Context: RBI Governor Shaktikanta Das said the government and the central bank are in discussion with South Asian countries to have cross-border trade in rupee. India had already made similar agreements with Sri Lanka, Russia and Mauritius and in early discussions with UAE to trade non-oil commodities in Indian rupee.
Need for trading in local currencies:
- Reduce transaction costs: When countries import and export goods and services, they have to make payments in a foreign currency. Since the US dollar is the world’s reserve currency, most of these transactions are settled in dollars.
E.g., If an Indian buyer enters into a transaction with a seller from Germany, the Indian buyer has to first convert his rupees into US dollars. The seller will receive those dollars, which is then converted into euro.
Here, both the parties involved have to incur the conversion expenses and bear the risk of foreign exchange rate fluctuations.
- Geo-political shocks: Geo-political tensions often create challenges in seamless trade between the countries.
E.g., Recent Russia-Ukraine war resulted in western sanctions on Russia which created challenges for India to trade with Russia in dollars.
- Reduce dependency over foreign currency: Increasing use of Indian rupee for cross-border transactions will not only reduce our dependency over foreign currency but also increases the credibility of rupee in the global market adding weight to Indian economy.
- Insulate from external shocks: Reducing dependence on foreign currency makes India less vulnerable to external shocks like mitigating the pain of reversal of capital flows.
Mechanism of Rupee trade settlement:
Vostro accounts are accounts a bank holds on behalf of another foreign bank. Rupee Vostro accounts keep a foreign entity’s holdings in the Indian bank, in Indian rupees. Recently RBI permitted various Indian banks to open 12 special vostro accounts for trade in rupees.
A Rupee Vostro account is used to facilitate international trade transactions in Indian rupee. When an Indian importer wants to make a payment to a foreign trader in rupees, the amount will be credited to this Vostro account, and when an Indian exporter needs to be paid for supplying goods or services, this Vostro account will be deducted, and the amount will be credited to the exporter’s account.
Challenges with Internationalisation of Indian currency:
- Unfeasible with all the countries: Countries with whom we run trade deficit may reluctant to use this rupee settlement because the vostro accounts are left with surplus amount.
- Hampers independent monetary policy:
- Internationalisation of a currency could make simultaneous pursuit of exchange rate stability and autonomous monetary policy challenging.
- 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.
Global financial contagion: Effective internationalisation of a currency would require taking steps towards full convertibility on the capital account, which may put at the India at the risk of global financial contagion.