Implications of the New Bank Indonesia FX Hedging Requirements on Foreign Currency Loan and Bond Transactions

Bank Indonesia regulation 16/20/PBI/2014 (the “Hedging Regulation“) sets out new hedging requirements for Indonesian corporates that obtain loans denominated in foreign currency (regardless of whether such loans are funded by financial or other institutions or by way of intercompany loan). The Hedging Regulation could have significant implications for offshore USD loan and bond transactions. The rules come into full effect from 1 January 2016 but are effective in part immediately. There is a grace period until 3Q 2015 before sanctions can be applied.

The requirements are intended to promote prudence in managing foreign exchange exposure. This comprises three components – exchange rate risk, liquidity risk and over- leverage risk. These risks are required to be managed by maintaining:

1. a Foreign Currency Hedging Ratio of 25% (20% until 31 December 2015)
2. a Foreign Currency Liquidity Ratio of 70% (50% until 31 December 2015)
3. a Credit Rating of at least BB from an accredited Indonesian ratings agency (from 1 January 2016).

Based on our informal conversations with Bank Indonesia, the borrower is required to comply with these requirements as soon as it has drawn down the loan, and as such we anticipate that, as these Regulations become effective, Lenders will require evidence of compliance by way of conditions precedent and although bonds are not specifically mentioned, our understanding is that the regulation is intended to apply to borrowings in loan or bond form.

A closer look at these ratios suggests that there may need to be considerable thought given to offshore loan and bond transactions to determine whether the borrower is, in fact, in compliance with these requirements.

Foreign Currency Hedging Ratio

The Foreign Currency Hedging Ratio requires hedging of 25% of the shortfall between an Indonesian company’s Foreign Currency Assets and its Foreign Currency Liabilities falling due in the following two quarters.

It should be noted that there is a critical difference between the definition of Foreign Currency Assets and Foreign Currency Liabilities. On the debit side, Foreign Currency Liabilities include any current obligation (principal as well as interest) falling due within the time period. However, on the credit side, Foreign Currency Assets is essentially a definition of cash and cash equivalents (including marketable securities) plus hedging receivables.

Accordingly, under a strict reading of the rules, it is therefore not possible to offset foreign currency receivables against foreign currency liabilities for these purposes. Ironically, an export oriented company (such as a mining company) with substantially all of its revenues denominated in USD, might find itself required to purchase hedging simply because its assets are not sufficiently liquid.

Foreign Currency Liquidity Ratio

The Foreign Currency Liquidity Ratio requires a company to have Foreign Currency Assets equaling at least 70% of its Foreign Currency Liabilities for the following quarter.

The same definitions apply. In practice, many of the implications of these requirements might be dealt with Ashurst Singapore November 2014 in a relatively straightforward manner by formalizing them into debt service reserve requirements. We note that any such solution would also need to take into account any changes in repayment amounts due to scheduled amortization. This could have the effect of ‘bringing forward’ back-ended amortization obligations.

There would appear to be a particular issue with respect to ‘bullet’ payments at the end of a loan tenor – and even more so, with respect to the maturity of a bond (for which the principal amount becomes due and payable in full at maturity). In these cases, the borrower would technically be required to hedge 25% of any foreign currency shortfall for the two quarters prior to maturity, and hold 70% liquid assets for the quarter in which maturity occurs.

If lenders wish to promote strict compliance with these rules (and – as we explain below – they would be well advised to do so) – they may need to make available ’embedded’ hedging solutions. Based on our review of the qualifying hedging alternatives, we believe there are likely to be attractive embedded solutions available for most commercial borrowing.

Ratings Requirement

Ratings Requirement The foreign currency borrower is required to maintain a BB rating from an accredited Indonesian ratings agency. (It is not required that the specific loan be rated, but that the borrower maintain a rating for instruments of comparable type and maturity).

For non-rated borrowers this may increase the costs of borrowing and potentially lead to more complex structuring, for example having loans being denominated in IDR with embedded hedging solutions. Noting that many hedging solutions may be imperfect, this may also be an imperfect solution for many lenders.

We understand from our banking clients that it should not be too much of an obstacle for major commercial borrowings to obtain a credit rating under the current criteria of the accredited Indonesian ratings agencies. However, there is a risk that this requirement could shut out smaller borrowers from the market if Indonesian rating standards are brought in line with international rating standards.

Exceptions

The law contains a broad exception for ‘trade credit’ – which is not defined specifically. It also contains a limited exception from the ratings requirements (but not the hedging and liquidity requirements) for:

• 'refinancing' (again not specifically defined); and
• infrastructure project funding by bilateral/multilateral international institutions. The ‘trade credit’ and ‘refinancing’ exceptions may prove helpful in applicable situations.

The ‘trade credit’ and ‘refinancing’ exceptions may prove helpful in applicable situations.

Reporting Requirements

Companies are required to report to Bank Indonesia quarterly regarding their compliance with these requirements. Lenders will want to receive copies of these reports also.

Sanctions

The Hedging Regulations provide for administrative sanctions on non-compliant corporations. This would initially take the form of a written warning, which would be copied to various regulatory authorities in Indonesia, and the foreign creditor concerned. Further ‘administrative sanctions’ are not described specifically in the Hedging Regulations themselves.

Litigation Risk

While the regulation does not place express duties on foreign lenders, the breach notification is clearly intended to reinforce the fact that foreign lenders doing business in Indonesia are expected to support Bank Indonesia in ensuring compliance with the law. The only express sanctions under the Hedging Regulations are administrative sanctions for the borrower, however we believe lenders should take this seriously and be proactive in monitoring compliance with the law. In particular, recent litigation cases (such as the Nine Am Case on the language law) have shown that even a minor taint of illegality can be held sufficient to void a loan agreement. It is not a major stretch to argue that a lender is at fault if it makes a loan which it should have known would put the borrower in breach of these regulations.

Recommendations

For existing borrowings, it is likely that the general compliance with law and information covenants in standard finance documents will be sufficient to require compliance with the Hedging Regulations.

For new borrowings – as a matter of ‘best practice’ – lenders making offshore loans into Indonesia should:

• use reasonable efforts to make sure the borrower will be in compliance with the Hedging Regulations at the time of drawdown; and
• monitor compliance through reporting, if appropriate.

A plan for compliance with the ongoing hedging requirements will need to be agreed with the borrower, including the obtaining of a credit rating (whether as a future obligation, or as a condition precedent once that obligation comes into effect). Ideally, the terms of the loan – whether through debt service reserves or embedded hedging – would ensure compliance.

In the future, we anticipate that express provisions will be incorporated into the finance documents including specific maintenance covenants to ensure continued compliance with the Hedging Regulations, monitored through the regular reporting requirements.

Conclusion

We believe the Hedging Regulations are a useful measure to enhance prudence in foreign exchange planning by non-bank Indonesian corporations, although it may increase the overall cost of borrowing. However, there are two aspects in particular which may cause unintended effects:

• their application to ‘export-oriented’ companies who principally derive revenues in US Dollars; and
• their application to facilities with ‘back-ended’ or ‘bullet’ repayment schedules.

We would note that the Hedging Regulations do not come into full force and effect until 1 January 2016 and it is still early days to see how Bank Indonesia will interpret and enforce these rules – there is ample opportunity to further clarify the above points. Even in the absence of clarification, we believe there are also likely to be structuring solutions available to assist in compliance with the Hedging Regulations.