Secret of Raghu's Raj on Rupee
When India attained independence, the value of the rupee was on par with the US dollar. However, due to a variety of reasons, the Indian rupee depreciated year after year, touching a record low of Rs68.85 to a US dollar. In other words, it has depreciated at an average of one rupee every year since Independence.
It was 28th Aug 2013; our home currency Rupee slumped to a record low near 69 to the dollar on growing worries that foreign investors will continue to sell out of a country that facing stiff economic challenges .
As part of efforts to rescue the sinking rupee, the Reserve Bank of India (RBI) came off with "festival sale offer", in the form of abnormally high interest rates on foreign currency non-resident deposits (FCNR).
Don't be deterred by this ugly abbreviation – FCNR. It simply means Foreign Currency Non Resident. It's a savings account offered by banks to Indians living abroad and who deposit money in dollars. In this account, the depositor gets back the money as dollars.
There are some accounts where the dollar gets converted into rupees and it gets a rupee interest rate, like in any Indian bank. That's NRERA. But we can ignore this for now. In the FCNR account, the rates given are comparable to what a non-resident Indian gets in any country. It moves with the US Fed rate or the LIBOR and the India country risk. Indian banks pay 4% over LIBOR for FCNR dollars.
On September 4, the new RBI governor Raghuram Rajan, announced that foreign banks can swap (exchange) this money for rupees for 1-3 year periods at 3.5 percentage points lower than the market rate. After the 3-year period, RBI will give back the money in dollars, whatever the cost of the dollar.
For a similar arrangement in the market, i.e. to swap money into rupees and get back dollars after 3 years, one would be charged LIBOR plus 7%. RBI doing the same for LIBOR plus 3.5% is a steal for the banks. But the idea was to attract more dollars into the country so that the attack on the rupee stops. The FCNR swap was open till November 30, 2013.
Has this helped our Forex reserves?
Obviously it should, The RBI has collected a phenomenal $10 billion through the FCNR dollar swap arrangement and Forex reserves have been been augmented. Banks sell the dollars to the RBI for rupees (at 3.5% p.a.) and the dollars sit on the RBI balance sheet until the swap is unwound (a minimum of three years).
But does it also given an enormously unfair advantage to wealthy Non-Resident Indians on the returns they earn?
Foreign banks like Citi, DBS and Standard Chartered are providing 90% – 190% leverage to their clients, depending on risk profile and will be rolling out upfront loans. This basically means if a client wants to invest $100 in an FCNRB deposit, the bank is willing to deposit $900 to 1900 on the client's behalf in an FCNR account enabling the client to earn interest on not just his $100, but also the bank's loan. This effectively gives the NRI a return of between 20-40% on his investment. For banks too, this is a win-win as their loan gets covered by the FCNR deposit and they get access to funds at a lower cost. Don't forget the real cause of global financial crisis is leverage.
My reason for saying all this is that the stability of the rupee is not coming for free. The nation is allowing foreign banks to make huge profits. Yes, the dollar has weakened and there is stability. But let us look at the counter factual. The Indonesian rupiah, Brazilian real , Turkish Lira and South African Rand were all decimated in August and all of them recovered in September as the Fed said "no tapering" and as the Syrian crisis subsided somewhat. We are probably giving more credit to the FCNR product than needed.
In fact every time the country piles up a large current account deficit (CAD) and the rupee depreciates rapidly, the country begs for dollars from foreign institutional investors (FIIs) or foreign banks giving them huge sops like don't pay taxes if you are investing through Mauritius, no withholding tax or through this current FCNR scheme which benefits foreign banks hugely.
There is a national cost involved in that RBI has to pay back the dollars in one, two or three years.
Then three years later, it's time to return this money, and we better hope we have our act together by then. Because then this is Sep-Nov 2016 – we will have to remove Rs. 60,000 cr. from the system, which can contract liquidity. But importantly, that many dollars go out of RBI reserves can create yet another weak point for the currency.
I accept there was a need to stop the run on the rupee, which was creating more macro problems. But a slower depreciation of the rupee is better way to strengthen the country's exports, lower competitive imports and give a boost to Indian industry all rounds. The enforced appreciation of the rupee cuts this boost to industry. India should withdraw this product as quickly as possible as stability has returned.