FCNR redemptions: Time to gear up for increased market volatility

Historically, it is seen that a volatile currency market is contagious and transfers the volatility to equity markets

Traders are anticipating Indian currency and bond markets to witness one of the most volatile times over the next three months. According to Bloomberg, rupee volatility is already at a three week high of 5.62 per cent. Money market is also reflecting it as visible from the forward premium and T-Bills.

The reason the markets are jittery is because the ventilator that RBI governor Raghuram Rajan used at the start of his tenure to save the crashing rupee will be withdrawn over the next three months.

In September 2013, RBI under the new governor Raghuram Rajan offered a subsidized swap scheme to banks under the Foreign Currency Non-Resident (FCNR—B) window. This resulted in banks being able to raise dollar deposits from non-resident Indians (NRI) at a subsidised rate for a three year period. In a span of three months, the country saw inflows of $26 billion which was nearly 10 per cent of the foreign exchange reserves at the time.

The three year period is now expiring and banks will have to repay the amount. The problem is banks do not have the dollars with them to repay. The dollars raised in 2013 by banks were given to traders who on account of the global slowdown and other factors are unable to return it on time.

Rupee will come under pressure when the FCNR (B) redemption begins and there is a supply demand mismatch. RBI to its credit has hedged nearly 90 per cent of the requirement of dollar which is likely to keep volatility under check to some extent. But the question remains how will the demand with actual currency payments be met?

Bank of America Merrill Lynch (BofA ML) mentioned in their report that they expect $15 billion of FCNR outflows in September. If the outflows are greater than the banks’ ability to fund, RBI will have to sell foreign exchange and counter balance it by injecting rupee liquidity via OMO (open market operations).

BofA ML’s report points out that RBI’s foreign exchange forward book stands at $21.4 billion as of June 2016 to cover $25 billion (including interest) of 2013 FCNR (B) deposits. However, the research firm feels that banks may not be able to deliver in full as they need to maintain working nostro balances (sort of trading escrow account needed to maintain inflows and outflows) of around $10-15 billion. Thus they may either have to run down their foreign loans or purchase currency from the market, which means RBI will have to supply the currency to meet their appetite.

The report points out that banks nostro balances stands at $30.2 billion but if one leaves the $10-15 billion liquidity needed at any point of time, then the amount is insufficient to meet the $25 billion of FCNR (B) outflows and $5.5 billion for Iran oil payments. Banks will be short by anywhere between $10-15 billion or around Rs 70,000 crore to Rs 1 lakh crore.

Considering RBI’s forward position, the central bank has a net short position of $6 billion over the next year. This would leave around $7 billion which the banks will have to arrange either by running down their loans or selling government securities. BofA ML feels banks will sell government securities to generate liquidity.

While these transactions are taking place the general assumption is that equity markets would be stable and there are no withdrawals by FIIs. But historically, a volatile currency market is contagious and transfers the volatility to equity markets. In such a scenario the entire ideal case calculation goes for a toss.

What is certain is irrespective of how the events play out, market participants, across currency, money market and equities will be on the edge of their seats.