Foreign Currency Debt: Opportunities from an Indian Perspective
Growing demand for foreign currency loans
Overs the years, akin to the rationalisation of the foreign direct investment (FDI) regime to maintain the flow of equity instruments into the country, the foreign investments route for debt investment has also been liberalised to improve the financing and creation of long-term assets in India. While the current regulatory regime incentivises foreign lending to borrowers in India to meet the capital expenditure and infrastructure requirements, the regulatory approach towards the raising of foreign debt by domestic companies to meet working capital requirements, capital expenditure or equity/acquisition financing has been largely conservative. This is mainly on account of concerns around so called "hot money" flowing easily in and out of India through the debt route without creating long-term assets, which can put pressure on the Indian currency in the short to medium term. In a sense, India's foreign debt policy has been formulated with the intention of facilitating the flow of foreign debt into the country with a "long-term and asset creation" perspective and, at the same time, balancing the risk of currency fluctuation and export deficiencies.
Even within this regulatory regime, the cross-border borrowings by Indian corporates have seen a rapid rise over the years, both for industrial companies borrowing directly and for borrowings by intermediaries like non-banking financial institutions registered in India (NBFCs). Traditionally, external commercial borrowing (ECB) was the most common route for Indian borrowers. This, however, came with a host of restrictions, including eligibility criteria for lenders and borrowers, end-use limitations, a minimum average maturity threshold and a ceiling on all-in-cost. This avenue has mostly been used by foreign lenders to finance infrastructure and other industrial projects as well as for capex requirements for manufacturing and infra companies. In addition, NBFCs lending to the infrastructure and manufacturing sector have also borrowed through this facility for domestic on-lending.
In order to create more affordable borrowing avenues for Indian borrowers, the ECB regime has been gradually relaxed in order to widen the universe of eligible foreign lenders to include non-institutional lenders, funds etc as long as they are from certain compliant jurisdictions, as detailed below. In addition, the number of options for allowing foreign portfolio investors (FPIs) to lend to Indian companies in Indian rupee (INR) have been expanded. While fund raising from FPIs is comparatively less restrictive on end use (except where they are lending for real estate, capital markets etc), they are required to lend in INR and with an average maturity restriction which is lower than that of ECB. This effectively creates another avenue for foreign debt to flow into the country at rates which may be significantly higher than ECB (but still lower than domestically available credit and for purposes for which local banks cannot lend for regulatory reasons) and with fewer restrictions on end use. Also, with the currency of borrowing being INR, the borrower is insulated from foreign currency fluctuations.
While the options for foreign debt to flow into the country have increased, the stress on the finances of the infrastructure sector in India, coupled with the downfall of major NBFCs like Infrastructure Leasing and Financial Services (IL&FS) and Dewan Housing Finance Corporation (DHFL) in the last few years, have impacted the credit growth in the domestic market in India as regards corporate lending. This has also deterred Indian banks and financial institutions from lending to NBFCs with the ease and comfort that was previously seen, which has created a liquidity crunch for NBFCs and even reduced credit for sectors which were largely dependent on NBFCs ie, construction financing. The exposure of Indian mutual funds in NBFCs has also seen a steep decline for the same reasons. Some of the key factors that have contributed to the slowdown in corporate lending in the domestic market, which also creates opportunity for foreign currency loans (FCLs), are set out below.
Apathy among conventional lenders to do new financing in the wake of growing stress and distress in the Indian banking system
With the onset of the COVID-19 pandemic, the general trend of loans and borrowing made available to corporates and individuals in India has seen a subdued growth of 5-6%, which is almost half the rate recorded prior to the pandemic. Recent trends show that despite banks having adequate liquidity, the funds are being parked with the Reserve Bank of India (RBI) despite a drastic reduction in the reverse repo rate by the RBI. This is an indicator of increasing risk-averse behaviour in the present circumstances. The RBI has acknowledged that bank credit growth has experienced a slowdown in 2019-20 and a further setback in 2020-21 in the wake of COVID-19 lockdowns. Further, the RBI’s annual report 2019-20 stressed that the pandemic has triggered extreme risk aversion and elevated volatility in the financial market with bank credit growth remaining subdued. Hence, in the absence of conventional sources of credit, corporates are increasingly moving towards FCLs to solve their liquidity issues. Management of the pandemic to a considerable extent in the developed economies has provided the FCL lenders a better standing than their Indian counterparts. India’s ambition of moving towards full capital account convertibility has also provided an indirect impetus to this growing trend of availing FCLs.
