FCNR Rates: Too Good To Be True?

January 17th, 2015

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Raghuram Rajan: This man is ultimately responsible for the very high rates you see on FCNR accounts.

Why Googling 'FCNR' Blew My Mind

A reader recently emailed to ask me if borrowing money to make bigger FCNR deposits made sense.

At first, I had no idea what he was talking about. but when I googled 'FCNR', what I found blew my mind.

The term 'FCNR' stands for 'Foreign Currency Non Resident'. It's a savings account held by an East Indian living outside of India, denominated in the currency of the country in which he or she lives in. For example, an East Indian living in Canada can have an FCNR account that holds Canadian dollars.

Since FCNR accounts are only available to Indians, you might wonder if there's any point in reading further if you're not Indian. Well, reading the rest of this article will help you understand what a currency swap is, and provide you with insight into a fascinating global event. So it's up to you.

When I googled FCNR, I was amazed by what I learned. Right now, Canadians can hope to get around 2.2% per yearat best on a 3-year GIC from a well known financial institution. In contrast, Indians can get upwards of around 4.7% per year.

That's a very big difference.

How Indians Can Potentiallly Achieve Double Digit Returns

4.7% per year is actually higher than the rate at which some Indians can borrow. This means that they can borrow money to make bigger deposits in their FCNR accounts, and pocket the difference. Importantly, this profit comes risk free because the returns on their FCNR accounts are guaranteed.

Now, bankers are smart people. They're also in the business of making money from lending people as much money as they can without taking on risk. The banks know that if they lend money to Indians with FCNR accounts, they can expect to receive that money back without much risk - as long as the Indians deposit the money into their FCNR accounts. So they proposed a deal.

They said, "Deposit some money with us in our FCNR account, and we'll lend you 9 times the amount at a cheap rate. You can then deposit that money in the FCNR as well."

This is a very lucrative arrangement. Suppose an Indian deposited $10,000 in his or her FCNR account, and took the bank's offer and borrowed $90,000 at 3.5%. So the total FCNR deposit is $100,000. Then, that person would receive $4,700 in interest, and pay $3,150 in interest. This is a net total of $1,550. In other words, this person would enjoy a return of 15.5% a year on the initial deposit of $10,000. Best of all, it's totally risk free!

Or is it?

Whenever I hear about such great deals, my mind automatically becomes very skeptical. I ask myself, why does such a great deal exist? Understanding this 'why' often gives me insight into whether there's a catch.

In the rest of this article, I'll tell you why this opportunity exists, and what I think the risks are. Just to warn you, this is not a simple topic. I'll try to explain everything in simple terms, but understanding what I'm about to say might still hurt your head a little. So get ready.

How Currency Swaps Work

First, let me explain to you what a currency swap is using an example. For your benefit, I'll slightly oversimplify my explanation.

Let's say you have some U.S. dollars, and you want to turn them into Indian rupees. However, you know that 3 years from now, you'll want to turn those rupees back into U.S. dollars again. Now, currency exchange rates fluctuate over time, so you're afraid that by the time you change the rupees back into U.S. dollars, you'll have lost because the rupee will have depreciated a lot.

Well, I've got some good news. You can solve this problem by entering into currency swaps.

When you enter into a 3 year currency swap, you not only change your U.S. currency for rupees, but you also agree to exchange your currency back at the same rate. For example, you could enter into a swap where you receive 60 rupees per each dollar. But the swap will also stipulate that 3 years from now, no matter the exchange rate, you must exchange 60 rupees for each dollar.

This is a good deal if you think the value of your rupees will fall.However, entering into this swap will cost you. In fact, there's a tight relationship between interest rates in the U.S., India and the rate charged for entering into a swap. Let me illustrate.

Let's suppose that banks can borrow money at 1% per year for 3 years in U.S. dollars. Let's also say that banks can lend at 8% per year for 3 years in India, risk free. Note that these values are fairly close to today's actual rates.

Now, let's suppose that you can enter into a currency swap for free. If that's true, here's what the banks will do.

The banks will borrow money at 1% to enter into swap contracts, and exchange their U.S. dollars into rupees. Then, they will lend the rupees they received from the swapat 8%. At the end of their swap contract, they will exchange the rupees back to U.S. dollars. Because they received 8% interest from lending the rupees butpaid just 1%, the banks will have earned 7% on their money, risk free.

