Jamal Mecklai: To ECB or not to ECB

Last Updated: Fri, Nov 30, 2012 03:20 hrs

Exports have been on the ropes for over a year now. In average, they have been lower by nearly a billion dollars in each of the last 12 months. While the decline (about 2.5 per cent) may seem relatively modest given the sharp fall in global growth, the problem is compounded by the fact that our imports appear to be picking up. They have, on average, been higher by nearly $3 billion (a bit over 10 per cent) a month over the past 12 months. More alarmingly, they have risen to well over $40 billion in each of the past two months, probably reflecting the slightly better domestic growth picture.

As a result, the trade deficit has hit records in both September and October, with the October number crossing $20 billion for the first time ever. With global growth still anaemic, it is hard to see the average monthly deficit falling below even $15 billion this year, which confirms what the foreign exchange market seems to know — that the current account deficit is going to be a continuing serious problem as far as the eye can see, to quote an elegant young economist I know.

The government and the Reserve Bank of India, in trying to find the magic tap to bring in capital, are looking to widen the permissible use for external commercial borrowing (ECB). While this may not play very well with the rating agencies, it may end up working quite well in practice.

We advise a large number of companies of all sizes on managing the risk on ECB and find that, in general, most of them are uncomfortable with giving up the interest advantage fully. And notwithstanding the theoretical concept of hedging to keep the balance sheet secure, empirical evidence suggests that their intuitive business sense is often vindicated.

A telecom company we were working with drew down a large (around $250 million) ECB in December last year, when the rupee was at 51.50 to the dollar. They came to us some time in July this year, by which time the rupee had already depreciated to where the fully hedged cost was higher than 12.5 per cent, as compared to the 10.75 per cent it would have cost if they had hedged the loan at inception (the theoretically correct approach).

We wrung our hands jointly and debated the merits of taking the loss, hedging partially with a stop-loss, using call spreads and all of the above. Inertia and board indecision won out and the company did nothing. By October, the market had moved favourably and the fully hedged cost had come down to below the cost of hedging at inception. This was over and above the Rs 30 crore-odd the company had saved on interest (as compared to hedging on day one).

Emboldened, no doubt, by the gains and still driven by inertia, the company remained open. Sure enough, the rupee collapsed again — and, by the time of the first principal payment, the hedging cost had again risen to nearly 12 per cent. However, if we add in the interest savings, which now worked out more than Rs 60 crore, the company is only about 50 basis points behind having hedged on day one. Admittedly, the cost has been helped by a nearly 50 basis point reduction in the cost of the interest rate swap — foreseeable, given the US Federal Reserve’s approach. Balance sheet volatility has been forestalled by the government’s generous permission to modify accounting rules.

Thus, focusing simply on cash – and, to quote Narayana Murthy, cash is real, profits are an opinion – the company hasn’t done too badly, particularly in a year when the rupee has fallen by nearly 10 per cent.

A better approach, of course, would have been to ride the market in response to the intuitive belief that the rupee cannot continue to fall forever (or at least over the period of the loan), but also to “take profits” on some part of the exposure whenever the market offered an opportunity, as it did in October. And when the company does take profits, it should use call spreads to continue to retain opportunity. We have another client, a much smaller company, who has about 25 per cent of its ECB portfolio (some of it drawn down two years ago) hedged partially with outright calls (at 46!) and partially with call spreads (46/51, as I recall).

While the rupee remains on a slippery slope, few people would be willing to buy dollars five years forward at nearly Rs 75. Thus, keeping ECB unhedged or partially hedged is a good strategy to reduce interest costs, perhaps significantly, provided – and this is key – that the company remains vigilant and is reasonably disciplined.


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