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Search date: 02-04-2018 Return to current date: Click here

Foreign currency loan: Averting bitter experience of Asian tigers

First of a three-part article titled No hedging, but effective benchmark lending rate policy

Nironjan Roy from Toronto, Canada | April 02, 2018 00:00:00

Bangladesh Institute of Bank Management (BIBM) recently organised a workshop on "Benefits and Potentials of Interest Rate Hedging: Bangladesh Perspective". Some core areas of banking came up for discussion in the workshop and, among them, Interest Rate Hedging on Foreign Currency Loan, Secondary Bond Market and Effective Benchmarking Interest Rate are very important and much discussed topics.

INTEREST RATE HEDGING ON FOREIGN CURRENCY LOAN: In the workshop many participants have strongly recommended for practising and popularising interest rate hedging as an effective tool for mitigating risks associated with interest rate fluctuations. From the discussion, it is not clear whether they were focusing on interest rate hedging on domestic loan or foreign currency loan. If they refer to traditional so-called hedging previously practised in our country, then it is a different issue. Because that is not typical hedging rather a kind of forward booking or locking of exchange rate in future transaction.

However, if they mean hedging of interest rate on foreign currency loan in the international arena, then it is something which deserves utmost care and attention. During the recent past, it has been evident that hedging has not produced any fruitful result in mitigating risks associated with interest rate fluctuation. Potential risks associated with interest rate change are mitigated through hedging in the form of Forward, FRAs (Forward Rate Agreements), Futures, Swaps, Options, and Caps (Put and Call). These are known as highbred financial derivatives which are very complicated and extremely risky products in the financial market. In order to manage these hedging products, the concerned officers and the department will have to have expertise, high analytical skill, networking connection with market players and technologically advanced applications. But the expertise, tools and techniques in dealing with hedging are totally absent in our banking industry. Moreover, there is allegation regarding manipulation of loopholes in managing hedging practice. Besides, historically hedging has never protected the borrower, rather has always benefited the hedgers because they have more access to the market, thereby they can well identify market trend on interest rate. So, they easily foresee the notional rate on which they add their adequate margin to determine reference/strike rate applied on hedging. Therefore, the borrower will have to always pay more than the actual rate prevailing on the transacting date. However, it may provide some sort of mental peace for the conservative borrowers.

RISK OF FOREIGN CURRENCY LOAN: Although foreign currency loan is envisaged as a comparatively cheap source of borrowing fund, it bears high degree of interest rate risk and repayment risk too. With respect to foreign currency loan, interest and repayment will have to be truly made on every maturity date which our borrowers are not accustomed to. In our banking practice, business community borrows money but hardly pays back, even interest is not directly paid as it is accrued and accumulated with their loan balance. This type of practice is not allowed in international banking and therefore, the borrower may be treated as defaulter. Default in foreign currency loan may have severe impact on the borrower and the country as a whole because sovereign rating may even be adversely affected.

Moreover, foreign currency loan is governed by executing credit agreement between the borrower and the lender. This loan document is prepared as well as executed by renowned international legal experts. So, our bankers will have to be well-prepared to properly understand each and every clause of credit agreement and its consequence. Mentionable that almost every credit agreement contains the facility of callback clause which allows the lender to call back the loan extended to the borrower. Once the facility extended is called back under the clause stipulated in the executed credit agreement, the borrower will have to comply with it by repaying the outstanding loan regardless of their cash-flow stream; otherwise, the failure thereof will result in default. So, this type of clause must be reviewed carefully and negotiated to remove from the credit agreement.

Though foreign currency loan is a cheap source of fund, indiscriminate borrowing in foreign currency for random investment should not be allowed at all. Even working capital finance by borrowing foreign currency loan must be strictly restricted. In fact, there must be stringent control on borrowing in foreign currency and the business community may only be allowed to borrow in foreign currency where deployment of fund is required in foreign currency and for the investment which will generate cash-flow in foreign currency. Consequences of indiscriminate investment through borrowing cheap fund in foreign currency can be dire like those experienced by the Asian tigers in the middle of 1990s. South Korea, Hong Kong, Thailand and Taiwan had gone for massive development programmes through extensively borrowing in foreign currency and emerged as Asian tigers but were unable to pay back when these loans were suddenly called back by the international lenders which eventually caused severe financial crisis for them. Malaysia was the lone exception as it was able to escape this contagious financial crisis by maintaining stringent control over foreign currency transaction under the prudent leadership of Dr. Mahathir Mohammad.

OPPORTUNITY & ALTERNATIVE SOURCE OF FOREX FUND: Bangladesh is currently in the process of graduating to developing country status. There will be big investment opportunities in the country and many international lenders/banks will show interest to provide financing. We have to exploit this opportunity with prudent moves which can be ensured if proper regulatory mechanism, control and monitoring are put in place instead of resorting to the obsolete means of hedging. We can thus avert the bitter experience of the Asian tigers.

Since the requirement of fund in foreign currency is regular and persistent, efforts must be made to develop our own alternative source of foreign funding as there is the potential to mobilise funds from the expatriate Bangladeshis. Now millions of Bangladeshis are living all over the world, particularly in the developed countries where there is very little scope or no scope at all to save. Alternatively, these innumerable expatriate Bangladeshis have the opportunity to mobilise some investable fund at very low interest rate. In addition to their own savings, most of the expatriate Bangladeshis have the opportunity to borrow at nominal rate which they can invest if provided with the opportunity and security to invest in foreign currency instrument in Bangladesh. Introducing foreign currency bond for expatriate Bangladeshis, popularising those instruments among prospective expatriate Bangladeshis and a sort of government guarantee to return their money and allowing repatriation thereof may create a great opportunity for Bangladesh to substantially mobilise sustainable foreign fund which can easily supplement foreign currency borrowing.

Nironjan Roy is a banker based in Toronto, Canada.

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