ECB & its Regulations and Long Term Hedge Costs
Written by QuantArt Market
Updated on : 11th April 2022
What is External Commercial Borrowing?
External Commercial Borrowing (ECB) is a type of loan availed by Indian companies in which they raise funds outside of India in foreign currency. In actuality, ECB is a type of commercial loan for Indian corporate which they can avail from foreign entities through means such as loans from foreign banks or FIs, bonds, or securitized instruments.
ECB Forex
Though ECB is an easy route to raise funds it comes with its own limitations and risks, the most important being Fx risk for ECB. If not hedged properly it may take away the benefit of raising abroad instead of domestically.
ECB Routes
Indian corporates can avail of ECB through two routes as permitted by RBI guidelines, automatic route or approval route
Automatic Route: For the automatic route, the cases are examined by the Authorised Dealer Category-I (AD Category-I) banks.
Approval Route: Under the approval route, the prospective borrowers are required to send their requests to the Reserve Bank through their Authorised Dealer (AD) Banks for examination.
What is the government regulation on External Commercial Borrowings?
The existing ECB guidelines can be seen as a rationalized and liberalized framework. RBI had started relaxing much-needed rules from 2018. The expanded list of eligible borrowers, Lower minimum average maturity period, relaxation in end-use, and relaxation in mandatory hedging are the characteristics of the current framework. A summarized table for ECB guidelines and framework can be seen below.
| Parameters | Direction of framework | |
| Options of raising ECB | FCY denominated ECB | INR denominated ECB |
| Currency of borrowing | Any freely convertible Foreign Currency | Indian Rupee (INR) |
| Eligible borrowers | All entities are eligible to receive FDI. Port trust, SIDBI, EXIM Bank of India, and units in SEZ. (LLPs are not eligible) |
a. Registered microfinance companies and b. All entities eligible to raise FCY ECB |
| Recognized lenders | A resident of any FATF or IOSCO compliant country | |
| Minimum Average Maturity Period | The minimum average maturity is 3 years barring a few specific categories mentioned below. a) 1 year for manufacturing companies up to USD 50 million per FY b) 5 years when raised for equity foreign equity holder for working capital/general corporate purpose or for repayment of rupee loan c) 10 years for working capital purpose or general corporate purpose or for on lending for the same purpose by NBFCs d) 7 years for repayment of Rupee loans availed domestically for capital expenditure or for on lending for the same purpose by NBFCs e) 10 years for repayment of Rupee loans availed domestically for a purpose other than capital expenditure or for lending for the same purpose by NBFCs |
|
| All-in cost pricing | Benchmark rate plus 450 bps spread | |
| End-Use | Negative list: a) Real estate activities. b) Investment in the capital market. c) Equity investment. d) Working capital purposes, except for foreign equity holders. e) General corporate purposes, except foreign equity holders. f) Repayment of Rupee loans, except for foreign equity holders. g) On-lending to entities for the above activities, except in the case of ECB raised by NBFCs for the same. |
|
| Maximum amount | a) USD 750 million b) specifically for manufacturing company USD 50 million with MAMP 1 year |
|
| Hedging | a) 70% of P+I is the mandatory requirement for infrastructure space companies when the average maturity is less than 5 years b) not mandatory for any other category |
|
Strategies for External Commercial Borrowings:
External Commercial Borrowings provides clear savings over similar Rupee Borrowings when forex and interest rate risk is managed well. By being conservative, around 2% – 3% savings can be achieved compared to local borrowing. A few ideas are mentioned here:
A. Choice of Libor 1M-3M-6M
Libor basis is used in the pricing of any market instruments including IRS and it broadly reflects the credit charge component of Libor for a longer duration. Around 10 bps p.a. can be saved by choosing the lowest benchmark.
Given a choice 1m Libor should be chosen over 3m and 6m provided the spread over the benchmark remains the same irrespective of the benchmark. We recommend 1M Libor because of the “Libor basis”.
If the monthly cash flow frequency is a concern, 3m or 6m can be chosen with a preference for 3m.
B. Hedging Instruments
As per regulation by RBI/2018-19/71 A.P. (DIR Series) Circular No.11 dated 6th Nov 2018, no mandatory hedging requirement is there for companies apart from infrastructure space companies. Retail users (net worth less than 500 crores) can use Swaps, Forwards, Plain Vanilla Call Option and Call Spread to hedge the payables. Non-retail users can hedge with any instrument that AD 1 category banks can provide.
