According to specialists, banks are likely to see an increase in the cost of FCNR(B) deposits by 15–20 basis points above the interest rate agreed upon with depositors. This is because banks have to hedge dollar obligations arising from interest payments on these deposits themselves. The size of these expenses depends on the differentials in interest rates and foreign exchange forward premiums between the two currencies.
The Reserve Bank of India (RBI) covers the hedging costs for the principal amount of the deposit but does not cover the costs for paid interest. In the FAQ published in June after launching the preferential window for swaps for such deposits, the central bank clarified that it would provide a currency swap for the received deposits. This service is a simple purchase/sale of foreign currency by the RBI, which only covers the principal amount of the deposit, excluding the interest component.
Under the preferential swap window introduced to attract dollar deposits, banks attracted $127 billion through FCNR(B) deposits. This window closed on August 31, one month earlier than the RBI's initially planned deadline. The significant volume of funds attracted was due, among other things, to banks offering higher interest rates to attract deposits and providing credit leverage on FCNR(B) deposits, which allows Non-Resident Indians (NRIs) to potentially increase the return on their investments.
According to a senior banker at a public sector bank speaking on condition of anonymity, 'Banks must bear the costs of hedging the interest component themselves. That is why, although some banks pursued a very aggressive policy, we did not go beyond a certain limit.' This banker noted that his bank reached its own mobilization target and did not attract additional deposits due to the extra costs associated with the interest component.
A senior private sector banker also stated that the actual cost of attracting FCNR(B) deposits will be approximately 15–20 basis points higher than the deposit rate itself after accounting for the costs of hedging the interest component. For example, if a bank offers 6.5% per annum on an FCNR(B) deposit, its actual cost could be 6.65–6.70%.
The banker explained that the RBI did not take on the costs of hedging the interest component because banks offered various interest rates on FCNR(B) deposits, which complicated the application of a single hedging rate. Nevertheless, he added that attracting three-, four-, or five-year funds at a fixed rate of 6.5–7% remains attractive for banks.
According to a treasury official at a public sector bank, banks are studying various ways to hedge the dollar risk arising from future interest payments on FCNR(B) deposits. 'Options like forwards can be considered, but premiums have risen due to RBI buy/sell swaps,' the official stated. He also noted that the interest component on $127 billion of FCNR(B) deposits could represent a substantial sum, given that interest rates on such deposits varied from 6% to over 7.5% in some banks, and forwards are likely to become a key tool for managing future dollar risk.
Market participants noted that some banks left part of their interest rate risk unhedged due to the relatively high cost of fixing dollars for future interest payments. Banks that did not fully hedge the interest component may face higher rupee costs for servicing their dollar obligations if the rupee continues to weaken. The same banks that hedged the risk have already locked in additional costs.
The rupee fell below the 95 mark against the dollar last week amid rising crude oil prices above $100 per barrel due to escalating tensions in the Middle East, while the RBI intervened as expected through spot dollar sales and currency swaps.
A market economist warned that banks may face increased costs for hedging the interest component of FCNR(B) deposits if US rates and forward premiums rise. Expectations of tighter monetary policy in the US and concerns about the country's financial health could put upward pressure on US rates, while domestic factors could also influence forward premiums. The economist added that banks can use Overnight Indexed Swaps (OIS) to manage interest rate risks, and forwards and swaps to manage currency risks, with the exact impact depending on the banks' balance sheets and treasury strategies.
The mass attraction of FCNR(B) deposits also created liquidity management challenges for the RBI, as the scale of the inflow was higher than banks expected. The private banker mentioned earlier stated, 'We could handle less, at least $25–30 billion less than what came in,' adding that this would reduce the excess liquidity in the banking system by about 3 trillion rupees.
Since the excess liquidity in the banking system significantly exceeded the RBI's comfort threshold, the central bank began sterilizing excess liquidity through Variable Rate Repo Reverse Repurchase Agreements (VRRR) in August. The RBI has now moved to longer-term liquidity absorption tools, announcing the sale of Open Market Operations (OMO) worth 1 trillion rupees, which will be conducted during three auctions: September 17, September 21, and September 28. According to economists at QuantEco Research, the combination of the Standing Deposit Facility (SDF), VRRR operations, and OMO sales will allow the RBI to sterilize about 10 trillion rupees of excess liquidity from the banking system. QuantEco also calculated that this would leave a reserve of 2 trillion rupees for immediate sterilization, which could be provided through short-term buy/sell currency swaps or issuances of Market Stabilization Scheme (MSS) securities or Cash Management Bills (CMB). Analysts do not expect the RBI to currently resort to increasing the Cash Reserve Ratio (CRR) or extending the OMO sales program.