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Source: The post is based on the article “Internationalisation of rupee has risks but they are unavoidable: RBI deputy governor” published in Indian Express on 28th October 2022.
What is the News?
A deputy governor of the Reserve Bank of India(RBI) has emphasized the advantages and risks of the internationalization of the rupee.
What is the Internationalization of the rupee?
Internationalization of the rupee is a process that involves increasing the use of the local currency in cross-border transactions.
It involves promoting the rupee for import and export trade and then other current account transactions followed by its use in capital account transactions.
What are the advantages of the Internationalization of the Rupee?
Firstly, the use of the Rupee in cross-border transactions mitigates currency risk for Indian businesses. Protection from currency volatility not only reduces the cost of doing business, but it also enables better growth of the business, improving the chances for Indian business to grow globally.
Secondly, 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.
Thirdly, reducing dependence on foreign currency makes India less vulnerable to external shocks. For example, during phases of monetary tightening in the US and the strengthening of dollar, excessive foreign currency liabilities of domestic business results in a de facto domestic tightening. Reduced exposure to currency risk would substantially mitigate the pain of the reversal of capital flows.
Fourthly, as the use of the Rupee becomes significant, the bargaining power of Indian businesses would improve, adding weight to the Indian economy, and enhancing India’s global stature and respect.
What are the risks associated with the Internationalization of the Rupee?
India is a capital-deficient country and 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.
A reduced role for convertible currencies in external transactions could lead to reduced reserve accretion. At the same time, however, the need for reserves would also reduce to the extent the trade deficit is funded in Rupees.
Non-resident holdings of Rupees could exacerbate the pass-through of external stimulus to domestic financial markets, increasing volatility. For instance, a global risk-off phase could lead non-residents to convert their Rupee holdings and move out of India.
What are the steps taken for the Internationalization of the rupee?
Enabling external commercial borrowings in Rupees (especially Masala Bonds) was one step.
The July 2022 Scheme of RBI permitting Rupee settlement of external trade created a more comprehensive framework including the flexibility of investing surplus Rupees in Indian bond markets.
The Asian Clearing Union is also exploring a scheme of using domestic currencies for settlement. An arrangement, bilateral or among trading blocs which offers importers of each country the choice to pay in domestic currency is likely to be favoured by all countries and therefore, is worth exploring.
