The optimal hedge ratio for the External Commercial Borrowings (ECBs) raised by firms in India is estimated at 63 per cent for the periods of high volatility in the foreign exchange (forex/FX) market, according to a Reserve Bank of India (RBI) Working Paper.

An optimal hedge ratio is a ratio that implies the percentage of total asset or liability exposure that an entity ought to hedge against exchange rate fluctuations.

In times of typical high FX volatility, firms issuing ECBs may take recourse to hedge their exposure financially/ naturally in the range [63 per cent, 66 per cent], which would translate to the total cost on loan, including hedging cost, proportional to nearly 9 per cent,said Ranjeev, Assistant Adviser, Department of Statistics and Information Management, RBI.

Moreover, this strategy is likely to lead to protection against forex risk, as FX Value at Risk (VaR) reduces by 33 per cent.

Raised eligible resident entities

ECBs are in the form of cash bonds, securitised instruments, preference shares (non-convertible/optionally or partially convertible) and some hybrid instruments such as Foreign Currency Convertible Bonds (FCCBs) and Foreign Currency Exchangeable Bonds (FCEBs) raised by eligible resident entities from recognised non-resident entities.

Ranjeev observed that large and lumpy principal repayments liability may arise during a short span of time on account of ECB borrowings, which if unhedged may lead to domestic forex market susceptible to bouts of excessive volatility.

Given the interest rate differential between India and the developed markets, all foreign currency exposures carry a significant cost of hedging.

“Hedging all FX exposures in their entirety may not be optimal in the sense that with fully hedged FX exposure, the benefit of low-cost access to foreign capital is foregone and at the same time unhedged foreign currency exposures may lead to correlated defaults in debt servicing triggering build-up of systemic risk.

“Therefore, there is a need to understand the optimal hedge ratio as may be discerned from empirical estimation for a minimum variance hedge ratio.” the author said.

From a macro-viewpoint with outstanding ECBs in the vicinity of 6.5 per cent of nominal GDP, they constitute close to 30 per cent of India’s external debt, per the Paper. Therefore, from the standpoint of maintaining macro-financial stability, it is prudent to have a judicious policy on optimal hedge ratios.

The ECBs issuance (excluding refinancing of earlier ECBs) moderated significantly during 2013-14 to 2015-16, but have recorded a historical highest issuance of USD 48 billion in 2019-20. However, during the pandemic, it has fallen sharply.

According to the Paper, domestic economic activity and movements in the exchange rate of the Indian rupee are the two major factors influencing the ECBs issuance. Depreciation of the Indian rupee has an adverse impact on the issuance of ECBs in the short as well as long run.