Saturday, October 11, 2014

India's growing corporate external borrowings risk

In a speech early this week, the RBI Deputy Governor, HR Khan, had this to say about the rising share of unhedged foreign exchange exposure of Indian corporate,
In India, there is emerging anecdotal evidence of reduced propensity to hedge foreign exchange exposures arising out of a sense of complacency. The unhedged exposures in respect of External Commercial Borrowings (ECBs)/ Foreign Currency Convertible Bonds (FCCBs) lead to large scale currency mismatches in view of the bulk amount borrowed by domestic corporates for longer tenors with limited or no natural hedges. Further, the increasing use of bond route for overseas borrowings exposes the domestic borrowers to greater roll-over risk. As per indicative data available with the Bank, the hedge ratio for ECBs/FCCBs declined sharply from about 34 per cent in FY 2013-14 to 24 per cent during April-August, 2014 with very low ratio of about 15 per cent in July-August 2014. Large scale currency mismatches could pose serious threat to the financial stability in case exchange rate encounters sudden depreciation pressure.
Hedging or not, the fundamental reality has been the sharp increase in ECBs in recent years. ECB as a share of external debt has doubled since 2007. As I have blogged earlier, the government has consistently, in response to rising external imbalances, relaxed the ECB norms.
Similarly, short-term debt too has risen sharply in recent years. The portfolio of international bonds of all maturities, mostly raised by corporates and financial institutions, has risen dramatically since 2008. 
The decline in hedging has been attributed to the growing belief that the rupee value is likely to stabilize at Rs 60-62. Recent stability in rupee despite continuing turmoil in many other emerging market currencies, prospects of economic recovery, declining commodity prices (and consequent downward pressure on current account deficit), and a perception that RBI would aggressively defend the currency are thought to underpin this belief.

However, these optimists overlook India's persistent high inflation, easily the highest among all major emerging economies. This is unlikely to decline to the levels in other emerging economies anytime in the near future. The consequent depreciation of real exchange rate is not only inevitable, but also desirable. Further, as the US Fed exits quantitative easing and given the relative strength of US economy in comparison to the economic weakness in Europe, the recent trend of strengthening US dollar is likely to persist for the near future, thereby adding more downward pressure on the rupee.

If these trends play out, as they look likely to, then a depreciating rupee will leave the unhedged corporate borrowers in serious trouble. Once the US economic recovery takes firmer hold and interest rates start rising, coupled with a depreciating rupee, a backlash by way of capital flight, in whatever scale, is a real possibility. It would leave the Indian economy, especially its banking sector, exposed to problems similar to that experienced by countries like Thailand and Indonesia in the late nineties and Spain and Portugal just recently, albeit on a smaller scale.

It is therefore important that the RBI and government make corporates to periodically share the details of their external exposures. This will enable, as Paul Tucker recently pointed out, banks to deploy more prudent macro-prudential norms in their lending to corporates with larger unhedged external exposures.

Postscript : Nice article in Business Standard highlights the risk.

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