| EXTERNAL COMMERCIAL BORROWINGS |
27 February 2006
What role ECB has to play in our growth story? If we look at ECB as a vehicle for foreign direct investment, we can appreciate the role of ECB better in promoting economic growth. ECB provides medium and long term funds, bridging the gap between domestic savings and investment. At micro level ECB provides an alternate source of funds for Indian companies at competitive rates of interest and in the process, helps globalisation of economy.
ECB for funding current account deficit Current account deficit (CAD) is nearing 3% of GDP and is expected to be in excess of USD 41 bn. by end March 06. Non-inflationary deficit is generally associated with high growth rates, particularly when there is a large output gap - which is the case with Indian economy. It then becomes important as to how the deficit is funded and what is the end use of the funds.
CAD is funded by FII inflows into portfolio investment, foreign direct investment in permitted sectors and ECB raised by Indian companies. Portfolio investment really represents hot money deployed in trading of stocks and securities, that helps more of value transfer than value creation. Direct investment in equity and debt, on the other hand, is a long term investment, which does not cause inflation. ECB in particular, under current regulations, is tied to project expenses / capital goods import, and hence contributes directly to increase in output.
We may say that deficit is good for the economy, so long as the funds are used in capital formation. The aggregate amount raised by Indian companies by ECB route over the last 9 months exceeded USD 10 bn, funding a large part of CAD. Large ECB issues are in the pipeline and we may expect additional ECB of USD 3 bn by end March 06. By way of comparison, foreign direct investment is about USD 7 bn., and net FII inflows over the 9 month period amounted to USD 5.6 bn. only - though the latter are more visible on account of high turnover rate.
ECB effectively adds to the country’s external debt burden. However, given a stable credit rating, the ECB is constantly recycled and eventually, the cost of ECB works out to be less than the return on foreign investment in stocks. Additional investment in projects in the long term also results in output growth and growth in exports.
ECB and interest rate environment
After a long pause, domestic interest rates are showing an upward swing. Call rates, which we used to see at around 5% are nearing 7%, outside the ‘corridor’ of RBI. The latest hike in Repo and Reverse Repo rates emboldened the commercial banks to raise medium and long term interest rates.
There is a lurking fear that higher interest rates will affect the profitability of Indian corporates and would eventually bring down the GDP growth rate. While the central banks target only the short term rates to forestall inflationary trends, the transmission of monetary policy is such that the yields are affected across the curve. Central banks can not infuse liquidity into specific sectors to provide relief from higher interest costs.
The ECB not only supplements domestic liquidity, but liquidity enhancement takes place exactly where it is warranted, providing relief from higher interest costs. The liquidity does not leak into consumer sector, hence does not add to a demand-push inflation. The beneficial impact on medium and long term interest rates holds good, even if the rise in domestic interest rates is in sync with global interest rates - for, in the absence of global liquidity flows, credit expansion in domestic economy would push the interest rates even higher.
ECB in a way, scores over FDI in the above regard, as Indian companies raise ECB strictly to meet their specific requirement, while flow of FDI is on a selective basis, at the discretion of the foreign investors.
ECB and the Regulator
For a long time, I think till 2003, in line with Tarapore Committee recommendations, RBI had kept a ceiling of USD 8 bn. on ECB, which was surprisingly never breached. With the liberalization of ECB policy, presently there is no cap on external commercial borrowings of Indian companies, except for minimum restrictions under automatic and approval rates.
Even so, there is no justification to have sectoral restrictions, so long as RBI regulates end use of funds. In particular, infrastructure sector and financial institutions still need to go by approval route, where RBI approvals are accorded on a highly selective basis. These are the sectors which need long term funds at competitive rates, and by treating them on par with other corporates under ECB policy, RBI / Government would greatly help minimize the funding costs.
