In July 2022, the Reserve Bank of India (RBI) set up a mechanism to settle India’s international trade transactions with willing countries in rupees. Russia is the only country that has shown any interest in the new arrangement for now, and nine Russian banks have been permitted to set up Vostro accounts to facilitate rupee-based trade.
It should be noted that the RBI came up with the rupee settlement mechanism amid a steadily falling rupee, hoping that the move would help India pay for its imports using rupees instead of U.S. dollars from its foreign exchange reserves. But things are not going to plan.
Prominence of U.S. dollar –
- At the moment, the U.S. dollar is the predominant currency used to facilitate trade between countries. This means that countries trying to import goods or purchase foreign assets must first obtain U.S. dollars necessary to carry out these trades. And to do that, they must export goods or sell domestic assets.
- The U.S., however, has the power to create dollars at will and to use them to purchase foreign goods and assets as long as the market has a reasonable level of trust in the value of the dollar. It can also impose economic sanctions as global trade conducted using dollars is cleared by U.S. banks that are overseen by the American central bank.
- Other countries must sell sufficient goods and assets to obtain the dollars that they require to buy foreign goods and assets. This puts the rest of the world in a tricky situation wherein they could run out of dollars necessary to purchase essential imports needed to keep their economies going.
Why the rupee trade is significant?
In this context, the idea behind the rupee settlement mechanism is that if foreign trade is settled in rupees, this will free India of the need to procure U.S. dollars to import goods and to purchase foreign assets. Simply put, India can pay for its imports using rupees under this mechanism. But this is easier said than done, as is apparent in the case of India’s trade with Russia this year.
How is it performing till now?
- Since the start of the war in Ukraine, India has significantly increased its imports from Russia. While India wants to pay for these imports, which includes a substantial amount of oil, in rupees, Russia is unwilling to accept rupees because it does not intend to buy a similarly significant amount of Indian goods or services.
- Further, Russia cannot offload any excess rupees accumulated due to a trade surplus with India on to other countries since they too may not want to purchase much from India. So, Russia has demanded that India pay in U.S. dollars for its oil.
What are the lessons for us?
- The acceptability of any currency in the global market primarily depends on its purchasing power. The U.S. dollar’s position as the global reserve currency, for instance, comes from the strength of the U.S. economy. So, if a country produces goods and is home to assets that are valuable to foreigners, the purchasing power of its currency will rise automatically and make it more desirable to foreigners. In this regard, when compared to other currencies, the Indian rupee fails since India as an economy simply does not produce enough of what the world desires.
- Developing countries like India generally have higher price inflation than countries in the developed world, a sign that their central banks are debasing their currencies at a faster pace. This explains why currencies such as the rupee, for instance, have steadily declined in value over the decades when compared to developed market currencies such as the U.S. dollar. This, in turn, explains their poor acceptability as global money.
- For instance, foreigners generally want to avoid holding the rupee, which they know from history has steadily depreciated in value when measured against the currencies of developed economies. They would rather use the dollar, which is a relatively strong currency, to engage in trade with India.
The RBI’s rupee settlement mechanism does not really address these nagging fundamental problems with the rupee. Hence, it is unlikely to help much in India’s bid to internationalise the rupee.
Source – The Hindu
QUESTION – Discuss the viability of recent initiatives of the RBI to internationalise the rupee, especially vis-à-vis trade with Russia.