Lack of confidence in banks to finance NBFCs
The downfall of giants like IL&FS and DHFL has made the banks and financial institutions in India strikingly risk averse. This is largely due to the investigations and other civil and criminal proceedings in which the lenders who had exposure to IL&FS and DHFL find themselves involved. The fallout of this includes drastically less funding of NBFCs by banks. Additionally, the Securities and Exchange Board of India (SEBI) has reduced the sectoral limits for investment by mutual funds in any single sector from 25% to 20%. As a result, less money is flowing into debt instruments issued by NBFCs, making it harder for them to raise capital. According to CARE Ratings, the liquidity crisis is demonstrated by the decline in the percentage share exposure of debt mutual funds to NBFCs from 19% in July 2018 to 9.7% in February 2021.
Lack of domestic sources of long-term financing to fund long-term projects
The long-term nature of infrastructure assets along with frequent delays and cost overruns demands long-term finance, with the major share of financing today coming from the commercial banks. However, since a substantial share of a bank's funding comes from short-term deposits, this system poses an asset-liability mismatch (ALM). This system has resulted in major non-performing assets (NPAs) in the infrastructure sector causing banks, such as ICICI, to shut down their project finance divisions. This was also reflected in the decline in the share of the long-term assets (assets with maturity of more than three years), relative to total assets, on the bank's balance sheets. The growing decline in such lending has been demonstrated by several banks withdrawing from this sphere to focus on short-term retail and working capital loans. The lack of domestic funds makes foreign currency borrowing more lucrative to entities seeking funding for their infrastructure projects with repayment timelines matching their projected commissioning dates. This occurrence is evident in the decline in the status of IDBI Bank, which was set up with the objective of supporting credit demand for infrastructure assets and had until very recently been one of the pioneers in this area.
Cheaper cost of FCLs despite the hedging cost
The ECB route requires borrowers of foreign currency denominated loans to hedge 70% of their total exposure (where the average maturity of the debt is under five years), however, the same is offset by the low interest provided by FCLs, which are low interest loans wherein interest till recently was benchmarked as per the applicable LIBOR. Following the announcement of the Financial Conduct Authority (FCA), the UK has decided to discontinue LIBOR. Accordingly, the RBI has requested the banks to prepare for the adoption of the Alternative Reference Rates (ARR). Since the risk-free rate abroad is lower, the borrowers are able to obtain a lower interest rate loan as foreign lenders have a lower threshold for lending. The most common purpose for borrowing FCLs is to obtain a gateway to the hedging of foreign exchange exposure and flexible repayment options. Additionally, FCLs may cost less than borrowing in the domestic currency because the interest rate varies from country to country and speculative reasons may make foreign currency debt an attractive alternative. Corporates may raise FCLs for various purposes, including pre-shipping/post-shipping advance payment to the exporters, import of capital products, repayment of existing rupee loan, and repayment of existing ECB.
Opportunity to invest in stressed/distressed loan market
The enactment of the Insolvency and Bankruptcy Code 2016 (IBC) has paved the way for an increased attraction to distressed debt and special situations funds. Several international investors have now started seeking opportunities in dollar (or non-rupee) denominated debt to avoid the need to price in the expected depreciation of the rupee. For offshore investors, non-rupee lending facilitates the benchmarking of the expected returns in India against investment opportunities elsewhere in the world. This has led to numerous global and domestic private equity firms investing in the distressed assets in India, which are available at an attractive valuation and also offer the statutory safeguards provided by the IBC.
