INTERNATIONALIZATION OF INDIAN RUPEE

In an earlier blogpost (06/04/2022), We had discussed dominance of US Dollar. It’s time to explore internationalization of Indian Rupee ie. INR.

On 11^th July, 2022 in a landmark move, RBI relaxed guidelines for international trade in INR. RBI said “to promote growth of global trade with emphasis on exports from India and to support the increasing interest of global trading community in INR, it has been decided to put in place an additional arrangement for invoicing, payment, and settlement of exports / imports in INR.” In this context let’s examine internationalization of INR - past history, advantages / disadvantages and what lies ahead.

 What is Internationalization of Rupee ?
Internationalization of INR encompasses increased and freer use of the currency in cross border trade – both for imports and exports. Right now, most trade from and to India is denominated in US Dollars and an attempt is now being made to facilitate international trade in INR or making INR an international currency.

 Let us understand the distinction between internationalization of INR and it being an international currency. Former means greater acceptance of INR as a medium of exchange in international trade between residents and non-residents while the latter means gaining a status akin to USD or GBP or Euro as a free currency for trade in any part of the world. While the latter lies somewhere in the realm of future, internationalization seems to be progressively achievable.

Historical perspective

Post independence, the nascent Indian economy had very little exports while we were heavily dependent on imports even for our essential requirements like agricultural produce. This resulted in low forex reserves. This limited availability led to restrictions and controls in the form of the Foreign Exchange Regulation Act (FERA) of 1947, subsequently replaced by FERA, 1973. Economic reforms introduced in 1991 marked a distinct shift in approach towards foreign exchange management.

The process for internationalization of INR started with Union budget for the year 1992-93, when INR was made partially convertible wef 1^st March, 1992. Under this system announced for next one year, 60 % of forex earnings were convertible at market determined rates while residual 40 % were convertible at official fixed rates. In 1994, INR was made fully convertible on current account. FERA 1973, was replaced by Foreign Exchange Management Act (FEMA), 1999 thus changing the approach from control to management.

 

Here it may be pertinent to understand the distinction between Capital and Current account. A country’s balance of payments system comprises of two accounts - Capital and Current. Broadly, Capital account encompasses cross border movement of currency for loans and investments, current account covers trade of goods and services.

Progressively INR was made fully convertible on Current account ie. there could be unlimited conversion between INR and other foreign currencies like USD / GBP / Euro /JPY etc on account of trade of goods but INR remained partially convertible on capital account.  In this system, under automatic route (ie without prior approval from RBI) Indian corporates can freely raise forex denominated debt upto USD 500 million while individuals are authorized to invest upto USD 250,000 per annum in foreign assets and securities.

Why Internationalization of Rupee ?

World has changed drastically over last three years, both economically and politically, first due to Covid-19 and then Russia-Ukraine conflict. Global trade and logistics have been affected due to rising energy costs. A large number of countries are facing an economic crisis of sorts. Interest rates have risen across the globe and even developed economies of US and Western Europe are suffering from high inflation. A recession is being forecast. On the other hand, several developing countries are suffering from a currency crisis with dipping forex reserves. This has apparently got exacerbated due to dominance of US Dollar as the only international currency. Shortage of USD reserves is playing havoc with various developing economies. This has prompted several countries to look for alternatives to USD. Like China and UAE have started a Dirham based payment system for crude oil in place of USD earlier.

 

Same way, RBI has moved towards making INR a more acceptable currency in bilateral trade with several countries like Russia, Sri Lanka and Maldives eg replacing USD payments with Rouble /INR mechanism. This could be a win-win for both Russia and India. This move by RBI has triggered a discussion on internationalization of INR.

 

As per the 2022 Triennial Central Bank Survey of foreign exchange and derivative markets, USD accounts for 88.3 per cent of global foreign exchange market turnover, followed by Euro, Japanese Yen and British Pound Sterling. INR accounts for a mere 1.7 per cent of global market. This shows the urgency for gradual internationalization of INR, but sooner than later, if India has to realise its dream of becoming the second or third largest economy. The attempt is not to replace USD to any large extent for multilateral trade (as USD has been blessed historically in positioning itself as international currency) but to replace USD with INR in bilateral trade to the extent possible. Although invoicing of export and import transactions in INR was already permitted, but latest July 2022 RBI guidelines have enlarged the scope and made it more flexible eg. investment of surplus Rupees in Indian bond markets.