We may draw here a parallel to US economy. One of the reasons that the US yield curve is inverted, immunizing the long term interest rates from regular hikes in FED rates, is that the debt market is deep enough to absorb demand for long term funds from US Treasury and US companies. What we narrowly call ECB is nothing but debt issues by Indian companies (increasingly in the form of FCCB and Euro-dollar bonds), and globalisation of markets would only help bring down such issue costs. As Rupee is not yet fully convertible, RBI has the privilege of directing such flows only into project related end-use.
ECB vs. domestic debt
Lastly, Indian companies opt for ECB issues, no longer only for interest rate arbitrage. Such arbitrage is gradually disappearing as the markets get integrated. Indian companies’ preference for ECB arises when domestic liquidity is not adequate to absorb the credit demand (e. g. ECB issue of USD 1.5 bn. by Reliance group), and long term costs would get inflated in the domestic market. Global markets also help easier recycling of debt, due to large investor base.
Indirect benefits from ECB - with greater access to global markets - accrues from more rigorous credit rating of borrower companies and import of best practices into Indian capital market. Global markets also provide for better risk management through cross currency swaps and other derivative structures.
It is time that the Government and the regulators realize the benefits of ECB and pave way for greater liberalization, without sectoral restrictions.
Currency Market View - Rupee and Majors
INR Fortnightly movement: O-44.2600 H-44.6500 L-44.2050 C-44.4300.
Sentiment: range bound
Expected range for 1 Month: 44.00-45.00
Expected range for 3 Months: 43.80-45.25
The strength of the rupee bulls diminished as the market witnessed the domestic unit at a near 7 week low as it touched a level of 44.64 during the week. Sensex remained buoyant as it stayed well above the 10,000 mark helped by both domestic and foreign flows. However, flows did not aid the domestic currency as dollar buying was seen from nationalized banks for oil imports and possibly on behalf of the central bank to contain rupee appreciation and to improve the liquidity position in the money markets
With foreign fund flow likely to be continued amid expectations of a better budget for the domestic stock indices, the rupee is poised to attack the 44.00 ; however central banks likely to protect rupee appreciation and keep gains (if any) short lived.
EUR Fortnightly movement: O-1.1898 H- 1.1974 L-1.1848 C-1.1871
Sentiment - neutral but may improve
Expected range for 1 Month: 1.1800 -1.2400
Expected range for 3 Months: 1.1800 -1.2600
Last fortnight the euro ended about 30 pips lower after trading in a very narrow 1.1850-1.1975 range. The market seems to have turned a blind eye to a barrage of US data that was largely dollar supportive as also an unexpected rise in the German business climate index to a 14-1/2 year high. Instead, the market appears to have been pre-occupied with central bank policies. The new Fed chief Bernanke’s testimony on February 15 was dollar supportive but with a March 28 Fed rate hike almost fully discounted, the dollar appeared a bit immune to good US data. The market is also looking forward to the ECB chief’s likely comments after this week’s monetary policy meeting at which a 25-bp rate hike is widely expected.
The euro still appears likely to stage a smart rally though not without some help from the data and hints from the ECB about further rate hikes. However, if you are in no rush, it would be prudent to wait for a decisive break above 1.1975 or below 1.1850.
GBP Fortnightly movement: O-1.7435 H- 1.7556 L-1.7281 C-1.7448
Sentiment: neutral but may improve
Expected range for 1 Month: 1.7300 -1.8000
Expected range for 3 Months: 1.7300 -1.8300
Sterling slid sharply to about 1.7280 after UK inflation report was reported at 1.9% undershooting the 2% target for a 2nd consecutive month. However, sterling recovered and steadied following Bank of England’s inflation report stating that inflation is likely to be close to the 2% target. Disappointing UK retail sales data pulled sterling down once again before being buoyed by the minutes of this month’s MPC meeting showing the same 8-1 vote to leave rates unchanged.
From a technical perspective, sterling appears better poised than the euro at this juncture to rally against the dollar. However, this could well change if the ECB President, during his press conference after the ECB’s policy-setting meeting later this week, hints at further and faster tightening.
