Falling reserves

Falling reserves

Subject : Economy

Context:

The Indian central bank’s 2013 playbook to buffer the domestic currency against depreciation  and rebuild foreign exchange reserves is unlikely to prove fruitful.

Details:

• The Reserve Bank of India reduces its forex reserves by selling dollars to defend rupee depreciation.
• In 2013 RBI – swapped the U.S. dollars banks had raised via foreign currency non-resident (FCNR) deposits or foreign currency funding for rupees at concessional rates.
  • But these methods are unlikely to be as fruitful now due to a narrower US-IN rate spread and less aggressive rate hikes in this cycle versus back in 2013.
  •  India’s 3-year bond yields at 7.5% and U.S. yields at 4.5%, the 3% spread is unlikely to help investors make any profits given the current hedging cost is about 6.5%-7%.
• Possible measures
  • Floating sovereign bonds, like the Resurgent India bonds (RIBs) India Millennium Deposit bonds (IMDs) in the past, to help boost forex reserves.

Concept:

Foreign currency non-resident deposits?

• Foreign currency non-resident deposits, usually abbreviated as FCNR(B) – the B stands for banks, are term deposits that non-resident Indians (NRIs) can open with banks in India.
• These deposits are denominated in foreign currencies permitted by the Reserve Bank of India.
• This term deposit was started in 1993 and is available in tenures of one to five years.
• A term deposit lasts for a fixed period after which the amount has to be paid back with the interest being paid either periodically or lump sum at the time of maturity. Fixed deposits are a type of term deposit.
• This would provide for forex resources to banks to lend to their customers who might need foreign funding.

Is it the only way an NRI can invest in India?

• There are two more options: the non-resident (external) rupee account (NRERA) and non-resident ordinary (NRO) account. 
• These are similar to normal bank accounts and differ in the fact that the former is a term account with a maximum period of three years.
• Unlike FCNR(B) they are denominated in rupees.

What is a currency risk under FCNR(B)?

• Indian banks have most of their deposits in rupees and thus make most of their investments in the Indian currency.
• When a NRI invests $1,000 under the FCNR(B) scheme for 3 years, it raises the bank’s deposits by Rs 67,000 (considering $1=Rs 67). The bank then invests this amount.
• But in case over the period the value of the rupee depreciates to Rs 69. The bank will have to spend Rs 69,000 to get pay back the $1,000. This is called currency risk.
• On the other hand the bank stands to gain if the rupee appreciates.

About the Swap scheme:

• In 2013 — Indian currency depreciated which led to currency risk for banks.
• RBI introduced the three-month swap window for FCNR(B) deposits with a term for three years or more.
• Under this swap window RBI allowed banks to exchange (or swap) their FCNR(B) deposits with it by paying an interest at a fixed rate of 3.5% (3 percentage points less than market rates at the time).
  • This means that the banks swapped dollars raised through FCNR (B) deposits with the RBI for rupees at a fixed  interest rate of 3.5% and the RBI had to give back the money in dollars.
  • Example – Suppose the average exchange rate in September-December 2013 was Rs 62. At present, the exchange rate is  around Rs 67, down by 8%. But banks will pay back the amount with an annual interest of 3.5%, which means for the banks the effective exchange rate will be around Rs 69.
    • For the banks, this was a decent hedge – with only a minor depreciation – as they would have invested the money exchanged from RBI in high-return assets..

Impact?

• FCNR(B) deposits rose from $15.1 billion at the start of August 2013 to almost $40 billion by December 2013.
• Influx of foreign exchange stabilized the rupee, which appreciated from a high and volatile range of Rs67-68 a dollar to Rs 62-64 a dollar.
• Shift the currency risk to the RBI-  the idea meant giving banks a 3.5% subsidy to bring in foreign exchange.
  • The 3.5% can be considered as the banks’ hedging costs. If the swap window did not exist banks would have had to hedge rupee depreciation risk by entering swap agreements at as high as 7%.