detailed discussions on REITs and SEBI regulations, see here: http://vinodkothari.com/reits
[3]
From the use of the expression, it seems this will not be a mandatory
condition.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

1 comment

  • Reaction (impromptu)
    The purport or import ‘essence of the concluding suggestion on ‘withholding tax’ is not quite clearly understood. Subject to a close study, the suggestion could have validity, provided, for tax-ability in India, investment by a 'foreign' person in either of the two types of Bonds makes no material difference or is of legal significance. May be, the implications of DTAA as well call for a study and consideration.
    Over to the writer for correction, in case the foregoing points are prima facie without any substance or merit.

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