Globalization, at least for now, is turning out to be a bad deal for India. The economy, markets and private companies come under stress and suffer at the hint of any trouble in the world. Yet, they don’t seem to be able to benefit from opportunities the global situation presents from time to time.
A case in point is that cost of capital. Arguably the binding constraint faced by Indian firms today is the exceptionally high domestic rates of interest; a consequence of the Reserve Bank of India’s (RBI) inflation control strategy.
In the last 18 months, the cost of borrowing has gone up by 300 basis points. Taking the average lending rate of banks to be 10%, this works out to a 30% increase.
A good indicator of the interest rate spectrum is that the risk-free paper, or the sovereign borrowing rate in India, has touched the 8.75% mark. As against this, for the debt-ridden US government, it is just about 1.85%. The difference between the two rates is nearly 7 percentage points.
For the “global” Indian firms, the 10-year Mumbai Interbank Forward Offer Rate, or MIFOR—which tracks US interest rates and the dollar funding conditions closely—is the proxy benchmark for cost of funds. At present, it is at a relatively low level of 5.35%. Its counterpart in the US, the 10-year interest rate swap, is at 2.05%. The difference between the two comparable instruments is barely 3.3 percentage points.
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Analytically, there can be a whole range of reasons for this discrepancy. However, the basic reason is the structural inefficiency due to the lack of capital account convertibility. Be that as it may, the real point is not macroeconomic, but operational and regulatory.
From a transactional perspective, this appears to be the best time in more than a decade for Indian companies to avail of fresh dollar borrowings.
The interest rate differential between the government bonds (Indian G Sec-US treasury yield) and the interest rate swaps (MIFOR-USD swap) is currently at its highest level in recent times.
Indeed, in the last 10 years, the current levels have been breached only once—during the tumultuous days of late 2007-early 2008. At that time massive dollar selling against the rupee had led to a collapse in MIFOR, which had widened the difference.
This wide differential gives Indian firms a good opportunity to borrow in dollars. Even on a fully hedged basis, the cost will be lower than that of direct rupee borrowings. A back of the envelope calculation suggests that the cost of borrowing will be at around 9% —London Interbank Offer Rate plus credit spread and the hedge at 5.35% —on a fully hedged basis. This means virtually borrowing at the same rate as the sovereign does domestically in Indian rupees.
Domestically, top notch firms will get money at 150 to 200 basis points (bps) spread over the sovereign, that is borrowing at 8.75%. For the bulky middle, we are talking of rates of 13% and for the one who really need it, it is either not there or only available at usurious rates.
This yawning gap of 300-350 bps could form the basis of a complete corporate debt restructuring/swapping programme for the highly leveraged companies. As an aside, it may even improve their financial figures and through that the asset quality of domestic lenders, thereby reducing the systemic risk that is now on the horizon.
This opportunity is transitory. For, once RBI halts or reverses its rate tightening cycle, the difference will be reduced and it will not be worthwhile to borrow in this form.
However, what prevents from this opportunity from being exploited to domestic advantage is the regulatory structure. Even though the external commercial borrowing guidelines were revised very recently, the regulation is that a firm can’t borrow to repay existing rupee loans with dollar borrowings, except to the extent of 25% for companies in the infrastructure area. Even as the entitlements have been liberalized, access continues to be restricted which makes it virtually impossible to do any debt swapping. The simple point is that these borrowings are limited only to financing capital expenditure.
Allowing a more open access and entitlement, would increase the paying of MIFOR, assuming firms hedge their dollar borrowing, thereby gradually bringing the MIFOR rate in line with the actual rupee cost of borrowing. This would reflect fundamentals better.
Additionally, one anomaly that needs to be addressed is that a firm converting the rupee loan into an MIFOR loan gets a cost reduction of only about 3.3%, which is half the government differential of 6.7%. The firms need to be adequately compensated for taking on the foreign exchange risk. Going by the whole concept of interest rate parity and carry trades, the investor should get the interest rate differential as compensation for taking the exchange rate risk.
Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at email@example.com