Borrowing in US$ actually acts as a synthetic hedge against future dollarized receivables.
Dollarization of commodities has its roots in the pricing formulae used to derive fair value.
To facilitate transparency in pricing, international benchmarks for pricing crude and natural gas have evolved. These benchmarks are generally quoted in US$.
The effect of pricing, based on these benchmarks, is similar to receiving US$ for sale of a product. Even where transactions are settled in INR, US$ pricing exposes an oil and gas exploration and production company whose financial statements are denominated in INR to currency risk.
Invariably, a rupee appreciation leads to a lower realization in INR terms, thereby affecting the rupee value of profits.
Borrowing in US$ actually acts as a synthetic hedge against future dollarized receivables. Cost of hedging US$ denominated borrowings further increases the weighted average cost of borrowings.
In the past, however, Indian corporate organizations have preferred to hedge US$ borrowings, thereby creating a mismatch in the currency of earnings and payable obligations.
The inclination to hedge foreign currency borrowings stems from the quarterly revaluation of foreign currency borrowings as per AS-11, wherein any depreciation in INR vis-à-vis US$ leads to an impact in the profit and loss (P/L) statement.
While hedging US$ borrowings may appear to nullify the impact on financial statements, it can lead to a real cash flow loss. This scenario is depicted below:
Unhedged foreign currency borrowings
Hedged foreign currency borrowings
*Refer to the attached PDF for source information.