Friday, September 25, 2015

RBI’s Proposal for a Major Recast of ECB Norms

[The following guest post is contributed by Vinod Kothari of Vinod Kothari & Co. It deals with the details of the proposals announced by the RBI.

In an earlier post, Pratik Datta sets out the background to RBI’s proposals]

The Reserve Bank of India (RBI) has proposed a major recast of the norms for external commercial borrowings (ECBs). While India is still far from capital account convertibility, the RBI has proposed two new options for borrowings, which, in terms of end-use restrictions, will almost be at par with foreign direct investment (FDI). These two are: long-term foreign borrowings, and rupee-denominated foreign borrowings.

These proposed reforms seem to be a part of a larger exercise to ease the existing regime for ECBs. Recently, the RBI allowed rupee-denominated trade credit.[1] It has also proposed permitting rupee-denominated offshore bonds, for which draft guidelines were circulated earlier, and now, in view of the already liberalised approach towards long-term ECBs, it seems that the end-use restrictions in case of rupee-denominated overseas bonds may be linked with their tenure.

Reforms to the ECB framework were suggested by a Committee headed by Mr M S Sahoo, which, in an elaborate and highly readable report, made several far reaching recommendations.

Long-term ECBs

The key stance of the proposed new ECB framework, set out in the press release of 23 September 2015, is the creation of a new class of ECBs, long-term ECBs (LTECBs). An LTECB is one that has a minimum maturity of 10 years. The maturity will be 10 years average maturity in case of loans, and 10 years tenure in case of bonds, assuming, perhaps, that the bonds are bullet-repaying bonds. In case of LTECBs, the new framework will only lay a minimalistic negative list, and therefore, practically, the end-use restrictions will be bare minimum.

For the sake of context, it is notable that the primary differentiator between ECBs and FDI is the end-use restrictions. ECB is a debt; it has a repayment obligation – hence the RBI allows ECBs to be used with strict end-use restrictions. FDI, on the other hand, is contribution to capital, and hence, does not involve any repayment obligation on the investee. Therefore, there are no end-use restrictions in case of FDI. The most common end-use restriction on ECBs is that ECBs are allowed to be used only for capital expenditure. A very limited window exists in case of ECBs provided by a foreign direct equity holder, subject to limits and conditionalities, where the ECB may be used for working capital as well. ECBs may also be used, subject to limits, for repaying rupee loans taken for working capital.

The negative list in case of LTECBs is proposed with the following items:

i. Real estate activities other than development of integrated township / affordable housing projects;

ii. Investing in capital market and using the proceeds for equity investment domestically;

iii. Activities prohibited as per FDI guidelines;

iv. On-lending to other entities with any of the above objectives;

v. Purchase of land

Notably, this negative list is almost similar to that in case of FDI.

Interestingly, the restriction on on-lending to other entities seems to be applicable only if the downstream borrower entity is engaged in one of the restricted activities mentioned above. In this respect too, the restriction is similar to that in case of FDI, where downstream investment by FDI recipient companies is applicable if the end-recipient is engaged is one of the activities in which FDI is either prohibited, or is subject to sectoral caps.

Rupee-denominated ECBs

The other instrument that RBI proposes to allow, once again with minimum end-use restrictions, is rupee-denominated ECBs. While in this case, the end-use restrictions are similar to those for LTECBs, the added feature is that real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) are also allowed to avail of such ECBs. It is notable that SEBI regulations permit REITs and InvITs to leverage up to 49 per cent of their asset value.[2]

Rupee-denominated ECBs leave the Indian borrower free from any foreign exchange risk. Therefore, the cost of these borrowings is intended to be completely left to the discretion of the borrower – they will be commensurate with domestic borrowing costs. However, the lender here takes the risk of INR. Therefore, the lender will be “allowed”[3] to hedge INR exposure by on-shore hedging. It is common knowledge that a foreign investor or entity having exposure in INR may either hedge himself in India, using deliverable forward contracts, or may hedge outside India, using the so-called no deliverable forward market, or may leave the exposure unhedged.

Some further liberalisations in the existing ECB framework

In addition to the above proposals, there are several liberalisations in the existing ECB framework, that is, 3 years minimum average maturity.

First of all, the end-use list is proposed to be expanded to include the following:

1. To repay trade credit taken for period up to 3 years for capital expenditure;

2. For payment towards capital goods already shipped / imported but not paid;

3. Purchase of second hand domestic capital goods / plant / machinery;

4. On-lending to infra-Special Purpose Vehicles;

5. Overseas direct investment in Joint Venture/ Wholly Owned Subsidiaries by Core Investment Companies coming under the regulatory framework of RBI;

6. For on-lending to infrastructure sector and for import and/or domestic purchase of equipment for the purpose of giving the same on hire purchase, as loans against hypothecation or leasing to infrastructure sector by all NBFCs (subject to minimum 75% hedging). Note that the existing policy allowed only for infrastructure leasing.

The list of eligible lenders is also proposed to be expanded to include the following:

1. Overseas regulated financial entities: this generalised term will mean any entity which is regulated by the regulator of the jurisdiction. Thus, offshore funds, if regulated, will also be eligible. Offshore leasing entities will be eligible to provide financial leases, and so on.

2. Pension funds;

3. Insurance funds;

4. Sovereign wealth funds and similar long term investors.


The proposed changes in the ECB framework are welcome. Hopefully, these will help the cost of domestic borrowings to come down, by establishing a benchmark yield curve of rupee borrowings overseas. IFC’s Masala Bonds and other similar offshore rupee-denominated issuances have created quite an interest in the market, and practitioners are now eagerly awaiting the final regulatory framework for rupee denominated bonds as well. It is important for the Central Board of Direct Taxes to also come up with necessary changes in the rules for withholding taxes – otherwise, the current disparity between withholding tax applicable to a foreign portfolio investor registered in India, and a foreign investor investing without an FPI registration, will continue to remain.

- Vinod Kothari

[1] Trade credit includes short-term borrowings, that is, for a weighted maturity up to 3 years, for financing imports.
[2] For detailed discussions on REITs and SEBI regulations, see here:
[3] From the use of the expression, it seems this will not be a mandatory condition.

1 comment:

vswami said...

Reaction (impromptu)
The purport or import ‘essence of the concluding suggestion on ‘withholding tax’ is not quite clearly understood. Subject to a close study, the suggestion could have validity, provided, for tax-ability in India, investment by a 'foreign' person in either of the two types of Bonds makes no material difference or is of legal significance. May be, the implications of DTAA as well call for a study and consideration.
Over to the writer for correction, in case the foregoing points are prima facie without any substance or merit.