1. Introduction
2. External Debt and External Liabilities of Banks
3. Trends in External Liabilities of Banks

III.1 External Liabilities versus External Assets

III.2 External Liabilities on Banks’ Balance Sheet

III.3 Off-Balance Sheet External Liabilities of Banks

III.4 Trends in Non-Resident Deposits

III.5 Concentration of External Liabilities Across Banks

4. Banks’ Assets against External Liabilities
5. External Liabilities of Banks – Major Issues

V.1 Reserve requirements on Non-resident Deposits

V.2 Tax regimes governing Non-resident Deposits

V.3 Interest Rate Arbitrage

V.4 The Issue of Repatriablity

V.5 Authorisation to accept Non-Resident Deposits

V.6 Liquidity Risk

V.7 Exchange Risk

V.8 The Issue of Dollarisation

6. Conclusions and Recommendations

Tables 30-43

Annex I Major Items of External Liabilities of SCBs
Annex II Present Non-Resident Deposit Schemes
Annex III Interest Rates on NR Deposits – A Brief History
Annex IV Reserve Requirements on External Deposits Country Practices

External liabilities of banks need to be seen in the overall context of external debt. Though the non-debt creating remittances have been consistently accounting for a dominant component of NRI inflows, the non-resident and other foreign currency deposits have substantially increased their share in total external debt during the last ten years. International liabilities of banks are now nearly double of their international assets which is another issue of serious concern.

Following are the major recommendations of the Group:

• Reserve and liquidity requirements on NRI deposits may be left unaltered for the present.

• NRE savings deposit interest rate may be delinked from domestic savings deposit rate and may have the ceiling of one-month LIBOR/SWAP rates on US dollar deposits.

• The interest rate on NRE term deposits may be changed to LIBOR of the corresponding maturity.

• The non-banking financial companies and non-financial corporates should be phased out from accepting NRI deposits and the acceptance of NRI deposits should be restricted to only Authorized Dealers.

• The Resident Foreign Currency (RFC) scheme may be made non-interest bearing. The EEFC and RFC(D) accounts should continue to remain non-interest bearing.
• NRO deposits may have the nature of current/savings accounts only. The existing NRO term/recurring deposits may be allowed to be maintained till maturity.

• For better availability of export credit in foreign currency, the present ceiling on interest on such credit may be deregulated. If complete deregulation is not considered feasible, the interest rate ceiling may be raised by 50 basis points to LIBOR plus 125 basis points to ensure greater availability of export credit in foreign currency.

1.1 With a view to comprehensively reviewing the status position and examining the various policy issues relating to the External Liabilities of banks, Governor had constituted an internal group with Principal Monetary Policy Adviser, Principal Adviser, Department of Economic Analysis and Policy (DEAP), CGM-in-Charge, Department of Banking Operations and Development (DBOD), CGM-in-Charge, Department of External Investment and Operations (DEIO), CGM-in-Charge, Foreign Exchange Department (FED), Adviser (MPD) and Adviser (DEAP) as members.

The terms of reference of the internal group are as follows:

1. to study the recent trends in external deposits and other external liabilities of banks and the concentration of such liabilities across banks;
2. to evaluate risks associated with the existing exposure of the banks to these liabilities and to consider the impact of various existing external deposit schemes on the health of the banking sector in relation with associated costs and benefits;
3. to review the effect of reserve requirements in past and present on such deposits and to suggest appropriate policy on the same for future;
4. to study the impact of tax regime on such deposits and to assess whether existing tax incentives are appropriate;
5. to consider interest rate policies in respect of such deposits, specially in respect of interest rate prescriptions by the Reserve Bank; and
6. to study any other related policy issues and make policy recommendation on the above.

1.2 The Group co-opted Dr.O.P.Mall, Director, MPD as Group-Secretary. The secretarial assistance to the Group was provided by MPD.

1.3 The Group held four meetings to deliberate on the issues referred to it. The Group members had the benefit of interaction with the Governor, Deputy Governor (Dr.Rakesh Mohan) and Executive Director (Smt.Shyamala Gopinath) in its third meeting held on April 12, 2004.

1.4 The rest of the report of the Group is organized as follows. Section II analyses the behaviour of external liabilities of banks in the context of the evolving external debt scenario. Section III discusses the trends in external liabilities of banks including the non-resident deposits which are the largest component of these liabilities. The concentration of non-resident deposits across banks is also discussed in this section. Section IV discusses the utilization pattern of external funds by banks. The major issues in banking sector’s external liabilities are discussed in Section V. The concluding Section VI presents the recommendations of the Group.

2.1 Developing countries typically accumulate external debt/liabilities for financing their current account deficits with a view to achieving higher levels of investment as a means of accelerating the process of long-term economic growth. The current account deficits are financed by recourse to foreign savings either by way of non-debt creating foreign investments or by way of debt flows in the form of bonds, loans and deposits, etc. The recipient countries are thus able to make larger domestic investments without cutting their current consumption while the foreign lenders also reap the benefit of having appropriate returns on their capital. Over a period of time, the increased investment is expected to put the economy on a higher growth path. This enables the economy to increase the potential to generate current account surpluses to service the accumulated debt/liabilities over the years. This process not only facilitates the growth of the economy but also achieves consumption smoothing for both borrowers and lenders.

2.2 In the Indian context, the structure of foreign savings was circumscribed by the pursuit of self-reliant growth in the early years of the planning period with particular emphasis on domestic resources. However, the current account deficits of an average of two per cent per annum in the 1980s, necessitated the absorption of a higher level of foreign savings. The two oil shocks in 1970s shifted substantial resources towards oil exporting countries and international banks acquired a central position in international finance reflecting the preferences of oil-exporting countries. The oil shocks also provided investment opportunities in the oil-rich countries and the resulting employment opportunities attracted a large number of Indians. These Non-Resident Indians (NRIs) repatriated a part of their savings in the form of current transfers. The potential of surplus savings of NRIs prompted the authorities to devise specific deposit schemes to tap these savings. Consequently, the recourse to such relatively high-cost as well as short maturity sources of external finance increased significantly to supplement external assistance as a source of external finance.

