It isn't the financial crisis of 1997 by any means, but the
economies in Asia are struggling—again.
The Japanese yen, Indian rupee, and the Indonesian rupiah have
depreciated 30 percent on average in the last 24 months. Growth
rates for India and Indonesia that were around 9 percent and 7
percent respectively two years ago have dropped off significantly,
with India now at half that rate. Two of the once mighty BRIC
economies (Brazil, Russia, India, and China) are now included as
part of a group of countries (namely Brazil, India, Indonesia,
South Africa, and Turkey) that have been dubbed by Morgan Stanley
as the "Fragile Five."
This Commentary considers the implications of slowing
growth, currency depreciation, debt exposure, and capital egress
for emerging markets, in particular India, together with the
connected legal issues.
Taper Tantrums
In late May this year, the U.S. Federal Reserve (the
"Fed") foreshadowed plans to taper its US$85 billion per
month asset purchases, possibly from as early as October. While
there have been fluctuations, the general market reaction was
increased long-term interest rates in the U.S. and an egress of
capital from developing countries, such as Brazil, India, and
Indonesia. However, on September 18, Fed Chairman Ben Bernanke
surprised commentators and markets by announcing that tapering of
the Fed stimulus would not start yet because the economy was seen
as too fragile to withdraw its support.
The Brazilian real, the Indian rupee, and the Indonesian rupiah
have all fallen significantly against the U.S. dollar in recent
months, and yields on bonds in emerging countries have jumped
significantly. However, emerging markets did receive a boost from
the news that tapering by the Fed will not commence in the near
future. Nevertheless, the Fed's tighter monetary controls and a
rising U.S. dollar predicated Latin America's crisis in the
early 1980s and Asia's crisis in the 1990s, and there are
suggestions that similar difficulties may still develop again. The
machinations over Fed tapering have revealed some fundamental
concerns regarding the status of certain emerging market economies,
and these will not necessarily be resolved by the recent fillip
provided by its postponement (especially as the delay was due to
concerns regarding economic fragility).
The Asian currency crisis of the 1990s truly began when
Thailand's central bank floated the baht after a run on the
currency in July 1997. The decision triggered a financial and
economic collapse that spread to other countries in the region,
causing growth to plummet and companies to go bankrupt with the
only solution being IMF-led bailouts.
The crisis of the late 1990s was exacerbated by a number of
factors, including fixed or semi-fixed exchange rates, high
domestic interest rates, heavy offshore borrowing, and large
deficits. The present circumstances are different, not least
because of the way in which Asian countries reacted after the
previous crisis. Most Asian economies now have sizeable current
account surpluses (including China, South Korea, Taiwan, Thailand,
Malaysia, and the Philippines, although both Thailand's and
Malaysia's balances have deteriorated recently) and foreign
exchange reserves, and the proportion of non-performing loans on
banks' balance sheets has generally declined. However, that is
not to say all countries are in the same comparatively healthier
position or that companies operating or investing in emerging
markets are similarly protected.
Looking at India specifically, the country has a substantial
deficit, the rupee has dropped by around 30 percent recently, and
stock markets have fluctuated dramatically. In particular, the
shares of banks with balance sheets suspected to hold a significant
proportion of bad debts or with deposit funding shortfalls have
fallen sharply. Taking another example, Indonesia is experiencing
slowing growth, high inflation, and a substantial deficit.
The deficits of India and Indonesia highlight the fact that in
many emerging markets, as in Europe, the availability of
"hot" money appears to have covered a multitude of sins.
Upcoming elections in both countries also mean that the ability to
address these problems may be limited as policy makers try to avoid
losing electoral capital by implementing policies to address
economic indiscipline and structural reforms.
Debt Dependency
There are serious concerns that emerging market economies have
been too dependent on debt. Such concerns are also mirrored at the
company level, particularly in countries where companies, buoyed by
strong domestic performance, have embarked on foreign investments
or capital raisings.
The problems of company indebtedness are seen acutely in India. A
significant number of India's industrial conglomerates are
heavily in debt and suffering the ramifications of ambitious
capital projects (often stalled in regulatory and bureaucratic
mires). The fact that such debt is very often in U.S. dollars makes
the plight of such businesses worse given India's depreciating
currency. Indeed, recent research from Credit Suisse shows that 10
of India's most heavily indebted industrial conglomerates
(including Reliance, Vedanta, and Essar) had combined debts in
excess of US$100 billion at the end of the last financial
year.
