FCNR(B) Deposits – RBI to call off hedge scheme prematurely; and rightly so

RBI has finally decided to close the FCNR(B) deposits a month earlier than scheduled. Instead of closing on 30-Sep, the RBI FCNR special window will close on 31-August itself. Any FCNR(B) deposits after that will not be eligible for currency swap.

Flows have been better than expected

It needs no reiteration that the forex flows since 08-June have been much better than expected. While the foreign flows started slowly, they have picked up momentum in the last few weeks. As of 13-August, total dollar flows through the special window have been close to $60 billion, of which $56.5 billion was accounted for by FCNR(B) deposits and the rest via OFCBs and ECBs. It is estimated that by the time the revised window closes on 31-August, FCNR(B) flows may get closer to $75 billion with overall flows in the region of $80 billion. That is good enough to boost forex reserves and offset dollar shorts.

If the dollars are coming, why is rupee still weak?

That is a question that continues to confound market observers. Despite more than $56 billion coming through the FCNR(B) window, the rupee has not appreciated. In fact, the rupee has continued to gradually weaken against the dollar. There are 3 things to remember. Firstly, the rupee is weakening despite the dollar inflows because the yen continues to strengthen and is putting pressure on the rupee. Secondly, the idea of FCNR(B) was never to strengthen the rupee. It was more to boost the forex reserves. Thirdly, the FCNR(B) flows is still serving its purpose because it reduces the need for RBI to intervene and sell dollars, as well as offsets the short dollar trade unwinding.

Early closure is to prevent a liquidity glut

The inflows have been much better than expected and the RBI will have to undertake measures like VRRRs to mop up the excess liquidity in the system from these dollar flows. The glut of liquidity has led to fall in bond yields at the short end and the long end. In fact, the fall in the short end of the yield curve has been much sharper than the long end. In the process, it has made the India yield curve a lot more upward sloping. That is a good thing, but further liquidity infusion is not required at this point of time. Hence, closing the FCNR(B) window early is a logical step. However, there is a bigger concern for the government on the risks that these FCNR(B) flows are bringing with it.

FCNR(B) flows are not as innocuous as they appear

There is a major cost to the current round of FCNR(B) deposits. Banks are paying between 6.5% to 7.0% interest on these deposits. The RBI is footing the currency hedging bill, by underwriting the currency risk and that becomes a contingent liability. Then there is the tax that the government is foregoing on these deposits, apart from the easy prudential norms on FCNR(B) deposits. However, the biggest risk that the RBI sees in these FCNR(B) deposits is the leverage ranging from 8X to 19X. That is what can cause the unknown-unknown risk for FNCR(B) deposits. RBI has rolled out the red carpet for NRIs to bring in the dollars, but RBI cannot allow depositors to go and paint the town red.