Foreign banks are pushing to raise billions of dollars from expatriate Indians in response to New Delhi's drive to defend its weak currency, which could mean the government can avoid the need for a sovereign bond or state-backed deposit scheme to attract inflows.
The foreign banks are offering upfront financing for wealthy non-resident Indians (NRIs) to set up dollar deposits in India following various central bank incentives, including cheap dollar/rupee swap rates, private banking sources told Reuters.
This would resurrect a practice which proved successful in drawing in dollars from non-resident Indians (NRIs) in 2000, when the rupee was also under pressure. The sources said banks could raise about $10 billion or more.
"It's a disguised NRI bond because you are basically getting in money locked in," said Rajeev Malik, senior economist at CLSA Singapore. One of the things unique about the scheme was the leverage being provided to non-resident Indians, he said. The other was the central bank's offer to swap the dollars for rupees cheaply.
"All this is being done mainly because government-related actions that will be more constructive are either not coming or slow in coming."
The rupee slumped to a record low of close to 69 per dollar in late August as investors saw India, with a record current account deficit, hefty fiscal deficit and slowing growth, as one of the most vulnerable economies in emerging markets to any tapering of the U.S. monetary stimulus program.
The banks will offer their wealthiest segment of private banking clients roughly 90 percent of the foreign currency deposit placed in India, four of the private bankers said.
"Client equity in these deposits is just 10 percent and the client effectively makes between 18 and 21 percent on the dollars," said a private banker with a European bank.
The scheme is a variation of the foreign currency non-resident bank account (FCNR), which are term deposits non-resident Indians can maintain in five currencies, including U.S. dollars, euros and pounds, at banks onshore and earn a fixed rate of interest.
As part of efforts to rescue the sinking rupee, the Reserve Bank of India (RBI) freed interest rates on FCNR deposits last month.
It allowed banks to offer as much as 400 basis points over the London interbank offered rate (LIBOR) for deposits with maturities between 3 years and 5 years. It exempted these deposits from statutory bank reserves.
To incentivise banks, the RBI also offered to swap FCNR deposits of maturities above 3 years into rupees at a fixed rate of 3.5 percent, less than half the prevailing market levels. That swap window is available until Nov. 30.
Investors need to have just 10 percent of the amount of deposit they intend to place, and can earn nearly 20 percent on their dollars.
Foreign banks can earn 3-4 percentage points over Libor for their dollars, while local banks in India can swap those dollars into rupees more cheaply than market rates using the central bank swap window.
"You will get the dollar inflow, that's not the point," said CLSA's Malik. "It's offering a selected subsidy on a swap and it's encouraging others to actually lever up. Are the means justified by the end? Are they so desperate that a central bank offers a discount on hedging costs?"
Gaurav Kapur, senior economist at Royal Bank of Scotland in Mumbai, estimated the banks would raise about $5-7 billion "easily".
Kapur also noted a sovereign bond would not have been ideal at this time for a government that runs a fiscal deficit and when Standard & Poor's has a negative outlook on India's sovereign debt.
Banks, both foreign banks with presence in India and local ones, have made a huge push to raise money from India's vast diaspora since the RBI relaxed rules on FCNR deposits. The FCNR deposits can be used as collateral to borrow overseas.
The difference in the new upfront financing scheme is that the banks pool their resources with non-residents and place deposits in India, thus creating bigger deposits with each new account.
One private banker with an American bank said the practice had been prevalent in the 1980s and 1990s and widely used by banks in 2000, when they raised $5.5 billion through an India Millennium Deposit scheme.
Indian authorities discouraged the practice thereafter because they were worried about hot money flows, he said. The Reserve Bank of India did not immediately comment.
One source at a European bank said banks were cherry-picking clients for this product.
"For every billion dollars I place in India, the bank has to fund $900 million," he said. "We can't allow just any customer to piggyback on us, only a handpicked few."
Still, bankers said the scheme was not without hurdles.
For one, the effective cost of the rupee funds would be about 8.5 to 9 percent, he said, which limited the investment options. Ten-year rupee government bonds yield 8.5 percent.
Secondly, there were unresolved issues of how much credit exposure foreign banks wanted to take on their India branches, and who would place the collateral for the loans and take the risk of premature withdrawal of the deposit by the non-resident Indian.
Lastly, investors placing millions of dollars would need assurance that their money could eventually be repatriated, without the risk of capital controls. One European bank was already offering insurance against this risk, for a price, the private bankers said.