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A recent report by DBS Group Research stated that external commercial borrowings (ECBs) have risen to a decade high. Money that is borrowed from foreign sources for financing the commercial activities in India is called ECB. As stated in the report, ECBs as a percentage of Nominal Gross Domestic Product (GDP) has risen to 9% at the end of the June 2015, compared to 3.6% in March 2005. ECBs come with a risk of foreign currency fluctuations. More the rupee depreciates; higher will be the cash outflow to repay the interest as well as the principal.
Recently, RBI Governor, Mr. Raghuram Rajan, warned corporates against the ill-effects of over borrowing. Further, RBI has also prepared a database which is being shared among the banks to avoid over-borrowing by the large corporate houses.
Earnings of corporates India have not improved for quite a while. This has impacted their interest coverage ratio (ICR). ICR is a measure of a company's ability to honor its interest-payment obligations. Reportedly, ICR of the BSE Sensex companies has fallen from 10.56 times in FY11 to 5.63 times in FY15. Even worse, the ICR of the BSE Small Cap companies has fallen from 3.03 times in FY11 to 1.33 times in FY15.
To add to this, US Federal Reserve has increased interest rates by 0.25% in its recent meeting on 15 December. This essentially means the hot money flow from the foreign institutional investors (FIIs) into emerging markets could reverse though at a gradual pace. India's case this would lead to the depreciation of the rupee. This would add to the woes of corporates which have borrowed foreign debt. However, we believe RBI has adequate foreign exchange reserves in order to curtail the rupee depreciation.
But the worst part of this situation is that most of the foreign debt was unhedged till a year back. Indian companies have now increased their hedging ratio to 39% of their total foreign currency exposure as compared with 15% a year ago. Still this ratio needs to improve further we believe to protect corporates from the downside risk. Recently, Amtek Auto had defaulted in the repayment of its bonds leading to a sharp correction in the share price.
We suggest investors should be very careful while investing in companies where the ECBs are high. Due consideration to interest coverage ratio, debt service coverage ratio, cash flow from operations should be given before investing in such companies.
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