India's stressed assets market is estimated to be over USD115 billion and the availability of good quality distressed assets has already attracted major global funds including Apollo Global, Oaktree Capital, Nithia Capital, Brookfield Asset Management, Blackstone, Davidson Kempner and Cerberus. Investors are increasingly clinching distressed deals at attractive valuations amid the economic slowdown and uncertainty caused by the pandemic. With over USD150 Billion of NPAs in the Indian banking system, many foreign hedge/distressed debt funds are lining up in the market to help banks clean up their balance sheets. These funds typically acquire debt through asset reconstruction companies available in India.
Improvement in recovery prospects
Historically, the recovery regime in India was perceived to be long winded and skewed in favour of borrowers on account of the delays that recovery processes involved. The available recovery tools did not always provide equal rights to the foreign lenders on par with the domestic lenders for recovery of debts. In particular, the specific recovery legislation, such as the Recovery of Debts and Bankruptcy Act, 1993 (the “RDB Act”) and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (the “SARFAESI Act”), did not vest rights in the foreign lenders to enforce the security and recover debts from the domestic borrowers. As a result, the foreign lenders were left with limited recourse to recover debt, such as approaching a civil court in India or enforcing a foreign decree/arbitral award through the execution process involving civil courts. This situation invariably led to poor recovery for the foreign lenders and ultimately impacted the confidence of foreign debt investors. The delay in recovery also impacted the viability of underlying secured assets, which significantly deteriorated recovery potential even if the recovery proceedings could eventually deliver some success.
However, under the IBC, it has now become possible for any foreign lender to initiate insolvency proceedings against the Indian borrowers and actively participate in the resolution process on par with domestic lenders. The change perpetrated by the IBC has significantly improved the influence and stake of foreign lenders in the insolvency resolution process and created a level playing field vis-à-vis the domestic lenders in any situation of distress. In addition, the insolvency resolution process under the IBC is much faster, which enables the creditors to put the corporate debtor under court mandated administration and find a viable resolution for the borrower in a time bound manner, thereby retaining the viability of the underlying assets.
Types of Indian entities borrowing FCL
The RBI has reported a 100% increase in overseas borrowings by NBFCs in India in the financial year 2020. The total external commercial borrowing of India has soared to a fresh high of USD51 billion out of which, the financial services sector, which covers NBFCs, housing finance companies (HFCs) and microfinance institutions (MFIs), raised close to USD21 billion.
Some of the corporates which have raised FCLs in recent times include the following.
Financing structures and instruments available for the foreign debt regime
The principal routes and onshore investment vehicles to FCLs in India are discussed below.
External commercial borrowing
ECB is governed by the regulations of the RBI under the Foreign Exchange Management (Borrowing and Lending) Regulations, 2018, Master Direction - External Commercial Borrowings, Trade Credits and Structured Obligations (ECB Master Directions) read with the Foreign Exchange Management Act 1999 (FEMA). ECBs are commercial loans raised by eligible resident entities from recognised non-resident entities and, as discussed above, ECBs need to comply with certain specifications such as minimum average maturity, permitted and non-permitted end-uses, ceilings on all-in-cost, etc.
Traditionally, the major advantages of the ECB route are as follows:
While the lender universe under the ECB route was previously very limited, there have been several regulatory relaxations. Presently, under the ECB Master Directions, any non-resident investor is eligible to lend as long as the investor is a resident of a Financial Transaction Task Force (FATF) or International Organisation of Securities Commissions (IOSCO) compliant country to become a recognised lender.
The RBI, with a goal of facilitating investment norms and raising foreign investment in India, presented various relaxations through the ECB structure which has given a solid impetus for investors.
Foreign portfolio investment
A foreign portfolio investment (FPI) is a type of an investment by non-residents who can satisfy the eligibility criteria to invest in the Indian securities, such as shares, corporate bonds, government bonds, convertible and non-convertible securities.
FPIs are primarily regulated by SEBI in terms of the SEBI (Foreign Portfolio Investors) Regulations, 2019, repealing the 2014 Regulations (SEBI FPI Regulations). Additionally, FPIs are, inter alia, also required to comply with the FEMA and the Income-tax Act, 1961.
