What are foreign currency non-resident deposits?
Foreign currency non-resident deposits, usually abbreviated as FCNR(B) – the B stands for banks, are term deposits that non-resident Indians (NRIs) can open with banks in India.
These deposits are denominated in foreign currencies permitted by the Reserve Bank of India. This term deposit was started in 1993 and is available in tenures of one to five years. 

How does FCNR(B) it work?
Under the FCNR(B) scheme, banks have to pay an annual interest at a rate of LIBOR/Swap plus 200 basis points for terms between 1-3 years and LIBOR/Swap plus 300 basis points for terms between 3-5 years. 100 basis points is 1 percentage point. LIBOR or London Interbank Offered Rate is the benchmark interest rate at which international banks lend to each other. These vary according to currencies and the term for which the loan is taken.

This structure is decided by the RBI and banks use the LIBOR rate on the last working day of a month to fix the FCNR(B) rate for the following month.

Why was FCNR(B) started?
FCNR(B) goes back to 1975 when they were known as FCNR(A) – with A for accounts. FCNR deposits where started in order to shore up foreign exchange. This was the pre-liberalisation era and there were very few ways that India could raise funds – foreign exchange reserves are used by a country to finance its current account deficit (CAD).

What is a currency risk?
Indian banks have most of their deposits in rupees and thus make most of their investments in the Indian currency. When a NRI invests $1,000 under the FCNR(B) scheme for 3 years, it raises the bank’s deposits by Rs 67,000 (considering $1=Rs 67). The bank then invests this amount.

But in case over the period the value of the rupee depreciates to Rs 69. The bank will have to spend Rs 69,000 to get pay back the $1,000. (This excludes interest payments). This is called currency risk. On the other hand the bank stands to gain if the rupee appreciates.

If banks are dealing in FCNR(B), where does the RBI come in?
RBI came into the picture in 2013 when it introduced the three-month swap window for FCNR(B) deposits with a term for three years or more. Under this swap window RBI allowed banks to exchange (or swap) their FCNR(B) deposits with it by paying an interest at a fixed rate of 3.5%. During the period, the interest rate ceiling on these deposits was also increased to LIBOR/Swap plus 400 basis points.

The idea meant giving banks a 3.5% subsidy to bring in foreign exchange.

But why did banks want to pay 3.5%?
In order to shift the currency risk to the RBI, the 3.5% can be considered as the banks’ hedging costs. If the swap window did not exist banks would have had to hedge rupee depreciation risk by entering swap agreements at as high as 7% as at that time the rupee was seeing significant downward pressure.

How FCNR’s will put additional pressure on strength of rupee adding to the demonetisation effect?
80% of the FCNR(B) deposits swapped during the three-month were of a three-year tenure. This means that the banks swapped around $27 billion (Rs 1.67 lakh crore) between September and December 2013 with the RBI for rupees.

Now RBI will have to give back the money in dollars. The average exchange rate in September-December 2013 was Rs 62. At present, the exchange rate is hovering around Rs 67, down by 8%. But banks will pay back the amount with an annual interest of 3.5%, which means for the banks the effective exchange rate will be around Rs 69.

For the banks, this was a decent hedge – with only a minor depreciation – as they would have invested the money exchanged from RBI in high-return assets. On the other hand RBI will not have to bear any currency risk.

Post demonetisation effect, the redemption of FCNR's in foreign currency will generate the demand of US dollars, leading to the further depreciation of rupee.