A quality issue

BS OPINION

While the central bank clearly believes that the London Inter-Bank Offer Rate (Libor) plus the 250 basis point ceiling it had stipulated for NRE deposits in July was not low enough, and dropped it further to prevent arbitrage and curb the inflow of dollars, the ban on OCBs reflects the central bank's quiet discomfort with the quality of inflows into the Indian markets.

Of course, the RBI can afford to be choosy now, with forex reserves at a comfortable $ 87.4 billion. It also speaks volumes for the RBI's confidence that it has effectively slammed the door on one class of investors at a time when portfolio inflows are showing distinct signs of slowing.

Clearly, in the RBI's assessment, it is better to have a stronger framework that will attract inflows on a sustainable basis than hanker for hot money, which almost always leaves a trail of disaster.

It is not without sound thinking that the reduction of the ceiling to 100 basis points above Libor makes the fully hedged NRE deposit rates at par with those for FCNR dollar deposits.

At 100 basis points above Libor, a one-year NRE deposit will pay around 2.3 per cent, and with the one-year forward premium at around 1.3 per cent, the fully hedged return works out to 1 per cent. A one-year dollar deposit will pay Libor less 25 basis points, or about 1 per cent.

Simply put, the RBI is trying to eliminate the difference in returns between dollar deposits by NRIs and fully hedged NRE deposits. Thus, even as purely arbitrage inflows are being stopped, genuine NRI depositors have the option of keeping their funds in dollars.

At the same time, the blanket ban on the OCB investments shows that the RBI is not certain about the quality and can't do much at the moment since they are not regulated or registered with Sebi. It is quite possible that the RBI will review the blanket ban after putting some regulatory framework in place.

Will these moves stop the accretion to reserves and reduce the proportion of the unwanted elements? As far as the banning of investment by OCBs is concerned, it will surely reduce the supply instantly. No wonder that the rupee weakened on the news.

As far as the NRE interest rate is concerned, there is no doubt that on a fully hedged basis, the one-year NRE deposit is unattractive, since one-year certificates of deposit pay on average around 1.6 per cent in the US. But NRIs may opt for other avenues besides bank deposits, such as mutual funds or government securities.

A clear arbitrage is still available, even when fully hedged, in government paper, or in debt funds. If the RBI aims to discourage the build-up of inflows, it would do well to reduce interest rates across the board so that no arbitrage opportunity exists, on a fully hedged basis, in the government securities market as well.