Dodging The Hedge Is Weighing Heavy On Indian Companies Seeking Foreign Debt
The upcycle in interest rates has sharply driven up the cost of hedging foreign currency borrowings.
Financial conditions for companies seeking foreign debt have changed remarkably between March and August.
The Secured Overnight Financing Rate—a benchmark interest rate for loans and derivatives denominated in U.S. dollars—has jumped 268 basis points from 0.3% in April to 2.98% in September, according to data from the New York Federal Reserve.
"Sharp increase in SOFR and also for Indian benchmark has become a sore point for Indian corporates," Samir Lodha, founder of QuantArt, a foreign exchange and risk management advisory firm, told BQ Prime.
Corporates have been caught off guard by the rapid rise in interest costs, he said.
Non-financial Indian firms had an outstanding external debt position of about $255 billion at the end of June 2022. This accounted for 41.3% of India's overall external debt, according to RBI data.
U.S. dollar-denominated debt is the largest component of India’s external debt, with a share of 54.7% at the end of June 2022.
About 44% of India's external commercial borrowings was unhedged at the end of June, according to data released by the RBI.
While Indian corporates had taken advantage of low interest rates prevailing internationally over the last two years, they stayed away from hedging those loans completely as hedging increases the cost of foreign credit.
Earlier in January, a working paper released by the RBI had stated that optimal hedge level for foreign currency loans is closer to 63%.
"If one considers natural hedges, the unhedged exposures are not significant," Abhishek Goenka, chief executive officer at IFA Global, a treasury advisory firm, told BQ Prime.
Natural hedges arise when a company maintains an equal amount of receivables and payables in foreign currency, thereby eliminating the need for financial derivatives to guard against swings in currency and interest rate levels.
For those without the benefit of a natural hedge, though, the cost of guarding against interest rate risk has ticked up significantly.
The five-year U.S. swap rates have moved higher from 1.6% in March to 4.05% in September, Goenka said.
"Moreover, it does not appear at this stage as though the rates have peaked as the (U.S.) Fed continues to remain hawkish," he said.
Even though hedging interest rates has become dearer, foreign exchange hedging is cheaper as currency forwards have come down due to "narrowing of rate differentials between U.S. and India", Goenka said.
Since corporates typically take on floating rate debt from foreign financiers, this exposes them to the dual risk of both currency and interest rate risk.
"More than 80% of corporates would have gone for floating rate loans," said Ritesh Bhansali, vice president at Mecklai Financial Services.
Companies typically receive floating rate loans since banks find it difficult to do fixed rate lending for longer tenures, he said.
Although floating rate loans don't present much of a headache during low interest rate environment with limited volatility, a rapid uptick in rates and volatility can soon make them a sore point.
"Those with open SOFR are now hedging even at 4% levels using interest rate swaps," QuantArt's Lodha said.
Interest rate swaps are contractual agreements under which counterparts swap one set of future interest payments with another based on a set principal amount.
Such swaps are only one among many tools that can be used by borrowers to hedge risk, but the broader trend appears to indicate that there might be more pain in store for those with floating interest rates on their external borrowings.
"If one is looking to hedge both FX and rate exposure, one can do a cross currency interest rate swap," Goenka said. This would convert a floating rate U.S. dollar borrowing directly to a fixed rate Indian rupee one, he said.
Although the increased interest rates and hedging costs may dim the allure of external borrowings for the time being, a tightening of financial system liquidity in India could push corporates to lean on offshore borrowing.
"More than the hedging cost, the key incentive to raise (external commercial borrowings) is to lower funding cost by saving carry," Goenka said.
Such confidence will only emerge when there is greater clarity on rate outlooks. "As of now, interest rate and forex volatility are way too high for someone looking to raise funds in USD," he said.