[Answered] Discuss the risks and opportunities associated with local currency settlement systems like the one established between India and the UAE. How can policymakers balance these risks and opportunities?

Introduction:

The Reserve Bank of India (RBI) and the Central Bank of the UAE recently established a local currency settlement system to enable the use of the Indian rupee and the UAE dirham for cross-border transactions. This move aims to reduce reliance on third-country currencies like the U.S. dollar and promote bilateral trade. The establishment of this settlement mechanism offers both risks and opportunities for businesses and policymakers in India and the UAE.

Discuss the Risks and Opportunities Associated with Local Currency Settlement Systems:

Opportunities:

• Reduced Exchange Rate Risks: The local currency settlement system allows Indian and Emirati businesses to conduct trade without the need to consider exchange rate risks. This can enhance ease of doing business and foster greater trade between the two nations.
• Development of Forex Market: The system could lead to the establishment of a rupee-dirham foreign exchange market, enabling independent pricing of the two currencies. This development can support smoother transactions and boost financial market activity.
• Precursor for Internationalization of Rupee: The India-UAE settlement system can act as a model for other bilateral currency agreements, potentially contributing to the internationalization of the Indian rupee.

Risks:

• Dependence on Adoption: The success of the local currency settlement system depends on its adoption by businesses in both countries. If businesses do not fully embrace the system, its potential benefits may not be realized.
• Potential Liquidity Issues: Emirati businesses receiving payments in Indian rupees may face challenges in deploying these funds effectively, necessitating avenues for remunerative investment or becoming a currency entrepôt.
• Global Economic Uncertainties: In an evolving global economic environment, policymakers must consider the uncertainties and potential risks associated with local currency settlement systems, as they can impact trade and financial stability.

How Can Policymakers Balance These Risks and Opportunities?

• Promote Awareness and Education: Policymakers should engage in extensive awareness campaigns to educate businesses about the benefits of the settlement system and encourage its adoption.
• Encourage Investment Opportunities: To address liquidity concerns, policymakers can promote attractive investment opportunities in both countries to encourage the productive deployment of funds received in the local currency.
• Monitor and Mitigate Risks: Continuous monitoring of the settlement system’s impact and potential risks is essential. Policymakers should be prepared to implement mitigation strategies if any adverse consequences arise.
• Engage in Bilateral Dialogue: Regular communication and dialogue between Indian and Emirati authorities can help address concerns and identify new opportunities for collaboration and economic growth.

Conclusion:

The local currency settlement system between India and the UAE offers opportunities for trade and financial cooperation, but effective risk management and promotion of investments are vital for success.