Prepare well for the internationalization of the rupee

The Reserve Bank of India has set up a mechanism to facilitate the international trade of rupees. Now, import and export payments can be settled through a Vastro special account, while banks, with prior approval from the RBI, can act as authorized dealers for such transactions.

There is no doubt that this is a big step in the right direction considering the limitation of the use of the US dollar as a medium for international transactions, especially with countries under sanctions. This would also help to reduce currency risk on traders and pressure on the Indian Rupee.

Currently, global trade and the economy are going through difficult times, especially after the recession inflicted by the Covid-19 and the renewed geopolitical tensions in Eastern Europe. Many developing countries in Asia, Africa and Latin America are on the brink of a currency crisis with severe currency shortages and volatility. Imported inflation and higher interest rates are actually pushing these economies into a state of stagflation.

At this point, an alternative arrangement to the US dollar-based settlement system with a system using INR would be a win-win for both trading partner countries.

When the RBI launched the circular on this, there were broader discussions about the internationalization of the rupee. Although it can be called a step in this direction, such internationalization requires a number of short and long-term actions.

An international currency is a currency that is used in place of the national currencies of the parties directly involved in an international transaction, whether the transaction in question involves a purchase of goods, services or financial assets. The invoicing of trade in goods (over-the-counter (OTC) and organized exchanges), including in trade between third countries, the use of currency in the capital market, both national and international, where investors foreigners are the main players, are some immediate aspects of internationalization.

According to the latest triennial survey of central banks, the dollar represents 88.3% of global turnover on the foreign exchange market, followed by the euro, the Japanese yen and the pound sterling; the rupee is only 1.7%, underscoring the need to push the currency much further to gain an international tag.

It is true that the gradual internationalization of currency can occur with an increased share in international trade. However, in order to make the currency international to reap the benefits for trade and investment, multiple and concerted actions by government and regulators are important.

Concerted steps required

Some of these include the removal of restrictions on the purchase and sale of national currency in spot and forward markets; domestic companies are able to invoice exports and imports in their own currency; foreign companies, financial institutions, government institutions and individuals are able to hold the country’s currency and financial instruments; foreign companies and financial institutions and government institutions are able to issue negotiable instruments in the local currency; the country’s financial institutions and non-financial companies can issue instruments denominated in the currency of their country on foreign markets; international financial institutions, such as the World Bank and regional development banks, are able to issue debt securities in a country’s market and use its currency in their financial operations; and the currency may be included in other countries’ “currency baskets”, which they use to govern their own exchange rate policies.

With regard to the rupee, our currency is fully convertible on current account, i.e. in conversion mainly for the trade of goods and services, but partially on capital account, i.e. in conversion for the purpose of moving capital across the border. Here, it would be interesting to examine the position of the Rupee with respect to the above-mentioned points, which will explain why the Rupee is partially convertible into capital account. In fact, India has already come a long way in capital account convertibility, but with careful and gradual steps.

Although we have opened our economy to portfolio and direct investment, the experience of the East Asian crisis and other major currency crises has taught us to avoid any drastic steps in this direction. It should be noted that the idea of ​​issuing sovereign bonds in foreign currency, mentioned by the Minister of Finance in one of her speeches on the budget, has still not been acted upon.

Some of the benefits of the internationalization of the rupee would include limited currency risk for traders of goods and services, access to international financial markets for cheaper capital by domestic businesses and institutions without incurring currency risk, and broader business opportunities in global capital markets for domestic financial institutions.

On the government side, this can give more options to fill their budget deficit while the current account deficit issue can be resolved without drawing on official reserves.

Costs involved

On the cost side, currency internationalization will limit the country’s ability to anchor monetary policy in its domestic economic landscapes and have a fixed or heavily managed exchange rate regime. The domestic currency may also be subject to greater fluctuations and depreciation, as foreign investor sentiment will have wider ramifications on the currency when a large portion of currencies and instruments are held overseas.

Apart from these, issuing foreign debt securities in the domestic market can present risks, especially when debtors default. Most financial crises – whether those of the 1980s, 1990s or 2008 – testify to the costs involved.

Overall, currency internationalization is a double-edged sword, capable of hurting if we are not well prepared, but also having immense potential. As a growing economic powerhouse, wider use of local currency with fewer barriers will help support international trade and investment.

The recent initiative to charge trade in Rupee arises from a different global requirement and order, but for true internationalization and wider use of Rupee overseas, the opening of trade settlement in Rupee alone will not suffice. Greater openness and liberalized Rupee regulations for various financial instruments both in India and overseas markets are more important.

The promotion of rupee-based settlement in international trade and financial markets would also encourage more global players to opt for this option as the world moves towards a multipolar system where India will be a dominant power.

A strong foreign exchange market with an efficient swap market can be another prerequisite for the internationalization of the rupee. A further improvement in global economic fundamentals, the health of the financial sector, followed by an upward move in sovereign ratings will also bolster confidence in the rupee, preparing the currency for the next leg of its international journey.

The author is Director, Center of Economics and Finance, Administrative Staff College of India, Hyderabad

Published on

July 31, 2022

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