C. Hedging Strategies
To manage the fx and interest rate risk conservatively with an eye on savings, various optimized strategies can be evaluated.
1. Call spreads have low cost and a good IRR for most likely cases. This strategy has been widely used by large corporates and institutions and has been beneficial for long-term hedges. The same can be shown with historical data where it can be seen that after a sharp depreciation, INR stabilizes for a while to ensure that in any 5-year period cumulative depreciation is not extremely high.
2. As per prevailing RBI Regulations, Call Spread can be availed.
3. Also, between CCS and IRS+LTFX, we can see IRS+LTFX works out better in IRR terms since the cash flows are rear-ended and market instruments are discounted at Mifor, whereas generally borrowing cost is higher than Mifor.
4. Another alternative strategy can be a one-year full hedge using a simple option with Strike = Spot and Rollover of the same. Here the risks are completely covered, and the costs are higher. The advantage however is that if ever INR appreciates or long-term forward premium comes down, the full hedge can be done for a longer tenor and the benefit in interest is captured. We believe this is a good strategy as it will certainly perform in the current market. Safe and effective with worst-case well known.
5. In the one-year strategy, if a strike is chosen equal to the forward rate, then the cost is lower. Here the company will benefit from any depreciation which is less than the forward or in stability or in appreciation. The final IRR numbers can be monitored and locked in at any point in time.
These are overviews of different strategies. To know at any point, which strategy to implement and for what period it is important to understand the exposures.
Some of the hedge costs for various tenors are mentioned in the table below:
Spot Reference: 76.00
| Month | 13-Apr-23 | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized% |
| 1 | Forward | 3.06 | 3.95% |
| 2 | Plain Call strike at 76 | 3.59 | 5.02% |
| 3 | Plain Call strike at 79 | 1.86 | 2.60% |
| 4 | Call Spread (Buy Call at 76/ Sell Call at 79) | 1.88 | 2.62% |
| 5 | Call Spread (Buy Call at 76/ Sell Call at 80) | 2.25 | 3.14% |
| 6 | Call Spread (Buy Call at 76/ Sell Call at 81) | 2.54 | 3.55% |
| 7 | Capped Forward (76 to 79) | 1.29 | 1.80% |
| 8 | Capped Forward (76 to 80) | 1.66 | 2.32% |
| 9 | Capped Forward (76 to 81) | 1.95 | 2.73% |
| Month | 13-Apr-24 | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized% |
| 1 | Forward | 7.36 | 4.65% |
| 2 | Plain Call strike at 76 | 7.02 | 5.11% |
| 3 | Plain Call strike at 83.5 | 2.45 | 1.78% |
| 4 | Call Spread (Buy Call at 76/ Sell Call at 80) | 2.97 | 2.16% |
| 5 | Call Spread (Buy Call at 76/ Sell Call at 81) | 3.55 | 2.58% |
| 6 | Call Spread (Buy Call at 76/ Sell Call at 82) | 4.08 | 2.97% |
| 7 | Capped Forward (76 to 80) | 2.5 | 1.82% |
| 8 | Capped Forward (76 to 81) | 3.08 | 2.24% |
| 9 | Capped Forward (76 to 82) | 3.61 | 2.63% |
| Month | 13-Apr-25 | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized% |
| 1 | Forward | 11.4 | 4.66% |
| 2 | Plain Call strike at 76 | 9.79 | 4.97% |
| 3 | Plain Call strike at 87.5 | 2.72 | 1.38% |