2.3 The composition of external sources of finance has shifted significantly over the past five decades. The concessional external assistance flows in the form of official aid/multilateral and bilateral credits in the early period was gradually supplemented, albeit on a moderate scale, in the 1970s by commercial borrowings and non-resident deposits as additional sources of external finance. Moreover, the emphasis on external assistance flows in the early period was with the hope that the concessionality in these flows would restrict the debt-servicing in the early stages of growth and would not adversely affect the net transfers.

2.4 Prior to 1991, foreign direct investment was restricted and foreign portfolio investment was channeled most exclusively into a small number of public sector bond issues. Foreign equity holdings in Indian companies by way of portfolio investment were not permitted. The external payments crisis of 1990-91 brought about a paradigm shift in external sector policies, which ware conspicuous by a restrictive policy on foreign investment till then. Structural reforms which were aimed at imparting a competitive edge to the Indian economy appreciated the fact that foreign investment has an important role to play as a source of both finance and technology. Consequently, the share of non-debt creating foreign investment inflows comprising almost half of foreign savings expanded subsequently and debt-creating flows have correspondingly lost their share.

2.5 Comparable external debt statistics for India are available only from March 1990. While the external debt has increased from US$ 75.9 billion as at end-March 1990 to US$ 112.1 billion as at end-December 2003, the external debt-GDP ratio, which is a meaningful measure of an economy’s debt-servicing capability, has been declining after 1991. The debt-GDP ratio almost trebled from 14 per cent in 1980-81 to 41 per cent in 1991-92 and the debt-service ratio rose from 10 per cent in 1980-81 to a peak of 35.3 per cent in 1990-91. However, by 2002-03, the debt-GDP ratio moderated to 20.3 per cent whereas the debt-service ratio declined to 14.7 per cent following a conscious effort to encourage non-debt creating flows.

2.6 The perceptible improvement in overall debt scenario has been brought out by policy reforms incorporating, inter alia, the management of current account within sustainable limits with the current account showing a surplus since 2001-02. The major ingredients of the external debt strategy in recent years, inter alia, constitute: a distinct shift in the policy preference in favour of equity as against debt in the matter of capital inflows; monitoring of short-term flows; a market-determined exchange rate which has helped in avoiding the excessive risk-taking that occurred in some of the East Asian countries which followed a policy of either a fixed or a predictable exchange rate regime; a transparent policy on external commercial borrowings (ECBs) with the stated objectives of prudent debt management aimed at lengthening of maturity while keeping a ceiling on approvals, restrictions on end-use in the form of investments in stock markets/real estate; use of forex reserves to pre-pay some of the external debt and the policy efforts aimed at achieving a commensurate growth in current receipts, especially in exports, to service the existing debt.

2.7 While a large part of India’s external debt is on account of bilateral and multilateral loans (nearly 43.3 per cent in December 2003), there has been a significant rise in the proportion of (ECBs) (inclusive of export credit) over the 1990s (from 12.2 per cent at end-March 1991 to about 23.9 per cent in 2001 before declining to 18.3 per cent in December 2003) (Table 1). The proportion of Non-Resident and other foreign currency deposits which was at 13.8 per cent in March 2000, rose to 17.4 per cent by March 2002 and further to 25.8 per cent by December 2003.

2.8 NRI deposits pose potential problems for policymakers in times of crises, when they display a high degree of volatility irrespective of maturity constraints. For instance, in the case of FCNR(A) deposits, in contrast to an average annual inflow of US$ 1.3 billion (excluding accrued interest) during the three-year period 1987-88 to 1989-90, the inflow declined to a trickle (a mere US$ 168 million) in 1990-91 and turned into a net outflow of US$ 1.6 billion (excluding accrued interest) in 1991-92. The FCNR(A) outflow during 1991-92 was almost one-sixth of its outstanding balances as at end-March 1991, with the bulk of it moving out in the first quarter (April-June 1991). This illustration highlights the need for adoption of appropriate policies for (a) mobilisation of NRI deposits at internationally comparable interest rates, (b) foreign exchange guarantee by the central bank/government and, above all, (c) pursuance of sound macroeconomic policies to stabilise the capital flows.

2.9 An important feature of NRI deposits is that these deposits, like the domestic term deposits, can be withdrawn by the holders at any time, subject to usual penalty at the discretion of banks in terms of interest rate being lowered by one per cent (in addition, FCNR(B) deposits should have run for a minimum period of six months to be eligible for interest) except for savings deposits where no such penalty is applicable. As NRI deposits can be withdrawn at any time, they are different from short-term debt as roll-over problems could occur in the case of short-term debt only on the amortisation date. This option with depositors distinguishes it from other components of external debt which do not enjoy such facility. While bonds issued in the international capital markets come with both call and put options, the present policy restricts the Indian bond issuers in international markets from allowing these options. The fact that almost entire non-resident deposits are repatriable also has implications for foreign exchange markets.

2.10 From the country’s balance of payments point of view, NRI funds can come into India through two channels, namely, remittances recorded in the current account of the balance of payments and deposits which are recorded in the capital account. An increase in remittances (both official and private), helps reduce the current account gap. Such remittances are primarily on a non-repatriable basis and are not a part of the external debt. India is one of the few countries where invisible receipts form a substantial portion of the current account. Net invisible receipts have remained positive for the last 30 years (barring a marginal outflow in the year 1990-91 which witnessed the BOP crisis). Remittances account for a dominant share of inflows from NRIs and have been steadily increasing over the years. Table 6 presents the net invisible flows as percentage of GDP and the net annual inflows on account of private transfers (remittances) as well as NRI deposits. Since 1996-97, net invisible receipts have been amounting to more than two per cent of GDP every year. Within invisibles, the private transfers account for a substantial portion and net private transfers from NRIs amounted to about US $ 14.8 billion during 2002-03 compared to less than US $ 3.0 billion as NRI deposits. As remittances are non-debt flows, it is desirable that such inflows are preferred over NRI deposits which can be withdrawn at any time. In the recent past, it has been the Government policy to reduce the external debt by resorting to pre-payment. It would, therefore, be consistent with the overall debt management policy to make efforts to limit exposure to non-resident deposits.

