Should foreign deposits worry RBI?

FCNR(B) Redemption of foreign currency deposits have been termed as one of the first challenges that new RBI guv Urjit Patel will face. If that sounded gibberish, read on:

Foreign currency non-resident deposits, usually abbreviated as FCNR(B) — the B stands for banks, are term deposits, similar to fixed deposits, that nonresident Indians (NRIs) can open with banks in India. These deposits are denominated in foreign currencies permitted by the Reserve Bank of India.

Under the FCNR(B) scheme, banks have to pay an annual interest at a rate of LIBOR/ Swap plus 200 basis points for terms between 1-3 years and LIBOR/Swap plus 300 basis points for terms between 3-5 years. 100 basis points is 1 percentage point. This structure is decided by the RBI and banks use the LIBOR rate on the last working day of a month to fix the FCNR(B) rate for the following month.

LIBOR or London Interbank Offered Rate is the benchmark interest rate at which international banks lend to each other. These vary according to currencies and the term for which the loan is taken.

On July 31, 2016, reference LIBOR/Swaps rates in US dollars varied from 0.87-1.13% for one-five year terms. This means Indian banks can offer a maximum interest rate of 2.83-4.07% (LIBOR plus 300 basis points) of FCNR(B) deposits for August.

To be sure the FCNR(B) returns vary according to the currency also. For August, State Bank of India’s maximum return (for 5-year deposits) on FCNR(B) range from 2.95% for Australian dollar to 0.05% for the Japanese yen. For US dollar it is 2.13%.

FCNR(B) goes back to 1975 when they were known as FCNR(A) – with A for accounts. FCNR deposits where started in order to shore up foreign exchange. This was the pre-liberalisation era and there were very few ways that India could raise funds – foreign exchange reserves are used by a country to finance its current account deficit (CAD).

However, in 1991, India opened up its economy to foreign investment and the need for a separate instrument diminished. Also during the early 1990s “the outstanding liability on account of these deposits had risen to over $10 billion (almost ₹31,500 crore),” said an Indian Express report.

So FCNR(A) scheme was shut and replaced by FCNR(B) in 1993. Under FCNR(A), the Reserve Bank of India bore the currency risk while banks bear the risk under the FCNR(B) scheme.

Indian banks have most of their deposits in rupees and thus make most of their investments in the Indian currency.

When a NRI invests $1,000 under the FCNR(B) scheme for 3 years, it raises the bank’s deposits by ₹67,000 (considering $1=₹67). The bank then invests this amount. But in case over the period the value of the rupee depreciates to ₹69. The bank will have to spend ₹69,000 to get pay back the $1,000. (This excludes interest payments). This is called currency risk. RBI came into the picture on September 6, 2013 when it introduced the three-month swap window for FCNR(B) deposits with a term for three years or more. Under this swap window RBI allowed banks to exchange (or swap) their FCNR(B) deposits with it by paying an interest at a fixed rate of 3.5%. During the period, the interest rate ceiling was also raised to LIBOR/Swap plus 400 basis points.

Outgoing RBI governor Raghuram Rajan said the idea meant giving banks a 3.5% subsidy to bring in foreign exchange.

Balances did swell. FCNR(B) deposits rose from $15.1 billion at the start of August 2013 to almost $40 billion by December 2013, helping stabilise the rupee. In order to shift the currency risk to the RBI. If the swap window did not exist banks would have had to hedge rupee depreciation risk by entering into swap agreements at as high as 7% as at that time the rupee was seeing downward pressure. 80% of the FCNR(B) deposits swapped during the threemonth window were of a threeyear