Combining Cross-Border Direct Loans and Foreign Exchange Derivatives
Cross-border direct loans (CBDL for short) generally refer to a domestic institution (the ‘borrower’) which borrows money from a nonresident. This article refers to CBDL as a banking product: a combination financing arrangement against domestic guarantees. In this kind of financing arrangement，a domestic borrower，as a counter guarantor，applies to a domestic bank (the ‘guarantor bank’) to issue a financial guarantee in favor of an overseas bank ( the ‘lending bank’)，which may accordingly finance the domestic borrower (or its nominated enterprise) based on such a bank guarantee. The guarantor bank is often the main provider of the finance product，contacting the lending bank and sharing the profits with the lending bank. In consideration of the financing costs，the funds are more likely to be in foreign currency such as US dollars instead of renminbi. The borrower sells the foreign currency to the guarantor bank to get an equivalent amount of renminbi for domestic usage. At maturity，the borrower uses renminbi to purchase foreign currency from the guarantor bank to clear the principal and interest.
The key issue in finance products such as these is cost management. The total cost of the product is comprised of three parts: bank guarantee fees，interest on the loan，and the cost of forex settlements and purchases. When the loan is issued，all costs are known initially except the cost of purchasing forex，determined by the exchange rate at maturity. In order to lock in a total cost，the most commonly used tools are forex derivatives such as forwards and swaps. However，such traditional tools can merely fix the cost，while customized cost management addresses the needs of enterprises according to their risk-cost preference. Taking into account such needs，more comprehensive forex derivatives need to be introduced in CBDL，to help borrowers better manage and even lower their financing costs. This article aims to introduce three types of forex derivatives and emphasizes how they can be used in combination with CBDL，to better facilitate enterprises’ cost management.
Cross Currency Swaps
A cross-border direct loan may be medium or long term with interest paid in instalments，such as on a monthly or quarterly basis. That means the borrower needs to purchase forex for interest payments several times. The borrower could purchase forex each time at the spot rate，while he needs to bear the risk from forex rate fluctuations. Alternatively，the borrower could sign several forex forward contracts，though that might be viewed as unnecessarily troublesome. Instead，a cross-currency swap may be a good alternative.
A cross-currency swap is an agreement between a customer and a bank to exchange interest payments and principal on debt or assets denominated in two different currencies. The notional amount is determined by the prevailing forex spot rate and remains constant during the life of the swap. Specifically，under a cross-border direct loan，the borrower may sign a cross-currency swap contract with the guarantor bank. The contract may have an agreement on:
Principal swaps: The borrower initially uses foreign currency funds from a cross-border direct loan to exchange an equivalent amount of renminbi funds with the guarantor bank at a designated exchange rate. At maturity，the borrower uses the same amount of renminbi funds and exchanges them back into foreign currency at the same exchange rate，so that it can repay the principal to the lending bank in a foreign currency.
Interest swaps: Each time an interest payment comes due，the borrower makes a renminbi interest payment to the guarantor bank at an appointed interest rate (different from that of CBDL). Meanwhile，the guarantor bank pays foreign currency interest to the borrower at the same interest rate as that of the loan offered by the lending bank，so that the borrower is able to pay the foreign currency interest to the lending bank.
As a result，the borrower is able to obtain a renminbi loan whereby the principal is repaid in renminbi and the interest is at a renminbi rate. So，here is the key question: Why do banks develop such complicated combination products since it is much more convenient to borrow renminbi from a domestic bank?
This question leads to another important advantage of these combination products: lowering the financing cost. The determinants of a renminbi loan interest rate are essentially different from those of a renminbi interest rate in a cross-currency swap. In fact，the guarantor bank merely exchanges two currencies with equivalent value to the borrower，instead of offering money to that party. The renminbi interest rate of cross-currency swaps is mainly determined by two factors -- the actual foreign currency loan rate demanded by the lending bank and the risk premium of future forex rate fluctuation. The two components of the cost，plus the finance guarantee fee，are probably lower than the cost of a domestic renminbi loan.
Non-Deliverable Forwards
Forex forwards are one of the main tools used in CBDL when the borrower hopes to lock in the cost. Before 2018，a client had to actually buy or sell foreign currency at maturity of the forward contract. In February 2018，the State Administration of Foreign Exchange permitted the use of non-deliverable forwards. It is much more convenient for the borrower to choose a better forex forward price when an NDF is combined with a cross-border direct loan，so that the cost of buying foreign exchange may be reduced.
By the use of NDFs，customers could，according to hedging preference，buy or sell foreign currency without physical delivery of a notional amount and with the involvement of cash only for settling the gain or loss at the settlement date by taking the difference between the agreed upon forward exchange rate and the fixing spot rate at the maturity date. Actually，it makes no difference whether the notional amount is delivered since the borrower has to purchase forex for repayment. One of the most important features of NDFs is they allow an enterprise to sign an NDF contract with a bank and purchase forex at the spot rate at a different bank. This allows the borrower to choose any bank it likes to buy forex forwards (without delivery)，so that it is able to choose the best forward price in the forex market.
Specifically，each bank’s guarantee fee，forex forward rate，and the interest rate of its agent overseas lending bank is different from those of others . As such，the optimal path for the borrower is to minimize all three costs. However，in most cases，the borrower buys forex forwards from the guarantor bank. It is very difficult to minimize all three costs in one bank，since the borrower can only obtain a credit facility from a limited number of banks. Fortunately，an NDF provides a solution: Step one，the borrower chooses a bank with the lowest guarantee fees and interest rate of its overseas agent lending bank. Step two，after receiving the loan，the borrower signs an NDF contract with another bank with the lowest forex forwards rate. Step three，at maturity date，the borrower honors the NDF contract and receives a bonus or penalty. Step four，to repay the loan，the borrower purchases the foreign currency at the spot rate at the guarantor bank and uses the bonus or penalty from the NDF to compensate for the spot forex rate.
In short