Back-to-Back loan is also known as Parallel Loan or Credit Swap Loan. To understand this concept we need to imagine the following:
- An Indian Parent company having a subsidiary abroad (Suppose US)
- A Foreign (US) Parent company having a subsidiary in India
We assume that the foreign parent company wants to lend USD 100 to its Indian Subsidiary for a specific period- say 3 years.
At the same time, the Indian Parent company also has to lend USD 100 to its foreign subsidiary in that country for the same period of 3 years.
We can say that the funds are to cross borders in this case. The Indian Parent company will need to exchange its Rupees into Dollars and send the amount across US to its subsidiary. At the same time the US Parent company will have to exchange its dollars for Rupees and send it across to India to its subsidiaries. In both of these transactions, there is always an “Exchange Risk” exposure.
To avoid this exposure, there can be an arrangement. In this arrangement, the Indian parent company can lend Indian Rupees 5000 to the US subsidiary located in India at current rates (we suppose Rs. 50 a dollar). Simultaneously, the US parent company will lend USD 100 to the Indian subsidiary. When the loan term expires, the repayment can be done in the same way. This arrangement is called back-to-back loan.
Thus, in back-to-back loan the funds move within the country but serve the purpose of cross border loans.
Back-to-Back Loans and India
In India, the states directly cannot borrow from external agencies such as IDA. The Union Government plays a role of intermediary. Before 2004, the states in India received all the external assistance on the terms as decided by the Union Budget. The loans were transferred to India states as per the below flowchart:
External Agency →Government of India →State Governments.
The External agency here means the banks such as World Bank etc. We should know that India has been a “blend borrower” in the World Bank. This means that it used to borrow on 50:50 rations of IBRD Loans and IDA Credits. The ratio could change also. Now the Government of India passed the funds to states on basis of 70:30 Loans to Grant ratio. This means that this loan to grant ratio was regardless of the loan:credit composition from the World Bank.
The States argued that the Central Government was pocketing the concessional components of the loans borrowed from the external agencies and they should be allowed to approach the market directly. The Central Government argued that since it (central government) is bearing the currency risks too, the pocketing of concessional component was a fair trade. On this matter, the 12th Finance Commission recommended passing loans on ‘Back-to-Back’ basis to State Governments. This implied that
- States are encouraged to approach the market directly
- States would face same terms and conditions as that of Union Government such as concessional interest rates, grace period and maturity profile, commitment charges and amortization schedules on account of their access to finance from bilateral and multilateral sources.
- States would be exposed to uncertain movements in international rates of interest and currency exchange rates.
This means that though now states enjoy the same conditions as the Union enjoys, they are also exposed to the exchange risks. This recommendation was accepted by the Government of India for general category states and the arrangement came into effect from April 1, 2005. For special category states (Northeastern states, Uttarakhand, Himachal and J&K), external borrowings are in the form of 90 per cent grant and 10 per cent loan from the Union Government.
Passing loans on ‘Back-to-Back’ basis to State Governments implies that States would face identical terms and conditions (including concessional interest rates, grace period and maturity profile, commitment charges and amortization schedules) on account of their access to finance from bilateral and multilateral sources, as is faced by the Union Government.
This arrangement entails exposure of States to uncertain movements in international rates of interest (as multilateral agencies viz. IBRD benchmark their interest rates to a reference rate viz. the LIBOR) and currency exchange rates. As per the ‘Back-to-Back’ loan transfer arrangement, states would have to face currency risk since principal repayments and interest payments on such loans to external agencies are designated in foreign currencies. In case of adverse exchange rate movement(s) larger rupee provisions may be required to meet debt service obligations that may negatively impact the fiscal health of the state concerned.
Thus, direct exposure to interest risk and currency risk carry implications for debt service burden and therefore for the fiscal status of sub national Governments in India. Capacity building in finance departments of State Governments is required to ensure that debt is prudently managed.