This is a comprehensive answer about FCNR (Foreign Currency Non Resident) accounts. It answers the question, but does more than that for the general interest of readers.
My answer will tell you everything about FCNR accounts.
Background about FCNR
Many Indians living outside India earn in foreign currency. They have two options to invest their savings:
- Invest in foreign country – interest rates are very low in developed countries (about 1% in US). Hence their net returns will not be very attractive.
- Invest in India – They can get higher rate of interest in India (about 6%). But they would need to convert that money into rupees before depositing, and then convert it back into US dollars while withdrawing. During this time, if the dollar exchange rate rises, then their money’s return will fall. Hence, there is a risk in this option. Read more about currency fluctuation in the footnote. 
So they can choose a low return option, or a high return option with more risk. None of these options are absolutely convenient, hence there is a dilemma.
Reserve Bank of India had a solution!
What is FCNR account and why did RBI start it?
Indians living abroad now have a third option. They can invest their money in Indian banks without exchanging it into Indian Rupees. Hence, the problem of risk is solved. Further, the rate of interest is also higher than the interest rates prevailing in foreign countries. So, FCNR would be more attractive for the foreign investors.
RBI started the concept of FCNR long back. It was promoted a lot during 1980s. The main reason behind this scheme was that it allowed the inflow of foreign currency in India. We need US dollars to make payments for our import bills, such as oil.
One way to get dollars is to export from India, and another route is FCNR .
What do Indian banks do with those US dollars?
Banks can’t use the US dollars in India, only option is to convert the dollars into rupees. But, when they do this, they are actually taking the risk of that currency fluctuation.
But RBI covered this risk for the banks. So, this is what used to happen:
- Banks would get deposits from NRIs at a rate slightly higher than US rates
- Then they would convert this money in rupees and use it in India
- After the deposit period is over, they would convert back to dollars and return the money to the NRI
- In this process, if they lose money due to exchange rate, RBI will pay them.
NRIs were happy as they were getting higher returns without any risk. Banks were happy as they got more deposits without any currency risk. RBI was also happy as they were getting more foreign exchange which they needed to pay the country’s import bills.
All was well, until…
Why did the RBI close the original scheme?
In early 1990s, FCNR(A) was proving to be a costly affair for RBI. This was because the exchange rate was constantly rising and RBI was always in a loss. During that time, the Indian Rupee constantly depreciated against the dollar. See the sharp increase in the dollar’s price between 1988 and 1992 :
This means that if somebody had opened an FCNR account in 1986 and withdrawn in 1992, then the whole loss of rupee depreciation was borne by the RBI.
As a result of this, there was a massive loss to RBI. This was one of the reasons why India’s forex reserves depleted in early 1990 and groundbreaking 1991 reforms were needed. 
Hence, RBI had closed this scheme in 1994.
New scheme – FCNR (B) was launched
When the RBI closed this scheme, it was very good for RBI itself, but the NRIs were unhappy. They obviously wanted this scheme to continue. Hence, RBI introduced this scheme again with one big difference: currency risk will be with the banks.
As per this scheme, the RBI did not cover the exchange risk for the banks. So the same scheme can be offered by the banks, but if they lose money due to rupee depreciation, then RBI will not help them. (details of the scheme can be found here ).
In such a scenario, a natural question to ask is: why would Indian banks be ready to offer deposits to NRIs and absorb the currency risk?
How do banks manage this risk?
Banks can hedge this risk in the forward market. This is how hedging works:
Assume that banks accept deposit of $100 from the NRIs, when exchange rate is ₹ 60. We can assume the rate on FCNR (B) account as 4%. So, banks have to pay back $ 104 after one year. Who knows what the exchange rate will be after one year?
So, this is what the bank will do –
- Take a forward contract with other people for US dollars after one year – assume the rate to be ₹ 62. A forward contract means that, after one year, the bank will get US dollar at ₹ 62, regardless of what the actual rate is on that date.
