Needed: More stable foreign capital

Why in the News

Inflows through the Reserve Bank of India’s (RBI) forex swap facility reached $136.3 billion by 31 August. The facility was part of a set of measures announced in June to draw capital into the country, and it was opened against doubts about how much could be raised in tight global financial conditions. Foreign exchange reserves have touched a record $729 billion and the rupee’s slide has been arrested. The same inflow has pushed the banking system’s liquidity surplus to Rs 6.7 lakh crore, at a point when inflation is edging up and the Monetary Policy Committee (MPC) may need to raise rates. Most of the money arrived as Foreign Currency Non Resident Bank, or FCNR(B), deposits, which are repayable debt rather than the stable equity investment a current account deficit requires.

What is the FCNR(B) and swap route?

1. The deposit is a foreign currency liability of the bank: An FCNR(B) deposit is a term deposit placed by a non resident Indian in foreign currency with an Indian bank. The bank repays principal and interest in that same currency, so the depositor carries no rupee exchange risk.
2. The swap converts those dollars into rupees at a fixed cost: Under a swap facility the bank sells the mobilised dollars to the RBI for rupees, with an agreement to reverse the transaction at a pre agreed rate on a fixed future date.
3. A concessional swap rate is what makes the route attractive: The central bank absorbs part of the hedging cost, which lifts the effective return the bank can offer a depositor without taking currency risk itself.
4. Two borrowing channels run alongside: External Commercial Borrowings (ECB), meaning foreign currency loans raised abroad by Indian companies, and Overseas Foreign Currency Borrowings (OFCB) raised by banks, carry the balance of the flows.

How large were the inflows, and what did they buy?

1. The response exceeded expectations: $136.3 billion came in by 31 August, of which $63.5 billion arrived in the last ten days alone.
2. The deposit route dominated: $127 billion came through FCNR(B), with the balance through the ECB and OFCB channels.
3. Reserves hit a record: Foreign exchange reserves reached $729 billion on 21 August, which strengthens the buffer for external stability.
4. The currency stabilised: The rupee’s fall was stemmed and it touched a two month high of Rs 94.60 to the dollar on 3 September.
5. The window is not exhausted: About $9 billion more remains available through an ECB and OFCB swap window that stays open till December.

Why does the same inflow complicate monetary management?

1. Every dollar swapped injects rupees: The liquidity surplus in the banking system rose from over Rs 3 lakh crore at the beginning of August to Rs 6.7 lakh crore by the end of it.
2. Independent estimates put the overhang higher: Surplus liquidity stood at Rs 9.71 lakh crore on 2 September, against a preferred level of about Rs 2.7 lakh crore.
3. One absorption tool is doing all the work: The central bank has responded with variable rate reverse repo auctions, in which banks bid to park surplus funds with it for a fixed term. More tools will be needed at this scale.
4. The timing runs against the policy stance: Inflation is edging upwards and the MPC may need to tighten, and a large surplus pushes short term rates below the policy rate in the opposite direction.
5. Growth gives the committee room: Robust first quarter growth provides the space and comfort to tighten if the inflation trajectory demands it.

Why is debt type inflow not a substitute for stable capital?

1. The underlying deficit is unaddressed: India runs a current account deficit, which has to be financed every year regardless of what a one time window raises.
2. Equity flows remain thin against the need: Foreign portfolio investors have been net equity buyers over recent months and net foreign direct investment is inching upwards, neither at a scale that finances the deficit on its own.
3. Deposits are dated money: FCNR(B) deposits are repayable on maturity, so a large single vintage creates a redemption cliff for the central bank to plan around.
4. The external environment governs the next round: Tighter global financial conditions will influence flows, so a window that worked this year cannot be assumed to work again.

Challenges to the FCNR(B) and swap route

1. Redemption bunches at a single future date: A large tranche raised in one window matures together, so the central bank has to arrange dollars for repayment in one narrow period. Eg. The $26 billion raised through the 2013 FCNR(B) swap window came up for redemption together in 2016 and had to be managed through forward market operations.
   The Fix: Stagger maturities across tenors at the point of mobilisation rather than offering a single uniform term.
2. The subsidy sits on the central bank’s books: A concessional swap rate transfers hedging cost from the banking system to the central bank, which bears the loss if the currency moves against it. Eg. The 2013 window was priced at a concessional swap rate well below the prevailing market forward premium.
   The Fix: Publish the fiscal and balance sheet cost of the concession alongside the inflow figure, so the instrument is judged on net terms.
3. It raises the debt share of external financing: Deposits and borrowings add to external debt, and equity investment does not. The composition of external financing worsens as the headline reserve number improves. Eg. Short term external debt on residual maturity has repeatedly been flagged in the RBI’s own external debt statistics as a vulnerability indicator.
   The Fix: Tie the window to a parallel timetable for the sectoral foreign direct investment reforms that have been pending, so the debt raised buys time for an equity fix.
4. Sterilisation of the rupee injection is costly: Absorbing the liquidity created requires paying interest to banks on funds parked with the central bank, which erodes its income. Eg. The surplus is currently being drained through variable rate reverse repo auctions at rates close to the policy rate.
   The Fix: Use longer tenor absorption instruments, including open market sales of government securities, so the drain matches the maturity of the inflow.
5. The instrument is used as a currency defence rather than a funding decision: A window opened when the rupee is under pressure attracts money for the concession rather than for the economy’s return profile. Eg. Both the 2013 and the current windows followed a sharp depreciation episode.
   The Fix: Keep a standing, non concessional deposit and borrowing framework open through the cycle, so mobilisation does not depend on a crisis trigger.

Conclusion

The window has bought external stability and has handed the central bank a domestic liquidity problem in exchange. Neither outcome changes the structural position: a deficit country that finances itself with borrowed money stays exposed to the next tightening in global conditions. What to watch is the composition of financing over the coming quarters rather than the reserve headline, and specifically whether net foreign direct investment rises fast enough to reduce dependence on windows of this kind before the deposits fall due.

Matching Previous Year Question

“[2020] If another global financial crisis happens in the near future, which of the following actions/policies are most likely to give some immunity to India? (1) Not depending on short-term foreign borrowings (2) Opening up to more foreign banks (3) Maintaining full capital account convertibility Select the correct answer using the code given below: (a) 1 only (b) 1 and 2 only (c) 3 only (d) 1, 2 and 3 ANSWER: (a)”