India operates a huge trade deficit in excess of $150 billion. One of the best ways to counter this trade deficit is by introducing Rupee trade for major imports. The Rupee trade has been a point of discussion for over a decade now, but it never took off largely due to various geopolitical and economic constraints. Current global dynamics of trade demand availability of free currency, which is acceptable to both parties before such transactions are executed. Also balancing the strengthening or weakening of a currency means fixing of rates, impacting exports and imports.
The dollar has been the world’s principal reserve currency since the end of World War II and is the most widely used currency for international trade. Internationalisation of Rupee can lower transaction costs of cross-border trade and investment operations by mitigating exchange rate risk. But this, as per the RBI, “makes the simultaneous pursuit of exchange rate stability and a domestically oriented monetary policy more challenging, unless supported by large and deep domestic financial markets that could effectively absorb external shocks.”
Lessons from History
In early 1960s, the Rupee was the unit of account in India’s payment agreements with eastern Europe. Under the so-called gold clause in many of these agreements, the exchange value of the Rupee was fixed in terms of gold, thus effectively protecting holders of Rupee governed by such agreements from devaluation. The Reserve Bank was not in the picture when these agreements were made, and when little thought appears to have been given to the significance of this clause.
The devaluation of 1966 turned the spotlight on the gold clause. Not only did India discover that it was now on a sticky legal wicket — with the Soviet Union determined to dig in its heels and insist on the application of this clause to contracts between the two countries and the other countries waiting to see how this test case would be resolved — Rupee trade between India and east Europe came to a virtual standstill immediately after the devaluation. This caused great concern in India because at the time of the devaluation, only a quarter of the trade planned for the 1966 calendar year had been achieved.
Under the gold clause, the agreed value of the Rupee was defined in terms of gold, so that in the event of a devaluation of the Rupee, adjustment would be in the form of an additional payment in rupees. As exercises undertaken in the wake of the Russian demand for compensation revealed, the gold clause benefits worked to the detriment of the Indian exporter. While it was applicable to Russian exports to India, no similar protection was available to an Indian exporter exporting to Russia, since price contracts did not allow for domestic price increases arising from devaluation.
The 1966 devaluation experience reinforced India’s determination to incorporate a symmetric gold clause in future Rupee payment agreements. This was easier said than done, with the Soviet Union and Poland, in particular, opposing any move to protect the receipts of Indian exporters in the event of another Rupee devaluation. Disputes about the manner in which to overcome the problem continued for several more months and took some sheen off the bilateral payment agreements. The devaluation of sterling in 1967 added more confusion and uncertainty, but also highlighted the dangers of basing bilateral trade on third country currencies over whose parity neither of the contracting countries had any control.
Between 2016 and 2019, global turnover in foreign exchange markets rose by 33 per cent, but, emerging market economy currencies’ turnover expanded by close to 60 per cent boosting their global share to 23 per cent from 15 per cent in 2013. Among the key drivers is the Indian Rupee (INR) in which trading has almost doubled, in sharp contrast to the Mexican Peso (MXN), the South African Rand (ZAR), the Malaysian Ringgit (MYR) and even the Singapore Dollar (SGD). The INR Non-Deliverable Forward (NDF) market is the second largest globally in terms of average daily turnover and is larger than the onshore forward market (BIS, 2019). Volumes in the offshore NDF markets have also grown on account of various factors, like ease of access, market-making by global banks, availability of large participants like hedge funds, intermediation services like prime brokerage, favourable tax treatment, convenience of time zones and electronification.
Capital Account Convertibility
Capital account convertibility is the ability or freedom to convert domestic currency for capital account transactions. The capital account is made up of cross-border movement of capital by way of investments and loans. India has come a long way in liberating the capital account transactions in the last three decades and currently has partial capital account convertibility. Some of the recent moves include increasing the foreign portfolio investment limits in the Indian debt markets, and introducing the Fully Accessible Route. However, there is a need for more defined policy and liberalisation framework here.
Benefits of Internationalisation of Currency
First, internationalisation gives the country’s exporters an opportunity to limit exchange rate risk, and this benefit may be significant in the case of goods for which payment is made long after they are ordered.
Second, it permits domestic firms and financial institutions to access international financial markets without incurring exchange rate risk and borrow at cheaper rates and on a larger scale than they can at home.
Key aspects of Currency Internationalisation
A national currency can be regarded as an international currency if most of the following conditions (as enumerated by American economist Peter B. Kenen) hold:
1. First, the government must remove all restrictions on the freedom of any entity, domestic or foreign, to buy or sell its country’s currency, whether on the spot or in a forward market.
2. Second, domestic firms are able to invoice some, if not all, of their exports in their country’s currency, and foreign firms are likewise able to invoice their exports in that country’s currency, whether to the country itself or to third countries.
3. Third, foreign firms, financial institutions, official institutions and individuals are able to hold the country’s currency and financial instruments denominated in it, in amounts that they deem useful and prudent.
4. Fourth, foreign firms and financial institutions, including official institutions, are able to issue marketable instruments in the country’s currency. These may include both equity and debt instruments, not only in the country’s domestic markets but also in foreign markets, including, of course, the foreign firms’ own countries’ markets.
5. Fifth, the issuing country’s own financial institutions and non-financial firms are able to issue on foreign markets instruments denominated in their country’s own currency.
6. Sixth, international financial institutions, such as the World Bank and regional development banks, are able to issue debt instruments in a country’s market and to use its currency in their financial operations.
Advantages and Drawbacks of Rupee Trade
The drawbacks are:
1. Presently we need to have reliance on a third currency to set benchmark for the rates during contract expiry
2. Working with other global federal banks to define a working model
3. Standard policies and operating model by RBI to undertake trade in Rupee, and also control local effects of outside shock
The advantages are:
1. Probable reduction in trade deficit of approximately $20 billion on a monthly basis
2. Other countries adopting to take up Rupee as a currency for their trade activity
3. Strengthening of Rupee in the global market
4. Rupee becoming a reserve currency over a period of time for developing economies for trade
Benefits of Rupee Trade Outweigh Losses
An aggressive international trade lobbying is required to actively promote Rupee trade with dominant economies. On the other hand, we need to closely monitor the Indian exports. There are two dangers that we need to watch out for: first, diversion of Indian exports from the international market to other countries; and second, re-exports from third countries through the Rupee payment route.
With outlook in Delhi dominated by the country’s balance of payments problems, the advantage of paying for capital goods imports in inconvertible rupees was thought to outweigh such losses. The overall benefit of Rupee trade outweighs the negative factors in the long run. Also, to become a global trade player, the local currency should be the preferred trading instrument.
The author is a global expert in international trade policies and technology transfers. The views expressed in this article are those of the author and do not represent the stand of this publication.