The rupee’s borrowed breathing space

Why in the News

Banks mobilised $52.3 billion in foreign currency inflows between 8 June and 13 August under the Reserve Bank of India (RBI) special swap facility, with Foreign Currency Non Resident Bank, or FCNR(B), deposits accounting for the bulk of the funds. The RBI closed the swap window a month earlier than scheduled, and the rupee fell to a 17 day low of 95.61 against the dollar the same day. A country can defend its currency by earning dollars or by borrowing them, and this stabilisation belongs to the second kind.

How does the RBI special swap facility for FCNR(B) deposits work?

1. The deposit: FCNR(B) deposits let non resident Indians hold foreign currency with Indian banks, free of rupee risk, with tax free interest and full repatriation.
2. Step one, raising the money: Banks raise fresh deposits of three to five year maturity in foreign currency.
3. Step two, the swap: Banks swap those dollars with the RBI in exchange for rupees.
4. Step three, the subsidy: The central bank absorbs the hedging cost of that swap, which is the cost banks would otherwise pay to protect themselves against currency movement.
5. The result for the depositor: Once the cost is lifted, banks can offer dollar rates near 6 to 7.5 per cent, and some add leverage of 9 to 19 times.
6. The nature of the transaction: For a wealthy depositor borrowing abroad and placing the proceeds in India at a protected high yield, this is a carry trade with the currency risk removed by someone else.

What is a carry trade?

1. About: A carry trade is borrowing in a currency where interest rates are low and investing in an asset that pays a higher return, keeping the difference between the two rates.
2. The risk it normally carries: The lender bears the exchange rate risk, since a fall in the investment currency can wipe out the interest gain.
3. What is different here: The currency risk is removed by the central bank absorbing the hedging cost, so the investor keeps the yield without the exposure that usually pays for it.

What is a hedging cost in a currency swap?

1. About: A currency swap exchanges one currency for another today with an agreed reversal at a future date and a pre agreed rate.
2. The cost: The hedging cost is the price of that future certainty, set mainly by the interest rate difference between the two currencies and by expectations of depreciation.
3. Who pays it here: The RBI absorbs it, which is why the transaction is a subsidy rather than a market clearing price.

What is an asset liability mismatch?

1. About: An asset liability mismatch arises when a bank’s borrowings and its lending differ in currency, maturity or interest rate basis.
2. The form it takes here: Banks raise three to five year foreign currency money and lend against it in rupees on different terms, so repayment obligations and asset returns do not move together.

What did the swap window actually mobilise?

1. The headline number: Banks mobilised $52.3 billion in foreign currency inflows between 8 June and 13 August under the facility.
2. The composition: FCNR(B) deposits accounted for the bulk of the funds raised.
3. Early closure: The RBI closed the FCNR(B) swap window a month earlier than originally scheduled.
4. The immediate market reaction: The rupee depreciated 0.2 per cent to close at a 17 day low of 95.61 against the dollar, the worst performing currency in Asia that day despite a softer dollar.
5. The added pressure: A rise in crude oil prices to nearly $90 a barrel compounded the fall, with importers rushing to take forward cover and exporters holding back dollar sales.
6. The intervention: Intervention by the central bank prevented a sharper slide.

Why did the money need such inducement?

1. The prior position: Confidence had already left, since the rupee was Asia’s worst performing currency in the financial year 2025 to 2026.
2. The portfolio exit: Foreign portfolio investors had pulled out billions from Indian markets over that period.
3. The partial return: They turned net buyers in July, bringing in about $2.1 billion, a modest reversal relative to the scale of the preceding exodus.
4. The reading that follows: It is too early to read this as investors rediscovering India.
5. The revealing detail: The money recorded a sharp fall as soon as the inducement was withdrawn, which measures the incentive rather than belief in Indian assets.

Why does a subsidy work when good data does not?

1. The nature of currency markets: Currency markets move not only on fundamentals but on expectations about future movement.
2. The trap of one way expectations: Once investors believe depreciation is one way, good data stops persuading them.
3. The mechanism that breaks the loop: The way to break that loop is to make the bet against the rupee expensive, which is what the FCNR(B) window does.
4. The price of the fix: Flows surged only after the subsidy appeared, so the pace of mobilisation measures the incentive.
5. The conclusion drawn: Confidence that materialises only after the price is raised is not confidence, it is a purchase.

