The draft framework on ECBs is encouraging as it seeks to provide greater access to companies while minimising risks for the system. The significant changes are in the areas of widening the categories of lenders that could be on board, longterm borrowing and overall cost.
ECBs prima facie are attractive as long as international interest rates are low and their differential with domestic rates high. Typically one would borrow from the global market at an interest rate that would depend on the rating of the company and country, to which must be added the CDS cost. Libor for six months is around 50 bps and the CDS would vary from 150-250 bps, depending on the timing and the company.
The RBI has lowered the all-in-cost to 300 bps above Libor for ECB between three and five years and 450 bps for above five years. This would exclude several companies that now have to borrow at lower rates. If one were to currently borrow in the domestic market, with a base rate of around 10%, only the best companies could do. It could go up to 14-15% for others depending on the risk perception. The ECB route certainly looks alluring in comparison.
However, a major risk which is often not considered is currency; the rupee has become very volatile. This is a global phenomenon and not linked necessarily with our fundamentals. For companies that have a natural hedge in terms of exports or other dealings that earn foreign currency, this would not be a problem. But for others, this risk can be significant Companies today operate on the premise that the rupee will be stable and that the RBI will not let it depreciate too much. But, what is the right rate of depreciation that we are talking of ?
In a longer time frame, which is say, a decade, one can say the rupee will depreciate by 3-4% per annum (see table). But then the interim period can be one of movement in either direction and of differing magnitude, and given that the ECBs have tenure of above three years, the interest payments as well as the principal amounts would be susceptible to risk. This is where companies carry a high degree of risk on their books.
The solution is to hedge the forex risk by taking forward cover. However, today with the annualised forward cover being in the range of 6.5-7%, which is almost the same on the NSE forex derivative segment, the cost when added to the limit set by the RBI would be closer to 12%, with the benefit from borrowing in the global market being eroded considerably.
It is probably this factor that has caused the RBI to recommend lowering of the all-in-cost ceiling. It now appears that the domestic interest rates will be moving in the downward direction. On the other hand, global interest rates will tend to increase starting in the US and spreading to other developed nations in course of time.
In such a case, the cost of ECBs would increase and simultaneously, the spread between domestic and global rates will reduce. This becomes important in our context, because ECBs have been chiefly responsible for the increase in our external debt.
In 2014-15, external debt increased from $446.3 billion to $ 475.8 billion, implying an increase of $ 29.5 billion. ECBs in net terms increased by $ 32.4 billion, which was almost 110% of the increase in overall debt. Further, ECBs account for around 38% of the outstanding external debt. Quite clearly, the RBI’s proposed guidelines would like to reduce the differential between the two markets.
However, it is true that several companies are not hedging their forex risk given the cost involved and are relying heavily on the RBI to ensure that the rupee remains stable.
The assumption is that the rupee will in general not fall more than the forward rate. If interest rates are to move in only the downward direction, then the forward rate will come down proportionately and probably encourage companies to hedge.
An issue that may be thrown up for discussion is whether the RBI can insist that all foreign borrowings should be backed by partial forward cover. A ballpark number can be that if the loan is for five years, onefifth of the sum should be hedged every year, which will lower the blow in case the rupee falls sharply. If it is for 10 years, then one-tenth has to be covered every year and so on. Hence the cost of 7% would be lowered proportionately.
Alternatively, the RBI can, through say State Bank of India, create and maintain a fund, where all borrowers have to deposit a certain proportion of the money borrowed, which could be 1% or 1/2% of their borrowings. This in turn should be made available to the contributing companies, which face stress when the rupee falls drastically and payments have to be made at a concession.
It would be a kind of counter-cyclical buffer created on dollars to maintain stability in the system. While RBI provided this cover to the FCNR (B) deposits raised in 2014 by banks, for private players, a solution has to be from within. The RBI can only be the facilitator.
ECBs prima facie are attractive as long as international interest rates are low and their differential with domestic rates high. Typically one would borrow from the global market at an interest rate that would depend on the rating of the company and country, to which must be added the CDS cost. Libor for six months is around 50 bps and the CDS would vary from 150-250 bps, depending on the timing and the company.
The RBI has lowered the all-in-cost to 300 bps above Libor for ECB between three and five years and 450 bps for above five years. This would exclude several companies that now have to borrow at lower rates. If one were to currently borrow in the domestic market, with a base rate of around 10%, only the best companies could do. It could go up to 14-15% for others depending on the risk perception. The ECB route certainly looks alluring in comparison.
However, a major risk which is often not considered is currency; the rupee has become very volatile. This is a global phenomenon and not linked necessarily with our fundamentals. For companies that have a natural hedge in terms of exports or other dealings that earn foreign currency, this would not be a problem. But for others, this risk can be significant Companies today operate on the premise that the rupee will be stable and that the RBI will not let it depreciate too much. But, what is the right rate of depreciation that we are talking of ?
In a longer time frame, which is say, a decade, one can say the rupee will depreciate by 3-4% per annum (see table). But then the interim period can be one of movement in either direction and of differing magnitude, and given that the ECBs have tenure of above three years, the interest payments as well as the principal amounts would be susceptible to risk. This is where companies carry a high degree of risk on their books.
The solution is to hedge the forex risk by taking forward cover. However, today with the annualised forward cover being in the range of 6.5-7%, which is almost the same on the NSE forex derivative segment, the cost when added to the limit set by the RBI would be closer to 12%, with the benefit from borrowing in the global market being eroded considerably.
It is probably this factor that has caused the RBI to recommend lowering of the all-in-cost ceiling. It now appears that the domestic interest rates will be moving in the downward direction. On the other hand, global interest rates will tend to increase starting in the US and spreading to other developed nations in course of time.
In such a case, the cost of ECBs would increase and simultaneously, the spread between domestic and global rates will reduce. This becomes important in our context, because ECBs have been chiefly responsible for the increase in our external debt.
In 2014-15, external debt increased from $446.3 billion to $ 475.8 billion, implying an increase of $ 29.5 billion. ECBs in net terms increased by $ 32.4 billion, which was almost 110% of the increase in overall debt. Further, ECBs account for around 38% of the outstanding external debt. Quite clearly, the RBI’s proposed guidelines would like to reduce the differential between the two markets.
However, it is true that several companies are not hedging their forex risk given the cost involved and are relying heavily on the RBI to ensure that the rupee remains stable.
The assumption is that the rupee will in general not fall more than the forward rate. If interest rates are to move in only the downward direction, then the forward rate will come down proportionately and probably encourage companies to hedge.
An issue that may be thrown up for discussion is whether the RBI can insist that all foreign borrowings should be backed by partial forward cover. A ballpark number can be that if the loan is for five years, onefifth of the sum should be hedged every year, which will lower the blow in case the rupee falls sharply. If it is for 10 years, then one-tenth has to be covered every year and so on. Hence the cost of 7% would be lowered proportionately.
Alternatively, the RBI can, through say State Bank of India, create and maintain a fund, where all borrowers have to deposit a certain proportion of the money borrowed, which could be 1% or 1/2% of their borrowings. This in turn should be made available to the contributing companies, which face stress when the rupee falls drastically and payments have to be made at a concession.
It would be a kind of counter-cyclical buffer created on dollars to maintain stability in the system. While RBI provided this cover to the FCNR (B) deposits raised in 2014 by banks, for private players, a solution has to be from within. The RBI can only be the facilitator.
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