Banks likely to see 15-20 basis points rise in FCNR(B) deposit costs | Finance News

Costs on FCNR(B) deposits are likely to rise by 15-20 basis points for Indian banks, over and above the interest cost committed to depositors, as banks have to separately hedge the dollar liability arising from interest payments on these deposits, bankers said. The cost of managing this exposure depends on currency forward premiums and interest rate differentials between the two currencies.

The Reserve Bank of India (RBI) is absorbing the hedging cost on the principal amount but not on the interest payable. In FAQs released in June after operationalising the concessional swap window for such deposits, the central bank had clarified that it would provide a forex swap for the deposits received. The facility is a plain buy/sell foreign exchange swap from the RBI’s side, covering only the principal amount of the deposits and not the interest component.

Banks have mobilised $127 billion through FCNR(B) deposits under the RBI’s concessional swap window, introduced to attract dollar deposits. The window was closed on August 31, a month before the RBI had originally scheduled.

The strong mobilisation was driven partly by banks offering higher interest rates to attract deposits and providing leverage against FCNR(B) deposits, which allows non-resident Indians (NRIs) to potentially enhance returns on their investments.

“Banks will have to bear the hedging cost on the interest component themselves. That is why while some banks were very aggressive, we did not go beyond a point,” a senior banker at a state-owned bank said on condition of anonymity. The bank had met its own mobilisation target and did not pursue additional deposits because of the incremental cost associated with the interest component, the banker said.

A senior banker at a private sector bank said the effective cost of raising FCNR(B) deposits would be around 15-20 basis points more than the deposit rate once the hedging cost on the interest component is factored in. If a bank offers 6.5 per cent interest on an FCNR(B) deposit, its effective cost could work out to 6.65-6.70 per cent, the banker said.

The RBI did not absorb the hedging cost on the interest component because banks were offering different interest rates on FCNR(B) deposits, making it difficult to apply a uniform hedging cost, the banker said. Even so, raising three-, four- or five-year funds at a fixed cost of 6.5-7 per cent remains attractive from a bank’s perspective, the banker added.

Banks are evaluating various options to hedge the dollar exposure arising from future interest payments on FCNR(B) deposits, according to a treasury official at a state-owned bank. “Options like forwards can be considered but the premiums have inched up because of the RBI’s sell/buy swaps,” the official said, adding that the interest portion on the FCNR(B) deposits of $127 billon could be a substantial number, given the interest rate on such deposits varied from 6 per cent to over 7.5 per cent for some banks, and forwards are likely to be a key instrument for managing the future dollar exposure.

Market participants said some banks have left a portion of their interest exposure unhedged, given the relatively high cost of locking in dollars for future interest payments.

Banks that have not fully hedged the interest component could face higher rupee costs of servicing their dollar liabilities if the rupee weakens further. Those that have hedged the exposure would have already locked in the additional cost.

The rupee breached the 95-per-dollar mark last week as crude oil prices rose above $100 a barrel amid heightened tensions in West Asia, while the RBI was seen intervening through spot dollar sales and foreign exchange swaps.

Banks could face higher hedging costs on the interest component of FCNR(B) deposits if US yields and forward premiums rise, a market economist said. Expectations of tighter monetary policy in the US and concerns over the country’s fiscal position could put upward pressure on US yields, while domestic factors could also affect forward premiums, the economist said.

Banks can use overnight indexed swaps (OIS) to manage interest-rate risks, while forwards and swaps can be used to manage currency risks, the economist said. The precise impact would depend on banks’ balance sheets and treasury strategies, the economist added.

The strong mobilisation of FCNR(B) deposits has also added to the RBI’s liquidity-management challenges, as the scale of inflows was higher than banks had initially expected, bankers said.

“We could have done it with at least $25-30 billion less than what has come in,” the private sector banker cited above said, adding that this would have reduced the liquidity surplus in the banking system by around Rs 3 trillion.

With the banking system’s liquidity surplus rising well above the RBI’s comfort threshold, the central bank initiated sterilisation of excess liquidity through variable rate reverse repo (VRRR) operations in August. The RBI has now turned to more durable liquidity-absorption tools, announcing open market operation (OMO) sales of Rs 1 trillion, to be conducted through three auctions on September 17, September 21 and September 28.

The combination of the standing deposit facility (SDF), VRRR operations and OMO sales could enable the RBI to sterilise around Rs 10 trillion of excess liquidity from the banking system, economists at QuantEco Research said.