The hidden costs of RBI’s FCNR(B) scheme

The Foreign Exchange Management Act (FCNR(B)) scheme, managed by the Reserve Bank of India (RBI), has attracted a significant amount of money, totaling $132 billion. However, the extent of this success is debatable. The scheme has indeed increased the RBI's foreign exchange reserves, which rose from $682 billion at the launch on June 5 to $785 billion by September 4.

It has also positively impacted the rupee, stabilizing its value in the range of ₹94-96 per dollar. Nevertheless, the benefits derived from these outcomes for the economy are not so clear-cut.

For instance, it is not evident why the RBI required more reserves. At the time of the scheme's launch, $682 billion was already a substantial sum, which was more than adequate to cover any potential Balance of Payments (BoP) deficit for the current year or even the next five years. Similarly, the decision to consider a rupee strength of ₹95 to the dollar over ₹100 as beneficial for the economy is not clear.

While a weaker rupee can benefit importers by making foreign goods and services pricier, it may also assist domestic producers in competing with cheap imports from China. Furthermore, the depreciation can support exporters by making their products cheaper for foreign buyers and potentially attracting new markets. Thus, the advantages of higher reserves and a stronger rupee are not entirely obvious.

The costs, however, are substantial. RBI received more than ₹10 lakh crore in liquidity when Indian banks provided dollars to the central bank in exchange for rupees. This surplus liquidity is currently pushing interbank interest rates below the RBI's policy rate, which is problematic as the RBI set its policy rate at a level it deemed necessary to keep inflation under control.

To rectify this situation, the RBI must absorb this excess liquidity, a process known as sterilisation. For instance, if the RBI were to sell ₹10 lakh crore of 10-year government securities with a market interest rate of roughly 7%, the associated interest cost would be approximately ₹70,000 crore annually—a sizable expense.

Alternative approaches include asking the Government of India (GoI) to bear the cost by issuing new government securities or sharing part of the burden with GoI. However, even after accounting for income generated from US Treasury securities held by the RBI, the net cost to the public sector would still be considerable. Additionally, the RBI could impose a Cash Reserve Ratio (CRR) hike, which would penalize all banks, not just those that have not received dollar deposits.

Banks receive 6-7% interest on NRI deposits but do not receive anything on the surplus liquidity deposited with RBI due to a CRR increase. This would detrimentally affect the profitability of banks.

Moreover, RBI has taken on considerable exchange rate risk. For every dollar received from banks, the central bank received around ₹95, assuming this to be the prevailing exchange rate. When these deposits mature in roughly five years, RBI will have to reverse the transaction at the same exchange rate. However, if the rupee depreciates in the meantime, say to ₹105, RBI would incur a loss of ₹10 for every dollar swapped.

Even a minor depreciation could impose a significant cost given the enormous amount involved. Ultimately, returning $132 billion after five years could prove costly for the RBI, adding to the expense of sterilisation. Consequently, future dividends from RBI to the GoI would suffer.

Perhaps these costs would be justified if the scheme had been used to buy time to strengthen India's BoP. However, no such measures have been announced either to attract more Foreign Direct Investment (FDI) or more Foreign Portfolio Investment (FPI) into Indian equities. Partly due to this reason, and also because the war in the Middle East has intensified, the rupee has begun to fall once again. In conclusion, the FCNR(B) scheme has left the system in a weaker state than before. Therefore, was the scheme truly necessary?