2.11 In the light of above discussions, the major issue that arises in this context has been that the large increase in non-resident deposits has implications for external debt of the country. Since NRI deposits have to be seen in the overall context of external debt of the country, any sharp change in their levels or shift in their composition needs to be monitored carefully.

2.12 Non-resident deposit schemes were introduced at various stages in the past to attract foreign exchange funds by offering tax benefits, higher interest rates, exchange cover, etc. These deposits earlier offered much higher return in presence of these incentives than otherwise. Gradually, the interest rates on these deposits were aligned to domestic rates and international rates as relevant. While this issue needs further articulation in terms of structuring and rationalisation in the policy area, the Group feels that the policy preference relating to external liabilities management should continue to be in favour of equity as against debt, ensuring at the same time that an increasing proportion of non-resident flows into the country is in the form of remittances.

3.1 Banks in their role as financial intermediaries are part of the process of raising external resources. The external liabilities of banks can be classified into the following major categories:

1. Non-resident deposits
2. Own bonds (e.g., RIB/IMD)
3. Loans
4. Other liabilities
5. Off balance sheet exposure

These are detailed in Annex I.

3.2 An overview of movements in the International Assets and International Liabilities of banks since March 2001 is presented in Table 2. These are based on the International Banking Statistics (IBS) compiled by the Reserve Bank under the Bank for International Settlements (BIS) reporting system and published in article form in the RBI Bulletin on a quarterly basis. The commercial banks and cooperative banks authorised to deal in foreign exchange and accept non-resident deposits (Rupee and foreign currencies) are covered under the IBS system. It needs to be mentioned that the international liabilities of banks covered in IBS, as defined by the BIS, and external debt accounted for by the banking sector in India are not strictly comparable as certain items of liabilities like ADRs, GDRs, equities, etc., of banks towards non-residents are not part of external debt but are international liabilities of banks under the BIS reporting system.

3.3 The key point to note from Table 2 is that the international assets of banks are nearly half of their international liabilities which is a major systemic issue. The international liabilities of banks are predominantly to non-banks though this share has come down from 83.2 per cent in March 2001 to 76.4 per cent in September 2003. Foreign currency liabilities constituted 58.3 per cent of total international liabilities in September 2003 to non-residents. Over 96 per cent of international assets of banks are in foreign currency. The international assets in rupees (comprising of the Rupee loans to non-residents out of the non-resident deposits) are less than 4 per cent. A major shift has occurred in case of international assets of banks in the recent past and over 55 per cent of these assets are with non-banks in September 2003 whereas in March 2001 only 26 per cent of assets were with non-banks. The issue of composition of assets is further examined in Section IV.

3.4 Table 3 presents the trend in major external liabilities of scheduled commercial banks in Rupee terms since March 1997. It may be seen that the NRE deposits have increased more than five-fold since 1997 whereas FCNR(B) deposits have less than doubled during this period. The EEFC balances have declined after reaching the peak level in 2000 whereas the Lines of credit from abroad for Pre-shipment Credit in Foreign Currency (PCFC) and Export Bill Rediscounting (EBR) have increased substantially since 2002. The balances under two schemes, viz., the resident foreign currency (RFC) deposits which is meant for returning Indians, and the resident foreign currency (domestic) [RFC(D)] deposits which is meant for residents, have been showing marginal increase in the recent past (Table 3).

3.5 Tables 4 and 5 present the movements in the quantum and share of various components of external liabilities on banks’ balance sheet to the total external liabilities from March 2001 to September 2003. It may be seen that the share of banks’ deposits/borrowings in foreign currency in external liabilities has increased from 30.6 per cent to 35.5 per cent over this period due to a rise in the share of foreign currency borrowings from less than one per cent in March 2001 to over 10 per cent in September 2003. The share of ADRs/GDRs, increased from 0.6 per cent in March 2001 to 2.4 per cent in September 2003. On the other hand, the share of non-resident deposits has declined from 62.4 per cent in March 2001 to 57.6 per cent in September 2003. Composition wise, while the share of FCNR(B) deposits in the external liabilities has declined from about 25 per cent in March 2001 to about 20 per cent in September 2003, the share of NRE deposits increased from less than 20 per cent in March 2001 to more than 30 per cent over the same period.

3.6 An analysis of the guarantees given by authorised dealers (ADs) to non-residents on behalf of residents shows that such guarantees amounted to nearly US $ 2.9 billion in November 2003 and are largely issued to foreign branches. Guarantees for ECBs were for nearly US $ 0.36 billion in June 2003. Guarantees issued by FIs amounted to another US $ 1.2 billion in June 2003. The present RBI guidelines advise banks that before giving financial guarantees on behalf of customers, they should ensure that the customer would be in a position to reimburse the bank contingent on the bank making any payment under the guarantee. Also, in case of performance guarantees, banks are to ensure that the customer has the necessary experience, capacity and means to perform the obligation. Keeping in view these extant safeguards along side the restrictions relating to the quantum of exposures, the Group feels that the off-balance sheet exposures are not likely to pose any systemic concern as such.

3.7 As discussed earlier, the non-resident deposits constitute a dominant share in the external liabilities of SCBs. Table 7 presents the annual outstanding non-resident deposits (in US dollar terms) under various categories since 1991. The NRO deposits as of now constitute about three per cent of non-resident deposits and are not included in Table 7. Also, with the discontinuation of fresh deposits under NRNR scheme as at end-March 2002, the share of NRNR deposits which stood at around 25 per cent as at that time has gone down substantially to around 5 per cent of total NRI deposits by March 2004.

3.8 The total non-resident deposits have been increasing over the years and have nearly doubled during the past eight years. The increase has been more rapid during the last three years especially in the case of NRE deposits which has increased by around 187 per cent in Rupee terms (195.7 per cent in US dollar terms). A part of this increase can be attributed to the transfer of the maturity proceeds of NRNR deposits. The FCNR(B) deposits registered an increase of 23.3 per cent in US dollar terms during the last three years .

