 "RBI is losing $1.2 bn a year on deposit swap window")
RBI has mobilized $34 billion through the swap windows for FCNR B funds and Banks Overseas Borrowing as of 30th November 2013. The swap window was opened in September 2013 to attracted $ flows into the country at a time when the Indian Rupee (INR) had touched record low levels of around Rs 68 to the USD.
The INR has strengthened by around 8% since the opening of the swap window. INR strength over the last three months has been on account of the Fed postponing the tapering of its $85 billion a month asset purchase program, India’s current account deficit for the second quarter of 2013-14 falling to $5.6 billion from $ 21.8 billion seen in the first quarter of 2013-14 and the increase in foreign exchange reserves of the country from $274 billion to $286 billion since September 2013.
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The swap window has definitely helped the INR and India’s foreign exchange reserve position that was trending at multi year lows. However, the cost of opening the swap window is definitely high. RBI allowed banks to swap three years and above maturity FCNR B deposits at a fixed cost of 3.5% per annum.
The swap window has attracted $34 billion of deposits (RBI has not given split of banks overseas borrowing and FCNR B swap). What is the cost to the central bank on the swap?
The FCNR B deposit is open only for NRIs (Non Resident Indians). The depositor earns Libor/Swap rate plus 400bps on deposit maturities of three years to five years and does not incur currency risk. The Libor/Swap rates are published by FEDAI (Foreign Exchange Dealers Association of India) every month. The three and five year swap rate applicable for December 2013 are 0.66% and 1.51%. The FCNR B deposit rate is then 4.66% and 5.51% for three and five years respectively.
The FCNR B rates for November 2013 were 4.69% and 5.43%, for October 2013were 4.77% and 5.52% and September 2013 were 4.95% and 5.77% for three and five year maturity deposits respectively.
The NRI earns 400bps over Libor on USD deposits with banks in India without taking any currency risk. However without a swap window, Indian banks would be taking currency risk as at the end of three years or five years they would have to pay back the depositor in USD. At a time when the INR was steadily weakening, banks did not want to run the risk of unhedged USD positions and costs of hedging in the forward market was rising everyday and hence did not actively solicit deposits under the FCNR B window.
RBI by freezing the hedge costs for banks at 3.5% per annum enabled banks to go and actively solicit deposits from NRIs under the FCNR B scheme. However, in this process the central bank has incurred a loss. What is this loss and how it is incurred?
Loss to RBI on swap window
Banks received USD 30 billion (assumption, given that RBI has not given exact amounts for FCNR B and Banks Overseas Borrowing) from NRIs and went and swapped the USD into INR at 3.5% per annum with the RBI. Assuming that banks raised USD 30 billion in three and five year FCNR B deposits, split equally between three and five year maturities at USD 15 billion each.
RBI by swapping USD with banks is holding USD 30 billion and earning 3.5% swap rate. RBI requires to invest the 30 billion in USD assets and as the central bank does not take credit risk, it invests USD 15 billion each in three and five year US treasuries that are yielding 0.6% and 1.4% respectively. RBI is earning a total of 4.1% and 4.9% on its USD 15 billion each of three and five year swaps that it carried out with the banks.
RBI, when it swaps USD with banks, gives the banks INR in the process. Three and five year government bond yields in India are at levels of 8.5% and 8.7% respectively. In effect, RBI while earning 4.1% and 4.9% on three and five year maturity USD position has foregone yields on 8.5% and 8.7% on three and five year government bonds. The difference in yields that is 440 bps (4.4%) on three year government bonds and USD swap position and 380bps (3.8%) on five year government bonds and USD swap positions is the notional loss to the RBI.
On positions of USD 15 billion each of three and five year swaps, the notional loss to the RBI is USD 15 billion*4.4% and USD 15 billion*3.8% = USD 1.2 billion every year.
Arjun Parthasarathy is editor Investors are Idiots.com and INRBONDS.com. Follow him on twitter #investorsidiots
Arjun Parthasarathy has spent 20 years in the financial markets, having worked with Indian and multinational organisations. His last job was as head of fixed income at a mutual fund. An MBA from the University of Hull, he has managed portfolios independently and is currently the editor of www.investorsareidiots.com </a>. The website is for investors who want to invest in the right financial products at the right time.