External Commercial Borrowings can be a blessing, but concerns remain: Economic Times 4th April 2012

With a big question mark hanging over the future of interest rates, expectations surrounding the timing and the extent of interest rate cuts are being scaled down - especially with inflation remaining an enigma.A thought which comes to mind is whether or not ECBs ( external commercial borrowings) make sense, since the government will be borrowing an additional Rs 60,000 cr this year from the market which will impact liquidity.

The ECB route appears to be the way out. In FY12, the total approvals through the automatic and approval routes were $30 billion. But, is this the best solution? Today, the global markets are flushed with liquidity, thanks to quantitative easing by the US Federal Reserve and the ECB.

The financial systems have money to deploy and given that there is little growth taking place, there will be an urge to look at the emerging markets where prospects are brighter. Therefore, supply of funds should not be a concern for entities raising funds overseas.

The rupee volatility, however, has raised concerns over the cost-effectiveness of these funds relative to domestic borrowings. To begin with, not all companies are in a position to borrow from the euro markets.

Second, even if they can, the major constraint will be the country-rating, where India ranks just at the periphery which means all cannot get the finest rates. The RBI's ECB guidelines, however, fix the rate at which borrowings can take place to up to 500 basis points (bps) above 6 months of LIBOR. At the present rates, this would be around 75 bps plus 500 bps, amounting to 5.75%.

Next, the forex risk is sharp. While the rupee has held strong during the earlier years, since August 2011, there has been a tendency for the rupee to depreciate driven by two sets of factors: widening current account deficit and weak capital account coupled with a strengthening rupee vis-a-vis the euro as the Greek crisis once again unfolded.

Will this situation change?

Quite unlikely, as the trade deficit will widen due to the relative slowdown in exports and increase in imports due to rising oil prices (oil constitutes between 30-35% of total imports). The current account deficit will be under pressure in the 3.5% range of GDP as invisible receipts, especially remittances and software may not be able to compensate for the same in a global environment which ranges from a recession in the euro region to a recovery, albeit, not a smart one in the USA. Capital flows can be whimsical as FIIs have shown, which in turn could mean an eventual depreciation of the rupee.

The present forward rates for one year on the dollar range are between 6.5-7%. If this is added to the cost of borrowing, the effective covered cost of borrowing would be in the range of 12-13%. Companies may choose not to hedge, but then that would be taking a chance, especially when the time horizon could be anywhere between one and five years.
Currently, the base rate of banks is between 10-10.75%. Therefore, the decision to choose the mode of finance depends on the stature of the company. Those that can obtain finance at the base rate may actually be comfortable here while those beyond the periphery may still be better off with ECBs after taking in the hedging cost by buying forward dollars simultaneously.

However, for those which can get funds at less than 500 bps above LIBOR, (there will probably be a handful of them), ECBs will still work better than domestic borrowing. Or, for that matter, companies which need to import can save on forex conversion charges through this route.

An issue for the country, however, is that while ECBs can be a blessing for some companies, it raises the issue of sustainability of external debt at the macro-level. External debt of the country was $326 billion in September 2011 and exceeded the ballpark number for our forex reserves by over $30 billion.

With ECBs becoming attractive, they now account for 30% of the total debt; they could rise as long as our interest rate differential with those in the euro market is wide. The back-up in terms of reserves would increase primarily from hot money FII flows in the future, which may not be the perfect match. This, coupled with the forex risk, in the absence of hedging would be the two concerns going ahead.