How the RBI is creating conditions for foreign flows to come back to India

The RBI announced five measures on July 6 to further liberalise foreign exchange. The measures are aimed at creating a more enabling environment to attract dollars through banking deposits, ECB, FPI

At a time when domestic financial markets are witnessing record outflows of overseas investment and the country’s current account deficit is widening, the Reserve Bank of India (RBI) has announced a bevy of measures to bring back foreign capital.

The RBI announced five measures on July 6 to further liberalise foreign exchange flows. Broadly, the measures are aimed at creating a more enabling environment to attract dollars through three channels: banking deposits, External Commercial Borrowing (ECB) and foreign portfolio investment (FPI) in debt.

What are the changes the central bank has implemented and how would they work? Let’s find out.

Greater mobility for banks in handling foreign currency deposits

The RBI said that beginning July 30, banks do not have to maintain cash reserve ratio (CRR) and statutory liquidity ratio (SLR) on incremental deposits flowing into Foreign Currency Non-Resident Bank (FCNRB) and Non-Resident External (NRE) rupee deposits.

The relaxation will be applicable for deposits mobilised up till November 4.

FCNRBs refer to fixed and term deposits through which non-resident Indians (NRIs) can deploy their foreign currency earnings in Indian banks in the same currency as the countries in which they live. In NRE deposits, however, the foreign currency is converted into rupees.

SLR and CRR, which are regulatory reserve ratios, refer to the portion of deposits that banks have to mandatorily put aside as buffers for safety.

The SLR is primarily maintained in the form of investment through government bonds, and the CRR is a cash reserve.

At present, the SLR is 18 per cent of deposits, while the CRR accounts for 4.50 per cent.

By allowing banks the leeway to not maintain SLR and CRR on certain overseas deposits, the RBI is bringing down costs and essentially setting the stage for banks to pass on the benefits to overseas customers via higher rates.

Treasury officials said that the cost emanating from SLR and CRR maintenance on FCNRB and NRE deposits is around 30 to 35 basis points.

This brings us to the next step announced by the RBI:

Giving banks room to offer higher interest rates on FCNRB and NRE deposits

The RBI has temporarily removed a limit on interest rates that can be offered on new  FCNRB deposits. For NRE deposits, the RBI has temporarily exempted banks from adhering to a regulation that prevented interest rates on such deposits outstripping those on comparable domestic term deposits.

The fresh RBI norms kicked in on July 7, 2022 and will be available for the period up to October 31, 2022.

“While it is difficult to ascertain the quantum of flows, the measures are attractive for banks,” said Suvodeep Rakshit, senior economist, Kotak Institutional Equities.

Earlier this week, the country’s largest lender, the State Bank of India, and ICICI Bank raised rates on FCNRB deposits. SBI has hiked rates on US dollar FCNRB deposits above one year and less to two years by 85 basis points and for those on three-year to five-year deposits by 80 bps. ICICI Bank has announced rate hikes of a similar quantum.

Banks expect the increased rates to lure more overseas flows. Media reports quoted SBI’s Managing Director of Retail Alok Kumar Choudhary as saying that the funds garnered would be used to finance foreign currency borrowings by companies. This brings us to another measure announced by the RBI:

Wider scope of foreign currency lending by banks

The RBI has provided a window till October 31, 2022, for eligible banks to lend out borrowed foreign currency for a greater set of purposes than were permitted earlier.

According to norms, banks can undertake overseas foreign currency borrowing (OFCB) to the tune of 100 per cent of Tier 1 capital, or $10 million.

The earlier RBI rule was that funds borrowed through this route could only be used for the purpose of export finance.

“It has now been decided that AD Cat-I banks can utilise OFCBs for lending in foreign currency to entities for a wider set of end-use purposes, subject to the negative list set out for external commercial borrowings,” the RBI said.

The RBI measure comes at a time when higher interest rates in developed economies have made it challenging for many borrowers to access overseas markets.

“These steps should help the market meet short-term foreign currency funding requirements,” Ananth Narayan, associate professor at S P Jain Institute of Management and Research, wrote in a note for the Observatory Group.

The provision of wider access to overseas markets was in consonance with another measure announced by the RBI on ECBs:

Firms can raise more funds via External Commercial Borrowings

A key measure announced by the RBI was a sharp increase in the quantum of funds that Indian firms could raise through external commercial borrowings.

The central bank said that till December 31, 2022, companies availing of the automatic ECB route could raise up to $1.5 billion as against $750 million earlier.

The RBI also said that if the borrower had an investment grade rating, the ceiling for all-in costs – which include arranger fees, management fees, up-front fees and processing charges – was now raised by 100 basis points.

Media reports citing sources said that Housing Development Finance Corporation (HDFC) is likely to become the first Indian entity to take advantage of the RBI’s relaxations by increasing the size of a foreign loan to around $1 billion from $750 million earlier.

Analysts, however, are sceptical of the degree to which the RBI’s step would lead to more overseas borrowing. Indian companies had made a beeline to borrow funds through ECBs over the last couple of years, taking advantage of record low interest rates in advanced economies.

However, with major global central banks such as the US Federal Reserve and the Bank of England sharply hiking interest rates in 2022, raising funds overseas has become a much costlier affair.

“The cost of borrowing this time compared to the last time when they had borrowed is reasonably higher. The rates in the advanced economies have gone up more than India. Secondly, ECBs are priced with six-month or one-year LIBOR rates. And short-term rates have increased more,” India Ratings Director Soumyajit Niyogi said.

Another risk associated with raising funds through this route is the large portion of ECBs that are unhedged.

RBI data in its latest Financial Stability Report showed that 44 per cent of the total $179 billion outstanding ECBs were unhedged.

Companies may have opted to avoid the additional cost of hedging in the past couple of years as currency volatility was relatively low, but with the Fed’s monetary tightening plans in full swing, the rupee has experienced a greater degree of volatility in 2022.

Making Indian debt more attractive

The RBI expanded the basket of securities that fall under the ‘Fully Accessible Route’ for FPIs to include 7-year and 14-year sovereign bonds. Prior to this, FPIs were only allowed unrestricted investment in 5-year, 10-year and 30-year bonds.

The central bank removed a 30 per cent limit on overseas investments in government and corporate bonds with a residual maturity of less than one year till October 31, 2022. A window was also provided to permit FPIs to invest in commercial papers and non-convertible debentures with an original maturity of up to one year till October 31.

Through these steps, the central bank is essentially looking to bring in greater foreign investment in short-term securities, which hold a lower degree of risk on bond portfolios.

However, as evidenced by the fact that FPIs have utilised only 28.6 per cent of their Rs 1.9 trillion investment limit in Indian government bonds, the appetite for debt is tepid.

The fresh norms notwithstanding, traders do not see much overseas interest as persistently high inflation in India has eroded the fixed returns from Indian debt.

Even in the short-term maturity brackets of one-year, such as 364-day sovereign treasury bills, if one were to add in hedging costs, the returns would be less than 1-year US T-bills, treasury officials said.

With returns from overseas debt instruments climbing, FPIs would require signs of a sustainable fall in India’s inflation before opting to enter the market again, ICICI Securities Primary Dealership head of Trading Naveen Singh said.