ECB Hedging
Updated on: 13th January 2024
ECB stands for External Commercial Borrowings (ECB). ECB helps Indian corporations to raise funds from overseas lenders/foreign branches of Indian banks. ECB includes commercial bank loans, notes, bonds, debentures (not fully and compulsorily convertible), more than 3 years of trade credits, FCCB, and FCEBs. ECB may have primarily two kinds of risk –
a) Floating interest rate risk (if not a fixed-rate loan), and
b) Forex risk.
The forex risk can be further divided into Forex risk on Principal repayment, and Forex risk on Interest payment.
- Interest rate risk can be hedged using swaps: IRS (Interest rate swap), FRAs, Options: Cap and floor (Options on the interest rate), option structures like collar, etc.
- Forex risk can be hedged using forwards, options and swaps separately for P and I and together.
- Interest and forex risk both can be hedged using a cross-currency swap (CCS/CIRS)
- A combination of instruments also can be used to hedge ECB
ECB hedging guidelines
As per the current regulation apart from infrastructure space companies, there are no mandatory hedging requirements from RBI.
Infrastructure space companies are required to hedge 70% of the ECB exposure(P+I) if the average maturity of the ECB is less than 5 years. The tenor of such hedging needs to be a minimum of one year with rollover subsequently so that at any point in time the required hedging should be in place during the tenor of the ECB.
A natural hedge can be considered only to the extent that net inflow is offsetting the outflow within the same financial year.
Although RBI has not mentioned the instrument for such hedging, banks generally insist on using forwards, full swaps, and plain vanilla call options.
For INR denominated loans, overseas lenders can hedge their rupee liability in India. They can also hedge through any Indian bank’s overseas branches or through any bank having a presence in India on a back-to-back basis.
ECB Hedging RBI:
The ECB hedging falls under the umbrella of RBI regulations as postulated under the Master Direction – External Commercial Borrowings, Trade Credits and Structured Obligations (Master Direction), Master direction – Risk management and Interbank dealings, comprehensive guidelines on derivatives, and the Foreign Exchange Management Act, 1999 (FEMA).
RBI lays the guidelines for the banks and in turn banks ensure that corporate follow the guidelines. But the primary responsibility lies with the corporate to follow the guidelines and report to the RBI in the prescribed format in stipulated time.
ECB Hedging Loans:
- Loans can be hedged by considering all the possible available instruments in various scenarios, the lender’s covenants, regulations, the risk appetite of the company, etc.
- Two standard hedge cost tables with a few swaps and option costs are given below for illustration
- Instead of CCS, IRS+ LTFX also can be evaluated, and this choice provides better IRR as the hedge costs are payable rear-ended.
- Further, OIS fixed to float swap can be done on fixed rupee liability to reduce the interest cost if rates are favourable.
| Tenor | 3Y | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized % |
| 1 | Forward | 7.60 | 2.80% |
| 2 | Plain Call strike at 83 | 6.85 | 3.15% |
| 3 | Plain Call strike at 90 | 2.65 | 1.20% |
| 4 | Call Spread (Buy Call at 83/ Sell Call at 88) | 3.45 | 1.60% |
| 5 | Call Spread (Buy Call at 83/ Sell Call at 90) | 4.40 | 2.00% |
| 6 | Capped Forward (83 to 88) | 2.95 | 1.35% |
| 7 | Capped Forward (83 to 90) | 3.90 | 1.80% |
| Tenor | 5Y | ||
|---|---|---|---|
| Sl. No. | Strategy name | Cost | Annualized % |
| 1 | Forward | 14.20 | 2.90% |
| 2 | Plain Call strike at 83 | 10.70 | 3.15% |
| 3 | Plain Call strike at 97 | 3.00 | 0.90% |
| 4 | Call Spread (Buy Call at 83/ Sell Call at 90) | 4.65 | 1.35% |
| 5 | Call Spread (Buy Call at 83/ Sell Call at 95) | 7.20 | 2.10% |
| 6 | Call Spread (Buy Call at 83/ Sell Call at 100) | 7.20 | 2.10% |
| 7 | Capped Forward (83 to 95) | 6.70 | 1.95% |
| 8 | Capped Forward (83 to 100) | 8.25 | 2.40% |
| 1Y | 2Y | 3Y | 4Y | 5Y | 7Y | 10Y | |
|---|---|---|---|---|---|---|---|
| IRS | 6.24% | 5.61% | 5.33% | 5.19% | 5.12% | 5.07% | 5.07% |
| POS | 1.84% | 2.45% | 2.74% | 2.84% | 2.87% | 2.85% | 2.64% |
| COS | 6.31% | 5.74% | 5.54% | 5.50% | 5.52% | 5.66% | 5.92% |
| CCS | 8.15% | 8.19% | 8.29% | 8.34% | 8.39% | 8.51% | 8.56% |
| ****Assumed USD SOFR + 1.5% Spread |
Here IRS stands for interest rate swap. This instrument takes care of floating interest rate
POS stands for principal-only swap. This instrument takes care of forex risk on principal
COS stands for coupon-only swap. This instrument takes care of floating interest rate and forex risk on coupon
CCS stands for cross-currency swap. This instrument takes care of all the forex and interest rate risk
ECB Hedging Procedures:
- Fully hedged ECB should be compared with INR loan while availing ECB.
