The government is reviewing its proposal for taxing non-resident external deposits. In the Budget for 2004, the government had proposed to withdraw from April 1, 2005, tax exemptions on such deposits.

According to sources, the government's rethink has been prompted by fluctuations in foreign exchange inflows, growing import payments and increased pressure on banks to hike deposit rates to cope with the growth in credit.

The government, it is understood, was initially planning to tax only incremental deposits from the next financial year. However, it may not go ahead with the plan and leave all NRE deposits tax-free for some more time.

Market sources said with liquidity and interest rates likely to be under pressure in the new fiscal year, the Reserve Bank of India [Get Quote] might also roll back the hike in banks' cash reserve ratio in the coming credit policy in April. The CRR was hiked by 50 basis points in two tranches in September 2004, sucking out over Rs 8,500 crore (Rs 85 billion) from the financial system.

The rate of accretion of foreign exchange reserves has been gradually slowing down. Foreign exchange inflows are expected to be moderate in the new fiscal year as interest rates have been going up globally, especially in the US.

With the interest rates on NRE deposits having gone down, banks are not attracting much of these deposits. Raising foreign currency borrowings by banks is limited to 25 per cent of their tier I capital and the interest rate on foreign currency non-resident deposits (FCNR(B)) is capped at 25 basis points below the London Interbank Offered Rate.

An internal RBI group on the external liabilities of scheduled commercial banks had recommended that interest income from NRI deposits be made taxable in line with those on domestic deposits.

The report was of the view that NRI deposit inflows had grown much larger and, therefore, the tax benefits were unwarranted in the light of the comfortable foreign exchange reserves.