This paper examines the macroeconomic factors that drive the Indian corporates’ preference for overseas borrowings. Foreign borrowings by Indian corporates are characterised by a large number of companies accessing international capital markets for small size loans. The policy framework on foreign commercial borrowings has been effective in achieving a balanced maturity profile as also in channelising funds to productive sectors. It is observed that foreign borrowings by the corporates and import of capital goods display a close positive relationship. Since capital goods import is closely related to growth in industrial production, it implies that the demand for foreign borrowings by the corporates is generated by the underlying pace of real activity. The estimated error correction model revealed that Indian corporates’ long-run demand for overseas commercial borrowings is predominantly influenced by the pace of domestic real activity, followed by the interest rate differentials between the domestic and international markets (indicating arbitrage) and the credit conditions. The real variable dominates the price variable in driving the demand for overseas commercial borrowings.

JEL Classification   :   G1, G3, E51
Keywords               :   Financial markets, corporate overseas borrowings, credit, interest rate arbitrage

The rising access of the emerging market firms to international capital markets reflects the transformation of corporate financing led by cross-border movement of capital, deepening of global financial markets, strong interlinkage across markets and institutional developments, particularly the mechanisms for risk assessment. Large access to international borrowings is also indicative of greater trade linkages and an enhanced exposure of firms to foreign currency

* The author is Assistant Adviser in the Department of Economic Analysis and policy. The views expressed in the paper are those of the author’s only and not that of the institution the author is affiliated to. The usual disclaimer applies. The author expresses gratitude to Dr. Sarat Dhal for his insightful suggestions and Mrs. Jaya Sohani for patiently going through the page proofs of the paper.

A historical account of India’s approach to external commercial borrowings (ECBs) reveals that during the period 1950s to the early 1980s, the domestic firms’ reliance on international capital markets was restricted mainly to bilateral and multilateral assistance. In the 1980s, in the context of the widening current account deficit, the traditional external sources of financing were found to be inadequate and were supplemented with commercial borrowings from international markets including short-term borrowings. In the 1990s, the Indian corporates’ access to international capital markets increased with the liberalisation of the external borrowings policy, the gradual withdrawal of capital account restrictions and improved credit ratings. During the current decade (2000s), the sustained growth of overseas borrowings and the overall private capital flows to India reflects the momentum in domestic economic activity, resilient corporate performance, a positive investment climate, a long-term view of India as an investment destination and the improved sovereign risk. Besides these factors, the prevailing higher domestic interest rate coupled with a higher growth rate has moderated the risk perception and created arbitrage opportunities.

The recourse to commercial borrowings by the Indian corporates, though began in the 1970s, remained modest due to the dominance of concessional, non-market based finance in the form of external assistance from bilateral sources and multilateral agencies. Towards the end of the 1970s, the concessionality in the aid flows dwindled. Thus, with the rising external financing requirements beginning with the 1980s and the recognition that reliance on external assistance was not favourable, commercial borrowings from international capital markets were preferred. The commercial borrowings were, however, regulated by an approval procedure, subject to conditions on cost, maturity, end use and ceilings on borrowings. The upgrade in the credit ratings also facilitated access to international capital markets. In the second half of the 1980s, financial institutions and public sector undertakings increased their participation in the international bonds market – the Samurai market, the DM and the Swiss Franc public bond and the Euro-Dollar fixed rate bond markets. During the late 1980s, large inflows were also contributed by the development financial institutions which were encouraged to borrow overseas well in advance of their requirements. The rising reliance on commercial borrowings was manifested in the fact that the commercial borrowings constituted 27 per cent of net capital flows to India in the 1980s, more than double from 12 per cent in the 1970s.

Second, the thrust of the policy continues to be directed towards allowing ECBs an additional source of finance for the Indian corporate sector for financing expansion of the existing capacity and for fresh investment to augment resources available domestically. Although till recently, the policy sought to give greater priority to projects in the infrastructure, core and export sectors, all end-use restrictions were relaxed, except prohibiting the use of proceeds for investment in capital markets and real estate so as to avoid any speculative activities (Table 2).