3.9 A noticeable feature in non-resident deposits in the recent past has been that there appears to be a reduction in arbitrage possibilities following the lowering of the interest rate ceiling by RBI in July 2003 (which was subsequently lowered thrice). This has reflected in a slowdown of the growth in NRE deposits in the recent months particularly after September 2003. From Table 8, it may be seen that during 2003-04, the fortnightly average NRE deposits inflow was much lower at Rs.478 crore during September 06–March 19 as against the corresponding figure of Rs.1,309 crore during March 22-September 05, 2003. In contrast, the fortnightly average FCNR(B) deposits inflow increased by Rs.302 crore in the second period as against the decline of Rs.292 crore during the first period.

3.10 Table 9 presents the concentration of non-resident deposits for the last three years based on the information received in Form A (Section 42) return for the three categories of deposits, viz., FCNR(B), NRE and Total (=FCNR(B)+NRE+NRNR) deposits from scheduled commercial banks. More than half of the non-resident deposits with SCBs (53.9 per cent in March 2004) are concentrated with six banks. Also the concentration of deposits is more for the foreign currency deposits when compared to Rupee deposits. Nearly 61.4 per cent of FCNR(B) deposits in March 2004 were concentrated with top six banks as compared with their share of 50.2 per cent of NRE deposits.

3.11 Another interesting aspect has been the increase in concentration of FCNR(B) deposits across banks in contrast to the decline in concentration of NRE deposits. The share of top three banks in total NRE deposits declined from 39.3 per cent in March 2002 to 36.7 per cent in March 2004 whereas their share in total FCNR(B) deposits increased from 43.3 per cent to 45.6 per cent over the same period. This implies that the smaller banks are receiving increasingly higher share of the faster growing NRE deposits. On the other hand, FCNR(B) deposits are getting more concentrated with banks which have been holding large share of such portfolio in the past.

3.12 The fact that banks’ international liabilities are nearly double of their international assets is an issue of systemic concern as it may to translate itself into a liquidity risk in case of crisis of confidence. The concerns as detailed above need to be addressed and good risk management practices put in place to bring down the mismatches to reasonable levels. High forex reserves are a comforting factor but there are several complexities involved. The use of forex reserves by central banks for bailing out domestic institutions raises the moral hazard issue which has been discussed in detail in Section V.

4.1 Banks with a high concentration of external funds (especially FCNR(B) deposits), are in a better position to provide foreign currency loans to exporters/importers. Banks are presently allowed to extend PCFC and EBR facilities to exporters from the foreign currency balances available in EEFC, RFC & FCNR(B) accounts, under ESCROW accounts and also by availing lines of credit from abroad as well as from other banks in India.

4.2 Table 10 presents the international assets of banks classified according to liability type. A majority of these assets are in the form of loans and deposits. The share of Nostro balances (including balances in term deposits with non-resident banks and FCNR funds held abroad) in total international assets of banks has come down from 61.6 per cent in March 2001 to 34.4 per cent in September 2003. On the other hand, the share of foreign currency loans to residents (including loans out of FCNR(B) deposits, PCFCs, foreign currency lending and foreign currency deposits with banks in India, etc.) has increased from 16.2 per cent in March 2001 to 36.4 per cent in September 2003.

4.3 Table 11 presents the quarterly pattern of utilisation of FCNR(B) deposits by 15 major banks since March 2000. It may be seen that the share of foreign currency loans in FCNR(B) deposits increased from 44.8 per cent in June 2000 to 67.4 per cent three years later. Thereafter, it declined to 60.3 per cent by March 2004 (Chart 1).

4.4 FCNR(B) funds provide an important source for foreign currency loans including export credit. Table 12 presents the quarterly data on export credit outstandings in respect of pre-shipment credit in foreign currency (PCFC) and export bill rediscounting (EBR). It may be seen that, since December 1998, line of credit has been an important source of fund for banks for extending export credit in foreign currency and has accounted for 27.1 per cent to 39.5 per cent in the total export credit in foreign currency. The share of finance of PCFC and EBR through funds from major foreign currency deposits of banks (FCNR(B), EEFC, RFC, etc.) was below 4 per cent of these deposits during March 1998 through September 2002. Subsequently, it increased to 26.0 per cent by March 2004. However, it is interesting to see that the period of rapid increase in foreign currency export credit (September 2002 onwards) has not coincided with a major increase in FCNR(B) deposits. In fact, during September 2002 to September 2003, export credit in foreign currency other than those from lines of credit increased by Rs.8,138 crore, though FCNR(B) deposits declined by Rs.3,914 crore during the same period. This was the period of gradual appreciation of the rupee when the FCNR(B) deposit flows were lower but NRE deposits increased rapidly. The seven-fold increase from Rs.1,923 crore in September 2002 to Rs 14,947 crore in March 2004 in foreign currency credit (excluding line of credit) was, therefore, financed by banks despite the FCNR(B) deposits remaining unchanged in rupee terms (Rs.50,689 crore in September 2002; Rs.50,616 crore in March 2004).

4.5 Though the present interest rate ceiling of LIBOR + 75 basis points on export credit in foreign currency is intended to help small exporters, banks are finding it difficult to lend on these rates as these small advances have high transaction costs. Many banks are reported to have levied additional service charges to cover their transaction costs on these advances.

4.6 The Group examined the interest rate ceiling on export credit in foreign currency. It was recognised that the basic issue in export credit in foreign currency is that of pricing rather than availability of foreign currency. It was felt that since banks are permitted to access overseas lines of credit without limit for the purpose of on-lending to exporters, any removal of the interest rate cap will lead to a quantum jump in PCFC as well as in overseas borrowings by banks as this will give them an attractive spread.

