Risks linked with Fed’s approach & dollar strengthening behind RBI plans to advance FCNR(B) window
The RBI has taken various measures to strengthen and stabilise the rupee, particularly vis-à-vis the US dollar. Out of these, the foreign currency non-resident (bank) [FCNR(B)] — the new deposit scheme for NRIs including persons of Indian origin and overseas citizens of India — merits attention for its impact and size of mobilisation. It is somewhat akin to a similar scheme started by the RBI in 2013. It has newer dimensions, and in the earlier scheme the amount targeted for mobilisation was $10 billion. The current plan was designed with a target of $70 billion; however, we do not have any indication of the updated mobilisation plan now. Let us examine the mobilisation plan, and discuss the possible yield and risks associated with the FCNR(B) instrument for the depositors, banks, and the RBI.
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In the present programme, the RBI has gone further than in 2013 by absorbing 100% of the hedging cost rather than charging 3.5% as it did then. The next lever is raising the rate ceiling that banks can offer or extending the deposit-tenure sweet spot. This is the most direct precedent — in 2013 and again in 2024, the RBI moved the ceiling in stages (alternative reference rate + 250 basis points to 400 bps and 500 bps) as the conditions warranted. Though the FCNR(B) programme was originally scheduled to run till September 30, the RBI has revised the closure date to August 31; the other instruments will continue as earlier. According to the latest RBI data (as of August 13), the total inflows across the three instruments is $56.85 billion, of which FCNR(B) alone is $52.3 billion.
One of the biggest headwinds that the scheme faces right now is the strengthening dollar and the Fed policy decisions. The Federal Reserve’s benchmark sits at 3.50-3.75% under the new chair who took over in May. Its July meeting held rates steady, stripped off language about future cuts, and the dot plot suggested one more quarter-point hike by the year-end, a notably hawkish shift from where things stood earlier in the year. That matters directly for the FCNR(B) economics; the whole pitch to NRIs is 6-7% tax free on rupee — hedged dollars versus what they would earn parking money in a US account. If the Fed holds firm or hikes again, US dollar alternatives (certificates of deposit, money market funds) stay competitive and the spread, already thinner (2.5%) than in 2013 (5.25%), compresses further.
The other important aspect is the secured overnight financing rate (SOFR) — a mechanism used by offshore investors — which is siting at 3.62%. It tracks the Fed rates closely. A higher-for-longer Fed rate means higher borrowing costs on that leveraged structure, squeezing the spread between the 6-7% deposit yield and cost of the loan funding it. If Fed hikes rates again in September 15 when it is scheduled to meet, that carry compresses further, potentially cooling the leveraged uptake segment even if plain-vanilla deposit inflows hold up.
Now let us consider an interesting evaluation of the FCNR(B) for investors and banking companies arising out of the leveraging of the deposit. NRIs can avail from banks; however, under the present conditions vis-à-vis their yield or carry for the banks, they will have the inherent risk of dollar strengthening over the three- to five-year period of deposits. Banks are selling to NRIs with a designed loan facility with multiples, ranging from five to nine times and even more in case of foreign branches.
On June 23, the RBI issued an explicit clarification; commercial banks inducing their overseas branches are permitted to extend loans to non-residents, or issue standby letters of credit in favour of overseas lenders, against FCNR(B) deposits mobilised under this specific swap facility. The RBI did not cap the leverage multiple, it left the quantum entirely to the discretion of individual banks.
Let us now see what various banks, based on their risk appetite and ability to deploy dollars, are offering. Say an NRI opens an FCNR(B) deposit of $1 lakh at 6.00 to 6.5%. The bank will then mark a lien on that deposit and extend a loan against it — banks are broadly structuring the leverage five to 10 times. The loan proceeds get redeposited as additional FCNR(B) deposits, all earning the same 6-6.5% per annum, while the loan itself is priced lower than the deposit rate. The spread between what is earned and what is paid on the loan is the investor’s leveraged return. Analysts have published estimates ranging between 15% and 27% per annum. At today’s rate, at five times leverage it is at 12%, and at nine times leverage it is closer to 17%. These are tax-free dollar-denominated, RBI-guaranteed hedge returns. It is an extraordinary risk-adjusted proposition and perhaps explains why it has become the more newsworthy aspect of the FCNR(B) story in banking circles.
The neat arithmetic of 6-6.5% interest per annum is that another 1% on nine times the deposit amount would, at today’s rate, give a total yield of 15-15.5%. However, it breaks this simple calculation as the loan rate is not fixed. It is floating and linked to the SOFR, therefore the loan cost is a day-one number, not locked for the tenure of the deposit. If the SOFR rises over the holding period, which may be a live risk given the Fed’s current hawkish posture, the spread compresses — potentially sharply and, in an adverse scenario, if the loan rate rises to meet or exceed the fixed deposit rate, the carry shrinks towards zero or turns negative, even though the depositor still owes the full loan interest. This means the analyst estimates of yield should be best understood as based on current conditions, not a return NRIs can count on for the full period of deposit. Another complication may arise out of cash-flow timing. The FCNR(B) interest is typically creditted periodically or compounded, but the loan interest on facilities like these is usually serviced on a running basis, not deferred till maturity. If that is the structure, NRIs need separate liquidity to service loan interest payments. This may bring down the yield for the depositor to even below the numbers estimated by analysts. And of course, the NRIs may also encounter US tax — reporting for NRIs holding US citizenship/green card, a multiple leverage, and loan/deposit position will trigger Foreign Account Tax Compliance Act/Foreign Bank Account Report foreign asset reporting, which is a compliance risk.
In conclusion, going back to the timely and commendable measures adopted by the RBI, the target mobilisation can be reached through a combination of FCNR(B) and external commercial borrowings plus FPI debt flows and exports and overseas foreign currency borrowings by the banks. The factors that may have dictated the RBI’s plans to close the window earlier than scheduled are not known, except the risks associated with the US Fed’s revised approach and dollar strengthening.
The author is the managing partner at Ashvin Parekh Advisory Services LLP.
Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.
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