The Indian corporate sector appears to have stepped up its borrowing from the international market. Monthly figures on private external commercial borrowing (ECB) released by the Reserve Bank of India point to a significant increase in in the volume of such borrowing. As compared with a total of $12.2 billion borrowed over the six months ending January 2011, external borrowing over the subsequent six months (ending July 2011) had touched $19.3 billion. Moreover, underlying month-to-month variations in the volume of borrowing because of the presence or absence of large individual borrowers, is a trend pointing to a continuous rise. As a result, while the current ceiling on ECB is $30 billion in a single financial year, Indian companies have already borrowed close to $16 billion over the first five months (April-August) of this financial year (2011-12).
What is noteworthy is that the recent increase in borrowing has been accompanied by an increase in the trade and current account deficits on India’s balance of payments and signs of a weakening of the Indian rupee vis-à-vis the dollar. As argued below, both of these have implications for an assessment of the implications of the increase in external commercial borrowing.
The obvious cause for the close to 60 per cent surge in ECB over the last two six month periods for which data is available is the sharp rise in domestic interest rates. The Reserve Bank of India has announced 12 increases in reference rates since March last year, raising the cost of credit provided to the banking system by 3.25 percentage points to 8.25 per cent. This being the rates at which banks can borrow from the RBI, they in turn are charging higher rates on loans to their clients. In the event, there has been a widening of interest rates payable on borrowing from the domestic and external markets, with the latter being the cheaper source. When the differentials in interest rates between external and domestic markets widen, the normal tendency would be for firms to borrow abroad to meet even their domestic expenditures and finance their expansion plans targeted at the domestic market.
There are, however, two much-discussed dangers associated with this tendency. First, there arises a mismatch between the currency in which debt service commitments on external loans must be met and the currency in which revenues are garnered from the domestic market-oriented activities that are financed by such loans. Hence, a part of the foreign exchange earned or acquired in other activities would have to be diverted to these borrowers in the future so that they can meet their debt service commitments. This could put some strain on the balance of payments.
The second problem is that the borrowers themselves are taking on substantial exchange rate risks. While they may be obtaining finance at interest rates lower than currently charged in the domestic market, their debt service commitments in rupee terms can rise sharply if there is a depreciation of the domestic currency. This could more than neutralise the benefit of an interest rate differential.
Besides these factors, another possibility is a rise in in rates in international markets. Those interest rates are low now because central banks in the developed countries have pumped large volumes of cheap liquidity into the market in response to the crisis. But there is no guarantee that the era of access to cheap liquidity for emerging markets will continue, as illustrated by the difficulties being faced by the peripheral countries in the Eurozone. If rates rise, efforts to refinance maturing debt would require expensive borrowing. Put all of this together, and the rise in external borrowing increases the vulnerability of the corporate sector and the nation.
It is for these reasons that the widening of the current account deficit on India’s balance of payments and the weakening of the rupee against the dollar at a time when external commercial borrowing is rising give cause for concern. Faced with such a situation the government should seek to limit external borrowing to instances where access to foreign exchange is socially important, as for example when capital goods have to be imported for crucial infrastructural projects.
However, the government appears to be inclined towards loosening rules with respect to external borrowing, to dampen corporate criticism of the high interest rate regime. Under pressure from the corporate sector, the government had increased in May the ceiling it sets on total external commercial borrowing in a single financial year by $10 billion to $30 billion. More recently, the government has increased the cap on borrowing by individual firms in the microfinance, services and infrastructure (and other) sectors (for loans with maturity of more than 5 years under the automatic route) from $5 million, $100 million and $500 million respectively to $10 million, $200 million and $750 million. Moreover, the government has been permitting the use of ECBs for refinancing rupee loans. Telecom companies who borrowed in rupees at high cost to finance spectrum acquisition have exploited this facility substantially.
Thus, while retail borrowers are experiencing sharp increases in the equated monthly instalments or the tenure of the loans they took on to finance housing investments or purchases of automobile and durables, corporates are being offered an escape to cheap credit through means that increase external vulnerability. This quirky policy is clearly aimed at neutralising the impact of interest rate hikes in the domestic market on the corporate sector, so as to dampen criticism of the government’s mismanagement of inflation control and the failure of its policy of relying solely on interest rate increases to rein in prices.
There are conspiracy theories doing the rounds. Rumour has it that there is a standoff between the Ministry of Finance and the Reserve Bank of India over interest rate policy. The government seems completely at a loss to find ways of reining in inflation. Rather it is worsening the inflation problem through periodic hikes in administered prices, especially that of petroleum. This has forced the central bank to take on the burden of combatting inflation leading to the sharp rise in interest rates. But the Finance Ministry does not seem to like that either, and is using the ECB lever to counter the impact of the RBI’s intervention on the powerful corporate sector. But that could increase external vulnerability, which could be the next source of conflict between these two agencies.