What has India actually bought?

1. The two ways to defend a currency: A country can earn more dollars or it can borrow them, and the two look alike when the money arrives.
2. The category this falls into: India’s latest external sector stabilisation largely falls into the borrowing kind.
3. What was purchased: India has bought time, and a quiet transfer of risk.
4. The repayment obligation: These deposits will mature, and every dollar arriving now must be repaid in three to five years.
5. The correct classification: The surge is best viewed as a balance of payments stabiliser rather than a durable source of dollars.
6. The accounting reality: FCNR(B) deposits are ultimately a form of external borrowing and create future repayment and rollover obligations.

Where does the risk actually sit?

1. The scheme does not remove risk: The facility does not make the rupee’s risk disappear, it relocates it.
2. The first relocation: When the RBI absorbs hedging costs, the exposure moves onto the public balance sheet.
3. The second relocation: When banks raise three to five year money and lend against it, the risk resurfaces as an asset liability mismatch.
4. The transformation over time: A visible currency problem today can become a less visible banking problem tomorrow.
5. Who ultimately holds it: The depositor keeps a protected yield, and the currency exposure that yield was compensating for sits with the central bank and the banking system.

What is genuinely not in crisis?

1. Reserves: India’s foreign exchange reserves are large, giving the central bank room to intervene in the spot and forward markets.
2. Invisible earnings: Services exports and remittances cushion the external account against a goods trade deficit.
3. External factors: Part of the rupee’s weakness reflects the strength of the dollar rather than a domestic failure.
4. The correct qualification: Being out of crisis is not the same as being secure.
5. The deterioration that matters: India slipped into a current account deficit in May, which is the backdrop against which the FCNR(B) surge must be read.

What should India do with a window it has paid to open?

1. Treat it correctly: Treat the period as a purchased pause and spend it well, rather than as evidence that the external problem has been solved.
2. Build export surplus sectors: Develop sectors that earn a durable dollar surplus rather than relying on capital inflows to balance the account.
3. Attract foreign direct investment: Draw investment that takes a lasting stake, since it does not carry a fixed repayment date the way a deposit does.
4. Cut energy import dependence: Reduce the largest single item of the import bill, which is also the most exposed to geopolitical shocks.
5. Treat tourism as a foreign exchange industry: Recognise inbound tourism as an export earning activity and plan for it accordingly.
6. The blunt limit: If India earns too few dollars, no better way of borrowing will solve it.

Challenges in managing India’s external sector

1. Rollover risk on maturing deposits: Large foreign currency deposits raised in one window fall due together and must be repaid or renewed at whatever rate then prevails. e.g. the $34 billion of FCNR(B) deposits raised under the 2013 swap window created a concentrated redemption in 2016 that the RBI had to manage in advance.
2. Oil price exposure: India imports the overwhelming share of its crude oil, so the trade deficit moves with a price it does not set. e.g. crude near $90 a barrel in August 2026 directly widened the import bill and pressured the rupee.
3. Gold import demand: Household demand for gold converts savings into imports and worsens the current account. e.g. gold has repeatedly been the second largest item in India’s import bill after crude oil.
4. Volatility of portfolio flows: Foreign portfolio investment can reverse within weeks on a change in global interest rates. e.g. the taper announcement of 2013 triggered an exit that took the rupee past 68 to the dollar.
5. Narrow export basket and market concentration: A few products and a few destinations carry a large share of merchandise exports. e.g. tariff action by a single large trading partner can hit textiles, gems and jewellery and shrimp exports simultaneously.
6. Rising import intensity of exports: Electronics and refined petroleum exports require heavy imported inputs, so gross export growth adds less net foreign exchange. e.g. smartphone exports rely on imported displays, camera modules and cells.
7. Sterilisation cost of intervention: Defending the rupee by selling dollars injects rupee liquidity that must then be absorbed at a cost. e.g. the RBI uses open market operations and the standing deposit facility to drain the liquidity created by intervention.
8. External debt servicing: A rising stock of short term external debt raises the share of reserves committed to repayment. e.g. short term debt on residual maturity has at times exceeded a fifth of foreign exchange reserves.

