Evaluating India’s currency contingency plan

(The following article appeared on cnbctv18.com on August 13, 2018.

https://www.cnbctv18.com/views/evaluating-indias-currency-contingency-plan-502021.htm )

While INR has weakened this year, the RBI has since kept up a quietly determined defense. Friday’s data release confirms that the RBI sold US$ 25B during April-June 2018.

Yet, nervousness in our currency markets persists, and with reason.

First, while Turkey’s is an extreme situation that bears little resemblance to our own context, the events there underscore the brittle nature of global markets, geopolitics, and sentiment.

Second, our own vulnerabilities persist. India’s external balance is unhealthy. Last year, we borrowed fickle, carry-seeking funds to both pay for our higher oil, electronics and gold imports, and to increase RBI’s currency reserves. The balance looks worse this year, and existing large carry positions may reverse. Add the weaknesses in our banking system, a tricky fiscal balance, and an election year, and there is no room for complacency.

While hoping for the best (oil at $50 again, anyone?), RBI must plan for the eventuality that its reserves fall over the next few weeks and months, even as the unfavorable context persists.

The contingency plan – the swap window for FCNR deposits

We are not in any crisis now. RBI still has over $400B of reserves. But in any contingency planning exercise, analysts see RBI’s 2013 subsidized swap window as a core option for raising US$ during a crisis.

To recall, post the Bernanke taper tantrum of mid-2013, the RBI announced two special swap windows in September 2013.

First, it offered to swap US$ raised by banks from foreign currency non-resident deposits (FCNR) of maturity 3-year and above into INR, at a concessional rate of 3.5% p.a., about 3.0% cheaper market.  Second, it allowed banks to borrow additional FCY funds and swap them into INR at 1% below market. 

Collectively, the two swap windows brought in much higher-than-expected $34B that marked the end of the crisis and a change in INR narrative.

For all its successes though, with the advantage of time & hindsight, there are aspects of the swap windows that we must consider for any future schemes.

The NRI scheme that brought in bank money

A bulk of the $26B of FCNR deposits that came in 2013 was not non-resident Indian (NRI) money at all – it was overseas bank money routed through NRIs. Overseas banks lent to NRIs, who in turn placed FCNR deposits with Indian banks, who then raised cheap INR funds from the RBI.

The scheme allowed us to pretend that our diaspora was bailing us out during a crisis, when in reality we were borrowing from overseas banks.  It also clouded the actual cost of the borrowing, as opposed to a direct US$ sovereign bond.

The scheme discriminated against other legitimate sources of foreign currency into India, such as external commercial borrowings (ECBs). The restricted exclusivity granted high returns to the NRI ecosystem.

Overseas banks earned about 1% on their collateralized lending to NRIs.

NRIs in turn earned 1% spread on these borrowed funds, from the higher rate on the FCNR deposit. For every $1 of own money, the typical NRI borrowed $9 of overseas bank funds, and ended with an extraordinary 12% US$ p.a. return on her original $1.

Indian banks in turn swapped the FCNR deposit with RBI, and raised 3-year funds at 1.0-1.5% below risk-free Government of India yields.

The scheme left intermediaries very, very happy – and this no doubt contributed to its success.

The cost of funds for India

So what was the effective cost of funds for India in 2013?

Officials say that the scheme helped settle Indian markets, and so the benefits outweighed the costs. That skirts the issue though. We rarely hear anyone spell out the true original cost of US$ borrowing for RBI/ government.

Effectively, RBI borrowed USD funds. Against this, it lent INR funds to Indian banks at a subsidized interest rate. At the time, our government was borrowing INR funds at much higher rates. Given this, it is possible to show that the RBI/ government net borrowed US$ at about 4% spread over the corresponding 3-year US Treasury (UST) yield.

Suffice to say that a direct, transparent, India US$ sovereign bond at a high 4% spread over UST would have raised eyebrows – even in those troubled times.

Takeaways for the future

Perhaps any future subsidized swap window should avoid favoritism, and not be restricted to FCNR deposits alone. All legitimate long-term US$ funds – including bank borrowings from overseas branches, FCNR deposits, and client ECBs – could be allowed access to the RBI window.

By dropping the NRI pretense and exclusivity, we could make the scheme more equitable, channel funds directly into investments, and additionally save 1-2% p.a. of cost. On the 2013 funding, that would translate to savings of $250-$500 million p.a. – material by any yardstick.

Equally importantly, this would allow domestic industry – including government owned infrastructure finance companies - directly raise term funds at attractive rates for deployment into productive investments.

We could still have substantial money come in through NRI deposits, through this more open and fair process.

Lastly, any swap scheme is only a palliative that buys us time by bolstering reserves and sentiment. After 2013, lower oil prices and a stable government helped address the external imbalance.

Today’s core issues (tepid exports, deficient infrastructure, high manufacturing imports, amongst others) would still need to be separately addressed. We must continue to debate the external policy of both our government and the RBI.