The Burden of a Successful FCNR Scheme

The Reserve Bank of India’s provisional tally for the special foreign currency non-resident bank deposit window, which closed on August 31, exceeded even the most optimistic expectations.

Mobilisation reached $127.226 billion. Market estimates had begun at $50 billion–$60 billion in early June and gradually risen to $85 billion–$90 billion by end-August. The final figure was significantly higher than even the upper end of those forecasts.

The achievement is all the more striking because dollar funding rates were exceptionally high this time, unlike in 2013, when they were close to zero. Raising such a large sum amid volatile global conditions is no mean feat.

The currency market’s response was immediate. The dollar/rupee rate fell from the previous evening’s close of 94.95 to as low as 94.20 before stabilising around 94.45. That direction could persist unless the RBI steps in as a dollar buyer.

As this column argued on July 20, a sharp appreciation of the rupee was always more likely after the FCNR window closed. During the mobilisation phase, a dollar/rupee rate around 96 was also more favourable to the central bank’s economics when the dollars eventually have to be returned as the deposits mature.

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Now that the mobilisation is complete, however, the incentives and the policy challenge have changed.

Liquidity Deluge
Durable surplus liquidity could reach ₹11 trillion–₹12 trillion by end-September. If the RBI intends to begin tightening monetary conditions from its October policy review, it may have to bring forward measures to withdraw some of this liquidity.

The most straightforward option would be three-month Treasury bills issued under the Market Stabilisation Scheme. This would impose a fiscal cost on the government, but the expense would be relatively modest. Assuming a yield of 5.5%, a ₹3 trillion issuance would cost around ₹40 billion–₹50 billion over three months.

A second option lies in the RBI’s forward book. Its net short forward position stood at $138 billion at the end of July, of which $47 billion was due within one year. Allowing roughly half of these contracts to mature without being rolled over could absorb about ₹2.2 trillion–₹2.5 trillion of liquidity.

The RBI could undertake additional sell-buy foreign exchange swaps to remove more liquidity in the near term. But such swaps would provide only temporary absorption and would be difficult to justify after the central bank offered banks a near-zero swap cost under the FCNR scheme. Reversing that liquidity through market-priced swaps could crystallise losses on the central bank’s balance sheet.

Third, the RBI may have to sell dollars sporadically during the remainder of 2026–27 if global headwinds return, particularly if the conflict in West Asia again places the rupee under pressure. Such intervention could absorb another ₹2.5 trillion. About $10 billion of dollar sales may already have taken place over the past month.

Fourth, the normal rise in currency in circulation could drain around ₹3 trillion from the banking system by March 2027.

The increase in banks’ liabilities could also result in they maintaining higher cash reserve balances of around ₹500 billion.

Could an incremental cash reserve requirement be imposed for a short period of time? This move, however, would sit uneasily with the cash reserve ratio and statutory liquidity ratio exemptions attached to FCNR deposits. It could also penalise banks that mobilised little or no money under the scheme.

Taken together, these measures, even without Market Stabilisation Scheme bills, could remove most of the estimated ₹8.5 trillion of excess liquidity by the end of 2026–27.

The problem is timing. The immediate liquidity surge will occur between end-September and end-December. The RBI must therefore choose among Market Stabilisation Scheme bills, sell-buy swaps, an incremental reserve requirement and outright government bond sales. The last option would be particularly disruptive when bond yields have already risen substantially.

Future Liability
The scale of the mobilisation has also increased the RBI’s responsibility as manager of India’s foreign exchange reserves.

A large part of these deposits will mature between 2029 and 2031. The 2029 general election could bring its own political and market volatility. Foreign direct and portfolio investment may not recover sufficiently by then, leaving the rupee vulnerable at precisely the time a large stock of FCNR deposits falls due.

Any large-scale use of reserves to defend the rupee over the next few years must therefore be assessed against the dollars that the RBI will eventually have to return. The impressive headline addition to reserves is accompanied by a matching foreign-currency liability.

The public-sector balance-sheet cost is also multilayered. It includes the roughly 3% subsidy embedded in the concessional swap, the interest paid on liquidity parked through variable rate reverse repos and the standing deposit facility, and the direct fiscal cost of Market Stabilisation Scheme issuance if that instrument is used.

The cumulative effect could reduce the RBI’s annual surplus transfer to the government by as much as ₹500 billion. The eventual cost will depend on how the funds are deployed, how much liquidity must be sterilised and how foreign exchange and interest rates evolve.

The RBI may now be willing to tolerate faster rupee appreciation, either by staying out of the market as a dollar buyer or by selling dollars episodically. A stronger rupee could force exporters that have postponed hedging their receivables to sell dollars forward.

Exporter hedging has been only about half the level of importer hedging, leaving considerable room for exporters to increase cover. That could compress forward premiums and make it easier for the RBI to settle or run down parts of its existing forward book.

As argued earlier, an optimistic end-2026 scenario could take the dollar/rupee rate towards its 200-day moving average near 91.85. A more moderate outcome would place it closer to the 100-day moving average near 94.10. These are technical signposts rather than policy targets, but they indicate the scope for appreciation after the closure of the window.

The rates market, meanwhile, presents a striking contrast. Despite the enormous surplus in banking-system liquidity, one-year certificates of deposit continue to trade at yields of around 7.40%. Yields on two- and three-year AAA-rated public-sector company bonds have returned to levels prevailing before the FCNR announcement in June.

Part of this reflects heightened inflation concerns arising from the West Asia conflict and rising global bond yields. Investors have also become more selective amid continuing uncertainty. The 10-year government bond yield has rebounded from a low of about 6.65% to around 6.98%.

Abundant aggregate liquidity has therefore not translated into easy term-funding conditions. Liquidity, risk perception, bond supply and expectations about future monetary policy are pulling different parts of the yield curve in different directions.

On current assumptions, India’s balance-of-payments surplus in 2026–27 could exceed $90 billion, while foreign exchange reserves could cross $780 billion by end-2026. This assumes that mobilisation through FCNR deposits, overseas foreign-currency borrowings and external commercial borrowings reaches about $150 billion by the end of the calendar year.

The banking system’s funding and credit needs may consequently be secured for the foreseeable future. But FCNR deposits are borrowed money with a defined maturity, not a substitute for durable foreign direct investment or portfolio flows.

The window has bought India time for those flows to recover. The quality of the RBI’s liquidity management, foreign exchange strategy and the banking system’s deployment of the funds will determine whether the scheme remains a policy success when its full costs and maturity obligations come due.