4.7 On balance, the Group recommends that the present ceiling on interest on export credit in foreign currency may be deregulated for better availability of export credit in foreign currency though it may lead to higher overseas borrowings by banks. If complete deregulation is not considered feasible, the interest rate ceiling may be raised by 50 basis points to ‘125 basis points above LIBOR’ which will ensure greater availability of PCFC in the short-run by enabling banks to access larger overseas lines of credit at slightly higher rates than before.

5.1 In view of the increase in external liabilities of the banks, it may be that some banks are taking higher risk. This needs to be looked into from the angle of risk on the balance sheet, the growth component and the systemic issues. Especially in case of NRI deposit schemes, the issue needs to be reviewed in the light of the need to rationalize to ensure policy consistency and stability across the deposit schemes and maintaining relationship with the NRIs. In this connection, the Group deliberated on a number of issues involved which are discussed below:

5.2 While NRI deposits have been an important source of external finance, the accretion to these deposits form a liability of the banking system and also impact on the monetary aggregates. Capital inflows translate into overall balance of payments surpluses, which have been absorbed by the Reserve Bank as part of its exchange rate management strategy. This policy in turn has implications for monetary management. As NRI deposits differ in this respect from other components of capital flows, they have been regulated in the recent past as part of overall monetary management in the form of reserve requirements and interest rate stipulations taking into account the trends in external financing requirement and external capital flows.

5.3 In India, the cash reserve ratio (CRR) stipulation on NRE deposits was the same as on domestic deposits in the 1970s. In the 1980s, the CRR was significantly lowered to make these deposits more attractive in the wake of increasing current account deficit. After the external payments crisis of 1990-91, the composition of foreign currency deposits was preferred towards the non-repatriable NRNR deposits from macro-economic management point of view. The FCNR(B) and NRNR schemes were introduced in the early 1990s and were initially exempt from CRR requirements. However, as the NRI inflows steadily rose over the years, reserve requirements were imposed beginning 1994-95 so as to render these deposits relatively unattractive from the point of view of containing monetary impact. In 1995-96, in the wake of then prevailing high volatility in the foreign exchange market, CRR was initially reduced and finally withdrawn so as to facilitate greater flow of such deposits. Subsequently, with a view to bringing all liabilities to public under one umbrella of reserve requirements, incremental CRR was imposed on all deposits with effect from April 1997. While incremental CRR on Rupee deposits was withdrawn with effect from November 1997, that on FCNR(B) deposits was withdrawn from November 1999. Exemptions and multiple prescriptions made over time in response to specific requirements were also withdrawn with effect from November 2001 combined with a reduction in the overall CRR. Though the above movements in CRR were decided by the prevailing economic conditions, the use of SLR for such purpose has been rather limited.

5.4 Different reserve and liquid asset requirements for these categories of deposits alter the relative cost of these deposits which is likely to influence the composition of liquidity between resident/non-resident deposits and domestic currency/foreign currency deposits and also have an impact on the nature of foreign currency intermediation. In the Indian case, the reserve requirements as applicable for resident and non-resident deposits and also for domestic and foreign currency deposits are presently the same. Annex IV gives a brief review of the country practices in case of reserve requirements on external deposits.

5.5 The Group discussed the issue of reserve requirements on external deposits in detail and noted that the reserve requirements on different categories of deposits have already been rationalised. In accordance with the medium-term objective of reducing CRR to the statutory minimum level of 3.0 per cent in the spirit of recommendations of Narasimham Committee II on banking sector reforms, CRR has been brought down considerably over the years. However, the Group recognized that reserve/liquidity requirements are effective instruments of moderating the flows of NRI deposits and the option to influence the cost/return in respect of such deposits through reserve requirements may be left open. However, in the present context, no differential CRR needs to be introduced at this stage for different categories of deposits.

5.6 At present, the income from interest on funds held in NRE/FCNR(B) accounts is exempt from income tax. However, similar concession is not available in respect of balances held in NRO Accounts where deposits are subject to wealth-tax and interest income is subject to Indian income tax at source. In case of NRNR deposits, interest income from deposits will be free from Indian income-tax and deposit is also exempt from Gift-tax for one-time gifting in case of NRIs.

5.7 The Group deliberated at length on the existing tax regime governing NRI deposits including the appropriateness of the existing tax incentives. The Group feels that tax concessions on NRI deposits were given in the period of difficult balance of payment (BoP) conditions and low forex reserves to attract such deposits. Over the years, forex reserves situation has improved. The quantum of NRI deposits has increased substantially and their share in the country’s external debt is continuously increasing. The interest income on resident deposits as also on external commercial borrowings is taxable. Keeping these factors in view as also the need for maintaining uniformity of treatment, the Group recommends that interest income on non-resident deposits may be made taxable on par with domestic deposits and external commercial borrowings (ECBs) consistent with the current account convertibility.

5.8 The interest rate arbitrage could occur to restore interest parity and on exchange rate expectations. Under this dispensation, an investor in a country where interest rate is low would convert his funds into the currency of a country having high interest to benefit therefrom. The investor’s gain through the interest rate differential may be offset by a possible loss stemming from exchange rate changes. In the recent past, in the Indian case, while the former argument seems to have worked, the latter explanation did not hold. Though the domestic interest rate was relatively high, currency was appreciating against the US dollar though depreciating against other major currencies. However, the positive interest rate differential coupled with appreciating currency prompted large NRI inflows into Rupee accounts till the cap on interest rate was placed after which such inflows slowed down due to the reduced arbitrage opportunity.

5.9 As regards the FCNR(B) deposits, the scope for arbitrage due to interest rate differential seems to have disappeared, following the fixation of ceiling of interest rate offered on the former at 25 basis points lower than the corresponding international interest rates. However, though the interest rate on NRE term deposits has been capped, the interest rate applicable on NRE saving deposits continues to be the same as the interest rate on domestic saving deposits. This, in a way, gave rise to the anomaly of the short-term rate being higher than the long-term fixed deposit rates in the present context.

5.10 The quarterly data on NRE savings deposits obtained from four banks which have a significant share of NRE deposits along with their corresponding total NRE deposits based on the information supplied in the Form A (Section 42) return by them are presented in Table 13.