- All the available currency options to be explored in terms of IRR.
- While comparing different currency-denominated loans currency basis needs to be considered
- Proper calculation needs to be done and choices to be made accordingly if alternatives are available in choosing the benchmarks like O/N SOFR, 3m Euribor/ 6m Euribor, TONA, etc.
- Once the ECB terms are finalized, get a few hedging banks that can provide all the possible hedge choices and competitive pricing.
- Get the hedge lines ready with a maximum number of banks with favorable terms.
- Generate IRR for optimum alternative hedge choices in different scenarios.
- Make a strategy to negotiate and seamlessly hedge as per the need and choice.
NBFC ECB Hedging:
NBFCs have to hedge 70% of the ECB exposure(P+I) if the average maturity of the ECB is less than 5 years. The tenor of such hedging needs to be a minimum of one year with rollover subsequently so that at any point in time the required hedging should be in place during the tenor of the ECB.
FAQs on ECB Hedging
1. What is ECB Hedging?
ECB hedging refers to the hedging mechanism where the hedging would be used to offset the adverse price changes in the currency pair involved and /or hedging to offset the risk of adverse interest rate movement
2. Is Hedging Compulsory for ECB?
As per the current regulation apart for infrastructure space companies, there are no mandatory hedging requirements from RBI. Infrastructure space companies are required to hedge 70% of the ECB exposure(P+I) if the average maturity of the ECB is less than 5 years. The tenor of such hedging needs to be minimum one year with rollover subsequently so that at any point of time the required hedging should be in place during the tenor of the ECB.
3. What is the ECB hedging framework?
The existing ECB guidelines can be seen as a rationalized and liberalized framework. RBI had started relaxing much-needed rules from 2018. The expanded list of eligible borrowers, Lower minimum average maturity period, relaxation in end-use, and relaxation in mandatory hedging are the characteristics of the current framework. A summarized table for ECB guidelines and framework can be seen below.
| Parameters | Direction of framework | |
| Options of raising ECB | FCY denominated ECB | INR denominated ECB |
| Currency of borrowing | Any freely convertible Foreign Currency | Indian Rupee (INR) |
| Eligible borrowers |
All entities are eligible to receive FDI. Port trust, SIDBI, EXIM Bank of India, and units in SEZ. (LLPs are not eligible) |
a. Registered microfinance companies and b. All entities eligible to raise FCY ECB |
| Recognized lenders | A resident of any FATF or IOSCO compliant country | |
| Minimum Average Maturity Period |
The minimum average maturity is 3 years barring a few specific categories mentioned below. a) 1 year for manufacturing companies up to USD 50 million per FY b) 5 years when raised for equity foreign equity holder for working capital/general corporate purpose or for repayment of rupee loan c) 10 years for working capital purpose or general corporate purpose or for on lending for the same purpose by NBFCs d) 7 years for repayment of Rupee loans availed domestically for capital expenditure or for lending for the same purpose by NBFCs e) 10 years for repayment of Rupee loans availed domestically for a purpose other than capital expenditure or lending for the same purpose by NBFCs |
|
| All-in cost pricing | Benchmark rate plus 450 bps spread | |
| End-Use |
Negative list: a) Real estate activities. b) Investment in the capital market. c) Equity investment. d) Working capital purposes, except foreign equity holders. e) General corporate purposes, except foreign equity holders. f) Repayment of Rupee loans, except foreign equity holders. g) On-lending to entities for the above activities, except in the case of ECB raised by NBFCs for the same. |
|
| Maximum amount |
a) USD 750 million b) specifically for manufacturing company USD 50 million with MAMP 1 year |
|
| Hedging |
a) 70% of P+I is the mandatory requirement for infrastructure space companies when the average maturity is less than 5 years b) not mandatory for any other category |
4. What are the guidelines on ECB Hedging?
The ECB hedging falls under the umbrella of RBI regulations as postulated under the Master Direction – External Commercial Borrowings, Trade Credits and Structured Obligations (Master Direction), Master direction – Risk management and Interbank dealings, comprehensive guidelines on derivatives, and the Foreign Exchange Management Act, 1999 (FEMA). RBI lays the guidelines for the banks and in turn banks ensure that corporate follow the guidelines. But the primary responsibility lies with the corporate to follow the guidelines and report to the RBI in the prescribed format in stipulated time.
5. Can foreign Investors hedge ECB exposure in onshore markets?
Yes. They can hedge their exposure in rupee with AD Category I banks in India.
6. What is ECB funding?
External Commercial Borrowing (ECB) is a cheap source of financing for India Inc due to the interest rate differential between India and the capital surplus overseas markets such as the US and Euro Zone countries. It helps bring down the cost of financing for Indian enterprises. However, borrowers should be aware of the risks associated with this form of financing as any adverse currency movement at the time of redemption of ECB could singe them.
ECB can be used for general corporate purposes including working capital provided the ECB is raised from a direct/indirect equity holder or from a group Company for a minimum average maturity period of 5 years.