Redemption of foreign currency non-resident deposits have been termed as one of the first challenges that new RBI governor Urjit Patel will face upon assuming office. If that sounded gibberish, read on:
What are foreign currency non-resident deposits?
Foreign currency non-resident deposits, usually abbreviated as FCNR(B) – the B stands for banks, are term deposits that non-resident Indians (NRIs) can open with banks in India. These deposits are denominated in foreign currencies permitted by the Reserve Bank of India.
This term deposit was started in 1993 and is available in tenures of one to five years. A term deposit lasts for a fixed period after which the amount has to be paid back with the interest being paid either periodically or lump sum at the time of maturity. Fixed deposits are a type of term deposit.
Is it the only way an NRI can invest in India?
No. There two more options: the non-resident (external) rupee account (NRERA) and non-resident ordinary (NRO) account. These are similar to normal bank accounts and differ in the fact that the former is term account with a maximum period of three years. Unlike FCNR(B) they are denominated in rupees.
NRERA accounted for the highest portion NRI deposits at $71 billion as of June 30, 2016.
How does FCNR(B) it work?
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%.
Why was FCNR(B) started?
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.
What is a currency risk?
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 Rs 67,000 (considering $1=Rs 67). The bank then invests this amount.
But in case over the period the value of the rupee depreciates to Rs 69. The bank will have to spend Rs 69,000 to get pay back the $1,000. (This excludes interest payments). This is called currency risk.
On the other hand the bank stands to gain if the rupee appreciates.
If banks are dealing in FCNR(B), where does the RBI come in?
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 on these deposits was also increased to LIBOR/Swap plus 400 basis points.
According to outgoing RBI governor Raghuram Rajan 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. Since then FCNR(B) deposits have increased only $5 billion.
Also, the influx of foreign exchange stabilised the rupee, which appreciated from a high and volatile range of Rs67-68 a dollar to Rs 62-64 a dollar.
But why did banks want to pay 3.5%?
In order to shift the currency risk to the RBI. The 3.5% can be considered as the banks’ hedging costs.If the swap window did not exist banks would have had to hedge rupee depreciation risk by entering swap agreements at as high as 7% as at that time the rupee was seeing significant downward pressure.
Will it be a challenge for Urjit Patel?
80% of the FCNR(B) deposits swapped during the three-month were of a three-year tenure. This means that the banks swapped around $27 billion (Rs 1.67 lakh crore) between September and December 2013 with the RBI for rupees. Now RBI will have to give back the money in dollars.
The average exchange rate in September-December 2013 was Rs 62. At present, the exchange rate is hovering around Rs 67, down by 8%. But banks will pay back the amount with an annual interest of 3.5%, which means for the banks the effective exchange rate will be around Rs 69.
For the banks, this was a decent hedge – with only a minor depreciation – as they would have invested the money exchanged from RBI in high-return assets. On the other hand RBI will not have to bear any currency risk.
In effect, RBI, which has already said it is fully prepared for the redemption of FCNR(B), and its new governor will not face much of a challenge.