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RBI offering to bear the full hedging cost on eligible FCNR(B) deposits (effectively a subsidy of ~3% p.a., in our view) can drive inflows of US$100bn, in our view. Total inflows could be US$50-190bn, depending on i) base pool (US$5-10bn); and ii) leverage used (9x-19x). The 2013 experience suggests most of this would reverse 3-5 years later, but this is a feature, not a bug: with low external debt liabilities, anxiety in the FX market was due to dollar liquidity, not solvency. With oil prices falling, the RBI could face a problem of plenty. We expect it to cut its forward short book (lifting an overhang), and handle the liquidity challenges of the rest via CRR hikes and OMO sales.
FCNR(B) window redux: near-term inflows, to largely reverse over 3-5 years
As per the scheme announced on 5-Jun, the RBI will bear the full hedging cost on eligible fresh FCNR(B) deposits, estimated at ~3% p.a. In 2013, the concessional cost for swapping FCNR(B) inflows into INR was 3.5% p.a. Even as we assess potential flows, the lesson from 2013 is that capital inflows only last for the period when the RBI gives a concessional rate. We should therefore expect the inflows over the next 4 months to reverse once it is over (which would be 3-5 years).
Role of leverage in magnifying returns and thus driving higher inflows
Inflows in such a scheme aren’t organic i.e., NRIs aren’t reallocating more savings to this scheme. Instead, the surge in inflows is driven by the subsidy making it attractive (‘near riskless’) to use leverage, boosting expected returns. Total inflow depends on two factors: the base pool ($5–10bn) and the leverage used (debt-to-equity ratio of 9x–19x; i.e., LTV of 90% or 95%). While total inflows could range $50-190bn, we expect US$100bn.
Liability transformation or a rise in external debt? Impact on liquidity, yields
India’s external debt liabilities are currently low (vs. RoW and its own history). This allows raising debt to quench anxiety in the FX market: using solvency to address a liquidity issue. The 3-5-year respite on the balance of payments is a feature, not a bug. Given the fall in oil prices, and the likely reversal of speculative outflows, the RBI may end up with a problem of plenty. We expect it to cut its net forward short position of US$50bn over the next 1Y, making it effectively a liability transformation and not an increase in debt. Liquidity from the remaining amount could be absorbed by raising CRR. Additional inflows over the next two years from bond-index-inclusion could be handled via OMO bond sales.
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