Conclusion

The $52.3 billion mobilised under the swap window is borrowed rather than earned, and the currency risk that made it attractive has been moved onto the public balance sheet and into bank balance sheets. The central bank acted decisively and bought time, and every dollar of that time must be repaid within three to five years. What remains unresolved is the underlying position, since India slipped into a current account deficit in May and the flows arrived only after the price was raised. Rupee stability now rests increasingly on liabilities the country has paid to attract and must one day repay.

What is the Balance of Payments?

1. About: The balance of payments is the systematic record of all economic transactions between residents of a country and the rest of the world over a period.
2. Rationale: It exists to show whether a country is paying its way through what it earns, or financing consumption and investment through borrowing and asset sales.
3. Current account: Records trade in goods and services, primary income such as investment income, and secondary income such as remittances.
4. Capital and financial account: Records foreign direct investment, portfolio investment, external commercial borrowing, banking capital including non resident deposits, and reserve movements.
5. Errors and omissions: The residual balancing entry that reconciles the two accounts, since the sources for each side differ.
6. The accounting identity: A current account deficit must be financed by a surplus on the capital account or by drawing down reserves.

Key Concerns Regarding India’s External Sector Position

1. Deficit financed by volatile capital: A current account deficit funded by portfolio flows and non resident deposits is more fragile than one funded by foreign direct investment.
2. Dependence on invisibles: Services exports and remittances mask a persistent and large merchandise trade deficit.
3. Reserve adequacy measured wrongly: A large absolute reserve stock can still be thin when measured against short term external liabilities on a residual maturity basis.
4. Commodity price pass through: Oil, gold and fertiliser prices are set abroad, so a large part of the external position is outside domestic policy control.
5. Rupee internationalisation lag: Almost all of India’s trade is invoiced in dollars, so every trade shock passes directly into demand for foreign exchange.
6. Contingent liabilities of intervention: Forward market intervention creates future dollar delivery obligations that do not appear in the headline reserve figure.

Statutory Framework Governing Foreign Exchange and External Borrowing

1. Entry 36 of the Union List: Places currency, coinage and legal tender, and foreign exchange, exclusively with Parliament.
2. Entry 37 of the Union List: Covers foreign loans, the constitutional basis for regulating external borrowing.
3. Section 3 of the Foreign Exchange Management Act, 1999: Prohibits dealing in foreign exchange except through authorised persons.
4. Section 6 of the Foreign Exchange Management Act, 1999: Governs capital account transactions, including non resident deposits and external borrowing.
5. Section 47 of the Foreign Exchange Management Act, 1999: Empowers the RBI to make regulations to carry out the provisions of the Act.
6. Sections 17 and 33 of the Reserve Bank of India Act, 1934: Govern the business the RBI may transact and the assets backing the note issue, including foreign securities.
7. Preamble to the Reserve Bank of India Act, 1934: States the objective of operating the currency and credit system to the country’s advantage and maintaining price stability.

Laws and Rules Governing Non Resident Deposits

1. Reserve Bank of India Act, 1934: Establishes the central bank and its powers over currency, reserves and monetary operations.
2. Section 45ZB: Provides for the Monetary Policy Committee, which sets the policy rate that shapes the interest differential behind a swap.
3. Foreign Exchange Management Act, 1999: Replaced the Foreign Exchange Regulation Act, 1973 and shifted the regime from control to management of foreign exchange.
4. Foreign Exchange Management (Deposit) Regulations, 2016: Govern the operation of Non Resident External, Non Resident Ordinary and FCNR(B) accounts.
5. Banking Regulation Act, 1949: Governs the conduct of banking companies, including the reserve and liquidity requirements applicable to these deposits.
6. Foreign Exchange Management (Borrowing and Lending) Regulations, 2018: Govern external commercial borrowing and the terms on which residents may borrow abroad.
7. Prevention of Money Laundering Act, 2002: Applies customer due diligence and reporting requirements to non resident deposit accounts.
8. Income Tax Act, 1961: Provides the exemption that makes interest on FCNR(B) and Non Resident External deposits tax free for a non resident.

