Explained: What is RBI’s new international-trade settlement mechanism?

The RBI has been digging into forex to support the rupee and correspondingly taking measures to build the country's forex reserves. (Photo by DEV ROY/Pexels)

The Reserve Bank of India (RBI) on Monday gave the go ahead for a rupee-denominated settlement mechanism for international trade.

What is it? 

It is for international trade, and the mechanism will help for any such trade to be settled in rupees. Previously, under RBI’s exchange control regulations, international trade (except for those done with Nepal and Bhutan) has to be settled in fully convertible currencies such as the US dollar, the Sterling Pound, Euro and Yen. This latest notification allows trade to be billed and settled in Indian Rupee.

Also read: Will RBI let rupee adjust to new lows?

Why now?
The RBI has said this is to promote exports from India and because there is an increasing interest to trade in Indian rupee. Experts have said that the trade-settlement mechanism is to further trade with Russia, which has been cut off from its dollar reserves in the US, UK and the EU.

There is another reason too.

India’s forex reserves are healthy at $588.3 billion (as of July 8) which can cover nearly 10 months of imports, but the central bank has been generously spending from it to support the sliding Indian rupee–which the bank does by selling dollars. This, when India has been seeing massive outflow of foreign portfolio investments (FPIs) and is seeing record trade deficits–in June 2022, the country’s trade deficit was $25.63 billion, which was more than 2.5x what it was in June 2021’s $9.6 billion. Sensing which way the wind is blowing, the central bank had recently announced a few measures to preserve and even fatten the forex kitty. It allowed banks to raise interest rates on foreign-currency-holding accounts of non-resident Indians. It doubled the external commercial borrowing (ECB) limit under the automatic route to $1.5 in one fiscal year, and allowed FPIs to invest in more debt securities. With the latest rupee-settlement mechanism, if an exporting country is willing to accept rupee payments, then there will be less pressure on India’s forex reserve.

Also read: RBI measures should help outperform its EM peers: Experts

How will it work?

According to Ajay Sahai, Director General and CEO of Federation of Indian Export Organisations (FIEO), first another country has to express interest in setting up this mechanism, then its central bank and the RBI will set up a common pool of money putting in equal amounts. 

The central banks will authorise certain local banks to operationalise this trade-settlement mechanism; RBI’s note calls such banks on the Indian side as Authorised Dealer banks. The local bank in the other country will hold RBI’s money in their local currency and the bank in the Indian side will hold the other central bank’s money in rupees. 

That’s where the ‘Rupee Vostro Accounts’, mentioned in the RBI note, comes in. 

Vostro simply means “your money in our account”, therefore ‘Rupee Vostro Accounts’ keep the foreign entity’s holdings in the Indian bank, in Indian rupees.

When an Indian trader exports, he/she can approach his/her regular bank, which will send the invoice to the Indian AD bank. The Indian AD Bank will debit the Rupee Vostro account and credit the money to the exporter’s regular bank, who will in turn credit the money to the exporter’s bank account. When an Indian trader imports, he/she will transfer the payment into his/her regular bank, who will then transfer that to the AD bank. The AD Bank will credit the Rupee Vostro Account, and the exporter from the other country will be paid through the authorised bank there and in the local currency.  

The central pool of money will thus be debited and credited as long as the mechanism is in place, and at regular intervals, the country that has the balance of payments in its favour will decide what to do with what is remaining in the pool. “The deciding country may want to invest this money in the other country, or it may want the balance to be remitted to them in whichever currency and at whatever exchange rate the two countries decide,” said Sahai.

He said that a similar mechanism was worked out with Iran years ago but it has become dormant since India decided to stop importing oil from Iran in 2019. “We had converted all our oil dues to Iran into rupees and Indian exporters were being paid from that account,” he said. 

Going by RBI’s latest note, the whole process starts when a bank from another country approaches the AD bank in India, and says something like ‘We’d like to set up a vostro account for the rupee-settled trade’. Then the Indian bank will take that request to the RBI’s Foreign Exchange Department at the Central Office in Mumbai. The Indian bank has to ensure that the partner bank isn’t from ‘high risk and non-cooperative jurisdictions’. The banks simply have to refer the Financial Action Task Force (FATF)’s list, which names juridictions that have “weak measures to combat money laundering and terrorist financing”. 

The central bank has offered ‘add-on’ benefits with this.

What are these?
One, an exporter can receive advance payments in rupees through this mechanism. Two, if an exporter also imports from his/her overseas partner, then the exporter can ‘set-off’ or subtract the export receivable from the import payable. The balance would then be paid to the exporter. Three, these trade transactions can be supported with bank guarantees.

Exporters have however raised another kind of concern with the government. Sahai said, “Generally speaking, exports in rupees or in any currency other than specified foreign currencies are not entitled for export benefits. So, the government should clarify whether exports in Indian rupees will get the same benefits. These benefits are substantial and they add to the competitiveness of Indian exports.” He added that this had been done when the agreement had been reached between Iran and India.