US Fed Policy Challenges RBI’s FCNR(B) Deposits

The US Federal Reserve’s hawkish monetary policy and the appreciating US dollar are significantly impacting the Reserve Bank of India’s (RBI) Foreign Currency Non-Resident (Bank) [FCNR(B)] deposit scheme.

This dynamic challenges the scheme’s ability to attract foreign currency by narrowing the financial advantages for non-resident Indian (NRI) depositors and increasing risks for banks.

Understanding the FCNR(B) Scheme’s Structure

The FCNR(B) deposit scheme is a key tool the RBI uses to stabilize the rupee and mobilize foreign currency. A crucial difference from a similar 2013 program is the RBI’s commitment to absorb 100% of the hedging cost for these deposits.

• US Federal Reserve benchmark interest rate: 3.50-3.75%
• Tax-free yield on hedged rupee deposits for NRIs: 6-7%

However, the Federal Reserve’s current benchmark interest rate, along with indications of further hikes, directly reduces the attractiveness of FCNR(B) deposits. The spread between the tax-free yield on hedged rupee deposits and potential earnings in US dollar accounts is shrinking, making US alternatives more competitive.

Impact of Rising SOFR on Borrowing Costs

The Secured Overnight Financing Rate (SOFR) closely mirrors the Fed’s rates, meaning a sustained high Fed rate leads to increased borrowing costs on leveraged structures within the FCNR(B) scheme.

This rise in SOFR compresses the crucial spread between the deposit yield and the cost of loan funding, which could cool the leveraged uptake segment of the scheme.

Banks offer loan facilities against these FCNR(B) deposits, with multiples typically ranging from five to nine times, enabling NRIs to pursue leveraged returns.

Initial estimates for these leveraged returns were attractive, projected at 15% to 27% per annum, or 12-17% at current rates for 5-9x leverage.

Unpacking Leveraged Deposit Risks

Despite the initial appeal, leveraging FCNR(B) deposits introduces significant risks due to the floating nature of the loan rate, which is linked to SOFR.

If SOFR increases, the spread can rapidly diminish, potentially reducing the carry to zero or even turning it negative, while the depositor still owes full loan interest.

• Cash-flow timing: Loan interest must typically be serviced on a running basis, requiring separate liquidity from NRIs.
• US tax reporting: NRIs with US citizenship or green cards may face US tax reporting obligations due to foreign asset reporting requirements.

Given these compounding risks from the US Fed’s revised approach and the strengthening dollar, an early closure of the FCNR(B) window, while not explicitly stated, is a likely outcome influenced by these challenging market conditions.