The Reserve Bank of India (RBI) has been keeping a close watch on the burgeoning foreign exchange reserves, partly arising out of the significant liberalization both on the FDI/FII (foreign direct investment/foreign institutional investor) front and on the external commercial borrowings (ECB) front over the last several years. Indian companies raised over $16 billion (Rs66,080 crore) in ECBs during 2006-07, compared with just $2.7 billion in the preceding year, and the expectation was that in 2007-08, more than $20 billion would be raised through ECBs, including foreign currency convertible bonds (FCCBs). FII inflow has also been very robust and over the last few years, FDI inflow has also begun to gather steam. Over the last few months, RBI has been progressively tightening its noose around the ECB regime.
ECBs have been defined as commercial loans, bank loans, buyer's credit, supplier's credit and securitized instruments availed from non-resident lenders with a minimum average maturity of three years. The ECB regime is also applicable to FCCBs.
When it comes to end use, a 1 August 2005 circular from RBI spells it out thus: "ECB can be raised only for investment (such as import of capital goods, new projects, modernization/expansion of existing production units) in real sector—industrial sector including small and medium enterprises... and infrastructure sector—in India. Infrastructure sector is defined as (i) power, (ii) telecommunication, (iii) railways, (iv) road including bridges, (v) ports, (vi) industrial parks and (vii) urban infrastructure (water supply, sanitation and sewage projects)"
Such ECBs are permitted under the automatic route, that is, they do not require RBI or government approval. Basically, companies can raise loans from recognized international sources including international capital markets, suppliers of equipment and foreign collaborators for a variety of purposes; however, the end uses permissible are primarily investment (such as import of capital goods), new projects, modernization/expansion of existing products in the real sector, and for the infrastructure sector.
ECBs of up to $20 million are permitted with a minimum average maturity of three years, and over $20 million and up to $500 million per borrower are permitted with a minimum average maturity of five years. A company can raise a maximum of $500 million or equivalent in a financial year.
The ECB regime has undergone some changes in the last few months, primarily in the first quarter of 2007-08. The recent tightening has been in relation to a variety of dimensions, including the end use of ECBs, reduction in the permissible ceiling of all-in costs (basically, all-inclusive cost; includes the spread, commission, interest payment and any other fees resulting from the transaction) and liberalizing the prepayment regime to facilitate premature repayment. All-in costs were reduced from 200 basis points over the London inter-bank offered rate (Libor, which is widely used as a reference rate for financial instruments) to 150 basis points for ECBs with three-year maturities, and from 350 basis points to 250 for five-year maturities. The prepayment limit was raised from $200 million to $300 million in December 2006, and further to $400 million in April this year.
There are a variety of implications of the tightening from a commercial standpoint and a regulatory standpoint. So far as the commercial standpoint is concerned, ECBs, having accounted for $16 billion out of the $36 billion foreign exchange inflows in 2006-07, will probably have an impact in terms of strengthening of the rupee and increase in costs of local borrowing and, therefore, the profitability of companies. In any case, the liquidity currently in the system will ensure that the issue will not really be of availability of money, but that more of companies having to resort to more alternative and expensive sources of money supply. As such, large, big-ticket borrowers will be affected more, since smaller borrowers can still resort to the RBI approval route for end use of ECBs being expenditure in rupees. Incidentally, RBI has not come out with any separate guidelines in relation to such approval; however, informal inquiries with RBI officials suggest that existing guidelines applicable under approval route would also apply here.
Clearly, the end-use restrictions now put in place would mean that for import of capital goods, either for new projects or for modernization, the ECB route would be available, but not if the intent is to acquire such goods domestically. In a sense, that is a dampener for capital goods suppliers in India. On the other hand, the fact that the end use is restricted, would probably encourage overseas acquisitions, that is, greater incentive to build production basis globally rather than in India.
Another implication is regarding the profitability of companies as manifested by the financial statements. Due to an amendment to the Accounting Standard 11, gain/losses on conversion of ECBs were to be disclosed in the profit and loss account.
Before this amendment, such gains/losses, if attributable to asset acquisition, were to be adjusted against the cost of the asset. In the first quarter of 2007-08, a significant amount of such foreign exchange gains bolstered the profitability of companies. With the restrictions on the raising of ECBs, the potential for such gains has reduced to that extent.
Interestingly, a master circular on ECBs was issued only on 2 July, and that too with a sunset clause of one year, clearly demonstrating RBI's thought process that the ECB policy needs to be kept under constant watch given the dynamic situation. Just one month after that, the ECB end use restriction circular has been issued. Clearly, a lot more action is foreseen on the ECB front, given RBI's hawkish stand on this issue.