India proposes extra provisioning for unhedged foreign exposure of firms

Gving its warnings some teeth.

According to DBS, in a bid to give its warnings some teeth, the RBI proposed to mandate higher provisioning by banks against loans to corporates with unhedged foreign currency exposure.

Here's more:

The measure is still in the consultation phase and financial institutions have until early-Aug13 to provide feedback on these regulations.

Once finalised, the rules might become effective Oct13 onwards. These proposed rules are not without reason. Domestic corporates were encouraged to raise foreign currency loans to meet financing requirements, as an alternative to high borrowing costs at home and to tap low offshore rates.

While the former still holds, the latter is shifting northward, especially as the markets adjust to the possibility of Fed QE3 withdrawal. Rising US rates have narrowed the rate advantage that the corporates had tapped earlier, thus making it increasingly less cost-effective.

Meanwhile, the associated foreign currency exposure has become relevant in wake of recent substantial rupee depreciation and subsequent jump in the repayment burden.

As the accompanying chart shows, the scale of external commercial borrowings and foreign currency convertible bonds have been on the climb after the brief dip during the global financial crisis.

Much of the sharp rise in theseborrowings occurred when USD/INR was around 52.0, with the recent run-up likely to see redemptions face a firm 59.0-60.0, especially if the loans was left unhedged.

Assuming a USD 100 loan at 6mth Libor + 500bps basis, the repayments could jump by 12% on just INR7 slippage. This highlights the additional stress on the corporate balance sheets, at a time when profitability has already taken a hit on slowing demand and high borrowing costs.

In May, the central bank had estimated that about 60% of corporate loans were unhedged.

At the other side of the coin, the RBI is focused on shielding the domestic banking sector from probable corporate defaults. The operating environment for the banking sector is already far from ideal in midst of slowing deposit growth, tight liquidity conditions, lacklustre growth prospects and delayed infrastructure/priority sector loans, amongst others.

This has shown in the RBI’s recent Financial Stability Report, where gross NPAs for public-sector banks improved a notch to 3.4% in Mar13, from 3.6% in Sep12, but is still up from 2.95% in Mar12.

The rules surrounding restructuring of loans have also been tightened, especially as the latter was increasingly being used to contain extent of asset quality deterioration.

On a related note, loansextended to the industry and services sector made up bulk of the restructured loans and given that these also account for a good part of the credit market, the downside risks on the banking sectors’ finances could be significant.

In addition, banks’ capital needs are also expected to increase in the run up to the Basel III implementation and might further strain the banks’ books.

In sum, while the RBI calls on the corporates to ensure FX loans are adequately hedged, there is also a need to safeguard the banking system from any systemic risks.