India’s Credit Policy Provides A Boost To Forex Inflows
· Free Press Journal
How can the triple sundae with the layers of incentives for FPI, ECBs and FCNR (B) deposits be interpreted? The view held so far has been that the external position of the economy is fairly resilient, with the reserves covering 11 months of imports. The situation was nothing like what it was in 2013, when aggressive measures had to be taken. Yet, this offering was beyond expectations and would certainly help in shoring up forex reserves.
Let us look at them sequentially. The rationalisation of the system of taxation on FPIs was long overdue. Investors should be taxed in their territory of origin, and, hence, removing the capital gains tax as well as the tax on interest seems logical. In fact, having a withholding tax on interest earned on debt is messy. This is so because it cannot be set off in the home country where investors are liable to pay taxes. Further, the tax was being paid on the rupee value while the repatriation was in dollars, which could mean a loss given the rupee depreciation. In fact, the global rule is that such income is taxed in the home country. This has been a long-standing demand from the FPIs which has finally been accepted. Hence, this move was contemporaneous with the thought process of the RBI wanting to shore up the forex reserves.
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From the point of view of FPIs, the move is positive. This has been combined with greater access to the FAR bucket (fully accessible route) securities of higher tenures. While it is true that liquidity in GSecs is normally limited to a handful of papers, the global bond indices provide the clue for further flow of investment in this segment. This is where there can be a significant increase in inflows. But a factor that would also play out is the way in which investors diversify their portfolio. With interest rates set to rise in the Western countries, the Indian market would be one of the options. Here, the stability of the rupee is important because with the rupee falling by almost 10% last year, the real returns would have been much lower. This will also be positive for those investing in global indices of which Indian bonds are a part.
Second, the RBI has decided to allow PSUs to borrow in the ECB market at a swap rate of 1.5%, provided these are reckoned before the end of December. This rate is around 50% lower than the forward rate in the market. This move is interesting because, for the first time, the RBI is partly taking on the hedging costs of these borrowings. In the past, we have gotten around $60 bn, which, if replicated, would be substantial from the point of view of reserves. However, it is surprising that the benefit goes only to PSUs and not all the companies. As it is restricted to the PSUs, the amount which can come in would tend to be much lower, provided they do borrow upfront in the next few months. In fact, borrowing is normally linked to an investment project, and, hence, the response needs to be awaited. Ideally, this benefit should have been extended to all borrowers, as the intention is to garner more forex for the country.
Third is the announcement of the RBI bearing the swap or hedge cost on fresh FCNR (B) deposits that are garnered in the 3 and 5-year buckets before September 30th. This is analogous to the ECB announcement. Banks will have to take a judgement call on providing higher rates on such deposits. At present, the curve is inverted, where a 1-year deposit offers a higher rate than 3 or 5 years. The reason is straightforward—banks do not want to lock in funds at a higher cost for a longer period of time. But if the hedging cost of say 3% is taken on by the RBI, there will be a benefit for sure. Also, such funds will not be subject to CRR and SLR, where the opportunity cost can vary between 30 and 40 bps. These are good sources of funds for the banks, as the card rate will also be the ultimate cost.
Here there can be more certainty in terms of flow of funds, as these deposits are protected by definition from currency risk. The trick is to price them favourably such that the NRIs find it attractive to invest in these deposits. A US 5-year Treasury gives around 4.30%. An online bank can give a deposit with a card rate of 3.75 to 4.25%, while a corporate bond could go up to 5-5.25%. Higher-yielding corporate bonds can give returns ranging from 6.5 to 8.5%, but they carry a higher risk. Therefore, banks have to price the deposits appropriately while adhering to the RBI norm of alternative reference rate plus 350 bps. With SOFR at around 3.5%, the rate can go up to 7%. Banks will weigh this cost with their own cost of funds when deciding on the offering. From the point of view of RBI, any inflow will add to the forex reserves.
Therefore, the RBI has quite adroitly worked out this plan of enhancing forex reserves without raising any sign of panic, unlike in 2014. While starting off on the note that forex reserves are strong, these measures provide a delta to the external account in a rather unobtrusive manner.
The impact of these inflows would be positive for the balance of payments for sure. There can be an additional $40-50 bn of inflows, which will shore up the forex reserves. This, in turn, will help control the movements in the exchange rate. Interestingly, the announcement effect of these measures on the day of the policy was significant, with the rupee appreciating by almost 35 paise to Rs 94.40/$. Once the funds start coming in, there can be further steadying of the currency.
The author is Chief Economist, Bank of Baroda and author of ‘Corporate Quirks: The Darker Side of the Sun’. Views are personal.