During the recent visit of Malaysian PM Anwar Ibrahim, Narendra Modi announced that trade between India and Malaysia can now be settled in Indian rupees and Malaysian ringgits. This announcement is the next step in decreasing the country’s reliance on the US dollar after the Reserve Bank allowed settlement of international trade in the rupee in 2022. Just over a year ago, the India International Bank of Malaysia became the first in that country to operationalise this mechanism by opening a special rupee vostro account (SRVA) through its corresponding bank here, the Union Bank of India.
This is an important step for increasing India’s exports to Malaysia, which have stagnated over the past few years, resulting in an increase of over 60 percent in India’s trade deficit with the country since 2019-20. The question is, how effective will rupee trade be in addressing this problem?
Using the rupee for trade settlement has constantly been in focus since India decided to go against the sanctions imposed on Russia by Western countries after its invasion of Ukraine. As a part of the sanctions, seven Russian banks were denied access to SWIFT, which allows smooth transfer of funds across borders. Following this, India explored alternative routes of conducting trade, including using the rupee with one of its longstanding partners.
Responding to this development, the RBI issued a circular on ‘International trade settlement in Indian Rupees’ in July 2022, underlining the terms both for trade settlement and cross-border transactions. In March 2023, it was announced that banks from 18 countries, including Malaysia, were allowed to open SRVAs for settling payments in rupees. These arrangements were also endorsed by the latest Foreign Trade Policy (2023-28), which allows exporters to enjoy benefits of incentives even when their realisations are in rupees.
An important component of this arrangement is that rupee surplus balance can be used for capital and current account transactions by mutual agreement, including for making payments for projects and investments in Government Treasury Bills. In other words, foreign entities holding rupee balances are allowed to invest in India.
Interestingly, the RBI was considering internationalisation of the rupee for over a decade. Raghuram Rajan, the then governor of the RBI, argued in 2013 that as India’s trade expands, there would be “push for more settlement in rupees”. In 2021, RBI’s Report on Currency and Finance had expressed confidence that the “emergence of INR as an international currency appears inevitable”. The report argued “greater internationalisation of the INR can lower transaction costs of cross-border trade and investment operations by mitigating exchange rate risk”. In its continued efforts to facilitate the use of the rupee for trade transactions, the RBI has notified that banks can now open additional special vostro accounts for the settlement of their trade transactions in rupees.
Increased use of the rupee for trade has two advantages. First, it reduces currency risk for Indian enterprises by eliminating their exposure to currency fluctuations. This can reduce the cost of doing business and hence help in making exports more competitive in the global market. Secondly, the need for maintaining an ‘adequate’ level of foreign exchange reserves can be reduced if a major share of India’s trade can be settled in rupee.
Despite this, the process of internationalisation of the rupee has faced two challenges. One, rupee trade arrangements have not been easy to implement, amply demonstrated while dealing with Russia. Large rupee balances held by Russia stemming from India’s burgeoning trade deficit have been a constraint. A similar situation can arise in case of rupee trade with Malaysia, with India facing a mounting trade deficit.
A second problem is internationalisation of a currency could make simultaneous pursuit of exchange rate stability and a domestically oriented monetary policy challenging, unless this process is supported by deep domestic financial markets that could effectively absorb external shocks. As both residents and non-residents can buy and sell domestic currency denominated financial instruments, internationalisation can limit the ability of the RBI to control domestic money supply and influence interest rates in accordance with the requirements of domestic macroeconomic conditions.
Finally, effective internationalisation of a currency requires removal of restrictions to buy or sell its country’s currency, whether in the spot or forward market. This would imply a move towards full capital account convertibility, which successive Indian governments have avoided. Among emerging economies, China is the only one to have steadily internationalised its currency, while maintaining capital account controls. It has done this using two mechanisms. First, by formalising currency swap agreements between the People's Bank of China and the central banks of 43 countries to exchange currencies. Secondly, by creating an offshore market for its domestic currency that allows foreign entities to sell renminbi for dollars.
Thus, the government may have taken steps towards internationalisation of the rupee, but considerable thinking and planning would be required to make it function in a manner that does not adversely affect the economy’s fundamentals.
(Views are personal)
(bisjit@gmail.com)
Biswajit Dhar | Former professor, Jawaharlal Nehru University
and Vice President, Council for Social Development