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Friday, November 18, 2016

Long journey to sound capital controls on foreign currency borrowing

by Pratik Datta and Radhika Pandey.

Policy reform happens in three stages:
Setting course
Choosing the strategy for reforms.
New law
Enacting new Parliamentary or subordinate law.
Building State capacity to enforce the new law.
In India, the expert committee process is an important element of the first stage; we are learning how to draft better laws; and we have early insights on how to build state capacity for the third.

A major bottleneck in the implementation phase arises out of lack of coordination in these three elements. Often, expert committees recommend vital policy changes after extensive deliberations. But then implementation suffers at the end of the government and regulators. New regulations are issued after considerable delay and in a piecemeal manner. Law is too important to be left to the lawyers;  when the law is drafted by people who lack the relevant domain knowledge, this gives faulty drafting.

The recent changes in the framework governing dollar denominated borrowing (referred to as external commercial borrowing (ECB) in India) is one such example of delayed and piecemeal implementation. On November 7, 2016 RBI issued a Circular No. 15 clarifying its regulation on hedging in relation to short-term ECB by infrastructure firms. RBI clarified that wherever hedging has been mandated by the RBI, the ECB borrower will be required to cover principal as well as coupon through financial hedges. Effectively, this clarifies RBI's earlier March 30, 2016 circular which, for the first time, mandated 100% hedging for infrastructure firms engaging in short-term ECBs. This marks an important shift in RBI's stance towards hedging.

Why are regulations on hedging required?

ECBs expose borrowers to exchange rate risk. If left unhedged, this may expose the financial system to systemic risk. There is an extensive literature in international finance (see here, and here) on the adverse implications of unhedged currency exposure in the event of exchange rate fluctuations.  The international policy discourse, and recent experiences of peer economies such as Indonesia and SouthAfrica, shows that addressing these concerns is helped by regulations that constrain borrowers to hedge their exchange rate exposure.

Ideally, exchange rate flexibility should give private persons ample incentive to hedge. From 2007 to 2013, India was doing well on this, but from late 2013, India has gone into a soft exchange rate peg to the USD. Under these circumstances, private persons have an incentive to borrow in USD and leave it unhedged, hoping to free ride on the peg. Unhedged foreign currency borrowing is thus particularly problematic now.

RBI missed this point

One of the most effective arguments in favour of capital controls is this issue, of  hedging requirements for foreign currency borrowing. However, for many years, while RBI had an elaborate system of capital controls on ECB, there were no hedging requirement.

In the beginning of 2014, RBI took a small step towards addressing this. Around the same time, in order to discourage banks from providing credit facilities to companies that refrain from adequate hedging against currency risk, RBI prescribed guidelines on incremental capital and provisioning requirements for banks with exposures to entities with Unhedged Foreign Currency Exposure (UFCE).

These changes did not succeed in nudging firms to hedge their exposure. In a speech, the then RBI Deputy Governor raised an alarm about the reduced propensity of firms to hedge foreign currency exposure. He noted that the hedge ratio for ECBs/FCCBs declined sharply from about 34 per cent in FY 2013-14 to 24 per cent during April-August, 2014 with very low ratio of about 15 per cent in July-August 2014.

The IMF Article IV Report in March 2015 on India highlighted concerns of rising unhedged corporate exposure and underscored the need to strengthen regulatory oversight. The report recommended strengthened monitoring of corporate vulnerabilities in the wake of increased unhedged foreign currency exposure of banks. A year later, in March 2016 another IMF report raised concerns about unhedged foreign currency exposure. But the RBI abstained from imposing a direct obligation on firms to hedge their foreign currency exposure.

Sahoo Committee recommended hedging

In Februrary 2015, the Sahoo Committee for the first time recommended hedging to address the underlying systemic risk emanating from ECBs. The Sahoo Committee report recommended that the regulatory framework should require mandatory hedging by Indian firms which borrow in foreign currency. It recommended a complete dismantling of the extant regime of complicated controls on ECBs, as this merely introduced bureaucratic overhead and did not address any market failure; it recommended focusing the capital control on ECB on this one issue: hedging. The report recommended that the required hedge ratio should be decided by the MOF-RBI Committee keeping in view the financing needs of the firms and of the economy, the development of onshore currency derivatives markets and any other systemic concern such as volatility in global risk tolerance.

Partial and delayed implementation by RBI

While the Sahoo Committee submitted its report in February, 2015, the RBI did not prescribe mandatory hedging till March 30, 2016. Even then, RBI mandated hedging only for infrastructure firms that borrow for less than 5 years. While this is a good step as most infrastructure firms do not have a natural hedge against the currency risk, this is only an incremental move towards the optimal framework of mandating a hedge ratio across all sectors and across all durations of borrowing. As recommended by the Sahoo report, hedging should be mandated for all kinds of ECBs unless there is a natural hedge.


This episode illustrates how economic policy failures arise from communication gaps between expert committees, which figure out what is to be done, and the different arms of the State which implement it. Often the latter are either not fully aware of the committee's thinking, or have misaligned incentives. When the drafting of legal instruments is tightly linked to sound domain knowledge, the results are better.

The authors are researchers at the National Institute for Public Finance and Policy.

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