Overseas borrowing: a double-edged sword?

Subject: Economy

Section: External Sector

Context: Allure of cheaper rates may be deceptive as foreign currency loans can actually prove to be expensive

Multiple ways to boost companies’ capital

The first method would be to infuse excess earnings into the company through retained earnings.
The second would be to dilute the stake of existing shareholders of the company by creating a rights issue to infuse equity capital into the firm.
The third, and arguably the quickest method, would be to borrow money from banks directly, NBFCs or the open market through issuing bonds/debentures.
Fourth, borrowings denominated in foreign currencies

Arguments behind borrowing in foreign currencies

When there is interest-rate disparity between the domestic and foreign markets (favouring the latter), it becomes cheaper to service such loans.

Risks

It is crucial to note the borrower is still open to exchange risk, notwithstanding the difference in interest to be paid.
If the domestic currency were to decline compared with the foreign currency, the company is liable to pay more than it had bargained for in real terms.
Therefore, the currency risk must be offset by your revenue denominated in the foreign currency or by some other measure.

Example

Vedanta, a mining company with a market capitalisation of ₹93,896 crore (at the time of writing this piece), had borrowed $1.2 billion in February 2021 when the U.S. dollar to rupee conversion rate stood at roughly ₹72.6 but touched a high of ₹80.03 on July 18 this year. The dollar, in nominal terms, appreciated by 10.6% in over a year-and-a-half. An increase of 10.6% in the total interest payments amounts to $1.394 billion.

Challenges

The problem with borrowing in the current environment is the impending risk of a recession due to increased interest rates to curb inflation. Central banks worldwide, primarily the Federal Reserve, have raised rates unanimously.
The effect of rising rates has two facets,
- the first being the threat of lower earnings from a shrinking economy, and
- the second being the depreciation of the rupee compared with foreign currencies.
- Although the borrowing of these companies remains constant, their revenues decrease due to a recession, increasing the real burden of their debt.

NCDs (non-convertible debentures)

Debentures are long-term financial instruments that are issued by companies to borrow money.
Some debentures have a feature of convertibility into shares after a certain point of time at the discretion of the debenture holder.
The debentures which cannot be converted into shares are called non-convertible debentures (or NCDs).
There are two types of NCDs-secured and unsecured.
A secured NCD is backed by the assets of the company. If the company fails to pay the obligation, the investor holding the debenture can claim that through liquidation of those assets.
Contrary to this, there is no backing in unsecured NCDs if company defaults.