RBI’s New Deposit Scheme for NRIs

The Reserve Bank of India (RBI) has introduced a foreign currency non-resident (FCNR) deposit scheme aimed at enhancing foreign inflows. This initiative is particularly targeted at non-resident Indians (NRIs), providing them with attractive investment options. As of Wednesday, banks have started to increase interest rates on these deposits.

HDFC Bank, for instance, will offer an interest rate of 6% for deposits of three to five years, especially if rates rise over 200 basis points. Meanwhile, YES Bank has taken it a step further with rates ranging from 6.5% to 6.6%. Now, even though these returns exceed the 4.2% to 4.3% rates typically offered by American banks, there might be more to this than meets the eye, thanks to leverage.

Understanding Leverage

So, what is leverage in the financial world? Well, it’s essentially using borrowed money to amplify investment returns. For example, if someone borrows double the amount they have, their leverage is 2:1. If they leverage 10 times their capital, it’s 10:1. This strategy allows NRIs to maximize returns from their FCNR(B) deposits.

Imagine a non-US resident wants to hold $1 million in an FCNR(B) deposit for three years. If they simply put the money in at a 6% interest rate, that’s decent. However, they could also go to a US bank, borrow $10 million (at a low-interest rate), and deposit that in the FCNR(B) account. Presently, three-year loans in the US are around 4.5%.

Here’s the math: the interest earned on an $11 million FCNR(B) deposit in the first year is $660,000. The cost of borrowing $10 million is $450,000. That leaves a net income of $210,000. After three years, the $11 million deposit grows to about $13.1 million. If the $10 million loan, with interest at 4.5%, is paid off, the total owed would be approximately $11.4 million. This results in a total profit of around $1.7 million from an initial capital of $1 million, translating to about 19.3% compounded annually.

According to analysts at Jefferies, utilizing leverage between 7-10 times, and considering spreads of 1.5-2%, clients could expect annualized IRRs (internal rate of return) ranging from 17% to 27% over three to five years.

Returns Similar to Stocks?

Of course, the ultimate return will hinge on two key factors. First is the interest rate differential between FCNR(B) deposits and the rates at which NRIs can borrow abroad. A larger difference means a bigger return. The second is the level of leverage; higher leverage will yield higher returns.

Economists at MK Global Financial Services have noted that as leverage increases, returns from this deposit system start to resemble equity-like returns. They also mentioned that financial flows could potentially reach $50 billion to $55 billion, which would be about 1.2% of India’s GDP—or maybe even more.

Looking back, when RBI first introduced the swap facility in 2013 as a temporary measure to boost foreign inflows, it worked—NRIs leveraged their capital to invest $26 billion into FCNR(B) deposits, which was about 1.4% of that GDP at the time. HDFC Bank ended up with the highest amount of FCNR(B) deposits during that period.

Leveraging for NRIs

But how exactly can NRIs leverage capital? They can use a letter of credit. While Indian banks typically can’t provide guarantees or letters of credit for borrowed funds, the RBI has made an exception for this FCNR(B) swap scheme. This means an NRI can secure a letter of credit from an Indian bank with an FCNR(B) deposit and use it to borrow from an American bank, with the assurance of repayment once the deposit matures.

In this arrangement, everyone benefits—NRIs gain from higher returns, American banks lend money, Indian banks facilitate the process, and the Indian economy also gains in the long run.