Why RBI is returning to a ‘terrible’ idea to boost foreign inflows

Sometimes, the worst ideas are the best.

Speaking in August 2016, just before his term as Governor of the Reserve Bank of India (RBI) was to end, Raghuram Rajan said there were multiple ideas the authorities were considering to attract foreign money in August-September 2013 amid the market volatility caused by the speculation around tightening of monetary policy by the US Federal Reserve. “However, there was one that I found completely idiotic. I thought this was a terrible, terrible thing to do.”

That idea was the swap scheme for banks’ Foreign Currency Non-Resident (Bank) deposits, or FCNR(B) deposits: these are fixed-term deposits designed for Non-Resident Indians, Persons of Indian Origin, and Overseas Citizens of India. Such deposits allow account holders to park their earnings abroad in freely convertible foreign currencies without having to convert them into rupees.

Banks would get a 3.5% subsidy on the foreign funds they raised through these deposits, allowing them to offer attractive interest rates to those abroad. The facility ended up being wildly successful, resulting in an inflow of $26 billion and helping turn around investor confidence in the rupee and India.

But it was not always clear it would do the job. In fact, not only did Rajan think it was “idiotic” and “terrible”, but a clever suggestion from bankers to get the RBI to pay for the exchange rate risk these deposits entailed. Such were his misgivings that he even asked the outgoing Governor, D Subbarao, to announce the swap scheme before his exit on September 4, 2013.

“The morning that I was going to take over, I went to Dr Subbarao and said ‘would you like to announce it?’ He was gracious enough at that point to say ‘no, you go ahead’. And now I get the credit for that idea which actually I neither invented nor actually believed in,” Rajan said in August 2016.

So, why is the government considering bringing back this scheme and what would be the impact on the balance of payments? We explain.

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Foreign inflows

Now, nearly 13 years later, the FCNR(B) swap scheme is back. And while the removal of the capital gains tax on Foreign Institutional Investors’ (FIIs) investments in government bonds (meaning tax levied when FIIs earn profits upon selling or redeeming such financial assets) as well the withholding tax (refers to advance payment of income tax deducted directly at source of income) has captured much of the imagination, it is this swap scheme that will do much of the heavy lifting when it comes to bringing in foreign inflows.

RBI’s 2013 swap scheme effect on FCNR(B) deposits.

“…the same scheme mobilised ~$26 billion of flows in 2013, and that was 1.4% of GDP in that year (FY14). We believe a similar quantum may be raised this time, and that translates to roughly $50 billion of flows,” ICICI Securities Primary Dealership economists led by A Prasanna said in a note Sunday (June 7), adding that they expect around $100 billion of inflows over a period of 12 to 24 months from all the measures that were announced on Friday by the government and the RBI.

The FCNR(B) swap scheme is even more potent this time around. In 2013, the RBI provided a 3.5% subsidy to banks. Now, it will fully bear the exchange rate risk on new three- to five-year deposits mobilised until September 30.

“Current FCNR(B) Rate is ~3.35% (3 years). Presently cost of hedging, forward premium is ~3.5%. Current card rate for a 3-year deposit is 6.5%. Banks can thus offer attractive FCNR(B) pricing in the range of 5.5% and upwards (US treasury rates at ~4% of equivalent duration). Taking an annual hedging cost at ~2.5%, the total outgo comes to ~12.5% for a 5-year tenure, implying $125 million cost embedded per billion (dollars) raised,” Soumya Kanti Ghosh, Group Chief Economic Adviser at State Bank of India, said Friday.

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The cost of hedging refers to the cost of protecting an investment against adverse market risks such as currency fluctuations. This cost is determined by the “forward premium”, which refers to the concept that in forex markets, it costs more to buy a foreign currency for a future date than in the present.

It is this estimated $125 million cost (this time around) that changed Rajan and the RBI’s thinking back in 2013. The cost of hedging for the RBI is high only if a lot of money comes in – but if a lot of money does come in, the rupee would appreciate. And a stronger rupee would not only reduce the hedging cost for the RBI but also reduce India’s import bill.

“Think of having a stronger currency relative to an undervalued rate of about Rs 3-4, multiply it by $400 billion in imports. That would mean Rs 1.6 trillion in savings (per year) if we only stabilise the currency,” Rajan had remarked.

Balance of payments

The savings from a stronger rupee would be much greater now considering India’s import bill in 2025-26 was $775 billion.

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The government and the RBI have blown the steps taken in 2013 out of the water and delivered a “Balance of Payments (BoP) package” that has exceeded market expectations; so much so that economists now expect India to have a surplus or near-zero BoP from earlier expectations of a deficit of around $60 billion and even higher in some cases.

“The policy bazooka on rupee rescue is designed to address the large balance of payments deficit triggered by the compression of the capital account surplus amid current account deficit pressures, which we estimated was tracking as high as ~$70 billion in FY27 prior to these measures,” Nomura said in a note.