FCNR(B) deposits: Who bears the currency risk? | Explained

The FCNR(B) scheme is a classic tool used by the Reserve Bank of India (RBI) to manage balance of payments pressures and augment Foreign Exchange Reserves. By offering a special swap facility, the central bank effectively acts as an insurer against currency depreciation for the principal amount deposited by non-resident Indians. A currency swap involves an agreement to exchange cash flows in different currencies, allowing the RBI to absorb the exchange rate risk. This intervention provides banks with a cheaper source of dollar funding compared to borrowing in international markets. The RBI calculates that the yields generated from investing these mobilized dollars (e.g., in US Treasury bonds) will offset the estimated 3% annual hedging cost required to protect the principal's value. From a UPSC perspective, understanding the mechanics of how the RBI uses such schemes during periods of currency volatility (often triggered by external shocks like high oil prices or rising US interest rates) is crucial for questions on macro-economic stabilization.

A critical vulnerability highlighted in this analysis is the unhedged foreign exchange exposure of Indian commercial banks. While the RBI swap protects the principal, the interest payable on FCNR(B) deposits is denominated in foreign currency (usually dollars) and must be borne by the banks. Hedging involves taking a financial position (like buying a forward contract) to offset potential losses from adverse currency movements. Because hedging costs are currently around 3% annually, many state-run and private banks have opted to leave this liability unhedged to protect their margins, planning instead to buy dollars in the spot market when interest payments are due. This strategy exposes these banks to significant currency risk. If the Rupee depreciates sharply (e.g., from ₹95 to ₹100 per dollar), the Rupee cost of servicing that dollar interest increases proportionally. For Mains, this illustrates the tension between bank profitability and systemic risk management, a key concern for banking sector stability.

The aggregated unhedged exposure of the banking sector creates a potential systemic risk that could impact the broader economy. If the Rupee experiences significant downward pressure near the maturity dates of these three-to-five-year FCNR(B) deposits, banks will be forced to simultaneously purchase large quantities of dollars from the open market to fulfill their interest obligations. This sudden surge in demand for dollars would exacerbate the depreciation of the Rupee, creating a vicious cycle. This scenario demonstrates how individual bank decisions regarding risk mitigation can aggregate into macroeconomic instability. The situation underscores the limitations of the RBI's intervention; while it solved the immediate problem of bolstering reserves and stabilizing the currency in the short term, it deferred a portion of the currency risk to the future. Aspirants should analyze this as an example of the complex trade-offs inherent in monetary policy and foreign exchange management.