Third, the policy also aims at maintaining a minimum average maturity while keeping an annual ceiling on approvals. ECBs with an average maturity of 8 years and above are, however, outside the purview of the ceiling. Limits on individual borrowings are linked to an average maturity profile. Based on these criteria, the ECBs guideline/approval procedure has been substantially liberalised over time with a view to providing corporates a greater access to international capital markets. As a broad indicator of the maturity profile of commercial loans, the ratio of loans maturing during a year as a ratio to the loans outstanding at the beginning of the year can provide a fair idea about the maturity structure. The policy bias towards balancing of the maturity profile with longer maturity loans during the post-1991 period is amply demonstrated by the ratio of maturing loans to the loans outstanding at about 0.2, implying an average maturity of 5 years (Chart 1).

The computed weighted average maturity of ECB loans during the period 2004-07 has witnessed a balanced maturity structure (Chart 2). The maturity structure, however, seems to respond to the interest rate movements. The average maturity witnessed some compression with the hardening of international interest rates. However, moderation in the interest rate cycle seems to have had a favourable impact on the maturity structure.

capital markets is linked to the 6-month LIBOR for the respective currencies in which the loan is raised. It can be discerned from Table 4 that the interest rate spread over the LIBOR has been progressively reduced which might be driven by the improved credit rating and finer spreads on Indian bonds in the international markets and better aligning of the domestic interest rate to global rates.

The outcome of the above mentioned policy measures is evident in the secular reduction in the implicit interest rates on external commercial borrowings from 1990-91 through 2006-07 (Table 5).

The implicit interest rate on external borrowings has moved in a corridor between the 6-month LIBOR and the ceiling interest rate. Again, the spread of implicit cost of commercial borrowings over the LIBOR has significantly narrowed down during the period 1991-92 to 2006-07 from a peak of about 700 basis points in 1992-93 to 100 basis points in 2006-07, reflecting the deep and liquid global financial markets, benign liquidity conditions and gradual upgradation in the sovereign rating and improved corporate performance.

ECBs raised by Indian corporates in gross terms increased seventeen-fold between 1990-91 and 2007-08 (Table 6). A comparison of approvals and actual loans raised by the corporates provides an important indication about the market conditions and the behaviour of the companies intending to raise loans. A higher rate of realisation of the loans approved may take place during the periods of higher credit demand domestically or a higher interest rate spread between domestic and foreign interest rates. A stable and consistently high realisation ratio in the recent years indicates the higher credit demand by the corporates.

more than a six-fold increase between March 1991 and March 2008 (Table 7). The sharper rise in commercial debt has taken place in the 2000s, the period when corporate demand for external financing rose significantly due to a sustained rise in economic activities domestically and favourable conditions in the international capital markets. As a result, the share of commercial debt in India’s external debt increased from 12 per cent in March 1990 to 28 per cent in March 2008.

