Rupee Convertibility

The Rupee Trade: Legacy

The word “rupee” is derived from Sanskrit “Rupyakam”, meaning “wrought silver”. The mention of rūpya by Pāṇini is possibly the earliest reference in a text about coins. The Arthashastra, written by Chanakya (c. 340–290 BC), mentions silver coins as rūpyarūpa. ‘Rupya’ remained in use during the Mughal period, Maratha era, as well as in British India. The high standards of production and quality control ensured its sustained and widespread acceptability.

The earliest issuers of paper rupees include the Bank of Hindostan (1770–1832), the General Bank of Bengal and Bihar (1773–75, established by Warren Hastings, and the Bengal Bank (1784–1791).

The Indian rupee had a 500-year long ‘international” innings, with some Gulf countries using it even after Indian independence in 1947, due to their extensive trade ties. In fact for many years in the early and mid-20th century, the Indian rupee was the official currency in several areas that were controlled by the British and governed from India; areas such as East Africa, Southern Arabia and the Persian Gulf.

The rupee retreated because of emerging challenges before the RBI, some of which are listed below:

• Rampant gold smuggling from the Gulf region between 1950s to 1970s due to the price arbitrage supported by unrestricted availability of Indian Rupees from the mainland;
• The aftermath of the 1965 India-Pakistan war;
• A sharp deterioration in India’s economic strength and Balance of Trade;
• A severe drought in the country, requiring massive food assistance; etc.

The devaluation of the Indian Rupee in 1966 was the final trigger for these nations to transition to their own currencies.

Currency Convertibility

Until the early 1990s (pre-reform period), anyone willing to transact in a foreign currency would need permission from the Reserve Bank of India (RBI), regardless of the purpose. During the mid-1990s, the rupee was made current account convertible for all trading activities, remittances, and indivisibles. However, the rupee continues to remain capital account non-convertible as of now.

Convertibility envisages unobstructed transfers for trade and capital transactions in the non-home currency of either one or both the parties to the transaction. Currency movement between countries is broadly categorized as being on (i) Current Account for trade and remittances or (ii) Capital Account for transfer of financial assets. Depending on the strength of a country’s economy and its perception of the most advantageous trade features, permitted currency flows may be fully or partially free. Thus, a country may allow its currency to be convertible for transactions on current account or capital account, or both.

Payments through the medium of a settlement currency requires that a sufficient stock of the earmarked currency be available for the transaction to be consummated. The introduction of a 3^rd Party Settlement Currency introduces elements of financial risk arising from (a) non-availability of the settlement currency, (b) variable exchange cost for conversion from the currency of the contracting parties to the currency for settlement, (c) business risk due to disclosure of trade details to the settlement banker, etc.

The example of FATCA as a control factor introduced by the USA on US Dollar (USD) holdings given the wide-spread use of USD as a settlement currency, is a pointer in this direction. Disruption of trade relations by denying payment mechanisms like SWIFT in the recent sanctions imposed on Russia, is another. In addition, traditional trading partners or significant allies may be unable to pay for their dues in Convertible Currency due to temporary setbacks, eg. Sri Lanka.

Rupee Payments

In order to reduce the need for a settlement currency controlled by a third party and promote exports, the Reserve Bank of India issued a circular on July 11, 2022, allowing trade settlements between India and other countries in Rupees with immediate effect. Some of the key features in this regard are:

1. All export contracts and invoices from India should be denominated either in freely convertible currency or Indian rupees but export proceeds are to be realized in freely convertible currency. However, export proceeds against specific exports may also be realized in rupees, provided it is through a freely convertible Vostro account of a non-resident bank situated in any country other than a member country of Asian Clearing Union (ACU) or Nepal or Bhutan.
2. Additionally, rupee payment through Vostro account must be against payment in free foreign currency by the buyer in his non-resident bank account.
3. Free foreign exchange remitted by buyer to his non-resident bank (after deducting bank service charges) on account of this transaction would be taken as export realization under export promotion schemes of FTP.
4. Contracts (for which payments are received through Asian Clearing Union (ACU) shall be denominated in ACU Dollar. However, participants in the ACU may settle their transactions in ACU Dollar or in ACU Euro as per RBI Notifications. Central Government may relax provisions of this paragraph in appropriate cases. Export contracts and invoices can be denominated in Indian rupees against EXIM Bank/Government of India line of credit.
5. Invoicing, payment and settlement of exports and imports is also permissible in INRsubject to compliances as under RBI’s A.P. (DIR Series) Circular No.10 dated 11th July, 2022.
6. Export Realizations in Indian Rupees would be applicable to FTP Schemes, as notified.

