How External Commercial Borrowings Can Help Your Business Diversify Funding Sources
External Commercial Borrowings (ECBs) refer to credit or loans obtained via an entity (typically one of the governments or companies) in an international currency through foreign commercial lenders such as bank, banks, and other international institutions. ECBs are among the primary methods of obtaining funds for companies, primarily for infrastructure projects, expansion, or working capital requirements.
This article offers a thorough overview of ECBs' importance, the rules they enforce, and possible risks and benefits with their use.
What are External Commercial Loans?
External Commercial Borrowings (ECBs) are credits that are sourced by Indian companies or other eligible entities that are financed by foreign lenders. They typically are in international currencies, and they're governed in accordance with the Foreign Exchange Management Act (FEMA) in India. The purpose of ECBs is to allow businesses to obtain money from outside sources to meet their requirements for funding.
The borrowers of ECBs can be private sector firms as well as public sector organizations. The loans can be raised through different means including bonds, syndicated loans, and commercial paper.
Principal Features of the ECB:
Foreign Currency Loans: Most ECBs, however, are offered in foreign currency, which can be US dollars Euros, Euros, or any other exchangeable currencies.
Repayment Terms: The repayment term for these loans usually ranges from one year to several years based on the arrangement to be made with the lender.
Incentives: In the case of ECBs, interest rates ECBs are typically driven by market conditions and might be higher than local loan rates, based on the creditworthiness of the company borrowing.
Collateral: There are times when, borrowers may need to provide collateral or a guarantee to ensure the loan.
Intention of Increasing External Commercial Borrowings
Companies and entities have the option of raising ECBs for different reasons, such as:
1. Infrastructure Development
External Commercial Loans are commonly utilized to fund major infrastructure projects. These can be road projects, bridges, airports, and other vital public services that require a substantial investment.
2. Intensification of Business Operations
Businesses looking to expand their operation could consider using ECBs to finance new products, business units in addition to market development. These borrowings provide businesses with the funds needed to expand and expand their market.
3. Working Capital Needs
Businesses can benefit from ECBs by meeting the short-term requirements for working capital including the purchase of raw materials, paying salaries or managing day-to-day operations.
4. Refinancing Existing Debt
Many companies choose to utilize ECBs to refinance high-cost domestic loans or restructure existing liabilities, thereby reducing their expense for interest in a long term.
The types of commercial borrowings that are external to the market
ECBs are classified into a variety of types based upon the mode of borrowing and the nature of the repayment conditions:
1. Loans
The most basic form of an ECB is one in which an entity can borrow money from a lender and is willing to repay the loan in a predetermined time, usually with interest.
2. Bonds/Notes
In this instance the borrower issuing bonds or notes to international investors that are redeemable after certain time. This type of financing is usually used in large-scale financing needs.
3. Foreign Currency Convertible Bonds (FCCBs)
FCCBs are hybrid securities that offer a mix of both the equity and the debt. They are also able to be converted into equity shares at a later time which provides a dual benefit to investors.
4. Commercial Papers
They are short-term loans that are typically taken out by companies. They are a more flexible, short-duration instrument compared to bonds or loans. Commercial papers are often used for working capital financing.
Regulative Framework for ECBs
in India, External Commercial Borrowings are primarily governed by the Foreign Exchange Management Act (FEMA), 1999, and the Reserve Bank of India (RBI) provides specific guidelines related to ECBs. The principal regulatory rules for the ECBs are listed below:
1. The eligibility of borrowers
Indian Companies: Private and public sector enterprises are able to raise ECBs in the absence of certain sectors like real estate and agriculture.
Government entities: Certain government entities could also seek to raise ECBs under certain conditions.
2. End-Use Restrictions
The RBI and FEMA have set guidelines that specify the purpose for the purpose for which ECBs can be used. For instance, they are not able to be used for speculative purposes such as investing to the market. These funds must be used to fulfill productive needs, such as capital expenditure (or working capital).
3. Limitations on Amount and Currency
The ECBs need to be accounted for in foreign currencies and the amount of loan can be subject to restrictions set by the RBI. These limits are determined by the creditworthiness of the borrower and its nature.
4. Interest Rate Caps
The RBI has set restrictions on the rates that are allowed on ECBs to safeguard borrowers from excessively high fees. The rates are subject to change based upon the length of loan as well as the currency denomination.
5. Reporting, Compliance and Comply
Indian loanees are required to conform to various reporting obligations such as submitting monthly annual reports to RBI on the status of ECBs in the past, their use, and the progress of repayment.
Advantages of External Commercial Borrowings
External Commercial Borrowings offer several advantages for borrowers, including:
1. Acces in Large Capital
The companies can obtain large amounts of capital, which may not be obtainable through national financial institutions, especially for major expansion or infrastructure projects.
2. Less Interest Rates (in certain situations)
In many cases, interest rates on ECBs may be less than the rates that are charged by lenders in the United States which is especially true if the holder has a good credit score.
3. Diversification of the Funding Sources
ECBs can be used to diversify a company's sources of financing beyond traditional methods of financing in the United States. This is especially important when businesses are looking to expand into international markets.
4. Flexible Repayment Terms
Differently from many conventional loans, the ECBs tend to have higher flexibility for repayment, that help businesses manage their cash flow better.
Risks and Challenges of External Commercial Borrowings
While ECBs bring significant benefits but they also come with dangers and pitfalls:
1. Currency Risk
Since ECBs are based on foreign currencies, businesses are exposed to the threat of exchange rate fluctuation. A depreciation of the local currency can significantly increase costs of repaying the loan.
2. Interest Rate Risk
Since interest rates in the market fluctuate, ECB borrowers may face more expensive repayment charges if rates rise over the tenure of the loan.
3. Legal Risks
Modifications to regulations or policies related to foreign borrowing can affect the price or availability of ECBs. Businesses must be aware of the latest regulatory changes issued or imposed by RBI or the government.
4. Debt Burden
Excessive reliance on ECBs can lead to a higher cost of borrowing, which could be detrimental to a company's financial wellbeing if not managed carefully. There are times when a company might have difficulty in servicing foreign debt in times of economic decline or in which the company's profitability is low.
Conclusion
External Commercial Borrowings (ECBs) are an essential tool for raising funds for businesses, particularly those in emerging economies such India. They allow businesses to obtain foreign capital to fund infrastructure projects, expand operations, and also meet their working capital needs. However, companies need to weigh the benefits against the risks that come with it, in particular those related with fluctuations in currency or change in interest rates.
A thorough understanding of regulations as well as establishing an organized strategy for repayment and risk control is important for companies who want to gain from ECBs but also avoid potential negatives.