Back2Basics: Non Resident Deposit Accounts in India

1. FCNR(B) account: A term deposit held in a permitted foreign currency with an Indian bank, with maturity from one to five years.
2. Currency risk on FCNR(B): The deposit is denominated in foreign currency, so the depositor faces no rupee depreciation risk and the bank or the central bank carries it.
3. Non Resident External (NRE) account: A rupee denominated account funded from abroad, fully repatriable, with tax free interest in India.
4. Non Resident Ordinary (NRO) account: A rupee account for income earned in India such as rent, pension or dividends, with limited repatriation and taxable interest.
5. Regulatory basis: All three are governed by the Foreign Exchange Management (Deposit) Regulations, 2016 under the Foreign Exchange Management Act, 1999.
6. Policy use: The RBI periodically relaxes interest rate ceilings and reserve requirements on these deposits to attract dollar inflows when the rupee is under pressure.
7. Balance of payments classification: Non resident deposits are recorded as banking capital under the capital account, not as current account earnings.

Government and RBI Initiatives on External Stability

1. Special swap facility for FCNR(B) deposits: Absorbs the hedging cost of bank dollar deposits to attract diaspora funds during periods of currency pressure.
2. Special Rupee Vostro Accounts: Allow settlement of international trade in rupees with partner countries, reducing dollar demand for those transactions.
3. Gold Monetisation Scheme: Brings idle domestic gold into the financial system to cut fresh import demand.
4. Sovereign Gold Bonds: Provide a paper substitute for physical gold, reducing the import component of gold demand.
5. Liberalised Remittance Scheme: Sets the annual limit within which resident individuals may remit funds abroad, a control on outflows.
6. External Commercial Borrowing framework: Sets maturity, cost ceiling and end use conditions for corporate borrowing abroad.
7. Foreign exchange reserve management: Reserves are held in foreign currency assets, gold, Special Drawing Rights and the reserve tranche position with the International Monetary Fund.

Key Facts about India’s External Sector

1. Reserve composition: India’s foreign exchange reserves comprise foreign currency assets, gold, Special Drawing Rights and the reserve tranche position with the IMF.
2. Remittance rank: India is the largest recipient of inward remittances in the world.
3. Services strength: India is among the top ten exporters of commercial services globally, led by software and business services.
4. Import composition: Crude oil and gold are consistently the two largest items in India’s merchandise import bill.
5. The 2013 precedent: A similar concessional swap window in 2013 raised about $34 billion through FCNR(B) deposits and bank capital during that year’s currency crisis.
6. Exchange rate regime: India follows a managed float, where the rate is market determined and the RBI intervenes to contain volatility rather than to defend a level.
7. Convertibility status: The rupee is fully convertible on the current account and only partially convertible on the capital account.

Way Forward

1. Sequence the repayment: Publish a maturity profile of the deposits raised and build forward cover ahead of the redemption window rather than at it.
2. Shift the financing mix: Prioritise foreign direct investment and long term equity flows over interest sensitive deposits as the source of external financing.
3. Expand export capability: Target sectors with high domestic value addition so export growth adds net foreign exchange rather than gross turnover.
4. Reduce energy import intensity: Accelerate renewable capacity, ethanol blending and electrification of transport to shrink the crude oil bill.
5. Widen rupee trade settlement: Extend Special Rupee Vostro arrangements to more trade partners so a larger share of trade avoids dollar intermediation.
6. Treat tourism as an export sector: Fund visa facilitation, connectivity and destination infrastructure with the same seriousness as merchandise export promotion.
7. Report the contingent position: Disclose the forward book and swap obligations alongside headline reserves so the true net position is visible.

Matching Previous Year Question

“[2015, GS3, 12.5 marks] Craze for gold in Indians have led to a surge in import of gold in recent years and put pressure on balance of payments and external value of rupee. In view of this, examine the merits of Gold Monetization Scheme.”