It is in this context that, in August, the Reserve Bank of India
restricted overseas investment by companies to 100 percent of their
net worth (down from 400 percent). This move made foreign investors
fearful that their own funds could be trapped (as occurred in
Malaysia when capital controls were imposed following the crisis of
the late 1990s) and caused further capital egress from India.
Furthermore, such restrictions have been mirrored for individuals
as the level of permitted external remittances made by Indian
residents was recently reduced to US$75,000 from US$200,000.
In an environment of reducing growth and returns, firms may
struggle to meet their obligations, especially those in foreign
currencies. The possibility of increased insolvencies for
businesses will be a major concern for India's state-owned
banks that already hold a large amount of bad debt. A warning sign
for such banks is the rising level of credit default swaps on State
Bank of India that reflect a sense of growing risk.
Legal Considerations
The difficult economic circumstances give rise to a number of
legal considerations. Currency fluctuations may expose companies to
the risk that they may be unable to meet payment obligations. By
way of example, this exposure could arise in the context of power
supply contracts whereby a contractor or supplier has agreed to
provide power at a fixed cost but is subject to flexible and,
therefore, increasing input costs owing to currency changes. Other
similar exposures may also arise in respect of joint ventures or
acquisitions relating to emerging market investments, and in all
such scenarios there will be a number of legal issues to
address.
For example, firms may need to seek advice in relation to
potential insolvencies (either on their own part or on the part of
joint venture partners or other counterparties). Furthermore, where
a firm's counterparty has reneged on its obligations, firms
will need to seek advice on their enforcement rights and dispute
resolution options (which may include direct negotiations,
mediation, arbitration, or litigation). Alternatively, businesses
will require assistance in navigating the legal requirements for
terminating agreements and mitigating the related risks.
Issues Relating to Foreign Investment in Emerging
Markets. A prime historical example is provided by the
disputes relating to foreign investments in Indonesia to generate
electric power that were made prior to the Asian currency crisis of
the late 1990s. In 1994, Caithness Energy (U.S.) and Tomen (Japan)
agreed to develop specific Indonesian geothermal sites, if they
proved feasible, to produce electricity. Caithness, Tomen, Florida
Power (another U.S. firm joining in 1996), and a local Indonesian
partner (Sumarah Daya Sakti) incorporated Karaha Bodas Company
("KBC") to undertake the project. KBC was to deliver and
sell the electricity produced to PT PLN (Persero)
("PLN"), the state-owned electricity company, on a take
or pay basis at, initially, 8.46 cents (US$) per kwh.
After Indonesia was hit by the currency crisis and as demand
projections fell, it became apparent that PLN did not need and
could not pay the contracted price for all the power it had
committed to take. Furthermore, the fact that the energy sales
contract set prices in U.S. dollars meant that the rupiah payments
would be around five times the amount contemplated when the
contract was agreed. As a result, KBC served notice of arbitration
in 1998 seeking the termination of the relevant contracts and
damages for actual investments and expected future profits.
Eventually, KBC was awarded approximately US$260 million. The
present currency worries give rise to concerns that more recent
projects may suffer in a similar way.
Considering such issues from another angle, it is not only those
entities that owe obligations in stronger foreign currencies that
should be concerned by recent developments but also those that are
otherwise exposed to the same risk. For instance, foreign investors
will be wary of investments exposing them to aborted projects and
the possibility of extended dispute resolution and enforcement
processes to realize hoped-for returns.
Indeed, terminating agreements for these types of breaches can be
a particularly tricky area with many technical legal requirements
to be satisfied. Companies that wish to terminate an agreement for
a perceived breach by their counterparty should therefore seek
initial advice on the subject. It is very likely that there will be
formal stipulations relating to default and termination notices and
cure periods, which, if not followed, may invalidate, or at least
complicate, proper termination. Furthermore, companies should be
aware that, if they have previously waived breaches but
subsequently wish to terminate on the basis of further similar
breaches, their counterparty may seek to argue that termination
should be estopped.
