Foreign debt crisis

Why in news?

The government liberalised some aspects of the ECB norms to the manufacturing firms recently.

What are the measures?

• External Commercial Borrowers who are in manufacturing sector can raise ECBs up to $50 million or its equivalent.
• It will come with a minimum average maturity period of one year, compared to three years as previously required.
• The relaxed norms for ECBs may attract short-term capital flows in the country.

What is the status of foreign debt in India post-financial crisis?

• The increase in ECBs can be traced back to some of the policies adopted by the developed countries to counter the financial crisis of 2006-08.
• To come out of the recession, developed countries adopted accommodative and unconventional monetary policy tools.
• These policies increased liquidity in the system and pushed interest rates down to historically low levels in developed countries and international capital markets.
• While these policies may have been effective in their domestic markets, the global fallout has been quite significant.
• International investors began to encouraged the “carry trade”, wherein they borrow money at a low interest rate in developed countries in order to invest in an asset in developing ones that is likely to provide a higher return.
• This allowed firms from developing countries, including India, to borrow cheaply from international capital markets.
• High growth rate and the comparative stability of the Indian economy made Indian firms relatively more attractive to international lenders.
• Changes in domestic regulations also allowed Indian companies to access credit more easily from international markets.

What does it result in?

• Indian firms have borrowed a huge amount of money (over Rs 18 lakh crore, as per RBI data) from the international markets since 2007.
• These ECBs are now facing a double whammy from increased interest rates and a sharply depreciating rupee.
• A domestic firm borrowing from abroad usually pays a rate of interest which is a mark-up over some international benchmark rate like the LIBOR (London Interbank Offered Rate).
• This mark-up or the spread is generally decided taking various risk factors associated with the borrower, which may also include the country risk.
• A hike in US Fed benchmark rates results in higher international benchmark rates and so adds to the interest rate burden of the borrowing firms.
• On top of this, any depreciation of the rupee also increases the debt burden of these borrowing firms in terms of domestic currency.
• If this makes repayment more difficult, it will in turn add to the spread faced by the Indian borrower when turning over loans.

Why the problem still persists?

• The impact of depreciation will be less of a problem if the firm has earnings in foreign currency.
• A firm is said to be ‘naturally hedged’ if foreign currency earnings of the firm can pay off its repayment cost of external borrowings.
• Apart from the ‘natural hedge’, firms can also have a ‘financial hedge’ through derivative contracts with financial institutions.
• Since 2016, the RBI has pushed Indian firms to hedge their foreign currency exposures, but it is not clear whether this has been successful.
• A look at the balance sheets of the firms which have obtained ECBs shows that a large number of these firms have negative net foreign exchange earnings.
• These firms are unlikely to have any ‘natural hedge’ against foreign exchange risks.
• And as the rupee becomes more volatile, cost of financial hedging will ramp up significantly.

What are the other related concerns?

• From an investors' perspective when domestic interest rates rise, the risk-free returns go up as the government bond yields rise.
• Also, corporate bonds offer better returns when the government yields increase.
• In such an environment, investors will naturally opt for higher fixed rate of returns rather than an uncertain and potentially lower rate of return from equities.
• Hence, investors might be more willing to park funds into fixed income securities like bonds, fixed deposits etc., rather than equities.
• Added with that, rise in oil prices, faltering health of public sector banks, increasing inflation among others may lead to the equity market finding new lows in the near future.

What lies ahead?

• Any unhedged foreign currency exposure faces significant risk due to the dual shock coming from exchange rate depreciation and the rise in global interest rates.
• All signals from the recent US Fed meet suggest that the cycle of interest rate hikes will continue well into the 2019.
• So, the Indian currency will be under pressure in the foreseeable future.

Source: Business Line