[Saher Fatima and Siddharth Tandon are III year students at the National Law University, Jodhpur]
Over the years, external commercial borrowings (“ECB”) have become a preferred source of finance for Indian entities. ECBs refer to commercial loans in the form of bank loans, securitized instruments, buyers’ credit or suppliers’ credit availed of from non-resident lenders with a minimum average maturity period of three years. There exist three tracks through which loans can be raised by the way of ECBs: Track 1 are medium-term foreign currency denominated ECBs with minimum average maturity of three to five years; Track II are long-term foreign currency denominated ECBs with minimum average maturity of 10 years; and Track III are rupee-denominated ECBs with minimum average maturity of three to five years.
In order to address the currency risk, the Reserve Bank of India (“RBI”) in 2016 made it mandatory for the Indian borrowers to “hedge” ECBs completely. Hedging can be understood as an investment mechanism in order to lessen the adverse price movements in a loan, debt or an asset. Recently, the RBI eased the mandatory hedge coverage with the intention of boosting the declining number of companies opting for ECBs. The RBI reduced the mandatory hedge coverage from 100% to 70%. In this post, the authors discuss the importance of ECBs for Indian firms in the present scenario, largely focusing on the reasoning behind such a change, and the impact it will have on the Indian economy in the near future.
Importance of ECBs
ECBs are governed by sub-section 3(d) of Section 6 of the Foreign Exchange Management Act, 1999 along with various regulations issued by the RBI over the years. ECBs have been the largest component of total external debt in India for past many years now. Presently, ECBs have a 37.8% share of the total external debt, followed by NRI deposits at 24.2% and short-term trade credit at 18.8%. ECBs rose to almost two-fifths of the total external debt by gaining more than 11 percentage points over the last 8 years. This portrays the importance of ECBs, not only for the private companies (which comprise almost four-fifths the total debt), but for the governmental entities as well.
There are various benefits for a firm that chooses ECBs as a source of borrowings. Lower rate of interest in foreign countries is one of the most significant factors, along with diversified investor base and exposure to global opportunities. In order to lower its current account debt, the RBI has to ensure that the Indian entities gain from these benefits. As a result, it becomes the duty of the RBI to make sure that Indian companies are properly incentivised they will opt for ECBs rather than any other form of borrowing.
Reasons behind the Change
After facing a decline of about 2.8% over the previous quarter, India’s total external debt stood at $514.4 billion at the end of June 2018. The external debt may be denominated in any currency, be it rupee or any other foreign currency. In reality, the American dollar constitutes the largest component of India’s external debt with a share of 50.1%, followed by the Indian rupee at 35.4%.Thus, it is easily understandable that any kind of fluctuations or change in regulations affecting these two currencies will have a direct impact on companies transacting in ECBs or deciding whether to go for ECBs or not.
In recent times, we have witnessed a substantial change of factors and subsequent fluctuations in both these currencies. These changes have resulted in an unfavourable situation for the Indian borrowers, be it with respect to the dollar or the rupee. The change in dollar is because of the recent revisions of the rate cycle undertaken by the US Federal Reserve. On September 26 this year, the Federal Reserve increased its benchmark rate to a range between 2% and 2.25%. The interest rate which was 1.50% at the beginning of the year has come to this figure after the three rate revisions that the Federal Reserve has carried out. Jerome H. Powell, Chairman of Federal Reserve, has specifically mentioned that one more increase in the interest rate can be expected before the end of 2018. Any form of change in interest rates directly impacts the cost of federal borrowings and cost of hedging. Because of these subsequent changes, companies in India have begun to find it difficult to borrow by the way of ECBs as, along with interest rates, the cost of hedging has gone up.
The depreciation in the rupee has also resulted in problems for Indian borrowers. Rupee has become the worst performing Asian currency in 2018, losing more than 10% of its value, in comparison with the previous year. The Indian rupee which is 72.50 per dollar, as of this month, stood at 64.4 a year back. This slow but constant decline in the value of rupee has shown its impact by forcing the Indian companies to review their hedging strategies.
Due to higher inflation, lower exchange rate volatility, and a higher credit to GDP ratio external commercial borrowing is a dominant phenomenon in emerging market economies like India.[i] Moreover, due to the hedging requirements, firms tend to choose foreign currency debt when they have foreign income or foreign assets working as a natural hedge. Similarly, lenders have incentives to lend in foreign currency to firms that better tolerate exchange rate volatility. However, sometimes RBI intervention is necessary to secure the domestic market from exchange rate volatility. This in turn depicts the rationale behind the mandatory 100% hedging provision for external commercial borrowings.
As already mentioned, the RBI has recently reduced the mandatory hedging provision from fully-hedged to 70%. This will result in reducing the borrowing cost. Earlier, the difference in interest rates of a foreign currency loan and a domestic currency loan made the former cheaper as well as attractive. But, due to the mandatory hedging provision, the costs of borrowings increased, resulting in the creation of extra burden for the borrowing entities. Prima facie, it is quite clear that, as the costs have decreased, the situation has become more advantageous for the Indian firms. But this moves comes with certain drawbacks.
One of the major disadvantages is that it will expose Indian firms to a much bigger risk, i.e. the exchange rate risk. The lesser the borrowings being hedged, the more the chances of facing a higher debt burden, in case of depreciation of the local currency. Due to this currency mismatch there is a higher chance of default with additional negative consequences for firms. The negative impact on the investments of the firm was evidenced in a study carried out in Mexico in the 2005, which stated that “firms which have heavy short term foreign debt exposure had substantially lower investments after a large devaluation”.[ii]
Further, due to the increase in chances of default, the change in provision may result in making the lenders wary of providing loans to the Indian firms. This change might also lead to a disadvantageous situation for the consumers. This means that the firms, which are now unhedged for the remaining 30%, may face higher debt costs as a consequence of depreciation in the rupee. As a result, the firms may try to shift these additional costs onto the consumers, which may not always be possible in Indian market because of the high level of competitiveness. This will in turn force the firms to go for other forms of borrowings, which makes this situation a bit adverse for the borrowing firms as well.
The recent steps taken by the RBI, such as reducing the average maturity requirement for ECBs in infrastructure space from 5 years to 3 years, reducing the average maturity requirement for exemption from hedging from 10 years to 5 years, along with the thoroughly discussed change of reducing the mandatory hedge coverage, are all steps in the right direction. Though the changes of decreasing the maturity requirement can be termed as having no or very trivial disadvantages, the change of reducing hedge coverage does suffer with some serious drawbacks which may result in creation of problems in the future, as discussed in depth.
These recent steps make it crystal clear that RBI knows that ECBs are of utmost significance for future development of Indian economy. But with the plummeting rupee and an expected change in the rate by the US Federal Reserve in the near future, a change in hedging provision cannot be termed as the best solution.
The unexpected resignation of Dr. Urjit Patel from the post of Governor of RBI has added to the already existing problems, with the rupee facing even more pressure. At a time like this, Indian entities are expected to become even more careful before entering into any kind of foreign transactions. Thus, in the absence of proper steps taken by the RBI, the situation relating to ECBs may worsen.
Saher Fatima & Siddharth Tandon
[i] Sebastian Galiani, Eduardo Levy Yeyati and Ernesto Schargrodsky, “Financial dollarization and debt deflation under a currency board,” Emerging Markets Review, 2003, 4 (4), 340–367.
[ii] Mark Aguiar, “Investment, devaluation, and foreign currency exposure: The case of Mexico,” Journal of Development Economics, 2005, 78 (1), 95–113.