5.11 An analysis of NRE deposits for the selected banks showed that the share of new NRE savings deposits in the total new NRE deposits increased considerably once the ceiling on NRE term deposits was introduced in July 2003. After the ceiling was further lowered in October 2003, the incremental share of NRE savings deposits in total NRE deposits increased from 6.6 per cent in April-June 2003 to 39.5 per cent in July-September 2003 and further to 97.5 per cent in October-December 2003. This implies that while the NRE deposit inflows have come down in view of the reduced arbitrage opportunity in case NRE term deposits (as discussed in Section III.4), fresh NRE deposit inflows are largely reflected in NRE saving deposits due to the higher interest rate on NRE saving deposits.

5.12 The Group deliberated in detail on the issue of the present equivalence between the interest rate offered on domestic and non-resident savings deposits. It was felt that the saving accounts are not intended to be maintained for large deposits and, in the present context, NRE saving deposits are providing avenues for interest rate arbitrage. The NRE savings deposits are repatriable and can be drawn down sharply without penalty. The Group, therefore, recommends that NRE savings deposit interest rate and the domestic savings deposit rate could be delinked to reduce the scope of arbitrage as also to avert the scope for using the NRE saving accounts for unintended purposes. This option seems to be better than that of putting a cap on the quantum of NRE saving deposits which may be operationally difficult to implement. The Group recommends that interest rate on NRE saving deposits may be reset on a quarterly basis and may have an interest rate ceiling of one month US dollar LIBOR.

5.13 The Group feels that interest rates on non-resident deposits should be close to international rates available on similar tenor. In this context, the Group recommends that the interest rate on NRE term deposits may be changed to LIBOR of the corresponding maturity instead of the present rate of LIBOR plus 25 basis points.

5.14 The NRO deposits are the only category of non-resident deposits where the principal amount is non-repatriable. However, current income and interest up to US $ 1 million per calendar year is repatriable out of NRO balances/sales proceeds of assets. The large window for making remittances makes it virtually repatriable. In case of NRO accounts, banks are free to determine the interest rates except for the NRO saving deposits where interest rates are the same as domestic saving deposits. It was felt that in the present context of substantial inflows, there is little utility of non-repatriable deposit scheme. Also the interest rates on NRO deposits are deregulated (except for the savings deposits) and arbitrage opportunity exists. Therefore, interest rates on all non-resident deposit schemes need to be closer to the corresponding international interest rates.

5.15 In the light of the above, the Group had detailed discussions on the feasibility of discontinuation of NRO deposit scheme on the lines of NRNR deposits where fresh deposits were not accepted after March 2002. NRO deposits presently account for nearly three per cent (nearly Rs.3,600 crore in September 2003) of the total non-resident deposits. Interest income from NRO accounts is taxable and these accounts are intended to be mainly used for transactional purposes. Funds which do not qualify under the present regulations for remittances outside India are required to be credited under NRO accounts. It was recognized that the NRO scheme also serves the requirements of foreign nationals resident in India. Also, the average balances under NRO savings deposits are relatively small as these are generally maintained by small depositors for their operations in India.

5.16 Taking the above factors into account, the Group recommends that the NRO deposits should be in the nature of current or savings accounts only. The existing NRO term / recurring deposits may be allowed to be maintained till maturity after which the balances may be allowed to be repatriated or may be credited to NRO/NRE saving/current deposits if the account holder so desires. This would, in a sense, tantamount to further current account liberalization.

5.17 As discussed earlier in Section III, the spread of non-resident deposits is highly skewed and six banks accounted for more than half of non-resident deposits. At present, authorised dealers (ADs) and banks specifically authorised by RBI can maintain accounts in the name of NRIs. In addition, Financial Institutions, Non-Banking Financial Companies (NBFCs), Residuary Non-Banking Companies (RNBCs) and certain co-operative/ commercial banks (referred to as authorised banks) have been specifically permitted to maintain NRI rupee accounts even though they may not be ADs. RBI has recently clarified (March 18, 2004) that no entity other than a licensed banking company can solicit foreign currency deposits from residents. A company registered under the Companies Act, 1956 or a body corporate or created under an Act of Parliament or State Legislature can accept deposits from NRIs on repatriation basis subject to certain terms and conditions. Also an Indian company or proprietorship concern or a firm in India can accept deposits from NRIs on a non-repatriation basis under certain conditions.

5.18 Since Rupee accounts do not involve foreign exchange risk for banks, any restriction on acceptance of Rupee deposits from non-residents needs to be looked into from the point of view of non-resident customer relationship, the prevention of possible money laundering and the implementation of the Know Your Customer (KYC) policy in case of non-banks. In the present context, NRE deposits are additional source of funds for the institutions mobilizing these deposits. It is, however, important to mention that non-bank entities like NBFCs/RNBCs/MNBCs/non-financial corporates which accept NRI deposits, do not have DICGC cover. From the point of view of maintaining relationship with NRIs and for restricting any unscrupulous transactions involving money-laundering, it may be useful to phase out non-banks from accepting non-resident deposits and restrict the acceptance of NRI deposits to authorised dealers (ADs) as they are part of the network that extend credit in foreign currency. To smoothen such transition, any institution which is prohibited from accepting NRI deposits as convergence faces transitional problem, may approach RBI for special dispensation with a structured transition plan.

5.19 Banks in India are considered as implicitly guaranteed by the Government even though the DICGC cover is available for deposits up to a limit. In some cases, issues relating to international liquidity in balance sheet of banks can pose systemic problems affecting the general confidence of the public in the banking system. In the case of the Indian banking system, it was seen earlier (Section II and Table 2) that the foreign currency liabilities of banks were over 20 per cent more than their foreign currency assets and their international liabilities were nearly double of their international assets.

5.20 In the process of liberalizing capital controls, higher forex reserves are required to ensure adequate liquidity, as shortage of reserves would be costly as has been seen in the context of the Asian financial crises. However, the policies towards the management of liquidity risks have to be framed keeping in view the health of the financial system, the risk management practices, the level of unhedged foreign currency borrowings and the moral hazard of encouraging domestic borrowers to expect the Government/central bank to bail them out in the event of crisis. Any hedging within the domestic banking system may not provide adequate comfort as exposure is not reduced at the overall level.