From an investor's perspective, some of the advantages of FPIs are:
The benefits from a borrower’s perspective are as follows:
According to the National Securities Depository Limited, the net investment of FPIs in debt securities in financial years 2018-19, 2019-20 and 2020-21 has been negative. However, as on 10 December 2020, FPI investment through the VRR has increased by 81.45% as compared to the investments made in the financial year 2019-20. Based on SEBI's bulletin as of November 2020, FPI funds raised through corporate bonds till September 2020 are around 25% higher than the funds raised in the corresponding period last year.
Types of cross-border entities lending FCLs
Various overseas entities, such as banks, private credit funds, sovereign wealth funds, distress funds and microfinance institutions, have taken a keen interest in investing in India. Some of the recent funding received from these entities in India include the following.
Ways to fortify the position of FCLs
While the foreign debt flow into India has seen a consistent upward trajectory backed by a regulatory push and a growing economy, the following key aspects may need further consideration to develop and increase the same.
Access to secondary debt
While foreign lenders continue to have access to Indian assets in primary markets, they do not have access to buy rupee loans in secondary markets. In the context of the huge distress situation affecting the Indian banking system, it may be a good time to allow direct access for foreign lenders who are currently permitted to take exposure indirectly through local asset reconstruction companies (ARCs), if they are coming through the FPI route. This could potentially improve the timely resolution of distressed assets and the deleverage position of Indian lenders from these assets.
Addressing information asymmetry and assessing borrowing country’s adherence to financial sector principles
A key problem with assessing international credits is information asymmetry as compared to domestic credit files. US banks are often advised to attempt to reduce the currency risk by lending and requiring repayment in US dollars, but the effectiveness of this technique is limited and may simply substitute currency risk for transfer risk.
The most common practice for banks and foreign lenders is to analyse foreign currency statements in US dollars (with a single conversion from the foreign currency), versus US dollar equivalents at the end of each period, which could have several different conversion rates. Since financial information from foreign countries is not always reliable, the lender’s policies should enable it to determine borrower capacity and reputation by other means. One of the most effective methods is a programme of regular visits to borrowers’ countries by bank account officers and by obtaining credit references, followed by the preparation of candid reports that become significant parts of credit files. Banks along with foreign lenders can also consider the Financial Sector Assessment Programme, jointly established by the World Bank and the International Monetary Fund, which analyses a country’s adherence to sound financial sector principles such as the Core Principles of Banking Supervision prescribed by the Basel Committee on Banking Supervision.
Robust cross-border insolvency regime
As a next step in the reform of the insolvency law in India, a robust cross-border insolvency regime recognising foreign proceedings as well as recognition of Indian proceedings offshore may help the foreign lenders further to deal with offshore assets of Indian parties. While Sections 234 and 235 of the IBC providing for cross-border insolvency have come into force, a detailed mechanism for the implementation of the regime, including the adoption of the UNCITRAL Model Law, has not yet been put into motion.
Providing ease of enforcement to foreign lenders
Most of the ECB lenders do not have robust enforcement options in India because the specialised debt recovery laws in India, like the SARFAESI Act and the RDB Act do not permit such lenders to enforce their security interest by taking recourse to the summary procedure provided in these laws. It is opportune time that ECB lenders are given rights similar to local banks and NBFCs under the SARFAESI Act (and similar enforcement laws) to create a level playing field in terms of the enforcement of their security. In any case, FPIs, in case of listed debt instruments, have been given access through debenture trustee/security trustee to SARFAESI rights and it would make sense to extend similar benefits to ECB lenders as well as to FPIs in case of unlisted debt instruments subscribed by them.
It is evident that FCL is experiencing a boom in India. It provides a complementary and additional funding option for long-term projects and NBFCs, besides local funding by banks and financial institutions; however the finer nuances of a successful FCL deal structure remain plagued by regulatory asymmetry and market conditions. It is imperative in the current market that all stakeholders work closely and swiftly to bridge the gaps and remove disincentives that adversely affect bankability for foreign currency lenders. In the long run, this can help to deleverage the exposure of the Indian banking system to long gestation projects and help address ALM which often affects the Indian banking system. Overall, the continued momentum of flow of foreign debt into the country can be a win-win scenario for overseas lenders as well as the Indian economy if the fund flow remains channelled towards asset creation and helps funding requirements for long gestation assets through adequate regulatory and market incentives.