Dollar strength a reason why India Inc's debt hunger needs to be tamed

As easy capital sloshed around the world and investor optimism over India renewed following Narendra Modi’s victory in May, local companies made a run this year toward acquiring more cheap foreign debt.

According to a recent report, India Inc raised about $19 billion through foreign borrowings this year, a record high, and may borrow even more next year.

The move was helped by several economic developments, such as Modi’s victory, which triggered hopes the new prime minister would several take steps to boost growth, a stabilization in the rupee (leading to lower hedging costs) and the government’s decision to slash withholding tax from 20 percent to 5 percent, Moody’s said in an August note.

Borrowing abroad, especially in US dollars, is a cheap route for Indian corporate compared to borrowing within the country where the Reserve Bank of India has kept rates extremely high for a years, thanks to persistent inflation.

As a result, while borrowing costs could for a decently-rated investment-grade firm could be about 12 odd percent in India, the same could be a few percentage points less abroad (2 percent treasury yields + 2 percent risk spread + 5-6 percent hedging costs).

However, trouble arises when, companies, in a bid to cut down borrowing costs, leave a major part of their foreign currency-denominated debt unhedged in the hope the currency would remain stable.

The recent strength in the US dollar should have investors worried. For a major part of this year, the rupee was trading close to 60 to the dollar. While this stability would have also reduced borrowing costs, it appears it has also likely lulled borrowers into believing it would last.

A Mint report published in September estimated that, of late, companies had started hedging fewer of their borrowings and has much as half of short term debt and 75 percent of long term debt was unhedged. The expectation among companies, quoting a currency consultant, was that that the rupee was unlikely to weaken past 62-62.5/USD, a level that has already been surpassed.

It must be remembered in 2013, when the rupee plunged majorly, about half of India’s $200 billion corporate debt was unhedged (half of it being short-term), according to CRISIL, and this led to much problems for corporates as their borrowing costs went up and they had to show huge mark-to-market losses while declaring earnings.

A fall in the rupee does not affect companies that enjoy “natural hedges” in a big way: that is, ones that also benefit from a rising dollar, such as IT, pharma or metal exporters, oil-producing companies that price their products in US dollars, but for every such companies, you also have the cash-starved oil marketing companies or indebted telecom firms that have gone out and raised millions of dollars.

While analysts expect the rupee to weather an expected rise in the US dollar in 2015 (as the Fed unwinds its ultraloose monetary policy), a fall from further levels cannot be ruled out.

In a recent note, author and columnist John Mauldin warned of a major US dollar rally in 2015 and said most emerging market currencies will be unlikely to fight the rise. This, he added, will take a major toll on governments and companies that have borrowed heavily in the US dollar, as has happened in case of Indian companies this year.

“If the local currency is dropping significantly faster, then no matter how profitable a business is, it is sinking deeper into debt with every tick up in the dollar. That’s what happened in 1998, and it’s happening again today,” he warned.

Even the Reserve Bank of India, whose chief Raghuram Rajan, has warned of a reversal of capital flows when the Fed increases interest rates, is duly worried. The Mint piece said that the central bank has been exhorting banks to make sure clients hedge their overseas borrowings, but its pleas have apparently fallen on deaf ears.

In an editorial, the paper also touched upon this warning this debt bingeing had to be controlled, and cited research from the Bank of International Settlements to show how Indian and Chinese companies had gone out on a limb to borrow abroad.

“In essence, emerging market companies have taken on a carry trade by financing local assets with apparently cheap dollars,” it said. “But the turning tide of global liquidity can prove lethal for such trades.”