[This guest post is by Pratik Datta, who is a Consultant at the National Institute of Public Finance and Policy (NIPFP), New Delhi. He can be reached at firstname.lastname@example.org.]
Yesterday the Reserve Bank of India (RBI) released the draft framework for External Commercial Borrowing (ECB) for public comments on or before October 11, 2015. For the benefit of those who may be interested in providing comments, this post situates this development in the appropriate policy backdrop.
On January 1, 2014, the Ministry of Finance constituted a committee under the chairmanship of Mr. M. S. Sahoo to review the framework relating to ECBs. The Sahoo Committee submitted a detailed report in February 2015. The Committee argued that the purpose of any financial regulation is to address market failure. With regards to ECB, the only potential market failure arises from currency exposure.
To illustrate, if an Indian company (X) borrows $1 million from a US lender (Y) at an exchange rate of $1 = Rs. 60, X effectively has to repay Y a principal amount of Rs. 6 crores + interest; but if the exchange rate immediately depreciates to $1 = Rs. 70, then X effectively has to repay Y a principal amount of Rs. 7 crores + interest. Therefore, the exchange rate exposure will cost X Rs. 1 crore extra (without interest differential) unless X had hedged (insured) against the risk. X can hedge currency exposure by using INR-USD currency derivatives.
So is it not obvious that X will hedge its currency risk? Not really, because of two reasons. First, if X believes that the Indian Government and RBI will manage the exchange rate (and prevent depreciation), it will not waste money trying to hedge the risk. Research shows that Indian companies carried higher currency exposure when the currency was less flexible. This moral hazard problem can be solved only if there is no explicit or implicit state guarantee of exchange rate management. The second reason why X may not hedge is because currency derivatives market is not well developed in India and is consequently illiquid. Illiquid markets raise the cost of hedging through currency derivatives, which may keep X away. Therefore, there are good reasons for X to not hedge its currency exposure.
So if X had an unhedged currency exposure and consequently ends up losing Rs 1 crore, is this in itself a market failure? No. Everyone has a fundamental right to do business and take business decisions. Good decisions result in gains. Bad decisions may lead to bankruptcy. This is the normal rhythm of market economy. Inefficient companies wind up releasing labour and capital, which find better use in more efficient companies. Failure of individual companies does not cause the market to fail. The state has nothing to worry about (assuming it has provided for adequate bankruptcy framework).
However, if a large number of Indian companies have unhedged foreign currency exposure, there is a possibility of a simultaneous correlated credit distress of numerous companies (especially in the same or co-related sectors) due to a large exchange rate fluctuation. Many of them may not be able to absorb the distress and may go bankrupt. Even if they don't go bankrupt, distressed companies may have reduced ability to finance investment leading to macroeconomic issues. This can have a domino effect of negative externalities. For example, if vast number of companies in a sector goes bankrupt, domestic banks with exposure to that sector will now suddenly end up with a large volume of non-performing assets in their books, transferring the exchange rate shock from the real economy to the Indian financial sector. These may give rise to systemic risk concerns, which justify regulation of ECBs in the first place. Accordingly, the Sahoo Committee concluded that any regulation on ECB should be to address this one and only one potential market failure – systemic risk.
Tools to address this market failure
The Committee noted that there are three ways to address this market failure:
a. Hedging: The Indian company taking ECB may be required to mandatorily hedge against the currency risk. However, currency risk may differ across companies depending on their export volumes and natural hedges. In other words, an IT company, which is in the outsourcing business and has dollar income, has a ‘natural hedge’. In contrast, a domestic real estate development company, which has only rupee cashflow, is fully exposed to exchange rate fluctuations. This variation across firms across sectors makes hedging a difficult tool to implement in practice.
b. Tax: An Indian company will borrow from a foreign lender if the interest rates are lesser than that provided by domestic lenders. A tax can neutralise this interest rate differential and therefore kill the very incentive that motivates an Indian firm to borrow in foreign exchange. The Financial Transaction Tax (IoF) in Brazil is an example. However, this measure does not address the basic problem of unhedged currency exposure. It is more of a preventive measure than a curative one.
c. Auction: The idea is to auction the interest rate differential that motivates ECB. To illustrate, if the interest rate differential between foreign and domestic lending rates is 200 basis points (2%), the company that pays the most to raise ECB sacrifices the maximum volume out of this 200 basis points. In other words, the one who takes the least arbitrage benefit wins the bid. This acts like the tax in checking the volume of ECB flow but does not address the unhedged currency exposure risk.
Since, out of the three, only hedging is the curative measure, the Sahoo Committee preferred mandatory hedging over tax or auction of ECBs, in spite of the difficulties in implementing it. The idea was that the entire ECB framework could be liberalised provided the currency risk is mandatorily hedged by the domestic borrower.
The practical issues with implementation of mandatory hedging naturally led to disagreements among policy makers regarding the feasibility of such norms. In spite of this, the Sahoo Committee report permanently shifted the ECB policy discourse on at least three fronts:
1. Simplification: The report showed in detail how the present ECB policy is full of micro-distortions, carve-outs for various sectors etc. which made the entire framework unnecessarily complicated and many a times lacking any intelligible policy rationale. Consequently, on August 7, 2015, the Finance Ministry asked RBI to come up with a new simple and transparent ECB policy. The present draft ECB policy released by RBI is a consequence of this chain of events.
2. INR denominated borrowing: The report shaped the ECB policy debate by focusing on currency risk as the potential reason for market failure due to ECBs. This nudged the policy-makers to re-think the policy behind INR denominated borrowings, where the currency risk is completely borne by the lender thereby alleviating the systemic risk concern. The RBI in its First Bi-Monthly Policy Statement (paragraph 31) announced on April 7, 2015 proposed to allow Indian corporates eligible to raise ECB to issue rupee denominated bonds in overseas market. Accordingly, RBI proposed a Draft Framework on Issuance of Rupee linked Bonds Overseas on June 9, 2015.
3. Reporting of hedging: The RBI has taken steps to improve the reporting framework for disclosing information on hedging. The format ECB-2 Return (the form for monthly reporting by companies taking ECB) has been modified. A new part has been added which requires firms to disclose details of financial hedging contracted if any. The reporting firms are also required to provide details of average annual foreign exchange earnings and expenditure for the last three financial years.
Regulation making by financial regulators in India is slowly becoming more open and consultative in nature. The nudge has been provided by the FSLRC Handbook, which was adopted by all the financial regulators pursuant to a resolution of the Financial Stability and Development Council (FSDC) dated October 24, 2013. Now, public comments are not only required to be invited but must also be ‘considered’ by the Board of the regulator before finalising regulations. The ball is now in the court of the legal community to be more active in providing substantive comments and play a meaningful role at the stage of policy formulation itself.
- Pratik Datta