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Post-tax, foreign debt loses shine for Indian firms

Raising debt overseas becomes a less attractive option for Indian firms from Friday when a tax exemption on interest payments on such loans goes.

In its Budget for 2001-02 (April-March) unveiled in February, the government withdrew an exemption from withholding tax granted to interest payments on external commercial borrowings. The exemption is removed from June 1.

That effectively means the cost of raising debt overseas rises by about 10 to 25 per cent of the interest burden, depending on the country from which loans are being raised.

Investment bankers say shrinking interest differentials and the levy of this tax have narrowed the cost advantages of raising foreign currency debt substantially, and it now makes little sense tapping the external market for funding.

"The charm of borrowing abroad has gone. Unless a firm has some self-hedging mechanism, it cannot save any money on overseas loans," said R. Govindan, assistant general manager at cement and engineering firm Larsen & Toubro.

Local firms have been scurrying to tie up loans before the June 1 deadline to avoid the new tax, and bankers predict these large overseas issuance volumes will be a thing of the past.

"We are seeing a bunching of ECBs from five to six firms. Costs will rise by 60 to 150 basis points on account of the withholding tax, so plans to raise funds over the next few months have been advanced," a local investment banker said.

Big names like Reliance Petroleum, financial services firm ICICI, L&T, National Thermal Power Corp, Tata Iron and Steel Company and the Export-Import Bank of India are close to concluding loans worth nearly a billion dollars, with maturities from two and six years.

Bankers said there have been no fresh offshore Indian bond issues for a while, but even those will feel the pinch of the tax.

India is rated below investment grade in international capital markets, and on Thursday rating agency Fitch revised its outlook on the country to negative, citing worries over the fiscal deficit and foreign investment climate.

LITTLE BENEFIT

Over the past few years, and in line with falling interest differentials and the rapid growth in local debt markets, there has been a contraction in Indian ECBs.

In 1998-99, total approvals were $5.2 billion, which had declined to just $1.7 billion in April-December 2000.

Dollar LIBOR was around six percent in 1998, compared with India's benchmark bank rate at 11 per cent and domestic bank lending rates around 15 per cent then.

Treasurers said earlier they could raise dollar loans around eight percent and enjoy a large benefit, even if they paid close to five per cent to hedge the currency risk.

That gamble did not pay off last year, when falling domestic interest rates cut into the benefit and the rupee's sharp seven percent fall in 2000 skewed the estimates.

At current levels, the benefit is far less. With five-year dollar swaps around 5.9 per cent, and after adding credit spreads and the withholding tax, the cost of a five-year loan may be about 200 basis points lower than the 9.8-10.0 per cent coupons on similar five-year domestic top-rated bond issues.

In the case of those countries that India does not have a taxation treaty with, it will be a case of double-whammy as both lender and borrower pay taxes. "It makes no sense taking the currency risk when the differential gain is far below the long-range rupee depreciation rate of five to six per cent," L&T's Govindan said.

But, bankers said there are ways of getting around the new tax levy. One option could be Japanese yen loans, where interest costs are so low that the taxation is also minimal, and these could be swapped into the currency of choice.

And there is always the option of taking foreign currency loans from domestic banks, where the tax rule does not apply.

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