External debt - funding enigma

DIRECT TAX

The past few weeks have witnessed a flurry of debates with respect to offshore debt funding in general, and availability of non-equity financing options for real estate projects, in particular.

Historically, India's approach towards foreign direct investment (FDI) has been fairly liberal though offshore debt has been restrictive, given our monetary policy's desire to control inflow and outflow of foreign debt. The policy on offshore debt financing, referred to as external commercial borrowing (ECB) guidelines sets out an annual upper limit for servicing the debt and repayment obligations "" the underlying objective being to control the flow as part of central bank's monetary agenda.

Two recent significant developments have caused anxiety to investors; first, the Ministry of Finance's move to categorise non-convertible preference shares as debt, coupled with a reduction in the cost of servicing such debt by 50 to 100 basis points (bps). The second development being, RBI's move to impose an embargo on offshore debt funding for integrated townships. Prior to RBI's embargo, offshore debt funding was in general banned for real estate projects, though an exception was carved out for integrated townships. Integrated townships as defined under the FDI guidelines (Press Note 3 of 2002) include housing & commercial premises, hotels and resorts, city and regional-level urban infrastructure facilities.

There is no doubt that the RBI and Ministry of Finance have to coordinate the two recent directives. The government in its advocacy has voiced concerns over an unprecedented inflow of funds (in real estate) in the recent past and the debt route being resorted to frequently by small and medium-size players. A striking feature of the current developments to manage excessive foreign exchange reserves, inflationary pressure and interest rates is that the debate confuses several issues and has caused definitional challenges. Will the classification of non-convertible preference shares be different under the Companies Act, which does not distinguish between convertible and non convertible shares? Similarly, non-convertible preference shares will now be subject to end-user restrictions, something which is non-existent under the extant FDI policy. Further, under the FEMA regulations, dividends (to non-resident shareholders) on preference shares are subject to cap of 300 bps over SBI prime lending rate (approximately over 16 per cent). However, interest on ECBs (including non-convertible preference shares) will now be subject to LIBOR plus 150 to 250 bps, significantly lower than the FEMA limit.

The guidelines don't seem to resolve the debate with respect to classification of optionally convertible debentures (OCDs), an alternative instrument frequently used by investors. It is important that the government addresses these definitional challenges and articulates it position on permanent capital and contractual capital across monetary, fiscal and corporate legislation. Further, a classification of priority and non- priority sectors shall lend greater clarity to the ECB regime. It seems that by not raising the overall annual ECB cap, the government is comfortable from a monetary perspective, but would like to restrict flows to credible and non priority sector companies. Whereas some degree of capital control and temporary intervention is understandable, we should not lose sight of an overall milestone towards achieving capital account convertibility. Understandably, further opening up of capital convertibility should not risk monetary considerations.

The recent moves suggest that the government wants to paint the entire real estate sector with a common brush. There are elements within the real estate industry which are inextricably linked to economic development. Would anybody deny that housing is not a priority? Similarly, shortage of hotel rooms and convention centres could hamper the hospitability and tourism sectors. Aren't we contradicting ourselves by offering tax incentives on one hand and restricting capital flows on the other? One can just hope that these measures are temporary. Should the policy be tweaked to distinguish between priority and non-priority sectors within the real estate sector? Or should there be a real estate sectoral cap within the overall ECB limit?

Whilst, large realty players will resort to permanent financing and restructure their capital, it is important that the government pronounces a roadmap to review the current embargo. Similarly, to ensure that the medium size players do not land up in financial crises, alternate modes should be evaluated from a policy viewpoint. Given that NBFC's are well regulated (by the RBI) and follow stringent prudential norms, a re-look at the ECB policy is desirable such that NBFC's can access foreign borrowings to channel financing of integrated townships. NBFCs have played a significant role in the development of SME's that unlike large corporates would not have access to competitive financing instruments. Hence, if NBFCs are allowed access to ECBs, it would aid their cause and simultaneously achieve government's objective to block the ECB route to small players.

The recent changes need further calibration and definitive time frame to review them based on target milestone achievement, whether it is related to inflation related or capital flows related. The coming few months will assess the success and pitfalls of recent changes including the underlying objectives. What is required is an effective balance between the monetary policy, development of core infrastructure and flexibility of funding options.

To balance such divergent needs, we need dispassionate economic analysis and overlay of political philosophy. The weaknesses and flaws in hastily introduced measures will only damage the case for sensible fiscal policy in the long run.

The author is a partner with BMR & Associates and his views expressed here are personal