Tamal Bandyopadhyay: And the dollars keep pouring in...

Last weekend was quite dull for the vast majority of the non-resident Indian (NRI) community across the globe. The beer was flat and community gatherings were a bit colourless. The reason? The Indian central bank "" the Reserve Bank of India (RBI) "" told them last Saturday: "Stop sending dollars to India. We don't want your money any more."

The RBI cut the interest rate on savings bank deposits for NRIs by two-thirds "" from 3.5 per cent to around 1.16 per cent. This was done by linking the NRI savings account interest rate to the London Inter-Bank Offered Rate (Libor). To start with, the central bank has directed commercial banks to link it to the six-month Libor as on March 31, which was 1.16 per cent.

The cut on Non-Resident (External) Rupee deposits, or NRE term deposits, was less harsh "" 0.25 per cent or 25 basis points. The interest rates on NRE term deposits for one to three years will not exceed the Libor rates for the dollar of corresponding maturity. The one-year Libor is now pegged at around 1.6 per cent.

Hence, for a one-year term deposit, NRIs will get 1.6 per cent interest. Until April 17, they were getting 25 basis points above Libor.

This is the third round of rate cuts for NRI deposits over the last eight months. The NRI deposit rates were first linked to Libor rates for the dollar on July 17 last year when the ceiling was fixed at 250 basis points. It was cut to 100 basis points on September 15 and further lowered to 25 basis points above Libor rates on October 18.

What was the provocation for the third cut? Prima facie, the objective has been to stem the flow of dollars into the system and kill arbitraging on interest rate differentials by expatriates. Before we discuss this in detail, let's take a look at the history of NRI deposits.

The NRI deposit schemes are not unique to India. Developing countries the world over float such products to mobilise a part of their external capital requirements from non-residents. This is true of Egypt, Lebanon, Greece, Turkey, Israel, Spain, Thailand, some of the east European countries and even our next-door neighbours Pakistan and Sri Lanka.

Most of these countries offer their non-residents deposit products denominated both in domestic as well as foreign currencies; and the principal along with interest are repatriable.

The RBI first designed an NRI deposit scheme in February 1970 "" Non-Resident External Rupee Account [NR(E)RA], popularly known as NRE deposits. The objective was to tap the expatriates who were thronging west Asia in search of employment. Five years later, in November 1975, the Foreign Currency Non Resident (Account) "" FCNR(A) "" was introduced.

Under the FCNR(A) scheme, commercial banks were allowed to accept freely repatriable term deposits maturing in six months to three years from NRIs in four currencies "" dollar, pound sterling, yen and deutsche mark.

The exchange risk for the foreign currency liabilities of the banks (which were accepting such deposits) were borne by the RBI for the first 18 years, till July 1993, when the government stepped in to meet the exchange risk. The scheme was formally closed in 1994 but the last of the deposits under this scheme was redeemed in August 1997.

Since the government was not willing to bear the exchange risk any more, the FCNR(A) scheme was phased out, making way for Foreign Currency Non-Resident Bank (FCNR-B) deposits where the exchange risk was to be borne by the banks that collect these deposits.

Around the same time, a rupee-denominated scheme "" Non-Resident Non-Repatriable Rupee Deposit [NR(NR)RD] "" was also devised, which was initially non-repatriable but later, only the interest income was permitted to be repatriated. This scheme was withdrawn in April 2002.

At the moment, two major schemes where the NRIs park their money are dollar-, pound sterling-, euro- and yen-denominated FCNR(B) deposits and the rupee-denominated fully repatriable NRE deposits. In percentage terms, the proportion of foreign currency deposits, which was 72 per cent of the total NRI deposits in March 1992, dropped to less than 40 per cent in March 2003.

Now, take a look at the interest rates offered on these deposits. In 1985, when all rates were regulated, interest rates on the then prevailing FCNR(A) and NRE were two percentage points higher than the domestic deposit rates.