Potential Problems Arising from Overseas Investment by
Domestic Companies. Indian companies have grown
increasingly frustrated by the failures of policymakers to carry
out economic and infrastructure reforms over the past decade. For
example, businesses in the energy and manufacturing sectors have
often made foreign investments to offset unreliable power and water
supplies at home (for instance, investments in Malaysia, where
power and water are more abundant). Other companies have
diversified to offset slowing domestic demand in other
industries.
Furthermore, new land acquisition legislation in India may also
cause Indian companies to consider making further investments
overseas rather than at home. The Right to Fair Compensation and
Transparency in Land Acquisition, Rehabilitation and Resettlement
Bill 2013, which seeks to replace the Land Acquisition Act 1894,
was passed by the Indian parliament at the beginning of September.
The new legislation is designed to ensure that people losing land
will be adequately compensated and to streamline the existing
rather chaotic process, but it is also expected to significantly
affect the development of large infrastructure and other industrial
projects to the extent that they fall within its scope.
The amount of compensation for land acquisition is now expected to
increase by around three to five percent, potentially making
industrial projects unviable and raising costs in the overall
Indian economy. In addition, the mandatory consent requirements (80
percent of landowners must agree to the acquisition for private
projects and 70 percent of landowners for
public-private-partnership projects) may also delay the process for
land acquisitions and, in turn, the projects. Such legislative
changes may not only result in reduced domestic investment but may
also limit the future viability of infrastructure projects as the
increased input costs, potential consent, and resettlement delays
as well as continuing difficulties in monetizing such projects
raise the inherent risks beyond acceptable levels.
Such overseas investment has a substantial economic cost for
India. Overseas direct investment, including bank guarantees issued
to overseas units, was approximately US$20 billion in the first
seven months of 2013 (up around 40 percent from the same period in
2012). Foreign investment by Indian firms not only equates to the
loss of domestic investment and a heightened dependency on foreign
investors in India but also exposes Indian firms making such
investments to related currency risks.
Indian companies will often implement foreign investments through
the acquisition of established market players in foreign
territories and may also choose to create joint ventures with
overseas partners. In a cross-border acquisition context, one of
the key terms of any transaction will be the purchase price.
Commonly, forms of consideration include cash, shares, debt
instruments, and/or an element related to future performance known
as an earn-out. To the extent that the consideration is variable or
payment is staggered, this might give rise to exposure to
currency-related risks. Early advice should be sought in respect of
such issues, especially in the current climate.
To the extent that a joint venture structure is used, an option
agreement may be put in place in respect of shares in the joint
venture entity. These provide parties with the right but also
possibly the obligation to purchase the shares of another
shareholder or vice versa, for example, in the case of disputes.
Where the option price is set in a foreign currency (against which
the rupee may have depreciated, such as the U.S. dollar), the
obligation to purchase shares at a price that is effectively
inflated by currency fluctuations may be very burdensome.
Difficulties Relating to Debt. Companies
established in countries that have suffered recent currency
depreciation (including India) could be hurt by their significant
exposure under foreign currency bonds. Indeed, as the domestic
currency depreciates, the effective burden for such exposed
companies increases.
It is possible to protect against such fluctuations using hedging
mechanisms, but not all emerging market companies have been careful
to put such measures in place. Morgan Stanley has estimated that
approximately half of India's US$225 billion corporate bond
exposure is unhedged. Even those companies with the protection of
overseas revenues (such as energy and commodity conglomerates)
and/or with hedging insurance may suffer from the effects of
currency depreciation. Indeed, at the very least, the cost of such
insurance is likely to rise considerably. Firms should closely
consider their hedging strategies, to the extent these are
appropriate, with their professional advisors.
In light of such concerns, there are signs that international
investors are growing wary of private sector debt exposure and are
moving to protect themselves from potentially vulnerable markets.
In the same way as companies and investors, banks are also exposed
to currency risk. In India, the state-owned banks have high levels
of bad debts, with infrastructure and project loans being
particularly perilous, and they are exposed to the failure of their
borrowers. In turn, foreign shareholders in such banks suffer
exposure to related risks. If necessary, recapitalization of the
banks would likely make them more attractive to foreign investors
and facilitate more lending to boost any recovery. However, the
funding for such recapitalizations would likely need to come, at
least in part, from the government, which is already struggling
with its own deficit.
That being said, if India has to seek an alternative, such as
funding from the IMF, then this could be even worse both for India
and other emerging markets given the potential domino effect that
could take over in today's interconnected global economy.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.