Convertibility needs to precede the internationalisation of the rupee

The inclusion of the rupee in the International Monetary Fund’s special drawing rights basket has been recommended.

The Reserve Bank of India’s task force report on internationalising the rupee released recently defines a currency as internationalised when market participants (both residents and non-residents) “conveniently use it to trade, invest, borrow and invoice in it”. It has understandably taken a graded approach recommending short-term and medium-term measures for accelerating internationalisation.

Among the short-term suggestions are those relating to allowing non-residents to hold rupee accounts, integrating Indian payment systems (like the Unified Payments Interface) with other countries for cross-border transactions, the inclusion of government securities (G-Secs) in global bond indices and a few others. The medium-term recommendations relate mostly to taxation and settlement systems and permitting banking services in rupees outside India through offshore branches of banks. In the long run, it also recommends efforts for the inclusion of the rupee in the International Monetary Fund’s special drawing rights basket.

Changing Stand

But what is interesting are its views on internationalisation which it describes as a “continuous process involving progressive capital account convertibility, wherein the domestic currency increasingly acquires the character of a de facto freely convertible currency”. This is in striking contrast to an earlier RBI task force report of 2019 on a different but allied subject (Offshore Rupee markets) where the committee was of the firm opinion that capital controls were essential for India to avoid the impossible trinity problem.

The task force details many benefits of internationalisation for private users; for one, domestic firms by invoicing and settling their exports/imports in rupee could shift exchange rate risk to their foreign counterparts. Likewise for domestic firms and financial institutions accessing international financial markets. Besides, a larger and more efficient financial sector could help reduce the cost of capital for domestic firms. The government also benefits. It could part-finance its budget deficit by issuing domestic currency debt in international markets. It could also finance a part of its current account deficit without drawing down its official reserves. Another significant benefit would be in reducing the requirement to maintain large foreign exchange reserves (with its associated costs). At the macroeconomic level, it could also reduce the impact of volatility of capital flows, thereby enhancing its ability to repay external sovereign debt.

But the task force also cautions about the risks involved — importantly, increased volatility of the exchange rate in the initial stages besides the monetary implications in the form of loss of control as it would need to meet the global demand which could conflict with its domestic monetary policies. The conduct of monetary policy becomes complex, best exemplified by the example of the US. The international currency status of the US dollar means that its trade deficits (denominated in dollars) eventually return to the US in the form of equity or debt. These capital inflows not only prevent the depreciation of the US dollar (which trade deficits would warrant) but also depress domestic interest rates.  A former US Fed chief termed it a conundrum that the Fed ‘failed’ to get long-term rates to rise sufficiently due to foreign demand for long-term US bonds.

Benefits Outweigh Risks

But the task force believes that overall, the benefits — limited exchange rate risk, lower cost of capital, high seigniorage benefits and reduced requirement of foreign exchange reserves — far outweigh the risks. It believes the conditions are opportune now for the rupee to debut as an international currency. The task force also makes a few other important points. Currently, the offshore (or non-deliverable forward) currency markets are seen to influence domestic exchange rates. Ideally, two markets for domestic currency or interest rates cannot exist efficiently. With full convertibility, the case for offshore markets would disappear but with partial convertibility, efforts would be needed to integrate the markets to ensure that price discovery in domestic markets is efficient enough to disincentivise flows to the offshore segment. But this is easier said than done, as speculators (mainly hedge funds) without any underlying exposures are present in NDF markets. Overall, a combination of capital flow measures, macro-prudential measures and market intervention is what the committee suggests.

The RBI’s own views are not known yet though the governor had in the past stated that capital account convertibility will continue to be approached as a process rather than an event. This does not say much about the timelines or policy steps that are likely to emanate.

Perhaps the usage of the two terms, “internationalisation” and “convertibility” suggests their interchangeability, but as experts point out, they are distinct; the substantial international use of a currency presupposes the absence of significant capital controls. Convertibility thus precedes internationalisation which means the case for convertibility needs to be established first. This has been inconclusive ever since the currency turmoil witnessed in Asia during the 1997–98 crisis and later. Even earlier reports on convertibility have not recommended taking the full plunge. Besides, there are other important prerequisites for achieving internationalisation — the existence of deep and well-functioning domestic financial markets, a trusted legal framework for contract enforcement, low inflation, and stable and predictable macroeconomic policies. These are conditions that are desirable by themselves, and public policy could work to establish these preconditions.

SA Raghu is a columnist who writes on economics, banking and finance. Views are personal, and do not represent the stand of this publication.