RBI’s FCNR U-turn dents policy certainty

The Reserve Bank of India's sudden decision to halt a foreign currency deposit swap window a month early has raised concerns about policy consistency. The window was meant to attract foreign currency inflows as India aims to become a more reliable destination for overseas capital. Between June 8 and August 14, banks accumulated $52.3 billion via foreign currency non-resident (FCNR) deposits.

Notably, the RBI declared the "attractive response" warranted closing the swap facility on August 31, rather than the initial September 30 deadline. The window's allure stemmed from two key factors: the RBI absorbing all currency hedging expenses and permitting leverage trades, allowing banks to lend to non-resident Indian (NRI) customers in multiples of their initial deposits.

The arithmetic was appealing, with NRIs earning 16%-18% returns due to banks charging lower loan rates than the 6%-7.5% interest on deposits, which are tax-free.

The abrupt shutdown surprised bankers, as just ten days prior, Governor Sanjay Malhotra stated there was no plan to close the scheme prematurely. This timing is particularly inconvenient, as India is actively promoting itself as a stable and attractive investment location. The government has been emphasizing ease of doing business, reducing taxes for foreign portfolio investors, expanding special securities under the fully accessible route, and simplifying foreign investment rules.

Additionally, the Securities and Exchange Board of India (SEBI) has proposed easing Know Your Customer (KYC) norms for NRIs and foreign nationals to boost participation in Indian markets. The premature closure could send an unfavorable signal, especially as India needs durable foreign investment to stabilize the rupee and address its current-account deficit, which has increased due to rising energy imports following the conflict in the Middle East.

Ironically, the withdrawal occurs just before the PSB Manthan, an annual two-day summit where public-sector bank executives are expected to discuss strategies to attract foreign investment. The summit could see bank CEOs lobbying senior officials from the RBI and the finance ministry against prematurely shutting the swap window.

The challenge for banks is that many have arranged dollar borrowings to use as seed capital in the leverage facility. Several have agreed to pay a higher premium due to intensified demand for dollar loans in India since the RBI introduced the special scheme. Bankers say it usually takes 10-15 days to transform dollar funds into FCNR deposits through the leverage facility.

The early closure leaves lenders in a dilemma: accept narrower margins or adjust leverage based on dollar availability. This decision is also inconsistent with the initial official encouragement. When the scheme launched, the finance minister and RBI Deputy Governor Rohit Jain personally urged bank leaders in private meetings to aggressively pursue FCNR capital.

Some contend that the overwhelming response contradicts economists' advice to the central bank before the launch. Unlike in 2013, the interest-rate differential between India and the U.S. is smaller this time, at 2% compared to 6%. This smaller differential makes large inflows less likely, potentially prompting the RBI to keep the window open for four months instead of the original three.

Other risks include the high cost of raising funds when payments fall due in three to five years and the fact that despite dollar inflows, the local currency hasn't strengthened meaningfully, as the RBI continues to intervene to maintain market stability. While these are reasonable grounds for reevaluating the window, the unexpected reversal could have been avoided.

India has witnessed solid durable capital inflows in recent months, particularly in the financial services sector. This trend can continue as long as investors remain confident that rules will not change unpredictably, returns will grow, and the rule of law will be upheld.