RBI steps in to kill arbitrage

Bankers expect move to rein in Re rally.

The Reserve Bank of India's (RBI) decision to cut the interest on both term as well as savings bank deposits offered to non-resident Indians and to fine-tune import credit aims at stemming the flow of dollars into the system and killing the arbitraging on interest rate differentials by expatriates and foreign institutional investors. Bankers said the move would also rein in the rise in the rupee's value and protect exporters.

Some in the financial sector feel that the RBI could cut interest rates at home too in May to halt the continuous dollar inflow. Speculation is also rife that the RBI may raise the cash reserve ratio (CRR) to suck out excess liquidity from the system.

Banks will now pay at best Libor/swap rates to NRIs on both term and savings deposits""Non-Resident (External) Rupee deposits or NRE deposits. This means that on a one-year savings deposit, the interest rate will come down from 3.5 per cent to 1.6 per cent. The one-year London Inter-Bank Offered Rate is now around 1.6 per cent and the six-month rate is 1.3 per cent.

The maximum arbitraging was taking place on savings deposits as the interest rate differential was above 2 percentage points.

An NRI could have borrowed money at a very fine rate over Libor and put it in savings deposits. An extremely low forward premium rate was encouraging the inflow from NRIs.Under the NRE scheme, deposits are received in foreign currency and converted into rupees, and converted back into foreign currency on maturity.

The RBI wants to discourage short-term debt creating inflows and at the same time check the rise in the rupee's value. The rupee has gained about 4 per cent on the dollar since January on increasing dollar flows.

The ceiling on NRE interest rates was first imposed in July 2003 at 250 basis points, and then cut to 100 basis points in September. A month later, the ceiling was again lowered to just 25 basis points over Libor.

Now, it is on a par with Libor. Bankers said if this does not check the flow, RBI can decide to bring down the rates further to Libor minus 25 basis points or so, now offered on FCNR deposits.

Some analysts believe that the NRE rate cut could be a precursor to a cut in domestic interest rates to further curb arbitrage inflows. The bank rate is now pegged at 6 per cent and the short-term repo rate is 4.5 per cent.