Over 20% returns: How NRIs could make a killing after banks hike FCNR(B) deposit rates

The leverage is 2x if a person borrows two times the money they have, or their capital; it is 10x if ten times the capital is borrowed. For NRIs, it is this use of leverage that can allow them to make fantastic returns from FCNR(B) deposits.

Suppose a non-resident in the US wants to deposit $1 million in an FCNR(B) deposit for three years. While simply depositing this money will offer an annual rate of interest of 6%, the NRI can go to an American bank and borrow $10 million — also for three years — at their lower interest rates and put the borrowed money in the FCNR(B) deposit.

Currently, a three-year loan in the US will cost around 4.5% or so.

In summary, the interest earned from the FCNR(B) deposit of $11 million in Year 1 is $660,000. Meanwhile, interest spent on the borrowed $10 million is $450,000. This results in a net gain of $210,000.

After three years, the FCNR(B) deposit of $11 million at 6% interest will be worth a total of $13.1 million. Repayment on the $10 million loan from the American bank at 4.5% rate of interest will total $11.4 million. This leads to a total gain of roughly $1.7 million over three years on a capital of $1 million — or a compounded annual rate of interest of 19.3%.

“We estimate that with 7-10x leverage and spread of 1.5-2%, customers can generate 17-27% $-IRR (internal rate of return) annually over 3-5 years,” Jefferies analysts said in a note.

Equity-like returns

Of course, two crucial factors determine how high this final rate of return may be.

The first is the difference between the rate of interest on the FCNR(B) deposit and the rate at which NRIs can borrow abroad to leverage their capital. The greater the difference (or spread, in financial parlance), the greater is the return.

The second is the leverage. The higher the leverage, the higher the return. 

As economists from Emkay Global Financial Services note: “Returns from the scheme approach equity-like returns as leverage is increased”. And as investors take advantage of the ability to take leverage, “flows under the scheme could be at least $50-55 billion (around 1.2% of GDP) and possibly even higher”.

RBI’s 2013 swap scheme effect on FCNR(B) deposits.

In 2013, when the swap scheme was first announced as a temporary measure to boost foreign inflows, NRIs used leverage to pour in $26 billion — around 1.4% of India’s GDP at the time — into FCNR(B) deposits. HDFC Bank had raised the most FCNR(B) deposits back then.

Allowing leverage

But how is the NRI able to use leverage in the first place? Because of something called a letter of credit.

Normally, Indian banks can’t issue guarantees or letters of credit — called non-fund based (NFB) facilities that smoothen business transactions — that assure repayment of money that has been borrowed. However, the RBI has decided this rule does not apply for the purpose of this FCNR(B) swap scheme.

As such, an NRI can get a letter of credit from the Indian bank with which they are making the FCNR(B) deposit and use it to borrow from the American bank, who is now assured of being paid back by the NRI once the FCNR(B) deposit matures. 

The NRI wins, the American bank wins, the Indian bank wins, and the Indian economy wins.