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Fixed Income

The Low Risk NRI Mega Return Through Leveraged FCNR Deposits

Foreign banks are now rushing to fund Non Resident Indians who can invest the money into Indian dollar deposits under the FCNR scheme. The RBI has reduced the hedging cost of the FCNR deposit to 3.5%. (This applies for a 3-5 year term)

So the banks that offer about 5% in dollar terms. will have to earn about 8.5% which is a low cost of funds.

This can be hugely profitable if you are an NRI. Let us say you can borrow for 3 years on a balloon payment basis at 4% fixed rate. (that is, you get to pay only interest on the loan for therand then all the principal at the end) You borrow $200,000 against, say, a car or house and put it into an FCNR deposit with a bank in India at 4.95% for three years.

You will get an interest of $9,900 in year 1. And then, you must pay out $8,000 to your bank, and you keep the remaining $1,900. There is low risk of rupee drop or such because the 4.95% is guaranteed.

The return is magnified by the leverage. Assume you put in $50,000 in the same above scheme. Your return will be $2,475 on your own money plus the $1,900 you make on the borrowing (net). A return of about $4,375 on a 50K capital, which is more than 8% – a great return in dollar terms.

Of course, you do risk that the bank goes bust, but hey, one’s gotta take risks no?

There is a risk that US residents face a complicated tax regime (FCNR proceeds are not taxed in India, but they will be in the US). But residents in the middle east don’t have to deal with that.

Another risk is: falling Indian interest rates. If rates were to fall, a bank may not be able to invest and get the 8.5% they need to break even. This too is a low risk.

The last risk is: the rupee goes back to 75 from today’s 62. The NRI that invested $100,000 will get the bank Rs.6.2 million (62 lakh) today at a rate of Rs. 62. In a year, the bank needs to pay interest of Rs. 306,000 at a conversion rate of 62 (4.95% interest rate). But at Rs. 75 to a dollar, they may pay Rs. 371,000. That means their 62 lakh rupees should now earn at least 6% interest and including then the hedge cost of 9.5%!

Overall, this is a nice financing scheme for banks. The FCNR deposit gives them rupees at an effective rate of 8.5% (most banks are at this rate effectively, offering about 5% for a three year deposit and including the hedge cost of 3.5%).

But it’s a great return for the NRI – and with banks creating loan products to fund the exposure, this is going to take off in a big way. However, leverage always has a downside we can’t imagine today – I wonder what the catch is here.

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