Sunday, October 23, 2011

Foreign currency borrowings could lower interest cost for SMEs

Foreign currency borrowings could lower interest cost for SMEs
The Rupee has crossed the psychological barrier of Rs. 50 against the USD yesterday, raising concern among corporates about their foreign currency borrowing plans. But the prevailing low interest rates globally and the reasonably developed market for long term foreign currency swaps make a compelling case for foreign currency borrowings, which are significantly cheaper than rupee borrowings.
A historical perspective on foreign exchange rates reveals interesting facts.  While the pace of recent depreciation may have come as a surprise to many, the exchange rate is still within the levels observed in the past. Same day 10 years back, the exchange rate was Rs.48.03 against the dollar, yielding an average annual depreciation of 0.4%. The highest and lowest exchange rate observed during this ten-year period is Rs. 52 and Rs. 39 respectively, which is a reasonably narrow band for such a long period.  Given this history, and the current state of global and Indian economy, it can be reasonably assumed that, over the next ten years, the chances of rupee strengthening are higher than significant depreciation from current levels.
However, foreign currency borrowings can be – and should be – availed without taking any exposure to the currency fluctuations.  Long term foreign currency borrowings can be fully covered through swaps for entire tenure of the loan, insulating the corporates from the exchange rate fluctuations. 
Large corporates have been availing foreign currency borrowings for many years now. But mid-size corporates and SMEs have not been active in availing foreign currency loans in large numbers.   This reluctance may be due to risk aversion or lack of awareness about the process for availing foreign currency loans. Bankers to such SMEs may not also readily offer foreign currency loan options, as this may affect their lucrative rupee interest earnings.
But the interest cost savings in foreign currency borrowings is significant in today’s market making it an attractive option.  Most mid-size corporates can today avail fully-hedged foreign currency loans for long tenure – 5 years or more – at around 10% per annum, which is significantly lower than the 14-17% interest rate charged by banks for this segment.
Certain operational restrictions could make foreign currency borrowings cumbersome than availing rupee borrowings. Key restriction is in the end use of funds; proceeds from foreign currency loans can be used only towards prospective capital expenditure – including rupee denominated capital expenditure – and not against working capital funding, repayment of existing debt, reimbursement of capital expenditure already incurred or general corporate purposes.  Besides this, prepayment of foreign currency loan is subject to regulatory restrictions. However, in the long run the significant interest cost saving is a strong incentive to overcome these operational issues. 
A key aspect an SME should bear is about leaving the foreign currency loan un-hedged.   The cost of covering the foreign exchange loan is almost half of the total cost of the foreign currency loan, given the low interest rate regime globally.  If the exchange rate remains within a narrow band for a reasonable period of time, SMEs could yield to temptation or mis-placed advice and keep the foreign currency loan un-hedged; however, this may cause serious damage to the financial health of the corporate, if the rupee depreciates sharply against the dollar, as is witnessed in the last two months when Rupee depreciated 11% from Rs. 45 in August to Rs. 50 currently. 
N. Muthuraman is ex-Director Ratings, CRISIL and Co-founder of RiverBridge Investment Advisors Pvt. Ltd., a boutique financial advisory firm.
This is the blog of the Print Version published in Business Line dated 24th Oct 2011

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