Dipping NRI interest

The RBI lheadquarters in Mumbai. In September-November 2013, the RBI offered banks a special swap scheme for their FCNR deposits at an interest rate of 3.5 per cent a year, in essence allowing banks to earn a margin on these deposits.

UNCERTAINTY abounds on the impact that the end of the policy of quantitative easing in the United States would have on emerging markets such as India. An issue of concern for the government and the Reserve Bank of India is the evidence that inflows into deposit schemes for non-resident Indians (NRIs) are shrinking. Inflows into NRI deposits peaked at $38,406 million in the financial year 2013-14, which amounts to a monthly average of $3,200 million. In comparison, inflows during April to August 2014, or the first four months of the current financial year, stood at just $7,168 million, or a monthly average of $1,792 million.

The decline of over 40 per cent in monthly inflows is of significance because these are fixed-term deposits with maturity of one to five years. Most of them are in the lower maturity range. So if inflows decline, maturing deposits will not be replaced fully by new ones, resulting in net outflows under this head. At a time when expectations of an interest rate hike in the U.S. and other developed countries have given rise to fears that foreign investors will exit the country, the sign that NRI “investors” are also withdrawing is indeed a cause for concern.

What is often missed in this discussion is that this “danger” is a post-2011 development because of a surge in outstanding NRI deposits. Over the period 2000 to 2011, the maximum inflow into NRI deposits in any financial year was $4,321 million in 2006-07. However, starting in 2011-12, inflows spiked. They rose to $11,920 million in 2011-12, or 3.6 times the inflows in the previous year. The figure rose further to $14,486 million in 2012-13 and to a huge $38,406 million in 2013-14. It is against that high figure that we are witnessing a decline this financial year.

Further, more recently, there have been changes in the composition of inflows into NRI deposits. Since 2006, the RBI has permitted three kinds of NRI deposits. The simplest of them is the Non-Resident Ordinary (NRO) Account, which is similar to domestic deposits and available to eligible non-residents to receive rupee receipts from legitimate local transactions. The principal in such deposits is non-repatriable in foreign currency, though current income and interest earned are. In addition, repatriation to the extent permitted by the liberalised remittance rules applicable to residents is also allowed. Given their nature, these deposits are held largely by NRIs who need to engage in rupee transactions.

From the point of view of foreign exchange inflow, the deposit accounts of relevance are the Non-Resident External Rupee (NRER) Account and the Foreign Currency Non-Resident (Bank) (FCNR(B)) Account. Capital from both these types of accounts is repatriable, but the principal difference between them is that the former is designated in rupees and the latter in dollars. As a result, the foreign exchange risk on NRER term-deposit accounts is carried by the NRI depositor, who has to convert rupee capital to dollars when the deposits mature, but that on the FCNR account is carried by the bank, which has to settle the deposit in dollars at maturity.

Not surprisingly, banks have not been too eager to canvas deposits in FCNR accounts. So, if we consider the period from end-March 2006 to end-March 2013, the volume of deposits in FCNR accounts has been relatively stable, in the $13 billion to $15.5 billion range. On the other hand, the volume in NRER accounts rose from $22 billion to $26.4 billion between end-March 2006 and end-March 2011 and to $31.4 billion in 2012 and $45.9 billion in 2013. The year 2013-14 was the most remarkable, with the volume of deposits at the end of March 2013 rising to $52.9 billion in NRER accounts and to a huge $41.8 billion from $$15.2 billion in FCNR(B) accounts.

Two questions arise. Why were NRI deposits (driven by NRER accounts) buoyant after 2011? And, why did deposits in FCNR accounts spike dramatically in 2013-14? The answer to both these questions is the same: state policy, even if different ones. Since 1997, the RBI has allowed banks to set the interest rates they offer on NRI deposits of different maturities. However, in 2003 these rates were subject to a ceiling linked to the London Interbank Offered Rate (LIBOR) and the prevailing rate for rupee to dollar swaps. Initially, the ceiling was set at 250 basis points above the LIBOR/swap rate, but it was brought down in April 2007 and equated to the LIBOR/Swap rate.

