Rising foreign currency loans: Risks and mitigating strategies

Rising trend of foreign currency loans availed by private sector is a relatively new phenomenon in Bangladesh since access to international markets was liberalised only in 2008.

Since then, foreign loans taken by the private sector have picked up significantly and currently stand at about USD 8 billion.

Firms which have availed this new channel reduced their financial expense, since interest rates charged by foreign lenders is 6-7 percent lower than domestic lenders.

Additionally, for projects which require capital in excess of what domestic banks can facilitate, this new channel is a promising option.

Yet, these benefits come with several risks which need to be carefully evaluated so that appropriate mitigating strategies can be implemented in a timely manner.

WHILE EXPORTERS GAIN, NON-EXPORTERS FACE ELEVATED RISKS

Exporters benefit immensely due to higher access to foreign loans. Their interest expenses fall and they face little exchange rate risk since they earn in foreign currency.

However, firms which earn in Taka (non-exporters) risk currency mismatch if the Taka depreciates. Depreciation will create additional costs in local currency terms when repaying foreign-denominated loan.

How large is the presence of non-exporters in Bangladesh's foreign loan market?

A study conducted by Bangladesh Bank (BB) in 2014, showed that the highest receiver of foreign currency loans was the telecommunication sector.

Despite not being export-oriented, this sector faces lower risks since most companies are part of international parent organisations. But the power sector, which is the second highest recipient (18 percent of total approved foreign loans), is mostly domestically owned and is not export-oriented either.

This suggests there is definitely potential for currency mismatch. Moreover, as the preference towards foreign loan rises, it is unlikely that authorities will be able to keep out non-exporters from increasing their exposure.

If BB allows depreciation in the near-term, exporters' profitability will rise (when they convert Dollar earnings to Taka) while non-exporters' profitability will fall.

IMPLICATION OF TIGHTER GLOBAL FINANCIAL CONDITIONS

A large portion of existing foreign-denominated liability is based on 6-month floating interest rates. This suggests an increase in world interest rates will raise interest expense, imposing unprecedented pressure on firms' cash flow. Private sector firms should not feel that 5 percent foreign borrowing rate is here to stay.

Given that the US Federal Reserve is soon likely to increase short-term interest rates for the first time in several years, global financial markets will reflect such changes. According to Federal Open Market Committee (FOMC), which decides US monetary policy direction, short-term interest rates could be increased to 2-3 percent by the next two years (for details, see "Fed Dot Plot").

This implies foreign borrowing rates could also rise to 7-8 percent in the next 2-3 years. At the same time, lending rates in Bangladesh are on a downward trajectory.

Assuming domestic lending rates of 10-11 percent in the next two years, the interest rate differential between Bangladesh and foreign lenders could fall to around 3-4 percent.

Such a scenario has implications for private sector's financial management, since firms have to consider both lower interest rate advantage as well as exchange rate risks.

BANKING SECTOR FACING DIVERSE RISKS

As the private sector increasingly avails of foreign loans, the domestic banking sector has come under tremendous pressure in maintaining business.

Domestic lending rates have fallen to around 11.5 percent (August 2015; source: BB). But due to differences in liquidity positions, this reduction has not happened uniformly across the sector.

Consequently, lending rates in some banks (which have substantially lowered rates) are now close to deposit rates in others (for instance, the new banks).

Bankers suggest that this variability in interest rate has led some large local corporations to borrow at low rates from one bank and deposit the money at high rates in another.

This type of practice undermines the role of financial intermediaries and simply transfers assets across the industry without triggering any overall growth.

This predicament has been amplified by local corporations taking foreign credit and repaying their domestic loans (well before maturity), hurting growth of banks' loan portfolio and reducing profitability.

Finally, since large corporations have strongest access to international markets, local banks will tend to increase exposure to relatively smaller and less credit-worthy clients. This will, on average, increase credit risk and potentially exacerbate non-performing loan problem.

WHAT MITIGATING STRATEGIES CAN AUTHORITIES ADOPT?

• With emphasis on non-exporting firms, transacting in the forward exchange market needs to be mainstreamed. Only by strictly requiring non-exporting firms to utilise forward contracts, authorities can protect private sector firms from currency mismatch.

• To lock in low foreign borrowing rates, authorities need to aggressively promote interest rate swaps. Given the cost of using financial derivatives, authorities could consider creating a policy where only loans above a certain agreed threshold are required to be hedged by all corporations – large or small.

• Authorities could consider creating an automated platform which monitors foreign loan portfolio of private sector firms and impose a limit to foreign borrowing up to a maximum allowable threshold. Maximum thresholds should be carefully linked with each company's financial indicators. Such automated platforms could also include a quantified outlook on risks of each company's overall industry.

• Banking sector needs to diversify its client base beyond urban corporations. Several industries with sustainable growth potential such as food, agro-based business, light engineering and mushroom cultivation are gradually expanding beyond urban locations. Opening cost-efficient branches in semi-urban and rural areas will certainly help expand asset size while reducing risk of concentrating mainly on urban clients.

Without a doubt, liberalising foreign borrowing promises to catalyse private sector investment. But we need to look beyond the low interest rate advantage and tackle underlying risk if we want to maximise potential of this new channel of financial resource.

Sharjil Haque is a macroeconomic analyst in Washington, D.C.