Unhedged exposure via external commercial borrowing new threat to rupee

According to RBI data on external debt released, short-term debt on a residual maturity basis accounted for 44.1% of foreign exchange reserves at the end of March 2022

At a time when higher US interest rates and a global flight to the greenback have exerted pressure on the Indian rupee, currency experts have flagged another potential risk for the exchange rate -- unhedged exposure through external commercial borrowing (ECB).

Accompanying the unhedged exposure that Indian firms have to such overseas borrowings is increased scrutiny on the part of overseas lenders when it comes to Environmental Social and Governance (ESG) norms, analysts told Business Standard.

According to Reserve Bank of India data on external debt released at the end of June, short-term debt on a residual maturity basis accounted for 44.1 per cent of foreign exchange reserves at the end of March 2022, as against 43.8 per cent at end of March 2021.

These types of debt obligations include longer-term debt with original maturity falling due over the next twelve months.

As a percentage of India’s total external debt of $620.7 billion, the share of short-term debt maturing over the next 12 months was 43.1 per cent, the data showed. As of March 25, 2022, the RBI’s foreign exchange reserves were at $617.65 billion.

While some of the external debt due for maturity would be rolled over, with US interest rates hardening and hedging costs spiking on account of a weakening rupee, the exposure to ECB poses risks to the domestic currency.

The rupee has witnessed a bout of significant volatility of late, weakening to an all-time low of 79.36 per US dollar on July 5. The rupee has lost 6.2 per cent versus the greenback so far in 2022.

“We do have a problem of unhedged ECBs. A lot of people have taken ECBs. Roughly about 40% as per RBI estimates, is hedged, so the need for people to buy dollars is always there. Secondly, there are a lot of maturities coming up now. Now, in overseas markets, spreads have gone up for Indian paper,” Ananth Narayan, associate professor at S P Jain Institute of Management and Research told Business Standard.

“Therefore, there could be a problem of repayment of dollars which comes up in the short run, especially if these ECBs have not been hedged in the past. So will there be pressure on the rupee? Yes, possible,” Narayan who has in the past served on several RBI committees, said.

Within the broad global push for greater compliance with environmental regulations, the cost of overseas funds for Indian corporates stands to rise further.

Sensitivity to lending to firms, which may not be or may be partially compliant with ESG norms has increased significantly since the Covid-19 pandemic broke out, analysts said.

“Compared to domestic conditions, global banks and global investors are now very particular about the risk associated with ESG. And some of them would not lend or fund industries which are structurally known for ESG risk, particularly sectors such as the thermal power or the coal sector,” India Ratings and Research Director Soumyajit Niyogi said.

“Investors would possibly add premium in sync with the ESG risks. Even if someone is willing to pay, if they are not ESG compliant, the lenders might refuse to lend further,” he said.

While larger entities are typically more compliant with global ESG requirements and have access to multiple funding sources, smaller firms do not enjoy the same networks, analysts said.

Amid a widening current account deficit and the global, preference for the US dollar, the RBI earlier this week announced a slew of measures aimed at attracting foreign exchange flows. These include a higher permissible borrowing limit for firms under ECBs.

The RBI has dipped into its foreign exchange reserves at a rapid pace since the Ukraine war broke out in February in order to shield the rupee from excessive volatility.

From $631.53 billion as of February 25, the RBI’s headline foreign exchange reserves have dropped to $588.31 billion as of July 1, the latest data showed. In fact, in the previous week, the central bank’s reserves were reduced by a large $5 billion, mainly on account of a fall in foreign currency assets, the data showed.