Reasons for RBI’s initiative

The decision was taken against the backdrop of :

1. US sanctions on the use of the dollar for transactions with Iran and Russia.
2. Reduce the pressure on India’s forex reserves and stop continuous weakening of the rupee,

• Promote growth of global trade with an emphasis on Indian exports,

1. Buttress the increasing interest of the global trading community in the Indian rupee.
2. Trade in local currencies is a likely solution to avoid the current wave of wartime international sanctions that are hampering supply chains and global trade flows.

India is a net importer of goods and the value of the Indian rupee has been declining consistently. The rupee was the worst performing Asian currency in 2022, witnessing a fall of around 10% against the greenback. Using the rupee for international trade transactions will help check the flow of dollars out of India and slow, to some extent, the depreciation of the currency.

Currently, Russia, Sri Lanka, and Mauritius have opened Vostro accounts. A potential rupee-dirham payment mechanism with Saudi Arabia and the UAE might also begin soon. Around 60 Banks from 18 countries have reportedly been permitted by the Reserve Bank of India (RBI) to open Special Vostro Rupee Accounts (SVRAs) for settling payments in Indian Rupees. These include Botswana, Fiji, Germany, Guyana, Israel, Kenya, Malaysia, Mauritius, Myanmar, New Zealand, Oman, Russia, Seychelles, Singapore, Sri Lanka, Tanzania, Uganda and the United Kingdom.

Facilitating the rupee trade is also expected to spur exports to Russia, which dropped by 17% in the first half of 2022-23 to $1.6 billion, majorly due to the delayed receipt of payments. International trade settlements in rupee are expected to gradually contribute to the global acceptance of the currency, and later make it possible to repay loans taken from fund banks like the Asian Infrastructure Investment Bank.

In the last one year, India has finalized trade pacts with partner countries such as the UAE and Australia and begun negotiation with others such as the U.K. and the European Union while making inroads for the national currency in bilateral and global trade.

Possible difficulties

(Ref: Vaishali Basu Sharma “Wire’10/01/2023)

While the ‘internationalization’ of the rupee may lower transaction costs of cross-border trade and investment operations by mitigating the exchange rate risk, it could lead to the following complications:

1. Formulating the monetary policy will be rendered more difficult due to the introduction of multiple factors outside national control, eg., circulation of Rupees in foreign locations where RBI has no jurisdiction. RBI’s report warns that the ‘internationalisation’ of the rupee can potentially limit the ability of the Central Bank to control domestic money supply and influence interest rates as per the domestic macroeconomic conditions.
2. International trade transactions between nations are shaped by various factors, such political and economic relations, availability of goods, quality, competitive pricing and exchange rates. For instance, the currencies of several countries like Bangladesh, Turkey and the UK have depreciated against the US dollar by more than 10%. However, will Turkey, where Lira has depreciated by almost 94% against the dollar, import more from India even if we decide to have the exchange rate fixed?
3. The dollar’s proportion of global invoices is currently 4.7 times more than its share of global imports, making the dollar’s value considerably more important than bilateral exchange rates for forecasting cross-country trade flows.
4. The simultaneous pursuit of the exchange rate stability and a domestically oriented monetary policy will be more challenging, “unless supported by large and deep domestic financial markets that could effectively absorb external shocks”.
5. Apart from sophisticated financial markets, the most important prerequisite for the ‘internationalisation’ of a currency is price stability. As observed by RBI’s Deputy Governor, T. Rabi Sankar, in October 2022 “If a substantial portion of its trade is in rupee, non-residents would hold rupee balances in India which could be used to acquire Indian assets. Large holdings of such financial assets could heighten vulnerability to external shocks, managing which would necessitate more effective policy tools,”
6. In the prevailing global atmosphere of trade protectionism and geopolitical rivalries, promoting invoices in rupee with various countries will not be an easy task. Indian private banks with an exposure in the US are worried about getting involved in trade transactions with Russia. An attempt to challenge dollar dominance might indirectly affect the services sector for which we are dependent on the developed markets like the US and Europe.
7. India’s share in global trade is not significant and we are overwhelmingly dependent on the import of fossil fuels, edible oils, gold, silver, etc. making it unlikely for exporting countries to consider the Indian rupee as an invoicing currency.

To promote the rupee as a settlement currency, India must increase its exports and imports, backed by critical reforms that include capital account convertibility, deepening financial markets, and supported by suitable institutions to manage exchange and price stability.