In the early 1990s, the spread over domestic rates widened because the RBI was aggressively trying to mop up these deposits in the aftermath of the external payment crisis in 1991.

In October 1992, the RBI capped the rate on NRE deposits at 13 per cent and the very next year, the cap was brought down to 12 per cent. Banks were given full freedom to determine the rates in September 1997.

In the case of FCNR(B) deposits, in April 1997 banks were permitted to determine the rates subject to a cap prescribed by the regulator; subsequently in October 1997, the rates were linked to Libor. The NRE deposits, too, were linked to Libor in July 2003 when the banks were allowed to pay up to 250 basis points over Libor on these deposits.

There is yet another savings instrument available for the NRIs called Non Resident Ordinary (NRO) account. Here an NRI can park his local income, such as income from house rent, dividend on his equity holdings and so on. The money from this account is non-reptriable, but keeping in view the large doses of relaxations that have taken place on outward remittances, for all practical purposes the NRO proceeds are repatriable.

By cutting the rates on NRE term deposits by 25 basis points, the RBI has effectively brought the non-resident rupee and dollar deposit yield on a par. How? Banks will now offer around 1.6 per cent on a one-year NRE deposit as the one-year Libor is veering around this range.

Foreign currency FCNR(B) rates are pegged at 25 basis points below Libor, which means a one-year FCNR(B) deposit fetches about 1.35 per cent. Now, if an NRE depositor wants to hedge his currency risk, he needs to take a forward cover.

This is because under the NRE scheme, deposits are received in foreign currency and converted into rupees, and converted back into foreign currency on maturity. Since the one-year forward premium is now veering towards 25 to 30 basis points, on a fully-hedged basis the return on NRE equals that of the FCNR(B) deposits.

The immediate provocation for the RBI action was the over-$ 3 billion inflow in the first week of April, which took the total forex assets kitty to $ 116.06 billion as on April 9. But the fact is, NRE deposits' contribution to the overall inflow is not high. It is not the NRIs, but the foreign institutional investors (FIIs) who have been pushing the dollar flow to India.

Portfolio investment accounted for the largest chunk "" about 38.3 per cent "" of the foreign exchange reserves in the first three quarters of fiscal year 2003-04.

Banking capital, in contrast, contributed 21.3 per cent to the foreign exchange reserves. NRI deposits accounted for the bulk of the banking capital (net inflows: $ 3.4 billion). Within this segment, the NRE deposit flow is actually coming down while FCNR(B) flow is on the rise.

A cut in deposit rates may not halt the dollar flow. NRIs send money to India not for love of their motherland but to earn a little extra. This extra comes from rupee appreciation.

Hypothetically, if the RBI directs commercial banks tomorrow to treat all NRE deposits as current account and not pay any interest, the NRIs will still send money here as long as the outlook on the rupee is unchanged.

In fiscal year 2003-04, the rupee strengthened by 9 per cent against the dollar. That ensured a 9 per cent additional return on their deposits, besides the interest rates offered on these deposits. Since January this year, the rupee has gained about 4 per cent against the dollar.

So, it is a classic chicken-and-egg situation for the RBI. It wants to stem the NRI dollar flow by cutting the deposit rates since the excessive dollar supply is propping up the rupee.

However, the NRIs will continue to send dollars to India because they feel that the local currency is bound to appreciate against the greenback. Unless the outlook on the rupee is changed, the RBI can do nothing about the NRI flow.

The bearish outlook on the dollar is also behind the lukewarm response of investors to the $ 25,000 window created by the RBI recently.

Although resident Indians are allowed to invest up to $ 25,000 overseas, there are few takers for this because of the weakening dollar and superior domestic rate of return.

It's virtually impossible to stop interest rate arbitraging. A drastic way to do this could be by making NRE deposits fully non-repatriable.

However, that would be a retrograde step. The more permanent way of killing arbitrage is making the rupee fully convertible. But that will take a while since trade liberalisation must precede capital account convertibility.