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Earlier this week, the Reserve Bank of India (RBI) paved the way for global trade settlement in Indian rupees. In an official release, the central bank said, “In order to promote growth of global trade with emphasis on exports from India…it has been decided to put in place an additional arrangement for invoicing, payment, and settlement of exports/imports in INR.”
Before putting in place this mechanism, banks shall require prior approval from the RBI’s foreign exchange department.
This policy decision is a push towards the ‘internationalisation’ of the rupee, with the intent of lowering transaction costs of cross-border trade and investment operations by mitigating exchange rate risks. One must view this decision against the prolonged fall in rupee.
While it might be too early to gauge the consequences of this decision, it is important to discuss whether the rupee is ready to threaten the ascendancy of the US dollar.
Solving the ‘original sin’
The internationalisation of the rupee will bring significant benefits to the Indian economy.
First, it will enhance our integration in the global economy via increased trade and FDI flows. India is now the sixth largest economy in the world and an important trading partner for several countries. In 2021-22, India’s total trade with the world was valued at over $1 trillion, with exports crossing the $400 billion mark for the first time in a fiscal year.
India is also rapidly emerging as a preferred destination for foreign investment. In 2021-22, India received its highest ever FDI inflow at $83.57 billion. Using the rupee as an invoicing and settlement currency, Indian firms will be able to reduce the exchange rate risk faced in the international market which will ultimately reduce trade-related transaction costs. This will result in increased trade and investment flows.
Second, the internationalisation of the rupee will promote the development of financial markets. International evidence, as noted by an ADB Study (2014), suggests that currency internationalisation in terms of trade settlement has a significant and positive effect on the development of a financial market. A one-unit rise in currency internationalisation is likely to increase the development of the financial market by 0.2 percentage points in terms of private credit and 0.7 percentage points in terms of stock market total value.
Third, the internationalisation of the rupee would be helpful in reducing currency mismatch for financial institutions. It would alleviate the problem of the ‘original sin’, which is the inability of countries to borrow abroad in their own currency and lies at the core of currency crises and financial fragility.
Fourth, India has been witnessing a high trade deficit. As per latest data, trade deficit rose by 87.5% to $192.21 billion in 2021-22 as compared to $102.63 billion in the previous year. The primary reason for this burgeoning growth has been an increase in the prices of key commodity imports, particularly crude oil. It is anticipated that using the rupee for major imports will help reduce the trade deficit.
Fifth, the policy decision for rupee internationalisation will go a long way in increasing India’s trade with its South Asian neighbours. With Nepal and Bhutan, India’s international transactions were previously also officially allowed to be conducted using the rupee. Geographical contiguity reasons aside, this had also helped India emerge as the largest trading partner for both these countries. This move will now permit the rupee to be used officially in international transactions with all South Asian countries and help reinstate India’s dominant position in the region.
Not an easy road ahead
For the rupee to be recognised and accepted as an international currency, it is important that this measure is supplemented by adequate reforms aimed at developing and strengthening financial markets that are freely accessible by both residents and non-residents, and improving liquidity in financial markets. This would require India to liberalise its capital account to freely allow flow of capital across the border.
Simply put, a fully convertible capital account means that the rupee can be converted into foreign exchange without any controls or restrictions. The government has been progressively liberalising its capital account. For instance, the RBI introduced the Fully Accessible Route (FAR) to enable non-resident investors to invest in specified government securities without any restrictions. However, much remains to be done.
There are also concerns that India’s major trading partners may not accept the rupee for international trade settlements. The majority of India’s trade is being conducted with the US, UAE, China, Singapore and Saudi Arabia. The dollar has been widely recognised as one of the world’s strongest currencies and is accepted as the currency of choice for international trade transactions by nearly all countries in the world. The dominance of dollar may be difficult to challenge, at least in the short run.
To give an example of how tough it will be for India to provide an alternative to dollar, we can look at the Chinese example. The Asian giant has put in a lot of effort for several years to make the yuan a contender against the dollar. However, even today, only 3% of global transactions are done through the yuan (as compared to 40% through the dollar).
Whether India will be able to establish its currency in the global market or whether this will continue to be wishful thinking will be interesting to see.
Samridhi Bimal is a trade economist. Views expressed are personal.