The falling rupee is the talk of the town. Not surprisingly since the local currency reached kissing distance of 73 to a US dollar and fell by close to 12 percent this year. Some doomsday specialists even predicted that the rupee could touch the 100 to a dollar mark. Yet others have said that the fall is overdue anyway since the currency was overvalued for a long time on yardsticks such as the real effective exchange rate (the value of a currency in relation to those of its trading partners, adjusted for inflation). Still, there is near consensus that the situation is not as dire as during the so-called taper tantrum of 2013 because India’s macroeconomic fundamentals are stronger.
But the sharp and sudden fall over the past few days has prompted the government to dig deep for solutions. Prime Minister Narendra Modi is taking stock of the falling currency and rising fuel prices at an economic review meeting on Friday and Saturday. Moreover, there are talks now that the government will go back to tried-and-tested solutions of issuing NRI bonds/ deposits. It worked in controlling the rupee fall in 1998, 2000 and 2013.
News of the meeting and the idea of another round of NRI bonds breathed new life into the markets. From a low of 72.91, the rupee has rebounded to 71.85. The Nifty, on the other hand, has moved from a low of 11250 to 11,515 in two trading days.
Here’s a look at what these bonds are:
NRI bonds are just like any other bond offerings but they carry some incentives to attract NRIs to invest in the bonds. For instance, these bonds carry a guarantee by the central bank (RBI). When Raghuram Rajan allowed NRI deposits, he allowed the deposits to be raised in a foreign currency but allowed swapping of these dollar deposits to rupee at a concessional rate of 3.5 percent. Market rates for such swaps were around 7 percent then. The discount was the sweetener in the deal which the foreign banks exploited by advising their high net worth NRI clients to take a loan at just over Libor rates and deposit them in FCNR (B) accounts. This way they could earn a risk-free 2 percent after paying for their loan.
Need for NRI bonds
The government is essentially trying to plug the outflow of foreign exchange. Foreign currency is flowing out because imports are larger than exports and foreign investors staying away. Since September 2017, debt investors have withdrawn Rs 23,936 crore while equity inflow during the same period has been barely Rs 5,255 crore.
To be sure, the central bank has the option of raising interest rates. That will make Indian securities more attractive to foreign investors and induce inflows. However, as Indranil Sen Gupta of Bank of America-Merrill Lynch points out, only once in the previous three episodes of sharp rupee depreciation – in 1998 – did tightening have any success. That’s because foreign portfolio flows in equities are several times larger than those into bonds. Raising rates will be at the cost of growth which will scare away equity investors.
Sen Gupta also pointed out that NRI bond/deposits were able to fend off contagion in 1998, 2000, 2013. Against an expectation of $10-15 billion in 2013 Rajan’s move helped bring in $30 billion. A repeat of a similar performance will help rupee regain most of the lost ground.
Drawbacks of NRI bonds
While raising money from these bonds is desirable under the current circumstances, it is akin to kicking the can down the road. These bonds/deposits have to be repaid in the future as is the case any kind of debt instrument. Till the time the country does not have a positive balance of payments or foreign investment flow pick up again, the government will have to use all instrument at its disposal to control the currency market.