Concept of Hedging while Raising ECB

In India, to foster future growth, expansion, and diversification, companies and businessmen are increasingly taking investments from outside the country, which if done in the form of taking Debt/loan from Non-resident Entities is commonly referred to as External Commercial Borrowings (ECBs).

External Commercial Borrowings are governed by several laws, including the FEMA Act, Companies Act, and any other regulations that may be prescribed from time to time and ECBs should adhere to the criteria like minimum maturity period, maximum all-in-cost ceiling, permitted and non-permitted end-uses, etc.

What is Hedging?

1.    Any transactions made by Indian Entities in foreign currency are inherently exposed to foreign exchange fluctuations. Considering the past trends of depreciation of value of Indian Rupees in the global market, the organizations which are required to make an outward payment of foreign currency tend to safeguard themselves against the negative foreign exchange fluctuation     

2.    Hedging can be understood as a risk mitigation mechanism in which the price movements of a particular liability/Asset can be controlled. Hedging refers to adjusting a particular risk or an investment against the fluctuating price in the market. Therefore, a borrower would not focus on the amount of money made from investment but concentrate on reducing loss while using Hedging mechanism. Therefore, ECB hedging would be used to neutralize the adverse price changes in the market.

Advantages of Hedging ECB

1.    Indian businesses can take full advantage of lower interest rates prevailing in the Euro zone and US and Japan, by raising ECB from these economies.

2.    For large projects with revenues in foreign currency, ECB provides a good route to borrow large amount in foreign currency and improve the strength of the balance sheet and improve the profitability of the project

3.    By availing ECB, the company’s stakes aren’t diluted. Borrowers can raise funds without giving up control, as debtors will not have any voting rights in the company.

4.    Through ECB, domestic borrowers get access to global markets and exposure to global opportunities.

Types of Hedging for ECB

Below are the 3 most used hedging tools in the financial market:

1.    Forward Contract: it is a non-standardized agreement where two independent parties are involved in purchasing or selling foreign currency on a preset date at a certain price.. It includes contracts such as forward exchange contracts for currencies, commodities, and so on. Generally, the ECB borrower enters into an agreement with Banks or authorised foreign exchange dealers, to buy Foreign Currency at the date of payment of interest or principal of ECB and the rate is fixed on the date of agreement between the bank and the borrower. The Bank charges an upfront premium, mostly as a percentage of spread, over the amount to be repaid by the borrower.

• On the date of the payment of ECB instalment, the bank provides the foreign currency required by the borrower to repay the same.
• Practically, most of the banks are reluctant to enter into a foreign currency forward agreement with an ECB borrower due to uncertainty in the value of Indian Rupee in the global market for the whole tenure of the ECB loan. However, the borrowers find it slightly easy to enter annual contracts with the bank as it provides more visibility to the bank regarding the benefit from the contract.

2.    Futures Contract: It is a standardized agreement where two independent parties are required to acquire a foreign currency at a preset price on a certain date and amount. A futures contract contains a variety of contracts such as commodities, currency futures contracts, and so on.

• Under a future agreement, a borrower enters an agreement with a third party, mostly banks where a future rate for a foreign currency is fixed at a desired date
• The future contact is almost similar as a forward contract. However, the key difference lies in the execution of the contract. In a forward contract, actual delivery of foreign currency is made to the ECB borrower whereas in a future contract, only the differential amount i.e. on the foreign currency exchange gain/loss is paid to the ECB Borrower.

3.    Money Markets: It’s a major component of financial markets that involve purchasing, short-term lending, selling with a maturity of one year or less or borrowing. 

• It covers a wide range of financial transactions such as money market operations for interest and calls related to stocks where borrowing, selling, short-term loans and lending occur with a maturity of 1 year or more, money market operations, and currency trading.
• These include interest rate swaps, as well as natural hedging process such as setting off the future loan payable from the future receivables in foreign currency.

ECB Hedging Procedures

• A Completely hedged ECB should be compared with similar INR loan while availing ECB.
• All the available currency options need to be considered in terms of IRR.
• While comparing different currency-denominated loans, currency basis needs to be considered.
• Proper calculation needs to be made and choices to be made accordingly if alternative options are available in choosing the benchmarks like O/N SOFR, 3M LIBOR/ 6M LIBOR, 3M Euribor/ 6M Euribor, TONA, etc.
• Once the ECB terms are finalized, obtain quote form a few hedging banks that can provide all the possible hedge options and competitive pricing.
• Get the hedge lines ready with a maximum number of banks with terms favourable to the entity.
• Generate IRR for optimum alternative hedge choices in different scenarios.
• Develop a strategy to negotiate and seamlessly hedge the ECB as per the requirement.

Mandatory requirements for Hedging of ECB

1.    As per the paragraphs 2.4.1, 2.4.2 and 2.5 of Master Direction No.5 dated January 1, 2016 on “External Commercial Borrowings, Trade Credit, Borrowing and Lending in Foreign Currency by Authorized Dealers and Persons other than Authorized Dealers” issued by the reserve Bank of India (RBI), the below Entities issuing ECBs are in need to have a risk management policy duly approved by board of directors. They also need to keep their ECB exposure hedged 100 per cent at all times (in case the average maturity is less than 5 years):

• Companies in the infrastructure sector,
• Non-Banking Financial Companies -Infrastructure Finance Companies (NBFC-IFCs)
• NBFCs-Asset Finance Companies (NBFC-AFCs)
• Holding Companies and Core Investment Companies (CICs)
• Housing Finance Companies, regulated by the National Housing Bank, Port Trusts constituted under the Major Port Trusts Act, 1963 or Indian Ports Act, 1908

If any guidelines are issued by the concerned sectoral or prudential regulator in respect of foreign currency exposure, the above-mentioned entities need to follow those guidelines.  

2.    Further, the above entities/borrowers are required to obtain verification from the designated AD Category-I bank that 100% hedging requirement is complied with during the currency of ECB and the position is to be reported to RBI through ECB-2 returns.

3.    Other aspects of hedging: Wherever hedging has been authorized by the RBI, the following should be ensured:

• Coverage: Through financial hedges, the ECB borrower needs to cover principal as well as the interest amount. On behalf of ECB, the financial hedge for all exposures should start from the time of each such exposure (i.e. the day liability is created in the books of accounts of the borrower).
• Tenor and rollover: To ensure that the exposure on account of ECB is not unhedged at any point during the tenor of ECB, a minimum tenor of 1 year of financial hedge would be needed with period rollover.
• Natural Hedge: Natural hedge, in place of   financial hedge, will be accepted only to the extent of correcting projected cash flows / revenues in matching currency, net of all other projected outflows. The ECB considers natural hedging, if the offsetting exposure within the same accounting year has the maturity/ cash flow. The natural hedge will not be considered if the revenues are indexed in foreign currency in any other arrangements.  

Conclusion

In a rapidly interconnected global market, with the progressing demands of Indian businesses, the integration of global value chain has become important. The revised regulatory framework for External Commercial Borrowings has revised its framework to simplify existing procedures which align with current business and economic dynamics. By defining guidelines for ECBs, the framework shifts stimulates numerous overseas investment Opportunities in India.


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