India’s external commercial borrowings (ECBs) as a percentage of nominal gross domestic product (GDP) climbed to 9% at the end of June, the highest since 2005, according to data compiled by DBS Group Research.

This becomes important in the backdrop of the rate hike by the US Federal Reserve last week, which may lead to currency volatility and hurt corporates with foreign currency loans.

The rupee has already depreciated 4% since July and the volatility measured by standard deviation on a three-month rolling basis has increased sharply since August. Thankfully, Indian companies have increased their hedging ratio to 39% of their total foreign currency exposure compared with 15% a year ago.

Nevertheless, a falling rupee may still weigh on their unhedged exposure, crimping profitability and making it difficult to service their debt obligation.

“They would be affected by both the variable interest loans (denominated as LIBOR plus) as well as rupee depreciation, if it is significant," according to a Care Ratings note dated 17 November.

Companies may face repayment issues, which may increase the risk of downgrades in credit ratings and weigh on the debt servicing ability of corporates that are already stretched, said Dhananjay Sinha, head of research at Emkay Global Financial Services Ltd.

Private sector debt has increased to 52% of GDP last year compared with 35% in FY04-05. High corporate leverage and tough economic conditions will in turn hurt the banking sector whose stress assets are already high at 10-11% of total advances. Any signs of additional stress in external debt exposure could aggravate domestic leverage ratios, according to a DBS note dated 16 December. What is worrying is that ECBs are the fastest growing component of external debt. The ratio of external debt as a percentage of GDP climbed to a high of 23.8% as of March 2015, according to Reserve Bank of India (RBI) data.

But surely foreign exchange reserves are more than adequate? While forex reserves are hovering at $325 billion; they are slightly lower than the all-time high of $355 billion touched in June, as RBI is selling dollars to support the rupee. “If the target import cover is 12 months, reserves need to be raised by $38-40 billion more. As a percentage of GDP, other Asian economies are in the region of 30-80% of GDP (except Singapore). If this is taken as a gauge, the reserves stock needs to be raised by two-thirds to meet the lower band of the regional average. Next, if one targets to fully cover the external debt stock (from about 70% currently), reserves will need to be increased by about a third," said Radhika Rao, economist at DBS Bank Ltd.

The writer does not own shares in the above-mentioned companies.