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Swap deal on FCNR deposits: What it means for the NRIs
September 30, 2013, 10:27 pm
Recently the Reserve Bank of India (RBI) announced several measures to stabilize the Indian Rupee against the US Dollar. Among them was a swap deal on FCNR deposits where the RBI has opened a window to the banks to swap fresh FCNR dollar funds, mobilised for a minimum term of three years at a fixed rate of 3.5% per annum for the tenor of the deposit. The swap window will be open until November 30, 2013.
What does this mean and will it impact Non Resident Indians investing in FCNR (B) deposits? We find out.
What is an FCNR account?
An FCNR account is a term deposit account that can be maintained by NRIs and PIOs in foreign currency. This account can be a good option for Non Resident Indians (NRIs) looking to invest in India without worrying about currency risks.
The funds in an FCNR account must necessarily come from your overseas funds. FCNR deposits can be maintained in 'permitted currency' which means any a foreign currency which is freely convertible and includes US dollar, Pound Sterling (GBP), Euro, Japanese Yen, Australian dollar, Canadian dollar, Danish Krone, Swiss Frank and Swedish Krona among others.
What are the features of FCNR accounts? 
You can open an FCNR account for a minimum term of 1 year and maximum term of 5 years. The interest rates vary between terms and from currency to currency. Rates may also vary between banks. For instance, the rate for a 1 year FCNR deposit in US dollar would be in the range of 3-4% while the same for a deposit in Australian dollar would be 6-7%.
This interest is tax free in India. However, you may be subject to tax in the country of your residence for such interest.
Balances in FCNR can be freely repatriated outside India. You can also use the balance in FCNR account for making local payments in India.
How do banks manage FCNR funds?
Banks raise FCNR funds in various foreign currencies. They then sell the foreign currency in exchange for Indian rupees at the prevailing exchange rate and use the Indian rupees for domestic lending. When the FCNR deposit becomes due for maturity, banks would need foreign currency to pay the depositor. Waiting until the date of maturity to purchase foreign currency would leave the bank open to exchange rate risk.
In order to protect this risk, banks hedge their FCNR commitments by entering into forward contracts. To explain with an example, if an FCNR deposit was opened today for a term of 1 year, the bank would enter into a forward contract to buy the foreign currency after a year at a fixed exchange rate.
Currently the forward rate is at a premium of around 7% per annum. That means, if the exchange rate today is Rs 65 per dollar, banks would enter into a forward contract to buy the dollar at Rs 69.55 per dollar. This way, the bank hedges any uncertainty arising out of exchange rate risk.
What is the FCNR swap deal?
The swap deal was introduced as a means to encourage banks to attract more US dollars into India. The RBI has promised banks a forward rate at a premium of 3.5% per annum for all fresh 3-year FCNR deposits raised between now and November 30, 2013. So instead of hedging at the rate of 7% per annum, banks are getting this swap deal at 3.5% per annum. This acts as an incentive for banks to raise fresh FCNR funds as it lowers the cost of hedging.
This swap deal is open until November 30, 2013 and only for deposits opened in US dollar for a period of over 3 years. 
Will this benefit NRIs?
NRIs are likely to be swarmed with offers from banks to open FCNR deposits. For an NRI, the FCNR deposit itself can be an attractive proposition because the interest rates on US dollar deposits are in the range of 3-4% per annum as compared with rates as low as 1% in the US. Further, this interest is tax free in India and there is no currency risk.
The swap deal may not necessarily impact NRIs directly unless banks decide to share their gains and increase the interest rates on these deposits.
However, according to reports, what is happening is that foreign banks are rushing to lend funds to NRIs who can invest the money into FCNR deposits. For instance, an NRI would invest $100 of his own funds and borrow $400 from the US branch of his bank. The interest rate on the loan would be say 1%. The NRI would then open an FCNR account in the Indian branch of the bank and earn interest of 4%.
At the end of year 1, he would make a total interest of 4% on his own funds of $100 and a net interest of 3% on the borrowed funds of $400. That makes a total interest of $16 or 16% of the original investment. For banks too, this is a win-win as their loan gets covered by the FCNR deposit and they get access to funds at a lower cost.
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