Trade settlement in rupee major step towards internationalising currency, experts say

The Reserve Bank of India’s new mechanism to settle international trade in the Indian currency is a major step towards ‘internationalising’ the rupee in the long run.

However, near-term hiccups in implementation can’t be ruled out, experts and economists told Moneycontrol. These may include operational delays in setting up vostro accounts and creating demand for rupees in an uncertain global macroeconomic backdrop. A vostro account is an account that a correspondent bank holds on behalf of another bank.

“In the long run, the move could structurally benefit the rupee if internationalisation of currency picks up as a theme, thereby providing an alternative to domestic demand for dollars,” said Vivek Kumar, an economist at QuantEco Research. “Given the dominance of the dollar and euro in global trade, there won't be any immediate spurt in demand for rupee trade settlement. However, internationalisation of a currency is a gradual process and the RBI seems to have taken their first major step towards this objective.”

India, the fifth-largest economy in the world, has the scope to generate global demand for rupee trade as well as investment in rupee assets, Kumar added.

Amid a persistent weakness in the rupee’s exchange rate versus the dollar, the RBI, on July 11, announced a mechanism to settle trade transactions in rupee terms. The central bank said that the move was to promote growth of global trade and to support increasing global interest in the rupee.

If this mechanism is adopted on a larger scale in the long run, it would lead to ‘internationalisation’ of the rupee or adoption of full capital account convertibility. A capital account tracks the movement of capital between two countries via investments and loans. A fully convertible capital account means there would be no restriction on the amount of rupees one can convert into foreign currency to buy an asset overseas. Similarly, there would be no restraints on overseas investors bringing in dollars or acquiring assets in India.

Also read: India not ready to make big move on full capital account convertibility: experts

Why now?

The RBI’s moves comes amid the Indian currency hitting a record low practically every day against the dollar in the wake of Russia’s invasion of Ukraine. Russia’s attack on Ukraine saw several countries impose sanctions on Moscow to limit its ability to fund the war. The US has cut off Russia’s access to the dollar, making Indian companies, looking to take advantage of the lower price of Russian commodities, consider alternative modes of payment for imports. India has always looked to maintain trade ties with Moscow while not breaching the sanctions.

Kotak Mahindra Bank’s Managing Director and Chief Executive Officer Uday Kotak, in a Twitter post dated July 12, said that emerging market currencies need to be alert given the “supremacy of the US currency.” Some of the biggest risks emanate from currencies and can destroy some countries, Kotak said in the post, citing examples of Sri Lanka and Pakistan.

“It is clear that the primary motive of the scheme pertains to trade with Russia,” said Karan Mehrishi, an independent commentator on the economy. “Russian oil now accounts for almost 10 percent of Indian requirements and at the same time, western sanctions have forced Russian importers to look at Indian alternatives.”

Apart from Russia and other countries facing similar sanctions, the move can also facilitate trade with countries such as Sri Lanka, which has seen its forex reserves drop sharply during the course of the pandemic. This mechanism will help India facilitate trade with such countries without being paid – or making payments – in precious US dollars or euros.

The move also has to be considered in the wake of a widening trade deficit. India’s merchandise trade deficit widened to a record $25.63 billion in June. This exerts pressure on the current account deficit, which is expected to widen to more than 3 percent of gross domestic product in FY23, as per economists’ estimates.

Long-term implications

Experts said the RBI’s step to settle international trade in rupees could go a long way in improving the rupee’s share in global transactions. A pick-up in demand for the rupee internationally would reduce demand for dollars in the long run. This would curb large-scale depreciation pressures for the rupee eventually and help preserve forex reserves. It would also reduce currency risk for the rupee, said experts.

“If we are able to use rupees for trade settlements, then we could technically finance our trade deficit using rupees, not dollars and thus, won’t import inflation through currency depreciation,” said Kunal Sodhani, assistant vice president, global trading centre, Shinhan Bank India. “It also helps preserve forex reserves, which can be of help during uncertain times.”

Sodhani expects more countries apart from Russia, the UAE, Iran and Venezuela, to adopt this trade settlement mechanism eventually.

A major perceptible change is that surplus rupees available in a special vostro account can be used for certain capital and current account transactions by mutual agreement. As per the central bank, surplus rupees can be used to pay for projects and investments in government securities, among other purposes. Prior to the notification, investment in rupee assets was allowed only through the foreign portfolio investment, or FPI, route.

“This possibly can make rupee invoicing somewhat attractive for exporters or importers from outside, provided they find rupee assets attractive enough, in a relative sense,” said Vikas Bajaj, head of currency derivatives at Kotak Securities.

In the earlier regime of rupee invoicing, the proceeds were supposed to be converted immediately, thereby keeping dollar demand intact in the system. Now, with the benefit of investment and permission to set off against export receivables, immediate conversion pressure or dollar demand can see moderation, added Bajaj.

Implementation problems

However, the implementation of these measures is a long drawn process and the beneficial impact will likely be felt over the coming years. It will require extensive deliberations with trading partners and its success will depend on how many countries are willing to trade in the rupee, said experts.

“There is a possibility that if India asks for its import settlement in rupees, the trading partner may ask for its import settlement in its local currency, which indicates that the RBI, along with other central banks, will have to hold their foreign exchange reserves in many currencies,” Motilal Oswal Financial Services said in a note.

It has to be seen whether foreign traders would want to block their receivables in rupees during this volatile time.

“The rupee simply cannot provide stability to holders at this time,” said Mehrishi. “In the medium to long term though, the RBI and commercial banks will solve the teething problems and this can emerge as an attractive payment alternative for Indian traders.”

Further, bankers expect the opening of special vostro accounts to take about 30 days with compliance and regulatory approvals. Plus, there is uncertainty among bankers about how this measure will be implemented.

“There is still no clarity whether the corresponding bank also needs to open a vostro account with the bank in return. We will have to wait and see how that pans out,” said a treasury official at a state-run bank, requesting anonymity.

Barclays’ Managing Director and Chief India Economist Rahul Bajoria these measures will take some time to operationalise.

“However, from a longer-term perspective, greater flexibility on use of the rupee, along with the modest correction in commodity prices and some incremental weakness in demand, can help stabilise the current account somewhat,” he added.