Why it could be a real headache for the RBI?
It is by now well known that the Indian economy has a huge payout of $25 billion in the form of FCNR deposits redemption. These deposits were raised by the banks from their NRI clients at the behest of the RBI at the peak of the currency crisis in August 2013. But first a background of the crisis!
Why FCNR was necessitated…
Back in August 2013, the current account deficit had touched a high of 5% of GDP. This resulted in a run on INR as FPIs who had invested in Indian debt withdrew nearly $12 billion of money in a short span of time. This created a crisis as the rupee plummeted from Rs.53/$ in June 2013 to Rs.68/$ by the end of August 2013. To overcome this crisis the RBI had urged banks to attract NRI deposits through the FCNR route by giving them an attractive yield. The kicker for the NRIs was that since an FCNR deposit will be denominated in dollar terms, they would not be running the currency risk in this deposit. This resulted in an influx of FCNR deposits to the tune of $34 billion, which eventually resolved the currency crisis of 2013.
Why are we worrying about it now?
A chunk of these FCNR deposits were raised by banks with tenure of 3 years. (Remember, FCNR deposits can be for a maturity of 1-5 years). There was an additional benefit that RBI offered to these banks raising NRI deposits to encourage the raising of FCNR deposits. The banks were allowed to swap their liability at the end of the tenure at an annual cost of 3.5%. This was a big booster for the banks as normally their cost of hedging would have been nearly 7% on an annualized basis.
What happens now?
Banks will have to repay FCNR deposits to the tune of nearly $25 billion between September and November this year. That could put tremendous pressure on the banks as many banks would not have equivalent dollars and will have to rely on RBI to supply them with the requisite dollars. There are 3 things to understand here.
Firstly, most of the FCNR deposits came in from NRIs using leveraged funds. Hence renewal of deposits is highly unlikely unless the interest rates offered is really attractive. Higher rates may impel the NRIs to roll over these FCNR deposits. Secondly, the redemption of FCNR deposits could lead to a sharp demand for dollars and the consequent demand would lead to the weakening of the rupee. Last but not the least, the FCNR redemption will lead to sharp fall in the deposits of banks. They will have to compensate with domestic deposits for an equivalent amount. This will put pressure on domestic yields with negative implications for bond prices. It is surely going to be a testing time for RBI and the bond markets.