5.21 Though central banks in many countries (e.g. Norway, Sweden and Korea) have used their forex reserves to give liquidity support to the banking sector to meet the inter-bank liabilities denominated in foreign currency, it needs to be recognized that the use of forex reserves to meet a banking crisis can send a wrong signal and, in some cases, may lead to a currency crisis. The reliance of the banking system for such purposes, therefore, needs to be reduced by promoting self-reliance within the system. This needs to be approached by relating exposure limits to certain assets and also through ensuring proper risk assessment systems in banks.

5.22 In terms of implications for the health of the banking system, foreign currency deposits are different from the Rupee deposits. The foreign currency deposits bear exchange rate risk which the rupee deposits do not. Exchange risk in mobilising NRI deposits of banks is a potential gain or loss for banks that occurs as a result of an exchange rate change. Banks face such a risk in mobilising NRI deposits in foreign currency.

5.23 In the case of NRE and NRO deposits, banks do not face any exchange risk as they are repayable in domestic currency. In the case of FCNR(B) deposits, the bank bears the exchange rate risk which is partly covered through hedging and appropriate risk management systems. Further, to cover themselves from the exchange risk, banks resort to maintaining assets like foreign currency loans, overseas investments, etc. where they get returns linked to international interest rates. Banks face credit risk in case of loans given against such deposits and, therefore, need to monitor their borrowers’ foreign exchange risk. The other external liabilities in foreign currency like EEFC, RFC, etc., can also be used for giving export credit, advances against such deposits, etc.

5.24 It emerged from Section IV that FCNR(B) deposits have not been used extensively for pre-shipment credit in foreign currency (PCFC). The latter is financed more by way of lines of credit and other sources. Though over one-half of FCNR(B) funds are used for giving foreign currency loans (FCL), the share of FCNR(B) loans to exporters is very low as non-export FCL are more profitable to banks in the absence of interest rate cap on them. However, these deposits are still useful sources of foreign exchange for banks and are relevant from the point of view of maintaining relationship with NRIs. The Group, therefore recommends, that the scheme may be continued in its present form.

5.25 Dollarisation occurs when residents of a country extensively use foreign currency alongside or instead of the domestic currency. In case of unofficial dollarisation, residents hold much of their financial wealth in foreign assets to protect against losing wealth through inflation in the domestic currency even though foreign currency may not be a legal tender as against the full dollarisation when foreign currency has exclusive or predominant status as full legal tender. The demand for foreign assets will be high in the case of crisis of confidence in the banking system in any emerging economy. Dollarised systems are prone to higher risk as they are exposed to both solvency and liquidity risks and, therefore, the entities with large foreign currency liabilities must balance their foreign exchange positions by either extending foreign currency lending to local currency earners or holding foreign currency assets abroad.

5.26 The recent liberalization in the foreign exchange regulations has, among other facilities, allowed the residents to open Resident Foreign Currency (Domestic) (RFC(D)) accounts. The original RFC account facility which is available for returning Indians is presently interest bearing whereas the EEFC and RFC(D) accounts are non-interest bearing. Moreover, transactions using foreign currency are only allowed in select current and capital account items and RFC accounts are allowed for specific small proceeds which would not support dollarisation of Indian economy. Again under the recently released Liberalised Remittance Scheme (LRS), residents are allowed to make remittance upto US $ 25,000 per calendar year for any current/capital account transaction. LRS allows remittances of Indian residents to foreign countries and, therefore, discourages dollarisation in India. The scheme permits remittances for investments by resident Indians from their own sources for the sole purpose of utilisation abroad.

5.27 At present, the foreign currency deposit schemes (EEFC/RFC/ RFC(D)) available to residents do not constitute a significant proportion of the deposit accounts and the ratio of foreign deposits held by residents to total deposits is lower than one per cent which is not large enough to render the system vulnerable to the effects of dollarisation. The Group feels that all these accounts are essentially for transaction purposes and, therefore, they need not be interest-bearing. The Group recommends that the original RFC accounts may be allowed only in the form of current account. However, the existing term deposits may be allowed to continue till maturity. Also, regular review of the external liabilities at the aggregate level is necessary to ensure that the country is not exposed to the risk of dollarisation.

6.1 The Group examined the issues relating to the external liabilities of banks in the light of the changing pattern of India’s external debt and the capital flows, the utilisation pattern of external sources of finance, the relationship with NRIs, the systemic issues relating to health of the domestic banking sector, the cost of such funds, the opportunity for arbitrage and the risk of dollarisation.

6.2 The Group based its decisions on the following principles:

• External liabilities of banks need to be seen in the overall context of external debt. As non-debt creating remittances have been consistently accounting for a dominant component of NRI inflows, the deposit component which has implications for external debt needs to be evaluated cautiously;
• In the matter of capital inflows, there should be a continued policy preference in favour of equity as against debt;
• Non-resident deposit schemes provide linkage between the domestic and international markets. The relationship has to be seen both from macro and individual considerations;
• Interest rate on external deposit schemes should be comparable to international interest rates as these are essentially debt flows;
• The acceptance of NRI deposit schemes may be restricted to increase the effectiveness of policy changes relating to these deposits from the point of view of asset-liability structure of entities accepting such deposits;
• Non-resident accounts meant for transaction purposes may be allowed only in non-interest bearing form;
• Foreign currency accounts available to residents for transaction purposes should be non-interest bearing; and
• Tax treatment and differential reserve requirements are important instruments for moderating NRI deposit flows as witnessed in the past.