Analytical Underpinnings of Corporates’ Overseas Borrowing

The borrowing behaviour of corporates can be postulated to be determined broadly by the underlying investment demand – a demand led factor and the cost of capital – a supply-side factor. Investment demand can be financed through internal resources in the form of retained profits and external sources, motivated by the choice about the capital structure. The capital structure of a firm entails the firm’s choice between debt and equity capital.³ Equity capital can be raised from the firm’s promoters or capital market. Debt in the form of loans and bonds can be raised through floatation of corporate bonds or borrowing from banks and non-bank financial intermediaries.⁴ Furthermore, a firm’s choice between borrowings from the overseas markets and the domestic capital market is done typically after a deliberate process of long term financial planning (World Bank, 2007). Thus, a firm’s decision to raise borrowings from international capital markets can be a complex interaction of a host of factors. One, a firm’s potential demand for domestic investment, which in turn is a function of the expectations about future growth. Two, the credit constraint a firm might be facing in the domestic market due to underdeveloped and less liquid bond markets, which, on the one hand may hamper borrowings by smaller firms and on the other may not facilitate large sized bond issuances as well as offerings of long maturity horizon. International capital markets due to their highly liquid nature and capacity to absorb long maturity bonds, help firms from underdeveloped markets to raise adequate resources, reduce dependence on the narrow local markets and diversify the sources of funds. Three, firms persistently attempt to minimize the cost of capital with the progressive opening up of the trade and investment regime. Persistence of interest rate differential above a threshold level between the domestic and the international markets for similar financial assets together with the expectations about exchange rate movements, may lead to substitution of domestic liabilities with international liabilities by firms. It is argued that companies could raise funds from international capital markets at a lower cost (Saudagaran, 1988). Four, raising loans by the domestic firms from international markets may help firms acquire credibility and reputation, which in turn, may facilitate greater access to domestic markets. It is contended that firms that participate in international markets tend to obtain better financing opportunities and leverage for longer debt maturity (Karolyi, 1998; Chaplinksy and Ramchand, 2000; Miller and Puthenpurackal, 2000; Lins, Strickland, and Zenner, 2001; Schmukler and Vesperoni, 2001; Doidge, Karolyi and Stulz, 2002). Five, a firm achieving global scale of operations and having exposure to receivables and borrowings in foreign currency may provide a natural hedge to its balance sheet. In addition, firms may take recourse to international markets to finance their global operations. Six, foreign currency borrowings may also enable firms in managing risks through more sophisticated financial instruments.

Apart from the above factors, shifts in investor sentiment and phases of global credit cycles may play an important role in determining access of domestic firms to external markets. Country credit ratings have a predominant impact on the risk perception on corporate bonds and thus, access to international capital markets and also the cost of capital. The East Asian crisis (1997) and the Russian crisis (1998) have amply demonstrated that the currency crisis may have significant adverse spillovers for the corporate sector in terms of credit spreads in the international markets and the access to credit as the general risk perception rises. The exchange rate also constitutes an important element of borrowing cost of the corporate. The corporate tends to take higher recourse to borrowings in international markets when there are strong expectations of the appreciation of domestic currency as the effective cost of servicing such debt goes down in future. The reverse is true when the exchange rate of the domestic currency is expected to appreciate significantly. In a situation of fixed exchange rate, the exchange rate does not pose any risk to the corporate balance sheet and hence the cost of hedging of foreign exchange risk is zero for the corporate. To further extend the argument, if the exchange rate is managed narrowly within a band, it may provide more certainty about the exchange rate movement to the borrowers and hence, dispense with the need to incur additional cost of hedging foreign currency exposures. Besides the above factors, it is argued that certain institutional and economic obstacles may hamper firms from less developed markets to access international capital markets. These mainly include information barriers on firms from less developed markets, relatively low quality of corporate governance, volatile corporate earning cycles and higher country risk premium.

Interest Rate Arbitrage

A higher inflation wedge would, in principle, translate into higher nominal interest rates, create the opportunities for cross border interest rate arbitrage and hence encourage domestic firms to tap international capital markets. Consistent with the theory, movement in exchange rate would neutralise this as real interest rate differentials (interest rates adjusted for inflation differentials) are reflected in the movement of the exchange rate. However, in many emerging markets, despite the existence of significant inflation differentials, there is persistent pressure for exchange rate appreciation due to strong expectations of economic growth. Thus, persistence of a higher interest rate along with a higher output growth rate creates a lower risk perception and greater arbitrage opportunities.

Having established the evidence of significant interest rate differentials and hence the opportunities for the corporates to minimise their cost of capital by diversifying their liabilities, it would be pertinent to examine the relationship between the interest rate differentials and the pace of corporates’ recourse to overseas borrowings. There, prima facie, seems to be evidence of persistence of significant interest rate differential, which enables corporates to choose between domestic and overseas borrowings and also determines the pace of corporate borrowings in overseas markets (Chart 9)⁵ . The coefficient of correlation between ECB disbursements and interest rate differentials between domestic and external markets is observed to be high (0.75).

