Date: 01/12/2022

Relevance:  GS-3: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment; Effects of Liberalisation on the Economy, Changes in Monetary Policy and their Effects on Industrial Growth.

Key Phrases: Internationalising currency, Rupees Settlement Mechanism, Reserve Bank of India, Trade surplus, Purchasing Power of Currency, Global Acceptance of Currency, Volatile Nature, Dollar Currency, Central Bank.

Context:

• In July, the Reserve Bank of India (RBI) set up a mechanism to settle India’s international trade transactions with willing countries in rupees as a step in the direction of internationalisation of the rupees.

Key Highlights:

• At the moment, the U.S. dollar is the predominant currency used to facilitate trade between countries.

Internationalisation of the Rupee:

• This is a process that involves increasing use of the Rupee in cross-border transactions.
• Broadly, the process involves promoting Rupee for import and export trade and then other current account transactions followed by its use in capital account transactions.
• These are all transactions between residents in India and non-residents.

Factors Responsible for Acceptability of Currency:

• Purchasing Power
  • 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.
• Quality of Country’s central bank and its other institutions
  • The quality of a country’s central bank and its other institutions also matters in this regard.
  • 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.

Advantages:

• Use of Rupee in cross-border transactions mitigates currency risk for Indian business.
  • Protection from currency volatility not only reduces cost of doing business, it also enables better growth of business, improving the chances for Indian business to grow globally.
• It reduces the need for holding foreign exchange reserves.
  • While reserves help manage exchange rate volatility and project external stability, they impose a cost on the economy.
• Reducing dependence on foreign currency makes India less vulnerable to external shocks.
• As the use of Rupee becomes significant, the bargaining power of Indian business would improve adding weight to the Indian economy, enhancing India’s global stature and respect.

Potential Risks:

• India is a capital deficient country, and hence needs foreign capital to fund its growth.
  • If a substantial portion of its trade is in Rupee, non-residents would hold Rupee balances in India which would 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.
• Non-resident holdings of Rupees could exacerbate pass-through of external stimulus to domestic financial markets, increasing volatility.
  • For instance, a global risk-off phase could lead nonresidents to convert their Rupee holdings and move out of India.

Way Forward:

• These risks are real, but they are unavoidable if India is to progress to be an economic superpower.
  • Macroeconomic policy would need to measure up to such risks.
• Internationalisation would make domestic monetary policy more challenging but the alternative of compromising on growth by playing it safe is clearly not an optimal choice.

Conclusion:

• We need to calibrate our moves to the evolving size of our economy, particularly the size of the external sector and to our appetite for risk in framing policy for external trade and capital flows.

Source: BusinessLine

Mains Question:

Q. Internationalisation of the rupees presents both sides of the coin. Examine the advantages of internationalisation of the currency and associated risks. (250 Words).