The RBI Just Pulled a 2013 Playbook Move. Here’s What It Actually Does.

The rupee was under pressure. Foreign investors were pulling money out. The RBI needed dollars, fast.

So it did what central banks do in moments like this: it went looking for someone who already has dollars and made it very attractive for them to park those dollars in India.

The tool it reached for is called the FCNR(B) swap window. It worked spectacularly in 2013. The question now is whether the same trick can work twice.

First, What Is an FCNR(B) Deposit?

FCNR stands for Foreign Currency Non-Resident (Bank). It is a term deposit that NRIs, overseas citizens of India, and persons of Indian origin can open with Indian commercial banks like SBI or HDFC Bank.

Two things make it attractive for the depositor. One, the deposit and the repayment both happen in foreign currency, so if the rupee falls, the depositor does not lose anything. Two, the interest earned is tax-free in India.

So for an NRI sitting in the US or Singapore with dollars to spare, this is a reasonably clean deal: park your dollars in an Indian bank, earn interest in dollars, get your dollars back at the end, pay no tax on the income.

The problem is not on the depositor’s side. The problem is on the bank’s side.

Why Banks Hesitate

When SBI takes in, say, $100 million through FCNR deposits, it has no real use for dollars sitting in a vault. SBI lends in rupees. So it converts those dollars into rupees and puts them to work in the domestic economy.

Now here is where it gets complicated.

When the deposit matures, say three years later, SBI has to give the depositor their dollars back. But by then, SBI only has rupees. It has to convert rupees back to dollars at whatever the exchange rate is at that point. If the rupee has weakened in those three years (which, historically, it tends to), SBI ends up needing more rupees to buy the same number of dollars. That is a loss.

To protect itself, SBI enters into a forward contract the moment it raises the deposit. This is essentially a deal where SBI locks in today what exchange rate it will use three years later when it needs to convert rupees back to dollars. It does not matter what happens to the rupee in between. SBI has locked its exit rate.

This protection is called a hedge. And it is not free.

The Cost That Was Killing the Trade

The cost of hedging, at current market rates, runs to roughly 3.5 percent per annum on the dollar amount.

Add that to the interest SBI has to pay the depositor, say 3.6 percent per annum on a three-year USD FCNR deposit, and SBI’s all-in cost of raising one dollar through this route is about 7.1 percent per annum.

That is expensive. For a bank trying to deploy those funds productively, a 7 percent cost of dollar funds is often not worth the effort. So banks do not raise FCNR deposits aggressively, and NRI dollars do not flow in at any meaningful scale.

This is the bottleneck the RBI just decided to uncork.

What the RBI Is Actually Doing

The RBI announced that it will bear the hedging cost on behalf of authorised dealer banks for fresh FCNR(B) deposits raised up to September 30th, provided the deposit tenor is three to five years.

In plain terms: the RBI is paying the 3.5 percent annual hedging cost so that the banks do not have to.

SBI’s all-in cost of raising a dollar drops from 7.1 percent to 3.6 percent overnight. That is a meaningful enough reduction that banks will now go out and actively solicit NRI deposits.

The cost to the RBI? Roughly $34 million per billion dollars raised, per year, or about 325 crore at current exchange rates. The RBI is essentially subsidising the process of bringing dollars into the country by absorbing the currency risk that would otherwise sit with commercial banks.

Why This Works: The 2013 Proof

This is not a new idea. It is a tested one.

In the summer of 2013, the Federal Reserve’s then-chairman Ben Bernanke hinted that the Fed might begin tapering its post-2008 bond-buying programme. That single statement triggered a global selloff in emerging market currencies. The rupee dropped 29 percent in four months, from 54 to the dollar in May to 69 by August. India was lumped in with Brazil, Indonesia, Turkey and South Africa as one of the “Fragile Five” economies most at risk.

When Raghuram Rajan took over as RBI Governor in September 2013, the swap window was one of his first announcements. Banks were offered a concessional hedging rate of 3.5 percent, roughly half of what prevailing market rates were at the time.

The result: banks mobilised approximately $30 billion through the FCNR route before the window closed in November 2013. Net NRI deposits spiked to $39 billion in FY14, compared to an average of just $7.4 billion over the previous five years. The rupee recovered from 69 back to around 62. India’s balance of payments swung from a near-deficit to a surplus of 0.8 percent of GDP in FY14.

There is a footnote to this story worth knowing. Rajan, before becoming Governor, was serving as an officer on special duty under his predecessor Duvvuri Subbarao. When the FCNR swap window idea was floated internally, Rajan called it “completely idiotic.” His objection was straightforward: the government would have to foot a subsidy bill of 10,000 to 20,000 crore. Subbarao, the deputy governors and the Finance Ministry were all in favour.

Rajan eventually came around. His reasoning shifted when someone pointed out that a stronger rupee resulting from FCNR inflows could save up to 1.6 trillion rupees on India’s $400 billion annual import bill. The subsidy cost looked different against that number.

Subbarao let Rajan announce the window himself on his first day as Governor.

The NRI Arbitrage That Made It Work

Part of why the 2013 window raised $30 billion so quickly was that it created an almost textbook arbitrage opportunity for NRIs.

Here is how it worked, illustrated by a real example that former SEBI member Ananth Narayan documented:

A Singapore-based NRI with $100,000 of their own money could borrow an additional $900,000 from a Singapore bank at 2 percent per annum. They would then deposit the full $1 million in an FCNR account in India at 3 percent per annum, using that very deposit as collateral against the loan.

The maths: earn $30,000 in interest every year, pay $18,000 in interest on the borrowed $900,000, and pocket $12,000 net, which is a 12 percent annual return on the original $100,000. Risk-free, in dollars, tax-free in India.

NRIs did not need a lot of convincing.

Why This Time Is Harder

The mechanics of the RBI’s current window are nearly identical to 2013. The subsidy rate is similar. The structure is the same. But the environment is different in one important way.

In 2013, interest rates in developed markets were near zero. US yields were negligible. That made it easy for NRIs to borrow cheaply offshore and invest in India. Or even for those who had their own dollars sitting in low-yield accounts, a 3 percent FCNR rate looked attractive.

Right now, the yield on three-year US Treasury bonds is around 4.2 percent. Several US banks are offering 4.2 to 4.35 percent on dollar deposits. SBI’s FCNR rate is 3.6 percent. The simple carry trade that worked in 2013 does not work anymore, because dollar returns in the US are already competitive.

For the current window to deliver a similar $25 to 30 billion, Indian banks will need to pass on enough of the RBI’s hedging subsidy to depositors by raising their FCNR rates meaningfully. RBI Governor Sanjay Malhotra acknowledged this directly at the post-policy press conference: the expectation is exactly that banks will do this.

Whether they move fast enough and offer rates attractive enough to pull dollars away from US treasuries is the open question.

The playbook is proven. The conditions are less cooperative. But the RBI is betting that even a partial success is better than watching the rupee drift further.