Doing everything wrong on foreign borrowing
Business Standard, 4 April 2016
When firms borrow in foreign currency, they experience losses after a large rupee depreciation. This exposure is offset by hedges such as exports. For exporting firms, unhedged foreign borrowing is a remarkable low cost method for financing. In the Indian landscape, foreign currency borrowing (FCB) is taking place in the wrong places. This points to problems in the underlying policy environment.
When a firm is obliged to repay $100 at a future date, and the USDINR exchange rate goes from 65 to 75, the rupee value of payments that have to be made go up from Rs.6500 to Rs.7500. This risk is well understood. In a paper which is forthcoming in India Policy Forum, Nirvikar Singh, Ila Patnaik and I look deeper at the policy puzzles of this field.
Envisioning a rational world
Who should do foreign borrowing? Two kinds of firms fit naturally. The first is an exporter. While repayment of debt is harder after a rupee depreciation, revenues go up, which offsets the loss. For every exporting firm, it's possible to work out the magnitude of foreign borrowing that is safe, given the projected export revenues of the next few years. For such firms, foreign borrowing can be a remarkable low cost source of debt financing.
The second category of firms where foreign borrowing makes sense are those who make tradeables. `Tradeables' are things which can are freely transported across the border, e.g. steel. There is no barrier to arbitrage between the Indian market for steel and the world market for steel. As a consequence, the London Metals Exchange (LME) price of steel is multipled by the exchange rate to get the Indian price of steel.
Suppose there is an Indian company who makes steel and sells to an Indian customer. This may not appear to be exports. Yet, the exposure to the exchange rate is exactly the same as that of a company which exports steel. When a rupee depreciation takes place, revenues go up, in exactly the same way as is the case with an exporter. For such firms also, it's possible to work out the magnitude of foreign borrowing that is safe, given the projected tradeables revenues of the next few years. For such firms also, foreign borrowing can be a remarkable low cost source of debt financing.
Let's look at a generic manufacturing company. Most manufactures are freely tradeable across the border. The typical manufacturing company purchases raw materials of Rs.60 and sells output of Rs.100. Assuming all raw materials and all output is tradeable, there is a net exposure of an exporter of Rs.40. Even if the typical manufacturing company in India directly exports nothing, it has the currency exposure of an exporter to the tune of 40% of its sales.
In a rational world, foreign currency borrowing (FCB) in India should be done by exporters and makers of tradeables. They should borrow in foreign currency, and leave it largely unhedged. Makers of non-tradables should buy currency derivatives when they borrow in foreign currency, which is expensive and reduces the attraction of foreign borrowing.
That's not the world that we live in
In India today, we do not have this rational distribution of FCB. The share of FCB in total borrowing is 13% for medium leverage tradeables companies and it is 12% for medium leverage non-tradeables companies. There is particularly high FCB in non-tradeable sectors such as communications, construction, electricity, etc.
Why is this happening?
What is going wrong? Why are exporters and tradeables firms not strongly loading up on FCB? Why are non-tradeables firms using FCB so much? There are three groups of policy problems at work.
The first issue is the exchange rate regime. When the authorities are sensitive to exchange rate fluctuations, and promise the private sector that large rupee fluctuations will not be permitted, this encourages firms to take on currency risk. They know that if there is pressure on the rupee, the government will protect them by preventing a large currency depreciation.
While India has moved to de jure inflation targeting, there is a gap between words and deeds. Targeting inflation requires not targeting the exchange rate. However, the monetary policy framework is as muddled as it was before inflation targeting. The firms see that RBI does not walk its talk, and are exploiting it.
The second problem lies in the capital controls framework. If the exchange rate were determined by the market, there would be no need for capital controls on FCB, as firms would think twice before carrying currency exposure. Until the institutional structures for inflation targeting fall into place, there is value in having a capital controls framework, which pushes FCB towards naturally hedged firms and towards currency derivatives hedging. While we have a capital controls framework in which everything is controlled, it is intellectually confused, as is documented in the M. S. Sahoo Committee report.
Failures of financial markets policy has given a malfunctioning bond-currency-derivatives nexus. In this environment, currency hedging in the transaction sizes required by firms is very expensive. This has created an additional bias for firms to leave currency exposure unhedged.
Conclusion
These three groups of policy failures (monetary policy framework, ECB regulations and bond-currency-derivatives nexus) have given us a messy world where FCB is not low cost financing for tradeables firms, and there is a lot of FCB in the wrong places. The gains for India from low cost borrowing for makers of tradeables are not being obtained. In a future scenario of currency depreciation, the unhedged FCB firms will push politically for currency management. As an example, in the rupee defence of 2013, the 91 day rate went up by 400 basis points.
How can we obtain progress? We need to build out the intellectual and institutional machinery through which deeds match words for inflation targeting. We need a sound regulation-making process at RBI, which would yield improvements in the rationality of regulations such as those governing FCB. Markets regulation must coalesce at SEBI, which has the requisite skills.
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