ECB: Looking back or looking forward?

By Sanjay Asher, Bhumika Batra, Crawford Bayley & Co.

The Government of India, Ministry of Finance and the Reserve Bank of India, the country’s central bank, have been confronted by the challenge of surging capital inflows over the past five years.

Sanjay Asher, Partner, Crawford Bayley & Co.
Sanjay Asher
Crawford Bayley & Co

Until early 2007 the Reserve Bank of India had managed to insulate its hugely successful exchange rate policy from these surging capital inflows. But then things seemed to fall apart as the rupee-to-US$ rate appreciated from around 44:1 to 40:1 and there were corresponding changes in various real effective exchange rate indices.

The predicted costs of this avoidable appreciation are now showing up in a marked slowdown in exports of goods and services, sudden pressure from cheap imports on import-substituting activities, rising job losses in labour-using industries like textiles, sharply mounting trade deficits and massive problems of liquidity management.

The main proximate cause, it seems, is the major policy (failure) of the Ministry of Finance to enhance the annual external commercial borrowing (ECB) limit for domestic borrowers in each of the last two fiscal years, thus aggravating enormously the underlying problem of managing the surge in external capital inflows. Temporarily constraining domestic borrowers’ access to external commercial borrowing is a limitation, but seems well worth the benefits of containing capital surge and allowing a more competitive exchange rate policy, without spawning excess liquidity or unduly high fiscal costs from sterilized intervention.

Bhumika Batra, Associate, Crawford Bayley & Co
Bhumika Batra
Crawford Bayley & Co

The important aspect of external commercial borrowing policy is to provide flexibility in borrowings by Indian corporates, at the same time maintaining prudent limits for total external borrowings. The guiding principles for the external commercial borrowing policy are to keep maturities long, costs low, and encourage infrastructure and export sector financing which are crucial for overall growth of the economy.

The external commercial borrowing policy focuses on three aspects:

– Eligibility criteria for accessing external markets.

– The total volume of borrowings to be raised and their maturity structure.

– End use of the funds raised.

External commercial borrowings can be used for any purpose (rupee-related expenditure as well as imports) except for investment in stock markets and speculation in real estate.

They are a source of finance for Indian corporates for expansion of existing capacity and fresh investment, allowing them to supplement domestic resources and to take advantage of lower international interest rates. Corporates can raise external commercial borrowing from any recognized source, such as banks, export credit agencies, suppliers of equipment, foreign collaborators, foreign equity-holders, capital markets, etc.

As external commercial borrowings were allowed under the automatic route in most of the cases up to US$500 million, the central bank could not do much to contain the inflow.

This led to appreciation in the rupee, which affected the competitiveness of domestic companies. This forced the government to amend the policy to contain the external commercial borrowing inflow.

However, the government on 7 August modulated capital inflows through external commercial borrowing by modifying parts of the policy, namely:

– External commercial borrowing of more than US$20 million per borrowing company would be permitted only for foreign currency expenditure for permissible end-uses of external commercial borrowing. Accordingly, borrowers raising external commercial borrowing of more than US$20 million must park the external commercial borrowing proceeds overseas for use as foreign currency expenditure for permissible end-uses. The above modifications would be applicable to external commercial borrowing exceeding US$20 million per financial year both under the Automatic Route and under the Approval Route.

– External commercial borrowing up to US$20 million per borrowing company would be permitted for foreign currency expenditure for permissible end-uses under the Automatic Route and these funds shall be parked overseas and not remitted to India. Borrowers proposing to use external commercial borrowing up to US$20 million for rupee expenditure for permissible end-uses would require prior approval of the Reserve Bank under the Approval Route. However, such funds will still be parked overseas until actually required in India.

However, these conditions would not apply to borrowers who have already entered into loan agreements and obtained loan registration numbers from the Reserve Bank of India. Borrowers, who have taken verifiable and effective steps wherein the loan agreement has been entered into for external commercial borrowing in the previous dispensation, and who have not obtained the loan registration number, may apply to the Reserve Bank of India through their authorized dealer. The move would curb capital expenditure in rupee terms.

This is the second time in less than three months the government has tightened external commercial borrowing norms to curb excessive flow of funds into the country. It is still not clear if this move of the government is to look back on what has been done or to look forward on what should be done.

Sanjay Asher is a partner with Crawford Bayley & Co. Bhumika Batra is an associate.

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