A ceiling on the interest payable on these deposits is required to prevent deposits motivated by returns from arbitrage, or profits to be made from excessive interest rate differentials in borrowing abroad and in India. If interest rates in India are much higher than abroad, speculators will borrow abroad to make large investments, which would be volatile given the likely changes in the interest rate differentials.

The understanding implicit in the benchmark used is partly that the LIBOR provides an indicator of the interest rate NRIs could get from investing in deposits abroad. They are unlikely to come to India if they do not get at least that much. In addition, as noted earlier, when dollars are invested in India in deposits of different maturities, either the bank or the depositor carries the exchange rate risk. If the non-resident invests in a repatriable rupee account, the capital in rupees on maturity may yield fewer dollars than originally invested if the rupee has depreciated in the interim. If, in a similar situation, the investment is a repatriable dollar-denominated account, the bank in India that must pay back the capital in dollars at maturity will lose out. The swap rate measures the premium that must be paid to hedge against such risk. So, this rate is added on to the LIBOR to arrive at a rate that would cover the costs that must be borne to make deposits in India competitive, which determines the benchmark adopted by the RBI to set a ceiling on interest rates.

The policy issue that the RBI has addressed differently at different points in time is whether the benchmark ceiling should be set so as to equate the estimated maximum, effective interest rate payable in India with those received abroad, or whether it should be kept above or below that level to either incentivise or discourage inflows into NRI deposits. That decision does affect the volume of inflows. Thus, it was a decision to continuously raise the ceiling on the interest rate payable on NRI deposits that explains the more recent changes in inflows into such deposits. In 2008, the government decided to change its policy of setting the ceiling on interest rates paid on NRI deposits equal to the LIBOR/swap rate. Clearly, the intention was to incentivise NRI deposits rather than to ensure that those who wanted to make an investment in India were given a “fair deal”, depending on the LIBOR and the risk of rupee depreciation or benefit of rupee appreciation as perceived by the market. In September and October 2008, through directives issued in quick succession, the RBI hiked the ceiling rates. On October 15, 2008, an RBI directive (No. DBOD.Dir. 82 /13.03.00/2008-09) declared: “The interest rates on fresh Non-Resident (External) Rupee (NRE) Term Deposits for one to three years maturity should not exceed the LIBOR/SWAP rates plus 100 basis points, as on the last working day of the previous month, for U.S. dollar of corresponding maturities (as against LIBOR/SWAP rates plus 50 basis points effective from the close of business on September 16, 2008).”

And, “In respect of FCNR (B) deposits of all maturities contracted effective from the close of business in India as on October 15, 2008, interest shall be paid within the ceiling rate of LIBOR/SWAP rates plus 25 basis points for the respective currency/corresponding maturities (as against LIBOR/SWAP rates minus 25 basis points effective from close of business on September 16, 2008).” The two rates were further raised to “LIBOR/SWAP rates plus 175 basis points” and “LIBOR/SWAP rates plus 100 basis points” a month later on November 15, 2008.

Note the timing. This was immediately after the crisis when India was experiencing an exodus of foreign portfolio investment. Net portfolio investment flows into India were a negative $13.9 billion in 2008-09 compared with a positive $27.3 billion in 2007-08. So, the policy being adopted was one of incentivising NRI depositors so as to try and mobilise debt as a counter to the loss of portfolio investment. The strength of these incentives was probably influenced by the fact that flows into NRI deposits in 2007-08 were at a low of just $179 million. Soon, however, as a result of the huge infusion of liquidity into international markets by the Federal Reserve and other central banks, portfolio flows into India (and many other emerging markets) recovered smartly to $32.4 billion in 2009-10. This should have led to a reduction in the special arbitrage rates being offered to foreign portfolio investors, even if the original decision was correct.