| 4 | Call Spread (Buy Call at 76/ Sell Call at 81) | 3.73 | 1.89% |
| 5 | Call Spread (Buy Call at 76/ Sell Call at 83) | 5.04 | 2.56% |
| 6 | Call Spread (Buy Call at 76/ Sell Call at 86) | 6.64 | 3.37% |
| 7 | Capped Forward (76 to 81) | 3.34 | 1.69% |
| 8 | Capped Forward (76 to 83) | 4.65 | 2.36% |
| 9 | Capped Forward (76 to 86) | 6.25 | 3.17% |
| Month | 13-Apr-26 | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized% |
| 1 | Forward | 15.52 | 4.61% |
| 2 | Plain Call strike at 76 | 12.24 | 4.86% |
| 3 | Plain Call strike at 91.5 | 2.92 | 1.16% |
| 4 | Call Spread (Buy Call at 76/ Sell Call at 84) | 5.6 | 2.22% |
| 5 | Call Spread (Buy Call at 76/ Sell Call at 86) | 6.88 | 2.73% |
| 6 | Call Spread (Buy Call at 76/ Sell Call at 88) | 7.97 | 3.16% |
| 7 | Capped Forward (76 to 84) | 5.23 | 2.08% |
| 8 | Capped Forward (76 to 86) | 6.52 | 2.59% |
| 9 | Capped Forward (76 to 88) | 7.6 | 3.02% |
| Month | 13-Apr-27 | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized% |
| 1 | Forward | 19.23 | 4.41% |
| 2 | Plain Call strike at 76 | 13.99 | 4.64% |
| 3 | Plain Call strike at 95 | 3.11 | 1.03% |
| 4 | Call Spread (Buy Call at 76/ Sell Call at 84) | 5.27 | 1.75% |
| 5 | Call Spread (Buy Call at 76/ Sell Call at 86) | 6.53 | 2.17% |
| 6 | Call Spread (Buy Call at 76/ Sell Call at 88) | 7.79 | 2.58% |
| 7 | Call Spread (Buy Call at 76/ Sell Call at 91) | 9.39 | 3.11% |
| 8 | Capped Forward (76 to 84) | 4.91 | 1.63% |
| 9 | Capped Forward (76 to 86) | 6.18 | 2.05% |
| 10 | Capped Forward (76 to 88) | 7.44 | 2.47% |
| Month | 13-Apr-29 | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized% |
| 1 | Forward | 34.89 | 5.34% |
| 2 | Plain Call strike at 76 | 20.97 | 5.41% |
| 3 | Plain Call strike at 111 | 3.29 | 0.85% |
| 4 | Call Spread (Buy Call at 76/ Sell Call at 86) | 5.69 | 1.47% |
| 5 | Call Spread (Buy Call at 76/ Sell Call at 88) | 6.79 | 1.75% |
| 6 | Call Spread (Buy Call at 76/ Sell Call at 91) | 8.43 | 2.17% |
| 7 | Call Spread (Buy Call at 76/ Sell Call at 96) | 11.14 | 2.87% |
| 8 | Capped Forward (76 to 86) | 5.52 | 1.42% |
| 9 | Capped Forward (76 to 88) | 6.62 | 1.71% |
| 10 | Capped Forward (76 to 91) | 8.26 | 2.13% |
| Month | 13-Apr-32 | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized% |
| 1 | Forward | 54.48 | 5.25% |
| 2 | Plain Call strike at 76 | 25.42 | 5.21% |
| 3 | Plain Call strike at 130.5 | 3.5 | 0.72% |
| 4 | Call Spread (Buy Call at 76/ Sell Call at 88) | 5.4 | 1.11% |
| 5 | Call Spread (Buy Call at 76/ Sell Call at 91) | 6.71 | 1.37% |
| 6 | Call Spread (Buy Call at 76/ Sell Call at 96) | 8.88 | 1.82% |
| 7 | Call Spread (Buy Call at 76/ Sell Call at 102) | 11.45 | 2.34% |
| 8 | Capped Forward (76 to 88) | 5.3 | 1.09% |
| 9 | Capped Forward (76 to 91) | 6.61 | 1.36% |
| 10 | Capped Forward (76 to 96) | 8.78 | 1.80% |
Long term – IRS, POS, COS & CCS
Please find below the IRS, POS, COS & CCS for 1 to 10 years
| 1Y | 2Y | 3Y | 4Y | 5Y | 7Y | 10Y | |
|---|---|---|---|---|---|---|---|
| IRS | 3.71% | 4.36% | 4.50% | 4.49% | 4.46% | 4.44% | 4.42% |
| POS | 4.03% | 3.83% | 3.74% | 3.79% | 3.85% | 4.14% | 4.18% |
| COS | 3.85% | 4.60% | 4.83% | 4.92% | 5.00% | 5.19% | 5.52% |
| CCS | 7.89% | 8.43% | 8.58% | 8.71% | 8.85% | 9.33% | 9.70% |