Has RBI taken the wrong path by letting short-term volatile debt rescue rupee?
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Rising NRI deposits add to RBI worries

Reserve Bank of India deregulated the interest rates on bank deposits aimed at the rich NRI in a late-December decision. The central bank's logic was if dollar inflows rise, the pressure on the rupee will ease. But the big question among monetarists and forex experts is the risk such a surge in NRE deposits poses.

Ashutosh Atre, 39, an electronics engineer working in New York, suddenly feels richer. As do 27 million non-resident Indians, or NRIs, spread over some 200 countries. He is one of the beneficiaries of a late-December decision by the Reserve Bank of India, or RBI, to deregulate interest rates on bank deposits aimed at the rich NRI.

Almost overnight, Indian banks have raised the rates on the so-called Non-Resident (External) rupee, or NRE, deposits nearly three times: from around 3.5 per cent to 9.25 per cent for deposits of one year and above. For Atre, the deregulation of interest rates on the NRE account is nothing less than a jackpot.

The interest rate cap on ordinary non-resident accounts had been relaxed earlier, in November last year, but these have a limitation: the foreign currency deposited cannot be taken out of the country again. Deposits in NRE accounts can be.

"No one knows when the US will get back to three and four per cent rates on deposits that it used to offer when the market was at the peak in 2006/07," says Atre, who is holidaying in Mumbai. Currently, a depositor in the US earns 0.55 per cent on a one-year deposit.

Even if Atre spends, say, five per cent buying a forward cover, or a contract to buy the dollar at a rate fixed now, he would still earn a net 4.25 per cent, nearly eight times the amount he can make in the US. Such a bonanza comes on top of a weakening rupee, which today at Rs 52 to the dollar, is nearly one-fifth cheaper from a year ago.

In fact, that is what is driving the December decision of RBI. If dollar inflows rise - estimates suggest NRI deposits will surge by $10 billion from the current $52 billion - the pressure on the rupee will ease, goes conventional central bank logic.

But the big question among monetarists and forex experts is the risk such a surge in NRE deposits poses. Firstly, for the banking sector, the higher interest rates would have an impact on the cost of funds and net interest margins. "RBI is basically signalling Indian banks to learn to manage their profitability by setting their rates on commercial considerations," says Saurabh Tripathi, Partner and Director at Boston Consulting Group, or BCG, a consulting firm. "Assured margins are over."

The second worry encompasses the broader economy, though ratings firm Moody's Investors Service has upgraded India's credit ratings to investment grade from speculative. The upgrade reflected what it saw as a strong bulwark of foreign exchange reserves - nearly $297 billion - even in the face of a high current account deficit (exports net of imports and other inflows) and foreign debt obligations.

The current account deficit for the July-September quarter, the latest for which data is available, stood at 3.6 per cent of the country's gross domestic product, or GDP.

Yet, economists are concerned over the $137 billion of India's shortterm debt, which is maturing in less than a year. "We believe refinancing will be difficult in an environment o f global deleveraging, adding to the overall balance of payment stress," says Tanvee Gupta Jain, India Economist for Macquarie Capital Securities, a Mumbai brokerage of the eponymous Australian banking group, in an early-January report.

Rising NRI deposits can also add to the broader stress over India's total external debt, already at $327 billion as of September and equal to 18.1 per cent of GDP. Stewart Newnham, Head of Currency Strategy for Asia, Morgan Stanley, does not seem to agree with the Moody's optimistic view on India's forex reserves. He believes the scope for RBI intervention is also limited. In an early January report, Newnham highlighted that India's forex reserves are equal to 17 per cent of GDP. "We think the RBI might have to ration its interventions, using its scarce reserves sparingly," he wrote.

So has the RBI taken a myopic view or been too hasty? The jury is out. Some experts believe other alternatives could have been explored to attract dollars. They recall the Resurgent India Bonds, or RIBs, issued in August 1998, and suggest these should be revived. RIBs had attractive interest rates, and NRIs had responded enthusiastically.

Yet others, like Moses Harding, Head of the Asset Liabilities Committee at IndusInd Bank, feel that totally deregulating interest rates on foreign currency non-resident deposits, or FCNR, as they are called, would be a better step. But then again, the exchange rate risk in FCNR accounts is borne by the banks, and has the potential to affect them adversely.

Will the expected flood of NRI deposits turn out to be hot money? "The risk of withdrawal of the deposits is low," says Tripathi, the BCG consultant. Interest rates in the US and Europe are expected to continue to stay low in the foreseeable future. "So, the interest rate arbitrage between India and the West will stay for quite some time," he says.

Such an arbitrage opportunity will drive NRI inflows and, in turn, the current account deficit. That could turn out to be imported pain.