JPY Fortnightly movement: O-117.69 H- 118.99 L-116.41 C-116.75
Sentiment: positive (for yen) and will likely improve
Expected range for 1 Month: 113.00 -119.00
Expected range for 3 Months: 109.00 -119.00
The dollar slipped to about 116.75 on February 15 after the dismal TICS report from US as also an unexpected drop in US industrial production but then rallied after Bernanke’s hawkish testimony and encouraging US data to reach about 119 yen early last week. Even better-than-expected Japanese Q4 GDP data had only a short-lived impact on the dollar. It was only BoJ Governor’s hawkish parliamentary testimony last Thursday that pushed the dollar sharply down.
Last Friday, the dollar closed below 117 yen for the first time in 4 weeks. If the next Japanese CPI report due on March 3 is upbeat, market speculation will very probably increase about a BoJ policy shift at its policy-setting meeting next week and lead to further dollar losses.
Yen strength on expectation of a BoJ policy shift and year-end Japanese repatriation could, however, limit the rally of the European majors against the dollar if counterbalancing factors from the Eurozone/UK are not strong enough.
Dr. Risk's Prediction
What’s wrong with the dollar? And what’s wrong with the euro?? The euro was confined to a very narrow 1.1850-1.1975 range against the dollar last fortnight despite many surprises from the US and one from the Eurozone. US retail sales growth was reported on Feb 14 to have surged in January to a 2-year high of 2.3%. The very next day Fed Chairman Bernanke’s highly anticipated Congressional testimony shielded the dollar from an unexpected drop in US industrial production as also a sharp drop in net capital flows into the US, which fell below the trade deficit for the first time since last April. Then the Philadelphia Fed index zoomed from 3.3 to 15.4, its highest level since August 2005. The euro did dip as far as 1.1850 but managed to close above 1.19 except on one day. Last Friday, the University of Michigan consumer sentiment index dropped unexpectedly but that wasn’t enough to boost the euro very much.
This week the FOMC minutes showed continued consensus amongst the members for further Fed rate hikes. The US index of leading indicators rose 1.1% at the fastest pace in 6 months. Headline CPI outpaced forecasts rising 0.7% last month but core CPI rose 0.2% in line with expectations. Fed funds futures contracts show 96% chance of a hike next month and 66% chance of another hike in May but the dollar couldn’t make much headway. Yesterday the German IFO index rose unexpectedly to a 15-year high but a sharp across-the-board yen rally seemed to have spoilt the party for the euro.
With the May FOMC meeting still far away and a March rate hike almost fully discounted, the dollar is perhaps unable to benefit much from strong US data but could lose ground on a series of negative surprises. On the other hand, markets seem to be in no mood to give credence to good Eurozone data unless they get some real action from the ECB.
Another factor is likely yen strength and a major euro/yen downward correction. This could limit euro’s upside against the dollar and may even turn the tide against it. In the past we have seen both dollar/yen and euro fall. From May to December 1999 USD/JPY fell from 124.80 to about 101.25 while the euro fell from about 1.0840 to parity. Since the October 2000 all-time low of about 89, EUR/JPY has risen as high as about 144. A drop to say the 120-125 zone is quite likely on any yen strength and hectic unwinding of yen carry trades. Such an event could see dollar fall against the yen and euro fall against the dollar.
We seem to have little choice but to wait for a decisive range breakout but at this juncture, I will still back an upside break over 1.1975 on way to 1.23 and later 1.26 if I have to stick my neck out!
Japanese yen received hardly any boost from the better-than-expected Japanese Q4 GDP growth of 1.4% but surged yesterday after hawkish comments from BOJ Governor Fukui to the effect that a policy shift could be immediate once CPI stabilizes in the positive territory. After reaching about 119 yen, the dollar is now under 117. Next BOJ monetary policy meeting is on March 8 & 9. If speculation of an imminent BOJ policy shift grows, we could see a strong test and likely break below 115.50 on way to 113.50 initially and then 109.
Don’t be surprised if you see EUR/USD at say 1.10 and USD/JPY at or below 110 towards the end of 2006 or early 2007! That makes for euro/yen at 121 - just a modest correction after the rally from 89 to 144!!.
