The Hidden Cost of RBI’s $127 Billion FCNR Success

The Reserve Bank of India has every reason to celebrate the success of its special FCNR(B) swap window. It was meant to attract foreign currency, strengthen the external account and provide the rupee a cushion against global turbulence. By August 31, it had attracted a staggering $127.2 billion of FCNR(B) inflows, dwarfing the $5.3 billion raised through overseas foreign-currency borrowings and $3.9 billion through external commercial borrowings.

But behind the spectacular headline number lies an inconvenient question: at what cost?

The scheme looks like a roaring success if success is measured by dollars entering India. It looks rather different if one asks what those dollars will cost the Reserve Bank and, ultimately, the public balance sheet.

The first issue is the temptation to repeat 2013.

During the taper-tantrum crisis, the RBI opened a special swap window for three-year FCNR(B) deposits. Banks sold dollars to the RBI and received rupees, with the RBI agreeing to reverse the transaction at a fixed swap rate of 3.5% a year.

That was a very different world. Major central banks were expanding their balance sheets and flooding the global system with liquidity. Interest rates were exceptionally low. Dollars were plentiful and relatively cheap.

Today, the landscape is markedly different. Global central banks have spent years restraining, and in some cases shrinking, their balance sheets, while sovereign yields are considerably higher. Large fiscal deficits, heavy government borrowing and elevated term premia have changed the economics of global liquidity.

Yet India has resurrected a 2013 instrument in a very different monetary universe.

There is nothing wrong with adapting an old instrument. The question is whether the economics of the instrument were adequately assessed for the new world.

The 2026 scheme is, in several respects, considerably sweeter. Fresh three-to-five-year FCNR(B) deposits mobilised under the special window were exempted from CRR and SLR requirements. Combined with the special dollar-rupee swap facility, this created a powerful incentive for banks to mobilise foreign-currency deposits.

Then came leverage.

Banks could lend against FCNR deposits. SBI, for instance, offered a nine-times leverage product. In its five-year illustration, a 6% deposit rate against a 5.4% lending rate produced a reported return of 14.08% on the depositor’s original capital.

It is a remarkable incentive to bring dollars into India. It also raises the question of where the cost ultimately resides.

The RBI has effectively absorbed the currency-hedging cost that would otherwise have sat on banks’ books. Under a normal transaction, the forward premium on the rupee would form part of the cost of converting a foreign-currency liability into a rupee resource. Under the special facility, that cost is substantially transferred to the central bank.

The subsidy, therefore, has to appear somewhere.

It appears on the RBI’s balance sheet.

The RBI receives the dollars and supplies rupees. The dollars become part of its reserves and earn returns on foreign assets. But the rupees released into the banking system can create a sterilisation requirement. To the extent that the RBI has to absorb that liquidity at domestic interest rates above the return earned on the corresponding foreign assets, there is a negative carry.

The precise cost will depend on how much liquidity is sterilised, through which instruments and at what rates. But the economics are materially different from 2013, when the RBI charged a fixed 3.5% annual swap rate.

That is the crucial point.

The FCNR depositor gets an attractive return. The bank gets cheap hedging and regulatory relief. The NRI gets an unusually attractive leveraged proposition. The RBI gets the balance-sheet consequences.

External Mix
Another important question concerns the composition of the inflows.

The policy package did not favour FCNR(B) deposits alone. It also sought to encourage external commercial borrowings and overseas foreign-currency borrowings. Yet the mobilisation has been overwhelmingly concentrated in FCNR(B), with corporate borrowing accounting for only a fraction of the total so far.

It doesn’t mean FCNR resources are economically idle. Banks can intermediate the funds and deploy them through lending.

But the skew raises a different policy question.

Did the relative structure of the incentives make FCNR(B) deposits disproportionately attractive compared with other forms of external financing?

That matters because the different channels perform different economic functions. FCNR(B) inflows strengthen bank funding and the RBI’s reserve position. ECBs, meanwhile, place external liabilities directly on corporate balance sheets and can finance investment and productive activity.

The relevant issue, therefore, is not whether one dollar displaced another. It is whether the policy produced the intended composition of external financing, if it is intended at all.

If nearly all the response came through the channel carrying the strongest regulatory and hedging concessions, that itself deserves examination.

That does not make the scheme wrong. It makes the word “success” incomplete.

There is another irony. The RBI subsequently advanced the closing date of the FCNR window from September 30 to August 31. By then, the inflows had accelerated dramatically.

An orderly exit was understandable. Banks had transactions in the pipeline and customers responding to an officially announced window. Abrupt closure could have been disruptive.

But once a finite closing date was announced for an unusually attractive facility, a final rush was also predictable.

Markets do what markets do. Banks had every incentive to mobilise deposits before the deadline and get the dollars swapped with the RBI. The exit announcement could therefore itself accelerate the inflow.

The episode raises a broader question about how such windows should be wound down. Quantity caps, declining concessions or other price-based exit mechanisms might have produced a smoother adjustment than a hard closing date amidst avoidable confusing signals.

Recent developments illustrate the problem. As banks accumulated dollars, the RBI relaxed the frequency with which they could access the swap facility. The rush of dollar liquidity also sent the one-day dollar/rupee swap cost to around four times its usual level. On the other side of the transaction sits the banking system’s surplus rupee liquidity.

The irony is difficult to miss: a scheme introduced to address external liquidity pressures ended up creating a substantial domestic liquidity-management challenge.

There is also a fiscal dimension.

The RBI’s surplus is ultimately transferred to the government. They form a significant part of government revenues of late. If the FCNR programme creates a sizeable negative carry over several years, and sterilisation adds to the cost, the fiscal dividend from the RBI could be smaller than otherwise.

In other words, India may gain dollars today and sacrifice some rupee income tomorrow.

That may still be a worthwhile trade. Foreign-exchange reserves provide insurance against external shocks, sudden capital outflows and currency attacks. But insurance has a premium, and that premium deserves greater transparency.

Reserve Returns
The scale of the mobilisation also strengthens the case for examining the asset side of the RBI’s balance sheet.

If acquiring additional reserves carries a material cost, reserve allocation and income generation become more consequential. That includes the balance between interest-bearing securities, gold and other reserve assets.

Gold has risen substantially in value and offers diversification without sovereign credit risk, but generates little conventional income. There may be scope over time to examine whether some reserve assets can be deployed more efficiently without compromising safety, liquidity or availability.

The objective, however, should remain prudent risk-adjusted reserve management, not simply maximising yield or trying to make one reserve asset pay for the cost of another.

The larger point is simpler.

The RBI has demonstrated that it can manufacture a formidable external buffer when circumstances demand it. The harder question is whether the price of that insurance has been properly measured.

A $127 billion mobilisation is unquestionably impressive. But the final accounting should include the concession embedded in the hedge, the cost of managing the resulting rupee liquidity, the risk carried on the central bank’s balance sheet and the eventual effect on RBI surplus transfers.

Only then will we know not merely how many dollars India raised, but what it actually paid for them.