Beyond GDP, brace for turbulence ahead

Why in the News

Long term government bond yields in the advanced economies have risen sharply, raising the risk free return foreign capital can earn without entering India. Official growth estimates for April to June, together with car, two wheeler and tractor sales and Goods and Services Tax (GST) collections, show the economy absorbing the energy supply shock caused by the West Asia war. Strong output data does not settle the financing question, since capital compares India’s expected return against an assured dollar return. The dollars India did attract came through Foreign Currency Non-Resident (Bank), or FCNR(B), deposits, priced at rates Indian banks could offer only because the Reserve Bank of India (RBI) carried the hedging cost.

How does the FCNR(B) deposit and swap arrangement work?

1. The deposit: An FCNR(B) deposit is a term deposit placed with an Indian bank by a non-resident Indian, held and repayable in foreign currency.
2. The bank’s exposure: The bank owes repayment in that foreign currency, so a fall in the rupee raises what the deposit costs it in rupee terms.
3. The swap facility: The RBI bore the hedging cost against currency fluctuation through a special dollar rupee swap facility.
4. Where the risk now sits: The banks transferred the risk of rupee depreciation to the central bank, which is what allowed them to pay a high rate in foreign currency.

What do bond yields in Japan, the United States and the United Kingdom demonstrate about the cost of capital?

1. Japan: The ten year government bond yield crossed 3 per cent for the first time since 1996, and the thirty year yield stands at 4.1 per cent.
2. The United States: The ten year Treasury yield is at 4.8 per cent and the thirty year at 5.3 per cent.
3. The United Kingdom: The ten year yield is at 5.2 per cent and the thirty year at 5.9 per cent.
4. Why these set the benchmark: These instruments are virtually risk free, issued by governments that have never defaulted on their debts, so an assured 4.8 per cent dollar return is the floor any Indian asset has to beat.

What did India have to pay to bring in dollars?

1. The deposit rate: Indian banks offered 6 to 6.5 per cent interest on FCNR(B) deposits.
2. The volume raised: The window mobilised $127.2 billion.
3. The direction of travel: Foreign money no longer comes cheap, and the path of global bond yields points to it turning more expensive.

Why does a strong growth number not settle the external financing question?

1. The two measures test different things: Output and consumption data measure domestic demand. The financing question is whether a foreign investor’s expected return here beats a risk free alternative abroad.
2. Equity returns are the transmission channel: Long term foreign capital enters on growth prospects that translate into equity market returns, and those prospects must be compelling against elevated yields.
3. A window is not a policy: A special forex swap window is a one time reprieve for the external sector and cannot substitute for durable intervention.

What would durable resilience require?

1. Fiscal consolidation: In a rising interest rate environment a government cannot run high fiscal deficits, which crowd out private sector and other productive borrowing.
2. Keeping the external account financeable: Those deficits must not spill into current account deficits, which are difficult to finance when global capital flows turn volatile.
3. Export promotion: Exports are to be raised through increased access to global markets.
4. Cheaper inputs for exporters: Duties on imported raw materials and components are to be eliminated.
5. Predictability: Policy stability for foreign investors is the fourth durable intervention, alongside consolidation, exports and input duty removal.

Challenges to relying on the FCNR(B) swap route

1. The liability matures: A term deposit has to be repaid or rolled over on a fixed date, so an inflow raised in months becomes an outflow risk on a known one. Eg. The 2013 FCNR(B) swap window raised about $26 billion, and its redemption was concentrated in late 2016.
   The Fix: Stagger maturities across the deposit book and pre-announce the redemption profile, so repayment does not bunch into a single quarter.
2. The central bank absorbs the currency loss: A hedging cost carried by the RBI becomes a loss on its own books if the rupee falls further than the swap rate assumed. Eg. The rupee’s record low against the dollar has been reset repeatedly since 2022.
   The Fix: Disclose the swap facility’s cost to the central bank’s balance sheet, so the public subsidy inside the scheme is visible.
3. Debt creating inflows substitute for equity: A deposit is a repayable liability while direct investment is not, so the same headline inflow leaves a different obligation behind. Eg. Non-resident Indian deposits are counted within India’s external debt, and foreign direct investment is not.
   The Fix: Cap the share of external financing met through deposit schemes, so a reserve build is not increasingly borrowed.
4. The inflow is rate sensitive and reversible: Money that arrives for an interest differential leaves when that differential narrows. Eg. Foreign investors withdrew from Indian debt in 2013 once United States yields rose after the taper announcement.
   The Fix: Build the buffer through current account improvement and equity inflows, so the stock of reserves does not depend on a rate spread.
5. A headline reserves figure hides its composition: Reserves assembled through a swap window signal less resilience than the same figure built from a trade surplus. Eg. India’s reserves crossed $700 billion while the current account remained in deficit.
   The Fix: Report the hedged and unhedged components of reserves separately in the weekly statistical supplement.

Conclusion

India’s external position looks strongest at the moment it is most borrowed. A large stock of foreign currency has been assembled by paying for it, and part of that bill sits on the central bank’s own books rather than on the banking system’s. The tension left unresolved is one of timing: the measures that would make foreign capital cheap again work over years, and the rate environment that made it expensive changed in months. What to watch is whether a second window is opened when the first one matures.

Matching Previous Year Question

“[2013] Which one of the following groups of items is included in India’s foreign-exchange reserves? (a) Foreign-currency assets, Special Drawing Rights (SDRs) and loans from foreign countries (b) Foreign-currency assets, gold holdings of the RBI and SDRs (c) Foreign-currency assets, loans from the World Bank and SDRs (d) Foreign-currency assets, gold holdings of the RBI and loans from the World Bank ANSWER: (b)”