But that was not to happen. Rather, after some lag, the rates were hiked further in November 2011. The RBI, in a circular (DBOD.Dir.BC. 59/13.03.00/2011-12) announced: “Interest rates on fresh Non-Resident (External) Rupee (NRE) Term Deposits for one to three years maturity should not exceed the LIBOR/SWAP rates plus 275 basis points, as on the last working day of the previous month, for U.S. dollar of corresponding maturities (as against LIBOR/SWAP rates plus 175 basis points effective from close of business on November 15, 2008)”. It added: “In respect of FCNR (B) deposits of all maturities contracted effective from the close of business in India as on November 23, 2011, interest shall be paid within the ceiling rate of LIBOR/SWAP rates plus 125 basis points for the respective currency/corresponding maturities (as against LIBOR/SWAP rates plus 100 basis points effective from close of business on November 15, 2008).”

In December 2011, the interest rates on NRER deposits were deregulated subject to the condition that the rates could not be higher than those offered by banks on comparable domestic rupee deposits. The conditional clause was dropped in August 2013. It was this added incentive that tipped the barrel, leading to the huge flow of deposits into India noted earlier. But as stated earlier, these flows were largely into NRER accounts in which the NRI depositor carried the exchange rate risk. In mid-2013, the Federal Reserve’s decision to “taper” or exit from the policy of buying bonds to enhance liquidity resulted in a short-run outflow of portfolio capital from India and a depreciation of the rupee. In response, the RBI chose, once again, to rely on the NRI depositor to compensate for the “loss”. On August 14, 2013, the ceiling interest rate on FCNR(B) deposits of one to three year maturity was raised to LIBOR/Swap rates plus 300 basis points and that for maturity of three to five years was raised to 400 basis points above LIBOR/Swap from 300 basis points. Moreover, to ensure that banks utilise this opportunity, increments to these deposits were exempted from reserve requirements (such as cash reserve ratio, or CRR, and statutory liquidity ratio, or SLR) and NRER interest rates were completely freed.

On top of this, the RBI announced a special swap scheme valid for a three-month period (September to November 2013). Under the scheme, the RBI promised to swap dollars received by banks in FCNR deposits against rupees for the period of the deposit at an interest rate of 3.5 per cent a year. This essentially meant that banks were paying a forward premium for the dollar of 3.5 per cent a year, which was much lower than the market swap rate that determined the ceiling rate on the deposits. The RBI was in essence subsidising the banks, allowing them to earn a margin on FCNR deposits. Not surprisingly, banks went all out to mobilise such deposits during the September-November 2013 period. Outstanding FCNR(B) deposits, which stood at $15.2 billion at the end of August 2013, rose dramatically to $40.4 billion by the end of December 2013.

These policy shifts explain the spike in outstanding NRI deposits in 2013-14, with much of the increase occurring during September to December 2013. They also imply that the RBI was bearing the cost of attracting additional NRI deposits in order to deal with the effects of a potential outflow of portfolio capital. According former RBI Deputy Governor S.S. Tarapore, the swap arrangement had exposed the RBI to “losses of an estimated Rs.60,000 crore” ( Business Line , September 19, 2013). While the basis of that “estimate” is unclear, it suggests that the dimensions could be large.

‘Short-termism’

The RBI’s swap was an example of the “short-termism” that accompanies capital account liberalisation. It was incurring a huge cost to attract foreign funds that could help “stabilise” the balance of payments in the short run. Inflows into dollar-denominated FCNR funds are in principle locked-in for one year or more. Hence, these kinds of NRI deposits are not considered short-term capital inflows and are therefore “safe” capital. But there is nothing that prevents the depositor from paying a penalty and exiting earlier, which can happen if fears of currency collapse overwhelm markets. What is required is longer-term insulation against external “policy shocks” such as the taper. And that requires control over capital inflows rather than diversification of the nature of flows at a cost.