Be careful what you wish for’ is an old (and wise) saying. Getting what you wish for can bring unexpected results. And, at times, lead to unwanted outcomes. The saying fits the Reserve Bank of India’s (RBI) recent foreign currency non-resident deposit (bank), or FCNR(B), scheme to garner additional dollars to a T.
Rewind to 8 June. Faced with unrelenting foreign portfolio outflows and prolonged weakness in the rupee, RBI turned to its tried and tested strategy when faced with trouble on the external front. It turned to overseas Indians, luring them with attractive sweeteners, even as it prodded banks to resort to tactics it would have frowned upon had they dared to replicate them at home.
It virtually gave them carte blanche to extend loans against existing dollar deposits to fund fresh FCNR(B) deposits, a process euphemistically called raising ‘leveraged’ deposits, though, in truth, it was more akin to ‘ever-greening,’ albeit by another name.
The net result? Despite ending its special foreign exchange swap facility for FCNR(B) deposits on 31 August, a full month ahead of its original end-date, 30 September, inflows at $136.4 billion have far surpassed initial expectations. According to provisional data released by RBI, FCNR(B) deposits accounted for the bulk of the inflows at $127.2 billion, while overseas foreign currency bonds brought $5.3 billion and external commercial borrowings $3.9 billion.
The last time RBI attempted something like this was in 2013 when fears that the US Federal Reserve would raise interest rates led to what came to be known as the Taper Tantrum and put the rupee under severe pressure.
This time round, RBI went further. Not only did it liberalize rules on the maximum interest rates that banks could offer on FCNR(B) deposits, it exempted these deposits from statutory requirements like the cash reserve ratio (CRR) and statutory liquidity ratio (SLR). It also allowed banks to exclude such deposits from the ‘adjusted net bank credit’ calculation while determining their priority-sector loan obligations.
If the hope was that these short-term foreign currency inflows would give RBI the firepower (forex reserves) needed to intervene in the market to prevent the rupee from depreciating too far, and too fast, its hope has been realized. Forex reserves, which had touched a low of $ 681.4 billion in the week ended 22 May, rose to a record high of $729.3 billion in the week ended 21 August; an increase of almost $48 billion in just three months.
On the exchange rate front, though, the outcome has been less encouraging. The domestic currency has remained largely range-bound in the ₹95-96 to the dollar range.
If that’s not sobering enough, the reality is the very success of the scheme has brought a host of problems in its wake; problems that RBI as the central bank should have anticipated. But, unfortunately, seems to have over-looked. Consequently, fears expressed by some of the more prescient observers that the scheme would prove both hasty and costly now seem to be coming true.
Consider. Apart from the hedging cost that has to be borne by RBI, and eventually by the taxpayer, RBI is now faced with a huge increase in systemic liquidity. That too at a time when liquidity is already in surplus (10 of the 23 initial public offerings in August received bids of 100 times the shares on offer) and inflationary pressures are rising, globally and domestically.
Related to the surge in liquidity is the sudden increase in bank deposits (estimated at about ₹12 trillion), thanks to the conversion of dollar inflows into rupees. This (artificial?) increase in system liquidity, akin to a sugar rush, has a number of far-reaching and damaging implications.
Faced with so much liquidity, banks are likely to start chasing loans in a bid to deploy excess funds. We’ve already seen credit growth surge to nearly 20%. And we know what happens when banks lend hand-over-fist: Higher non-performing assets some months down the line.
To be sure, RBI can use a combination of tools to mop up excess liquidity—increase the cash reserve ratio, conduct open market operations, issue market stabilization bonds and so on. But each of these has a cost. They will raise interest rates, impacting the credibility of a central bank that has all along refused to heed warning signals.
Remember, FCNR(B) deposits have only bought us time. They might have bailed us out, but only for the moment. They have to be repaid, and in dollars. Let’s not fool ourselves about the motives of overseas Indians in responding to RBI’s overtures.
During the 1991 Gulf War, panic withdrawals of foreign currency deposits by overseas Indians added fuel to fire, possibly hastening the crisis. On top of all this is the very real possibility that the surge in liquidity will stoke inflationary pressures in a scenario where inflation is already rising.
In effect, all that RBI has done is that it has kicked the can down the road; it has postponed the day of reckoning. Instead of addressing the cause of the problem by curbing excess demand (reflected in the country’s current account deficit) through a rise in interest rates, it chose to address the symptom—a weakening currency.
It is a telling commentary that at a time when yields and interest rates are rising all over the world, for reasons that are far from clear, India’s central bank alone seems to believe in ‘Indian exceptionalism.’ The world doesn’t.
The author is a senior journalist and a former central banker.