A firm’s recourse to the international capital markets can be explained through various financial and real variables (Chart 10). From the demand side, real activity plays a crucial role. In a relatively open economy, the higher credit demand generated by the real activity can be financed by a combination of domestic and foreign resources. Among the financial variables, key drivers are interest rate differential, exchange rate and the hedging cost. In the standard economic theory, the demand for funds is inversely related to interest rates i.e., the cost of capital, other things remaining the same. Interest rates differential between home and abroad would be a complex interaction of a host of domestic and international factors. Exchange rate movements can significantly affect the effective cost of borrowings from the international markets. Illustratively, expectations of an appreciation of domestic currency over the medium term may reduce the effective cost of debt servicing and hence provide greater incentives for borrowings from external markets. Hedging costs and the availability of hedging instruments can also impact the borrowings by domestic firms from international markets. Higher hedging costs may narrow down the arbitrage available to domestic borrowers from international markets. Similarly, well developed hedging tools may minimize the risk to the borrower and enhance the incentives to borrow from overseas markets. We broadly follow the above

framework in the Indian context in order to examine the demand for external borrowings by the corporates.

Drawing from the above circular interaction of various factors in influencing the borrowing behaviour of corporates, the demand for overseas bottowing of the corporates is explained through an error correction and cointegration model. The error correction model subject to a long term tragectory of demand for ECBs can be specified as :

where y_t = corporate demand for overseas borrowings, x_t = [r^d, L_t and Q_t], vector of veriables i.e., r^d is the interest rate differential between the domestic and the international interest rates, L is the liquidity constraint faced by the firms in the domestic market, Q is the index of industrial production signifying the underlying domestic investment demand by the corporate sector. q and p are vectors of the short run coefficients and adjustment to equilibrium or long run path, respectively. v is the white note and ∆the first difference operator. The quarterly data for the period 1993:Q1 to 2007:Q4 were used to estimate the postulated model. The data were obtained from the RBI data base. The model was estimated using E-Views statistical package.

The optimal lag order of the model is determined by the Schwarz criteria (SBC); suggesting 2 quarter lag - typical of a financial time series where lag responses are quicker.⁶ All the variables were found to be difference stationary, i.e., I(1), suggesting a cointegrating relationship. The results of Johansen’s cointegration rank tests pertaining to Trace and Maximum Eigen value statistics are summarized in Table 10. Both the Trace and the Eigen value tests suggest that there is a single cointegrating vector or a long-run relationship among the four variables in the model. Furthermore, the LM test suggests that there is no serial correlation of the first order among the error terms.⁷ Chi-Square statistic suggests absence of heteroscedasticity.⁸

vector normalised to the ECB variable (i.e., ECB as the dependent variable) is shown in Table 11. It is evident that real activity, spread and liquidity have a statistically significant long-run effect on the ECB variable. The real activity and spread have a positive association while liquidity has an inverse relation with the ECB.

Variance Decomposition Analysis

Impulse Response

The impulse response analysis of ECBs reveals that a one standard deviation shock to real activity causes a significant variation in demand for the ECBs in the initial three quarters; however, in the subsequent quarters the impact gets stabilised (Chart 11). Further, the shocks to real activity cause persistence in the demand for ECBs, indicating more a permanent nature of such shocks. Positive shocks to interest rate differentials also lead to persistence in the demand for external borrowings. Shock to money supply causes reduction in the demand for overseas borrowings with increasing magnitude over the initial quarters, after which the impact stabilises. To illustrate it further, a high domestic liquidity growth would have a moderating impact on interest rates and also reduce the credit constraint faced by certain corporates thus, persistently reducing the demand for overseas borrowings.

Simulated Trajectory of ECBs

Notes

⁷     The LM Statistics at 23.54 for the first order lag is not found significant at 5 per cent level.
⁸     The Chi-square statistics with 190 degrees of freedom was found non­significant with probability value of 0.76. Thus, the null hypothesis that errors are both homoscedastic and independent of the regressors, is not rejected

⁹   This is equivalent to the average duration of the cycles of industrial activity in India as indicated by some empirical research in the Indian context such as Mohanty, Singh and Jain (2000).

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