Pranjul Bhandari: No sweat over non-resident deposit outflows

With the backing of Tinbergen's rule and a proactive RBI, there's a possibility that repayments could come and go without much pain

It is well known in mathematics that n variables cannot be solved with fewer than n equations. Jan Tinbergen, a Nobel Prize winner in 1969, extended this principle to economics when he argued that for every policy target there must be at least one policy tool. If there are fewer tools than targets, some policy goals will not be achieved, but if there is a tool for each goal, at least the chances are good. This principle may just explain why non-resident deposit outflows of as much as US$24 billion from India during the September to December period will not be too disruptive.

To recap, the Reserve Bank of India (RBI) introduced its Foreign Currency Non-Resident (FCNR) scheme in the crisis-like summer months of 2013 to slow the descent of the INR by attracting USD from non-resident Indians (NRI).

The scheme was hugely successful, attracting approximately $26 billion of inflows. About $24 billion of these deposits had a maturity of three years and may leave the country during the current quarter. The big concern is whether the repayment will happen seamlessly.

Broadly speaking, there are five main players here: (1) NRIs, who put the money in; (2) the RBI, which bought the USD and deposited the INR equivalent in India’s banks at a subsidised rate; (3) India’s banks which accepted the INR; (4) FX trading desks at banks that bought USD from the RBI during the post-election 2014 inflows, with a promise to pay it back around the time of NRI deposit maturity; and (5) exporters, who further bought these USD from the FX traders with a promise to repay at a later date, which the traders would then deliver to the RBI, and the RBI would return to the NRIs. If each plays his/her part according to plan, FCNR unwinding should occur smoothly. However, if any one of the players slips, there could be trouble.

We believe the most likely source of stress is a timing mismatch vis-à-vis exporters. Swap transactions between FX traders and exporters are common, but exporters traditionally tend to deliver only part of the USD on time, rolling over the rest to align with their own inflows.

If exporters don’t pay up the USD on time, there could be a period of temporary USD shortage. While there are many other channels available for procuring the USD, at worst, if a shortage persists, the RBI can jump in to save the day. It can temporarily draw down USD from its $365-billion-strong war chest of reserves.

However, when the RBI draws down FX reserves, it simultaneously sucks out INR liquidity from the system. In other words, solving the problem of USD shortage could lead to an INR shortage. Here, too, the RBI can solve the problem with some handy tools. There are two ways in which it can infuse INR liquidity. If it believes that the deficit is temporary, it can use the repo window. If it thinks the problem is more permanent, it can buy domestic government bonds, further stepping up the pace of open market operations. Already, the RBI has bought a whopping Rs 1,000 billion worth of government bonds over the last six months.

However, as soon as the RBI uses any of the two INR liquidity instruments, a third problem arises, that is, the pressure banks face in meeting the Liquidity Coverage Ratio (LCR) requirement that banks should maintain highly liquid assets such as government bonds. INR liquidity infusion from the RBI via repos or open market operations automatically lowers such holdings. This could create problems in meeting the statutory requirement.

However, here again, the RBI has a tool up its sleeve. It can allow banks to dip into their Statutory Liquidity Requirement holdings (otherwise a no-go) to meet the LCR requirement. Interestingly, it already moved on this front on July 21 when it allowed banks to use 11 per cent of deposits for the LCR requirement instead of the 10 per cent allowed earlier.

To conclude, then, FCNR outflows could trigger USD and INR shortages as well as a banking sector statutory liquidity shortage. Solving the stress in one market could create problems in another. But as we have seen, the RBI has a unique policy tool handy to take care of each of the three markets (USD, INR and LCR) individually. With the backing of Tinbergen’s rule and a proactive RBI at the ready, there is a good possibility that FCNR outflows could come and go without much pain.
The author is chief India economist, HSBC