[By Shriyansh Singhal]
The author is a student of National Law University Odisha.
Background
In a landmark decision, the Bank of Japan (BoJ) raised its interest rates for the first time in 17 years, triggering notable ripple effects across global markets, including India. After years of a negative interest rate policy, the BoJ raised its short-term rates from -0.1% to 0.1% in April 2024, followed by an increase to 0.25% in July. BoJ came forth with a negative interest rate policy to combat deflation and stimulate economic growth but its recent shift away from this policy has marked a significant change in global financial dynamics. This decision not only impacts the finance world but also affects the legal and regulatory challenges for markets like India, which are closely related to foreign capital flows as all the market regulators have recently been pushing investment facilitation and ease-of-doing business guidelines.
India’s response to BoJ’s Interest rate hikes
The Indian equity markets reacted to this policy change by witnessing significant drops in the indices such as BSE Sensex and Nifty, with increased volatility propelled by the destressing of the popular yen carry trade strategy where traders borrow in yen at low interest rates and invest in higher-yielding assets globally, to enjoy lucrative profits. Lured by the now higher domestic interest rates, Japanese investors have begun to repatriate funds back to their home country which was a reason for the noticeable outflow of Foreign Portfolio Investments (‘FPIs’) from Indian markets. The BoJ’s actions indicate a robust legal and regulatory framework to manage the intertwined global finance horizon and mitigate economic risks.
At present, Indian Regulatory Authorities such as the Securities Exchange Board of India (‘SEBI’) and the Reserve Bank of India (‘RBI’) are in the position of determining the stability of the financial system in the world turmoil. There emerges the need to reform the cross-border financial regulations with the increased market fluctuations, for instance in currency exchange and capital transfer for protection of the markets against manipulations and speculations.
Implications for India’s Financial Laws and Compliance
The BoJ’s rate hikes could significantly affect the Foreign Exchange Management Act (FEMA), 1999. The fluctuation in the exchange rate of the Indian rupee against the yen may cause the RBI to implement more stringent policies & strategies to bring changes in the laws on the exchange control system. In addition, SEBI may have to strengthen its FPI monitoring systems to ensure that such outflows do not cause fluctuations in the markets. Thereafter, some of the domestic corporates engaged in cross-border transactions may have to meet the stringent FEMA reporting requirements because of increased regulatory scrutiny of Foreign Direct Investors (‘FDIs’) and Foreign Institutional Investors (‘FIIs’) and their repatriation. It could also result in higher complexity of compliance with regulations concerning foreign exchange derivatives due to the necessity of hedging against currency risks.
The global shift in interest rates which is more likely to be initiated by the BoJ’s action is most likely going to exert pressure on the Indian debt markets. The Companies Act, 2013, which governs the issuance of corporate bonds and other debt securities, may see increased application if BoJ’s rate hikes lead to higher interest expenses for Indian firms, prompting them to rely more heavily on debt financing. Consequently, amendments to the provisions of the Companies Act concerning the issue of securities, including the regulatory approval, disclosure requirements and investors’ protection. This is especially important to maintain the competitiveness of corporate bond rules and protect investors’ rights, which may require SEBI to reconsider its rules in this regard. To make Indian bonds nearer to the reach of international investors, legal requirements related to the pricing and distribution of debt securities may also be looked into and aligned with international standards.
It could also make SEBI introduce stricter disclosure norms and more stringent rules regarding the repatriation of profits by FPIs, which could potentially require making amendments to the SEBI (Foreign Portfolio Investors) Regulations, 2019, especially in the registration and compliance obligations of FPIs. Enhanced scrutiny of market conduct related to insider trading and market manipulating activities could also be taken up by SEBI due to increased volatility. In periods of high volatility, there is a possibility to increase measures of SEBI (Prohibition of Insider Trading) Regulations, 2015 and SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 to prevent unfair practices. The impact on foreign investment in India will directly affect the taxes collected from these investments.
To address the issues concerning the taxation of capital gains and withholding taxes of foreign investors, the Government of India may contemplate changing the tax treaties or including the Income Tax Act, 1961. The exchange and interest rates may make those involved in cross-border transactions be subjected to a higher level of scrutiny under the transfer pricing regulations. To curb the multinational conglomerates from engaging in profit shifting or any other method of tax evasion, an even higher level of compliance with the provision of the Income Tax Act will be boosted.
It is also important to note that some of the Indian banks that have operations in the global markets may be affected by changes in the global interest rates including those occasioned by the BoJ. The Banking Regulation Act, 1949 may also have to be amended to ensure that the Indian banks are well-capitalized and in a state to meet the prudential Regulations in the face of Global Risks. The RBI may make new regulations on how to address the interest rate risks and foreign currency translation impacting statutory provisions of India’s banks under this Act.
Contractual and Financial Strain on Indian Companies
The rate increases by the BoJ can have severe contractual implications for Indian companies engaged in international business or having foreign currency debt linked to international benchmarks like the London Interbank Offered Rate (‘LIBOR’) or the Tokyo Interbank Offered Rate (‘TIBOR’). Foreign debt may be repaid at a higher cost because of the changes in the exchange rates that are occasioned by the change in the global interest rates and this may lead to a covenant (action to recover damages for breach of a sealed contract)or default on the loan agreement also increasing the overall cost of servicing current debt, shortening profit margins and eventually leading to liquidity challenges.
MNCs with debt denominated in yen or other foreign currencies might face increased currency risk. The cost of yen-dominated debt repayment would increase significantly when converted into rupees in case the yen appreciates as a result of the rate hikes.
It is evident that Indian companies reliant on debt financing find it difficult to refinance existing debt or raise new capital due to unfavourable and more stringent terms and higher interest rates. In order to attract investors, a high yield on newly issued bonds may be offered but this would increase the cost and make bond issuance less attractive. Consequently, with higher debt servicing costs and increased financial strain, borrowers may see their credit ratings downgraded.
The way forward
To avert such defaults, there may be a need for firms to change the loan agreements, probably by seeking waivers or changes in the terms. The exchange rate risks may also make multinational businesses reconsider their hedging policies to ensure that they are in a position to mitigate against any adverse exchange rate fluctuations. It may also lead to increased demand for legal services concerning dispute and contract alteration.
In India, compliance officers and legal advisors would require the client to go through their risk management strategy with more focus on the risks arising from changes in interest rates and exchange rates. This could involve reconsidering existing contracts once more to ensure that they are adequately protected against fluctuations in the economy which may not have been foreseen when the contracts were being drafted, particularly with partners in foreign countries.
In the present world where risks are on the higher side, there is a need for more protection and hence some of the important clauses of the contract including force majeure or material change clauses may need to be reviewed and possibly altered. Besides, since attention is paid to cross-border financial flows, it is possible that companies will need to strengthen compliance with the rules of international finance, primarily the Know-your-Customer (KYC)/ Anti-Money Laundering (AML) standards.
Conclusion
The current raised interest rates by the BoJ are a clear indication that the international markets including the Indian market are linked to the global policies. This development has implications and issues for Indian enterprises and policymakers. This is why there is a need to have a sound legal and regulatory framework that can address the challenges that are a result of changes in the international financial environment. These problems need to be addressed urgently and distinctly, emphasizing that India decides to implement some of the above-mentioned strategies that can reform the stability of the financial markets in India irrespective of the global economic trends.