6.3 On the basis of the above principles and the analysis contained in previous sections, the conclusions and recommendations of the Group are as follows:

• Non-resident deposit schemes were introduced at various stages in the past to attract foreign exchange funds by offering tax benefits, higher interest rates, exchange cover, etc. The share of NRI deposits and other foreign currency deposits in total external debt has increased from 12.2 per cent in March 1991 to 25.8 per cent in December 2003. NRI deposits can be withdrawn at any time whereas the rollover problem could occur in the case of other debt components only on the date of amortisation. In the recent past, there have been attempts to reduce India’s external debt by prepayment but NRI deposits have been a major source of increase in external debt during this period. The Group is of the view that in the fast-changing international scenario, there are dangers of excessive short-term debt and its share in overall external debt should be low.

(paras 2.7 - 2.11)

• The off-balance sheet exposures of banks in terms of foreign currency are restricted with safeguards on the quantum of such exposures and they are not likely to raise any systemic problem.

(para 3.6)

• Past experience shows that export credit in foreign currency is being financed by lines of credit and other sources in addition to the use of FCNR(B) deposits. The Group feels that the basic issue in export credit in foreign currency is that of pricing rather than availability of foreign currency. For better availability of export credit in foreign currency, the Group recommends that present ceiling on interest on such credit may be deregulated. If complete deregulation is not considered feasible, the interest rate ceiling may be raised by 50 basis points to ‘125 basis points above LIBOR’ which will ensure greater availability of PCFC in the short-run by enabling banks to access larger overseas lines of credit at slightly higher rates than before.

(para 4.5 – 4.7)

• The reserve requirements (CRR) and liquidity requirements (SLR) on various categories of deposits (resident / non-resident; domestic / foreign currency) are effective instruments of moderating the flows on NRI deposits and the option to influence the cost / return in respect of such deposits through reserve requirements may be left open. However, in the present context, these may be left unaltered.

(para 5.5)

• Non-resident deposit schemes were given tax benefits in the past to attract foreign exchange funds in the times of pressing BoP requirements. However, over the years, NRI deposit inflows have become much larger and there is no need to give such benefits on these deposits in light of the comfortable forex reserves. The Group recommends that interest income from NRI deposits may be made taxable on the lines of domestic deposits consistent with the current account convertibility.

(para 5.7)

• The linking of NRE saving deposits rate to the domestic interest rate, which is higher than the international interest rate, is providing arbitrage opportunities. Saving accounts are not intended to be maintained for large deposits but are presently providing clear avenues for arbitrage. The Group feels that the NRE savings deposit interest rate needs to be delinked from domestic savings deposit rate especially because NRE savings deposits are repatriable, and can be drawn down sharply without penalty as also to avert the scope for using the NRE savings accounts for arbitrage. This would be a much better option than putting a cap on the quantum of NRE savings deposits which may be operationally difficult to implement. The interest rates on NRE saving deposits may not exceed the one-month LIBOR/SWAP rates on US dollar deposits.

(para 5.12)

• The Group feels that interest rates on non-resident deposits should be close to international rates available on similar tenor. In this context, the interest rate on NRE term deposits may be changed to LIBOR of the corresponding maturity instead of the present rate of LIBOR plus 25 basis points.

(para 5.13)

• The Group is of the view that all non-resident deposits should be repatriable when the forex reserves position is comfortable. The Group recommends that NRO deposits may have the nature of current/ savings accounts only. The existing term/recurring deposits under NRO scheme may be allowed to be maintained till maturity after which the balances may be allowed to be repatriated or may be credited to NRO/NRE savings/current deposits if the account holder so desires.

(para 5.15 – 5.16)

• The Group is of the view that in order to increase the effectiveness of the policies relating to NRI deposits, to ensure good service to NRIs and also to prevent money-laundering, the non-banking financial companies and non-financial corporates should be phased out from accepting NRI deposits. The Group recommends that the acceptance of NRI deposits should be restricted to only Authorised Dealers who have better Know Your Customer policy when compared to non-banks and others.

(para 5.18)

• The international liabilities of banks are nearly double of their international assets. Any liquidity support by Government/ central bank to the banking sector to meet their asset-liabilities mismatch involves the moral hazard of encouraging domestic borrowers to expect the Government / central bank to bail them out in the event of crisis. The Group feels that in order to keep the systemic risks at bay, the external liabilities and assets of banks need to be regulated to ensure that the mismatch is not high and appropriate risk assessment systems are in place. Banks need to maintain good risk management systems to effectively use the larger availability of foreign currency in the system for expanding their business.

(paras 5.19 – 5.21)

• The Group is of the view that the country is not exposed to any risk of dollarisation for the present. However, continuous monitoring of the external liabilities becomes imperative so as to ensure that the country is not exposed to the risk of dollarisation. All foreign currency accounts that are allowed to residents for transaction purpose should be non-interest bearing so that the risk of dollarisation is under check. The Resident Foreign Currency (RFC) scheme may be made non-interest bearing. The EEFC and RFC(D) accounts should continue to remain non-interest bearing.

(para 5.27)

(Amount in US $ million)

Note: (i) Foreign Currency Assets include loans to residents/non-residents, Outstanding Export Bills, FC lending to banks in India, FC deposits with banks in India, Overseas FC Assets, Remittable profits of foreign branches of Indian banks, etc.

(ii) Rupees Assets with Non-residents includes Rupee loans to non-residents out of non-resident deposits.

(iii) Foreign Currency Liabilities are both to residents and non-residents.

(iv) Rupee Liabilities are liabilities to non-residents denominated in Indian Rupees.

(v) All Figures are inclusive of accrued interest

(v) Figures in parentheses are the percentage share in total assets / liabilities.

(vii) Data pertain to the reporting branches of banks under International Banking Statistics for the BIS System (Quarterly Article in RBI Bulletin).

(Rs. crore)

(Rs. Crore)

Note : In view of the incomplete data coverage from all the branches, the data reported under the IBS are not strictly comparable with those capturing data from all the branches.

(Amount in US $ million)

(in US $ million)

@ Including the amount raised through RIB and IMD schemes

Table 8: FCNR(B) and NRE deposits – Scheduled Commercial Banks

(Rs. Crore)

Note: Banks are ordered on the basis of their outstanding non-resident deposits in March ’04.

Table 12: Export Credit in Foreign Currency (Rs.crore)

(Amount in Rs.crore)