 

Acceptance of any currency internationally, reflects on the soundness of the parent country. Examples are US, Europe and Japan. Thus true internationalization of INR shall also improve credibility of Indian economy making it a better destination for international investments. USD being the dominant international currency enjoys unmatched privileges eg US Govt can pay its debts in its own currency thus saving its domestic economy from any exchange rate fluctuations. It’s a massive advantage. 

Advantages of Internationalization of the Rupee
There are numerous advantages of internationalization of INR.

As mentioned in the previous para, internationalization of INR shall help in insulating Indian economy from external currency volatility (just like USD). This shall bring down cost of doing business substantially.

Internationalization may reduce the requirement of holding foreign exchange reserves. It has to be understood that while reserves provide an umbrella against external volatility, but maintaining reserves beyond a level carries a cost.  Speaking at a function organized by the Foreign Exchange Dealers Association of India (FEDAI), the RBI Deputy Governor Shri T Rabi Sankar had said “there is a general agreement that India’s reserves are borrowed funds. Banks and corporate incur external debt at market rates which are then invested in Government securities issued by advanced economies (AEs). The rate at which external debt is incurred is substantially higher than the return on reserves,. Assuming an interest differential of 2%, on a Reserve base of say USD 600 billion, the cost of reserves would work out to USD 12 billion, annually. This cost represents a transfer of income from India to AEs. Reducing the requirement of reserves would save some of this loss of income.”

Internationalization of INR would add heft to Indian corporates and domestic financial institutions,  helping them realize global ambitions. It reduces currency risk in cross border transactions. Globalization of Indian corporates shall also increase India’s stature in world comity.    

An immediate benefit of INR internationalization has been wider options for importing crude during the current volatility in international crude prices. India has effectively used the Rouble / INR exchange mechanism to substantially reduce import bill for crude oil, thus insulating domestic economy from imported inflation to a large extent. It has also helped in overcoming sanctions imposed by US and Europe on Russia.

 

Increased acceptance of Indian currency may prompt other countries to include INR in their ‘basket of currencies’ for fixation of their own exchange rates. It may also lead to increased issuance and acceptance of ‘Masala bonds’ as well as issue of INR denominated debt instruments by World Bank / other multilateral financial institutions.  

 Disadvantages / Challenges in Internationalization of Rupee
On the flip side, there are also certain disadvantages of internationalization.

 

At this stage, We need foreign capital to fuel our growth. This capital comes to a large extent through remittances received from Non resident Indians. With increased internationalization of INR, Non residents may be prompted to maintain deposits in INR. In case of any international currency volatility, NRIs may take out these rupee deposits by converting into any other international currency, thus affecting domestic economic stability.

 

Internationalization of INR may also affect country’s monetary policy because policy makers will have to take into account global ramifications instead of limiting themselves to domestic economy, as hitherto. With increased global holdings, it may be difficult to efficiently insulate INR against any global financial crisis like Lehman Brothers in 2008.

 

Way forward

As discussed in the previous para, Internationalization of INR would increase challenges for Monetary Policy makers of the country, but that by itself cannot be a limiting factor. If India has to occupy its place amongst developed economies commensurate with its size and potential, then such risks have to be measured against growth. As seen above, INR internationalization can be a double edged sword with benefits and risks. But if India has to develop its economy, then not only barriers will have to be removed but INR will have to be proactively promoted as an international currency.  It may be argued that RBI’s July 2022 change of heart was prompted by compulsions of US sanctions on Russia, but it may be a blessing in disguise. Liberalization should not stop here but this opportunity may be used as a springboard for overall strengthening of the economy.

 

We have a comfortable forex reserve position, inflation is under control and economy is registering one of the highest growth rates in the world. To avail this opportunity and achieve true internationalization of INR, the next step could be full capital account convertibility. But Government’s approach remains very cautious.