Let’s assume you suddenly have a guest at home and you are running short of milk to prepare tea.
In such a scenario you will have no option but to borrow some from your neighbors, which you can replace later.
Likewise, external means non-Indian / foreign source, commercial would mean engaged in commerce and borrowing means acquire temporarily with a promise to return along with interest.
The concept of this strange sounding term is just as simple.
ECB has become a major source for raising money by large Indian companies in recent years. In comparison with India, interest rates are a lot lower abroad. Therefore, this is the single biggest incentive for companies raising money from overseas.
For example, even if a company borrows in the international market at 4% for one year; the cost of borrowing for a similar tenor may be close to 10% in the domestic market.
Companies in India are allowed to borrow from overseas, under certain conditions, through different instruments, with a minimum average maturity of 3 years.
The main objective is to provide companies with an option of low-cost capital.
However, it is not that ECB is always beneficial to a company and the country and does not carry any risk. There is a definite risk involved.
The depreciation of the rupee is the biggest hurdle to this kind of borrowing.
Let’s assume, I have borrowed $100 at 4% and converted it into rupees at Rs.85/- per dollar.
Now effectively I have borrowed Rs.8,500/- at 4%. Under normal circumstances, I will have to pay $104 after a year.
So, if the currency were to remain stable, I would have added the interest amount (4% of Rs.8,500/- which is Rs.340/-) to the principal to make it Rs. 8,840 and buy US dollars at the rate of Rs.85/- per dollar. This would fetch me Rs. 8,840/-/Rs.85/- = $104.
So far this makes complete business sense. Isn’t it?
But what if the rupee depreciates to Rs.100/-?
As far as the overseas party is concerned the liability of the Indian company is clearly $104.
At $1 = Rs.100/-, Rs.8,840/- would only fetch me Rs.8,840/-/ Rs.100/- = $88.40. There is thus a shortfall of $15.60 ($104 – $88.40).
Now, the cost of buying additional $15.60 at Rs.100 per dollar turns out to ($15.60 x Rs.100) = Rs.1,560/-. Thus, the interest which was planned as Rs.340 turns out to be (Rs.340/- + Rs.1,560/-) Rs.1,900/-.
Now if you were to calculate the rate of interest the business enterprise in India lands up paying turns out to be (Rs. 1,560 / Rs.8,500) x 100% which works out as 18.35% which is much more than the 10% interest rates prevailing in the local market.
Thus, in this case the borrower would surely feel short changed.
The opposite will be the scenario incase rupee appreciates against the dollar.