India’s central bank, the Reserve Bank of India (RBI) made a statement on October 3rd that will allow startups to accept foreign currency loans of up to US$ 3 million a year under the external commercial borrowing (ECB) route. Startups will now be able to raise the amount either in Indian rupees or any convertible foreign currency or a combination of both. Guidelines are expected to be issued at the end of the month.
Earlier in February, the RBI allowed startups to raise Indian rupee loans through the ECB route. Another advantage of allowing startups to borrow in foreign currency would be to cut down conversion costs. However, they will need to comply with guidelines like locking in foreign exchange rules. Prior to this easing of borrowing rules, in July, the Indian securities regulator – Securities and Exchange Board of India (SEBI) – introduced easier regulations for startups that wished to raise funds from the equity markets.
External Commercial Borrowing (ECB) Route
In simple terms, the ECB is used in India to facilitate access to foreign money by Indian corporations and public sector undertakings (PSUs) though it is now increasingly being used by foreign companies. ECBs are money borrowed from foreign resources, including commercial bank loans, buyers’ credit and suppliers’ credit, securitized instruments like floating rate notes and fixed rate bonds, and credit from official export credit agencies. ECB is different from foreign direct investment (FDI) in the sense that it is any kind of funding other than equity. If foreign currency is used to finance equity capital, it will be termed as FDI. Investments that are made towards the core capital of an organization, such as equity shares, convertible preferences shares or debentures, and any other direct capital are not included in ECBs.
Benefits of ECB
ECBs can be accessed via the automatic route and the approval route. For companies, the advantages of ECB is the ease in the transaction process since companies very often have to pay suppliers in other countries. In addition, the cost of funds borrowed from external sources may be cheaper than domestic funds. Borrowers can also diversify their investor base as the ECB route opens up the international market to them. The international market is also a good option for large investment requirements as the availability of funds is better than the domestic market. Foreign creditors also allow more flexibility in providing security for ECBs.
The RBI has also relaxed the rules under the approval process. It now allows companies to use the ECB route freely but submit approval plans only when borrowings are above a certain threshold limit. Prior to this change, all ECBs required RBI approval. Companies can raise ECBs through banks, export credit agencies, suppliers of equipment, foreign collaborators and equity holders, as well as the international capital markets.
One drawback of ECBs, however, is the fact that companies borrowing foreign funds have to hedge their foreign exchange exposure, which involves expenses. If it does not hedge its foreign exchange, the company takes on the significant risk of fluctuation in foreign exchange rates. The RBI has acknowledged this and has asked banks to monitor unhedged foreign exchanges, particularly for small and medium sized businesses.
The government typically encourages infrastructure and manufacturing sectors to use ECB for fundraising, and the extension to startups in the country is in line with the government’s Startup India campaign. The government has come to recognize that startups and entrepreneurs are integral to the economy and have a significant role to play. Nevertheless, studies in India show that almost 860 startups shut down at the growth stage due to the unavailability of funds, which doesn’t bode well for the nascent Indian startup sector (considered already to be the third largest in the world). Studies also show that in India, almost 60 percent of ECBs are done through secured loans and only 18 percent is through foreign currency convertible notes. Interest rates are lower for secured loans than for unsecured ones as they are considered safer by banks. Foreign currency convertible notes also have lower interest rates than loans but there is a threat of equity dilution if they are converted to equity, which lowers their appeal to borrowers.
The government is keen to increase FDI inflows. Along the same lines, the Ministry of Corporate Affairs recently made it easier to incorporate companies in India. The new guidelines will speed up the process of incorporating a company from the current period of four weeks. This will be done through an e-form called the Simplified Proforma for Incorporating Company Electronically (SPICE). The new amendment is part of the Companies (Incorporation) Fourth Amendment Rules, 2016, and should boost India’s ranking in the Ease of Doing Business Index released annually by the World Bank. The new rules for incorporation came into effect on October 3. With this the government hopes to continue to automate and digitize such regulatory processes.
ECBs in India rose by four times to reach US$ 3.17 billion in August as compared to the previous year. The borrowings were raised through both the automatic and approval routes. ECBs continue to be on an upward trend and with the RBI allowing startups to use ECBs for fundraising, this trend is expected to grow further. Analysts have stated that it bodes well for India’s economy, and will help companies as well as startups diversify their access to funds. Lastly, the new rules for incorporation are a part of the government’s move to digitize and simplify regulatory processes. Cumulatively, such reforms are expected to boost India’s ease of doing business rankings, the latest report of which is to be out in October.
This article was first published October 2016.
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