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  • Mar 31, 2010 - A risk that sits on Indian companies' balance sheets

A risk that sits on Indian companies' balance sheets

Mar 31, 2010

Post the global economic crisis, there was a significant slowdown in economic activity across geographies. While emerging markets have managed to somewhat wiggle out of the mess, their developed counterparts are continuing to go through rough times. To boost the economic activity in their respective markets, central banks of developed nations have kept interest rates quite low. The world’s most widely used benchmark for short-term interest rates is the London Interbank Offered Rate or Libor as it is commonly known. It has been on a constant decline over the last year. At present it stands at about 0.9% (12-month rate).

With interest rates in India being relatively higher than in the West, especially when compared to the Libor rate, eligible domestic companies are choosing the cheaper option. Particularly, accessing the ECB or external commercial borrowing route. In fact, there are quite a few companies like Bharti Airtel that have opted for taking the foreign currency borrowings route to acquire assets abroad.

Companies that borrow funds through the ECB route usually have to pay additional percentage points above the Libor rate. At present, the maximum cost of borrowing is six month Libor plus 300 basis points (or 3%) for loans of duration ranging from more than three years to five years. For long term borrowings, i.e. for duration of more than five years, it is six month Libor plus 500 basis points or 5%. The all-in-cost ceiling (the term used for the additional percentage points) as it is called could be lower, depending on the credit rating of a particular company.

The chart displayed below shows the foreign borrowing (including FCCB) over the last three years. In addition, we have also shown the Libor and PLR (prime lending rates, the benchmark rates of Indian banks) during the same period.

Data Source: WSJ Prime Rate, CMIE, RBI; *12-month

As you can see, there is a good amount of correlation between the three parameters. ECBs have risen when there is an increase in PLR rates and have remain subtle, when the PLR rates have been flat or on a decline. On the other hand, as mentioned above, the Libor rates have been on a constant decline. However, ECBs have not really gone to historical levels over the past few months even though the Libor rates are so low. A key reason for the same is the overall credit crunch. Plus, the PLR rates have remained stable as well.

As obvious as it may be, Indian companies would prefer to opt for the ECB route for funding international acquisitions. As per RBI, an ECB can be raised for specific reason only. Some of the key ones include importing of capital goods, new projects, and modernization/expansion of existing production units in industrial sector, infrastructure sector and specific service sectors. The latter includes hotel, hospital and software.

However, while on one hand foreign funds are very cheap when compared to the prevailing domestic interest rates, the company taking on debt through this route should be also prepared for the currency fluctuations. As you would be aware, the forex rates have been quite volatile over the past few years. Volatile enough to negate effect of the low interest rates on the ECBs!

Thus it is important to ensure that the company taking on foreign currency denominated debt can hedge the forex risks and does not buy assets abroad only in the allure of cheap foreign funding.

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