The Reserve Bank of India released a revised framework for External Commercial Borrowings (ECBs) on November 30. The framework makes some significant changes to the rules governing foreign borrowings by Indian residents. It classifies foreign borrowings into long-term foreign currency borrowings and short-term foreign currency borrowings, and eases several restrictions for the former. It allows long-term lenders such as pension funds and insurance companies to lend to Indian firms. It announces a framework for rupee-denominated borrowings. While these changes are necessary and perhaps important, this is yet another missed opportunity for reforming the rules for foreign borrowings by Indian residents.
First, in a mature economy, state intervention in the affairs of private citizens must be motivated by market failures and restricted to combating them. The framework governing foreign borrowings by Indians is scattered with multiple restrictions. There are restrictions on who can lend, who can borrow, what can the loan proceeds be used for and how much interest can be paid to the foreign lender. These restrictions cannot be traced to an underlying market failure. Unhedged foreign currency exposure on the balance sheets of Indian borrowers makes the economy vulnerable to systemic risk. This is the risk that the rules need, but fail, to address. While RBI has, in the past, sounded alarm bells on the low proportion of hedging by firms, the new ECB framework falls short of addressing this concern.
On hedging, the revised ECB framework merely states that borrower firms must hedge their foreign currency risk as per the requirements stipulated, if any, by the respective 'sectoral or prudential regulators'. It is not clear why the regulation is shy of mandating hedging requirements. It is also not clear why the 75 per cent hedging requirement originally proposed for foreign borrowings raised by NBFCs has been dispensed with. Moreover, who is the prudential regulator for a software company or an infrastructure firm, which borrows in foreign currency? This opportunity could have been used to implement a robust hedging requirement for Indian borrowers which do not have natural hedges (in the form of foreign currency revenue) or mechanisms to otherwise diversify their currency risk. The reform could have been then completed by simultaneously improving the regulatory framework governing the market for foreign currency derivative products which can be used by Indian borrowers (as well as foreign lenders in Indian currency) to hedge their currency risk. In the absence of a deep market which provides hedging opportunities, foreign currency borrowing with hedging requirements may become prohibitively expensive for both borrowers and lenders.
Second, the ECB framework continues to apply a sectoral approach towards foreign borrowings. Thus, for instance, while infrastructure and manufacturing firms are allowed to raise foreign borrowings to the tune of $750 million, a lower borrowing limit of $200 million has been prescribed for firms in the software sector. Similarly, while firms in the manufacturing, software development, shipping and airline sectors are permitted to raise short- to medium-term borrowings, other firms are not so allowed. Presumably, the state wishes to encourage investment in these sectors. The approach of encouraging investment in certain sectors, as opposed to others, is akin to industrial policy, which defies the principles of sound financial regulation. Moreover, it creates problems of political economy, incentivising lobbying by sectors which are left out, encouraging them to seek ad-hoc exemptions.
Third, the rules governing rupee-denominated borrowings from non-residents are now scattered across the current ECB policy, the rules governing foreign portfolio investment in corporate bonds and the framework for issuance of rupee-denominated bonds overseas. In economic terms, a borrowing made in rupees gives rise to the same kind of liability on the part of the Indian borrower, whether such borrowing is made through a corporate bond issued in India or overseas or otherwise through a loan. The rules governing them are, however, different. Thus, for instance, Indian NBFCs borrowing in rupees under the ECB framework have certain end-use restrictions. However, where a foreign portfolio investor invests in corporate bonds issued by an Indian NBFC, the proceeds generated from such investment are not subject to end-use restrictions. There is ample scope for harmonising the rules governing rupee-denominated borrowing into one coherent framework, which applies the same rules for all rupee-denominated borrowings, howsoever raised.
To take this one step further, in economic terms, there is no difference between a rupee-denominated loan taken by an Indian resident from an Indian lender and that taken by an Indian resident from a foreign lender. In both the cases, the Indian borrower does not take on any currency risk. Once a loan is denominated in rupees, the regulatory framework must be agnostic to the nationality of the lender.
Finally, the ECB framework attempts to address several concerns which should be a matter of private contract between parties and have no bearing on the systemic risk arising from foreign currency loans. For instance, the ECB policy mandates that Indian firms engaged in micro-finance activities must have a "satisfactory borrowing relationship for at least three years with an AD Category I Bank in India". Assessing the creditworthiness of an Indian borrower must be left to the foreign lender. We do not mandate such requirements for MFIs to access domestic loans. In any event, the principles for risk management in lending operations by financial entities are a matter of prudential regulation, and should apply equally to all lenders. Regulating the borrowers, through a framework for capital controls, is not an answer.
To conclude, the new ECB framework makes important improvements. However, there is ample scope for simplification of the policy, orienting it towards addressing market failures, and dispensing with unwarranted intervention tools which add to the complexity of the regulations. Hopefully, the next round of review of the ECB regulations will be more ambitiously reformative.
The writers are with the National Institute of Public Finance and Policy
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