External commercial borrowing (ECB) is a type of loan availed by Indian companies in which they raise fund outside of India in foreign currency. In actual, ECB is a type of commercial loan for Indian corporate which they can avail from foreign entities through means such as loans from foreign banks or FIs, bonds or securitized instruments.
Indian corporate is permitted to use ECB either for fresh investments or capacity expansion. The funding raised can’t be used for the following purpose:
- Real estate activities
- Investment in capital market
- Equity investment.
- Working capital purposes except from foreign equity holder
- General corporate purposes except from foreign equity holder.
- Repayment of Rupee loans except from foreign equity holder
- On-lending to entities for the above activities.
Indian corporate can avail ECB through two routes as permitted by RBI guidelines, automatic route or approval route
- Automatic Route: For the automatic route, the cases are examined by the Authorised Dealer Category-I (AD Category-I) banks.
- Approval Route: Under the approval route, the prospective borrowers are required to send their requests to the Reserve Bank through their Authorised Dealer (AD) Banks for examination.
Pros of ECB:
- ECBs are economical, i.e. the cost of borrowing through ECB is cheaper than resources available in domestically, taking the advantage of lower interest rates in Eurozone, United States or other international financial markets
- ECBs are a good way if the amount of funding needed is large as the availability of bigger market players in international markets can provide a larger sum of funding
- Borrowing from international markets may open more avenues for corporate to expand their businesses at a global level
- Being a loan, ECB doesn’t provide debtors with the right to have to control the company as it doesn’t provide voting rights as in case of when raised through equity.
- Lower cost of funding adds to the overall profitability of the company and also contributes to the economic growth of the country.
- Availability of hedge instruments like futures and swaps to manage FX risk arising because of borrowing in foreign currency adds to benefits of raising funds through ECB
Cons of ECB:
- Raising funds through ECB provides capital in foreign currency and hence the repayment of interest and principal is done in foreign currency, therefore forex risk arises, it not managed properly the Fx risk may cause heavy losses to corporate
- Availability of easy funds through ECB may tempt corporate to take large debts which will reflect on the balance sheet and hence may adversely influence financial ratios.
- Higher debt on balance sheet may lead to a downgrading of credit rating by credit rating agencies which will increase the cost borrowing by the company, and its share prices of the company may plunge down because of high debt
- RBI guidelines restrict the end use of funds raised through ECB, for example, ECB can’t be used for working capital needs.
Conclusion: Though ECB is an easy route to raise funds but it comes with its own limitations and risks, the most important being Fx risk, if not hedged properly it may take away the benefit of raising abroad instead of domestically. Moreover, ECB is a highly regulated form of raising funds as it has to be routed through as per guidelines of RBI.