FCNR(B): Has RBI bought forex stability at too high a cost?

RBI's FCNR(B) scheme has been lauded for attracting $132 bn. But is the amount attracted the right measure of success?

Without doubt, the scheme has had two positive outcomes. It has bolstered RBI's forex reserves, which rose from $682 bn when the scheme was launched on June 5, to $785 bn on September 4. It has also helped strengthen the rupee. In May, the rupee appeared headed towards ₹100 to the dollar. Since then, it has stabilised in a range of ₹94-96 to the dollar.

Those are clear results. But what benefits did these outcomes bring to the economy? This is less clear. For starters, it's not obvious why RBI needed more reserves. $682 bn was a sizeable kitty, more than sufficient to finance any prospective BoP deficit for this year, or even the next 5 yrs.


As for the exchange rate, there's no obvious reason why ₹95 to the dollar is better for the economy than ₹100. A more depreciated rupee does hurt importers by making foreign goods and services like education more expensive. But it also gives domestic producers some breathing space as they compete with cheap imports from China.

Depreciation also helps exporters by making products cheaper for foreign buyers and helping them find new markets. So, economic benefits of higher reserves and a stronger rupee are unclear. What about costs?

When Indian banks gave dollars to RBI, the central bank gave them rupees in return, creating more than ₹10 lakh cr of liquidity. This surplus liquidity is now pushing interbank interest rates below RBI's policy rate. That is a problem because RBI set its policy rate at a level it considered necessary to keep inflation under control. RBI now needs to 'mop up' this liquidity to bring interest rates back in line with its policy rate.

Doing so is expensive, and withdrawing this excess liquidity is called 'sterilisation'. For example, if RBI were to sell ₹10 lakh cr of 10-yr government securities carrying a market interest rate of roughly 7%, the interest cost would be about ₹70,000 cr a year. This is a sizeable sum.

There are other options. RBI could ask GoI to bear the cost by issuing new government securities or share part of the cost with GoI. The central bank's additional forex reserves would generate some income, for example, from US treasury securities. But even after accounting for this, net cost to the public sector would remain large.

Alternatively, RBI could make banks bear the cost by raising CRR. This has two problems. One, banks that have not received dollar deposits would also be penalised. Two, banks have to pay 6-7% interest rate on NRI deposits, but receive nothing on the surplus liquidity deposited with RBI because of CRR hike. This would undermine banks' profitability.

Potential costs don't end there. RBI has assumed considerable exchange rate risk. For every dollar that banks gave it, they received around ₹95 in return, assuming this to be the prevailing exchange rate. When the deposits mature in roughly 5 yrs, RBI will have to reverse the transaction at the same exchange rate. But what happens if the rupee depreciates in the meantime? If the exchange rate is, say, ₹105 when deposits mature, RBI would lose ₹10 for every dollar swapped.

Even a small depreciation could impose a large cost because the amount involved is enormous. Put simply, returning $132 bn after 5 yrs could prove costly for RBI, adding to the cost of sterilisation. Future dividends from RBI to GoI would consequently suffer.

Perhaps these costs would have been worth incurring if the scheme had been used to buy time to strengthen India's BoP. But no such measures have been announced either to attract more FDI or more FPI into Indian equities. Partly for this reason, and also because the war in West Asia has intensified, the rupee has begun to fall again.

In the end, FCNR(B) has left the system weaker than before. So, was the scheme really needed?

The writer is associate professor of Economics, Indira Gandhi Institute of Development Research, Mumbai