- Now, the bank converts the NRI’s money into Indian rupees at today’s rate (which is ₹ 60 * $100 = ₹ 6000). They can give this money as a loan to anyone in India. Assume they give this as a housing loan in India at 10%
- After one year, the bank gets back ₹ 6600 from the housing loan in India.
- After one year, they need to purchase $ 104 at the rate of ₹ 62 (see point 1 above). The total cost becomes ₹ 6448.
- Hence, after one year the bank receives ₹ 6600, and gives ₹ 6448.
- Net profit of the bank is ₹ 152
So, everything depends on the hedging cost…
Take your time to absorb the above calculation. The interesting thing is that, in this whole situation, the bank earned profit because they enter into a forward contract at the rate of ₹62. What would have happened if the forward contract was at ₹ 64? The bank would have lost money! Check the calculation yourself.
Hence, the entire gain of the bank depends on the cost of hedging. If the hedging is cheap, then the banks will be happy to give FCNR deposits, otherwise not.
What is the cost of hedging?
In the above example, we saw that the bank was earning 10% on the housing loan. But, it was giving 4% to the NRI, and 3% for hedging. Note that the cost of hedging was ₹2 on ₹60. That is, extra ₹2 as a premium, which translates to 3% of ₹ 60 (today’s rate)
So the total cost of the bank is 4% + 3% = 7%. Now, if the bank can give a loan at more than 7% (in our example, it was 10%), then the bank will be happy with FCNR deposits, because they would still make money.
But, assume that the forward rate was ₹ 64. In this case, the cost of hedging is ₹ 4 (that is, ₹64 minus the current rate of ₹60). This means ₹4 / ₹60 = 7%. So the total cost is 7% + 4% = 11%. In this situation, the total cost of FCNR (B) is 11%, whereas the bank is earning 10% on the housing loan in India.
Read more about hedging, if you are interested, in the footnotes 
What happened in 2013, when Raghuram Rajan came?
Now our story starts to get interesting. Raghuram Rajan joined as RBI governor in 2013 amidst a very bad time for Indian economy. The rupee was at it’s all time lowest then, at over ₹ 68 for one dollar. Something had to be done to bring down the exchange rate.
One way to do that is to increase the supply of US dollars in India. So, Raghuram Rajan encouraged the banks to accept more FCNR deposits from NRIs.
How did he do that? He gave the banks a choice to hedge their FCNR cost at a cheaper rate. Think about what we discussed above: banks are ready to accept FCNR deposits if their cost of hedging is low, right?
In 2013, RBI gave the banks a swap scheme, through which they could hedge their FCNR deposits at the rate of 3.5%. This scheme was effective because, at that time, the normal cost of hedging for banks was above 7%, hence this option of RBI was effective for the banks to hedge their forex risk effectively 
How did this scheme affect the RBI?
Now, do you see the funny side?
The original FCNR (A) scheme was closed because RBI did not want to absorb the currency risk. Remember what happened the last time we tried that? But, by giving this option of hedging, RBI again did the same thing: they absorbed the currency risk.
Only difference is that this was a temporary scheme. It was applicable only for three months in 2013. Raghuram Rajan’s idea was brilliant – it actually generated a lot of FCNR deposits. Some reports said that they actually raised $ 32 billion after this scheme .
This scheme affected the RBI in two ways: one – it got the foreign currency that it desperately needed to pay India’s import bills; and two – it came at a cost in the future. That cost… was the cost of currency risk!
Why is this topic relevant now?
In September 2013, many banks exercised the hedging option for three years. This means, many FCNR hedging contracts are expiring before December 2016.
RBI had promised, in September 2013, that the banks can hedge the forex risk. Most banks exercised that right. Now, it is the RBI’s turn to meet it’s promise. So, the RBI is preparing to return those US dollars to the banks who can pay it back to the NRIs.
All is well.
You can read more about this topic in the links below.
Kingshuk Bandyopadhyay took the time out to provide this exhaustive answer on Quora.