RBI policy drives arbitrage while strengthening bank margins

As bureaucrat Sanjay Malhotra settles into the Reserve Bank of India’s (RBI) corner office, he will have to not only have to metamorphose into an organization man rapidly but also come to grips with the institution’s policy legacy. An immediate concern will be wrapping his head around the latest monetary policy contours, seen through the lens of slowing growth, rising inflation and external economy pressures. 

RBI’s two policy interventions announced after the 6 December monetary policy meeting —allowing Indian banks to offer substantially higher interest rates on foreign currency deposits, popularly known as foreign currency non-resident deposits, and a two-stage cut in the cash reserve ratio (CRR)—are a direct outcome of past lessons learnt. But both measures also have additional outcomes, inadvertent in one and perhaps intended in the other. 

It might be worthwhile to understand the mechanics of these two policy measures. 

Banks have been allowed to offer 400 basis points over the alternate reference rate (ARR) on fresh FCNR(B) deposits for any maturity between 1-3 years and a 500-bps margin for deposits between 3-5 years. This is a vast improvement over the current margins of 250 and 350 bps, respectively. The idea behind the policy directive seems simple: it is designed to attract temporary foreign currency inflows that will help offset the downward pressure on the rupee exerted by rising currency outflows and a strengthening dollar. The RBI has used similar tactics in the past when faced with surging outflows or when Indian entities were stopped from borrowing overseas, though on occasion the instrument may have varied. 

Truth be told, the RBI had very little choice in the matter. The central bank has so far been intervening in all the foreign exchange markets—the spot, forward and nondeliverable forwards markets—to ensure that the rupee depreciation is orderly. The intervention—selling dollars which then sucks out rupees from the market—could have an adverse effect on liquidity and, consequently, on interest rates. The RBI’s intervention is constrained by these natural bounds, including the finite pool of foreign exchange reserves. 

If the RBI has dipped into its reservoir of institutional memory to fashion higher yielding FCNR deposits, it probably should also know that this consciously permits an old punt: interest rate arbitrage. The increase in the margin revives an old interest rate arbitrage that was prevalent during the 1980s and the early part of the 1990s. 

It goes like this. Assume a non-resident Indian (NRI) with a good credit rating borrows $10-million one-year money in the New York money market. The current alternative reference rate in the New York market is Secured Overnight Financing Rate, or SOFR. The RBI mandates that the SOFR announced by Financial Benchmarks India Pvt Ltd should be used as the benchmark for FCNR(B) deposits; the last available SOFR from FBIL, as of 27 November, is 4.57%. The NRI tipping over the borrowed funds at the Park Avenue, Manhattan, branch of State Bank of India as an FCNR(B) deposit for a year is then likely to be offered 8.57%, as per the latest RBI policy directive. The net gain for the borrower-depositor will finally depend on its credit rating, but there is a margin available for the asking. The sweetener is that, apart from the borrowing cost, there are no additional costs. FCNR(B) deposits are made in foreign currency and redeemed in the same currency, eliminating any currency risk and need for hedging costs. Plus, SBI’s deposits in the USA are fully insured by the US government’s Federal Deposit Insurance Corporation. 

Perhaps the RBI is not aware of this arbitrage opportunity. Even if it is, we have to assume that it is willing to overlook the unintended consequence as a necessary collateral cost for defending the rupee value. However, some other caveats must be kept in mind. One, the final margin will depend on the credit rating of the entity borrowing the money. Two, the FCNR(B) scheme locks funds up for a year. Also, while it is unlikely that all NRIs attracted to the new FCNR scheme will be borrowing to make fresh deposits, what is definite is that all fresh NRI inflows into the scheme will certainly be inspired by the gains promised. Even Indian banks are likely to gain as they will now be able to meet Indian corporate borrowers’ foreign currency needs without having to borrow in the overseas bonds markets to raise lendable resources. 

The second measure is the two-stage cut in the CRR, a monetary policy tool which constitutes a small part of liabilities which banks have to keep with the RBI. The central bank has said that the CRR cut is likely to infuse liquidity in the system, which banks can then use to make additional lending without having to scamper around for vanishing deposits. But the CRR cut and the resulting addition to systemic liquidity might serve another (intended) purpose: shoring up margins for many banks. The concatenation of various factors—a managed reduction in high-yielding unsecured retail loans, shrinking availability of deposits and rising incidence of impaired assets—has affected bank balance sheets adversely, pulling down margins and bottom lines. The availability of fresh liquidity will help some banks mitigate these incipient effects. 

Both these measures have been part of RBI’s playbook in the past when faced with similar situations. Regulatory institutions like RBI, with deep organisational strength, also enjoy an unenviable muscle memory. The evidence is the dredging up of old set-pieces for its latest monetary policy. Hopefully, governor Malhotra will also be able to leverage this asset meaningfully. 

Rajrishi Singhal is a senior journalist and author of the recently released book ‘Slip, Stitch and Stumble: The Untold Story of India’s Financial Sector Reforms’. 

Views are personal and do not represent the stand of this publication.