Foreign Currency Borrowing by Indian Firms: Towards a New Policy Framework

by Ila Patnaik, Ajay Shah, Nirvikar Singh.

A well established concept in the field of international capital flows is the problem of `original sin': where governments or firms have currency mismatches with foreign borrowing that is typically in dollars. When such exposures exist, there is the possibility of substantial balance sheet effects in the event of a large depreciation. In India, foreign currency borrowing has grown seven-fold, from \$20 billion in 2004 to \$140 billion in 2014. This has generated concerns about systemic risk. We have a paper which is forthcoming in India Policy Forum on these questions. Key ideas from this are presented here.

Rational firms are conscious about the destruction of wealth that comes with a large depreciation and unhedged exposure, and are likely to avoid currency mismatches. The moral hazard hypothesis suggests that firms choose to have unhedged foreign currency borrowing because governments and central banks communicate their intent to manage the exchange rate when faced with large depreciations. Concerns about unhedged foreign currency borrowing by firms are a greater issue in emerging markets where the monetary policy regime targets the exchange rate, as compared with mature market economies with floating exchange rates.

Capital controls are proposed as a way of avoiding moral hazard associated with foreign currency borrowing under pegged exchange rates. The puzzle lies in designing a capital controls system which interferes with unhedged foreign currency borrowing but not with foreign borrowing by firms with hedges. For firms who have natural hedges, unhedged foreign currency borrowing is a valuable source of low cost capital. These firms include not just net exporters, but net producers of tradeables where domestic output prices are set by import parity pricing.

What is a policy framework where hedged firms are able to obtain the economic benefits of unhedged foreign currency borrowing, while avoiding unhedged foreign currency borrowing? One strategy is to combat the moral hazard at the root cause: the monetary policy framework. A monetary policy framework which enshrines inflation as the target, and not the exchange rate, would remove the moral hazard. Inflation targeting central banks are, in general, associated with greater exchange rate flexibility.

The second element of the policy question is the capital controls regime. The Indian strategy for capital controls on foreign currency borrowing presently involves many kinds of restrictions. The dominant form of currency borrowing is ``External Commercial Borrowing'' (ECB) by companies. Rules restrict who can borrow, who can lend, how much can be borrowed, at what price, what end-use the borrowed resources can be applied for, who can offer a credit guarantee, when borrowed proceeds must be brought into India, when loans can be prepaid, when loans can be refinanced, procedural rules for all these activities, and rules for banks to force all borrowers to hedge currency exposure. Further, loans above a certain amount require approval.

The present policy framework is highly complex, uncertain, and, as has been suggested by the Sahoo Committee that was set up by the government to review the existing framework, fails to address some of the concerns of policy makers. For example, policy makers are concerned about the level of unhedged foreign currency exposure in the economy, issues of discretion and transparency, and policy uncertainty in the framework. Further, the recent focus on modern regulation making processes and rule of law has raised questions about the appropriateness of the existing policy framework. We compare the present distribution of foreign currency borrowing among firms against a normative ideal (foreign borrowing by naturally hedged firms), and find large deviations.

In recognition of these problems, in recent times, some policy changes have been introduced in the capital controls that may help reduce currency mismatch. These include allowing firms to undertake rupee-denominated ECB, an increase in the caps on FII investment in rupee-denominated corporate bonds (the cap has increased slowly to USD 51 billion in 2015), monitoring of the hedge ratio for ECB by requiring firms to report these, requiring infrastructure firms to fully hedge their ECB and prudential requirements for banks when lending to companies with unhedged foreign currency exposure.

For Indian firms, markets for derivatives are illiquid and costly owing to restrictive regulations, making it unattractive to hedge explicitly through these markets. On the other hand, while some borrowers may have natural hedges, the policy framework for ECB does not take this into account. This helps explain why firms with natural hedges, such as domestic makers of tradeables, are not strongly present in foreign currency borrowing.

The current restrictions on ECBs raise concerns about engaging in ill-defined or poorly justified industrial policy, about the scale of economic knowledge required to write down the detailed prescriptive regulations, the impact upon the cost of business and about rule of law. Recent research suggests that the large number of changes in the capital controls governing ECB are motivated by exchange rate policy and not systemic risk regulation. This raises questions about the process through which regulations are being made.

In the international discourse, there is renewed interest in capital controls, in particular in order to address the systemic risk associated with large scale unhedged foreign currency borrowing by firms in countries with pegged exchange rates. For those who are willing to intrude on economic freedom with capital controls, India is a poster child, with a great willingness to do central planning on what happens with cross-border activities. The careful examination of the Indian capital controls on foreign currency borrowing suggests that the Indian framework has not been effective in permitting safe activities while reducing systemic risk.