This sort of thing can't happen in a free market (i.e. there is no 'free lunch'). That's why a currency swap will cost 7% per year. That means the banks can borrow U.S. dollars at 1% and receive 8% on their rupees. But since they pay 7% on the currency swap, they gain 0% overall. This is how things are normally.

The Reserve Bank Of India Stirs Things Up

However, something recently happened in India that led to the breakdown of this relationship between the cost of swaps and interest rates.

Since around 2011, the value of the Indian rupee has plummeted, losing around 25% of its value. This meant that in India, imports such as oil and food started costing a lot more. Corporations that relied on imports also got hit.

The Reserve Bank of India (India's central bank) noticed the problem, and tried to combat the depreciation of the rupee. In one of their latest attempts, they announced the following unusual arrangement.

Whereas the U.S. dollar - rupee currency swap rate was costing 7% in the market, they announced that they would offer the same swap for 3.5%. But, this deal only applied to money held in FCNR accounts.

Why did they do this? Let's go back to our previous example on swaps.

In this situation, the interest rates haven't changed, but the rates on swaps have. Therefore, banks today can now borrow money at 1%, enter into a swap that costs 3.5%, and then earn 8%. In other words, they can gain 8 - 3.5 - 1 = 3.5% for no risk. But, there was only one catch. The U.S. dollars had to come from FCNR accounts.

Why FCNR Rates Are High

Upon this announcement, the banks began tripping over themselves to try to attract more dollars into their FCNR accounts. The more money they could access via those accounts, the more free money they earned.

Because the banks are in competition with each other, they started raising the rates they offered on FCNR accounts in order to attract more customers. This came at the price of accepting lower profits margins. Going back to our example, if the banks raise the FCNR rate by 1%, that means the cost of borrowing goes up by 1%. So if the U.S. dollar borrowing costs are now 2%, then banks would receive 8 - 3.5 - 2 = 2.5% for no risk. It's less than the 3.5% before, but it's still free money.

The rates offered on the FCNR rose and rose, until we have the situation we have today.

The Reserve Bank of India (RBI) in the meantime, is happy to take the money. Whenever a bank enters into a swap agreement with the RBI, the RBI takes in U.S. dollars, in exchange for rupees. We'll talk more about this later.

And that, in summary, is why you see such high rates on FCNR accounts today.

Are FCNR Returns Safe?

So now that we understand the gist of what's going on, it's time for the all important question. Are FCNR returns safe? If they are, this represents a golden opportunity for Indians living abroad. But if not, this would represent a highly risky deal, as it involves borrowing a lot of money from the banks. So which is it? Safe or risky?

Unfortunately, I can't give you a definite answer. That's because much of it relies on the future actions of the RBI, whose actions would in turn depend on geo-political factors that's almost impossible to forecast.

You must understand that the RBI is offering its currency swaps for a reason: to acquire U.S. dollars. Now, I'm not the governor of RBI, so I don't know what he'll do, but my sense is that he'll use the swap to defend the rupee. He can do this by selling dollars to buy rupees in the market, or he can lend the dollars to Indian corporations who need them, who in turn will probably sell the dollars to buy rupees (in a manner of speaking). Regardless of the exact method, dollars will be sold to buy rupees. This props up the rupee's price.

The problem is, when the swap terms end, the RBI will need to give back the U.S. dollars to FCNR account holders. This will require the RBI to do the reverse of what it's doing now. In other words, they'll need to sell rupees to buy U.S. dollars.

Now, this wouldn't be a problem if the rupee were strong at the end of the currency swap's term. The Indian entities would simply sell rupees to buy dollars. Done. But what if by the time the term ends, we find ourselves in a similar situation as today? In other words, what if the rupee keeps falling?

This would put the RBI in a big quandary. Buying U.S. dollars to pay back FCNR account holders would mean even lower exchange rates for the rupee versus the dollar. Not buying the U.S. dollars would mean defaulting on their obligations to FCNR account holders.

Which option would they choose?

I would think that the RBI would choose the first option, or find some other alternative. But I can't be sure. I don't know what forces are at work in India, and I have even less insight into what India will look like in 3 years.

In the end, I think each Indian will have to ask him or herself - "Do I trust the RBI?". Whether or not you invest in FCNR accounts will depend on this answer.

The RBI knows that defaulting on their obligations is a serious matter, so they have every incentive to honor them. But if you look through the annals of history, stranger things have happened.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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