Trade Settlement in Rupee – Explained, pointwise

Introduction

In July 2022, the RBI had issued a circular allowing international trade settlement in Rupees. The move had come amidst continuous fall in the value of Indian Rupee against the US Dollar. It is expected that the decision to allow Indian traders to settle imports and exports in rupees will ease the demand for US Dollar and help control the falling exchange rate. In addition, it will also help in facilitating trade with Russia which is facing sanctions imposed by the US-led Western nations, and is cut-off from accessing international financial mechanisms. The move has many benefits, however, there are certain challenges that must be addressed to ensure the efficacy of the decision and achieve desired outcomes.

What measures have been announced for Trade Settlement in Rupee?

At present, the majority of India’s trade (exports and imports) transactions are undertaken in foreign currency, primarily the US Dollar, and to an extent in Euro. The share of US Dollar (US$) in India’s export transaction settlement has risen from ~57% in 1991 to ~87% in 2014. Similarly the share of US$ in import transactions has risen from 59% in 1991 to  89% in 2014.

Source: Business Standard

This means that the Indian traders have to pay US Dollar to the import suppliers (in foreign countries), and receive US Dollar from the export receivers (in foreign countries). This creates a huge dependence of traders on US Dollar. It also exposes them to currency risk. With the rising interest rates in the US and increasing volatility (fluctuation) in exchange rate of the Rupee with US Dollar, this risk has increased.

To reduce this dependence, the RBI has allowed International Trade settlements in Indian Rupees (INR). The new measures are based on the framework for cross border trade transactions in INR under the Foreign Exchange Management Act, 1999 (FEMA) and Foreign Exchange Management (Deposit) Regulations, 2016.

For the purpose of transaction in Rupee, the exchange rate between currencies of two trading partner countries (say Rupee and Rouble) may be market determined.

The transactions shall be settled through Vostro accounts. For this purpose Indian banks may open Special Rupee Vostro Accounts of correspondent bank/s of the partner trading country.

Indian importers undertaking imports through this mechanism can make payment in INR which will be credited into the Special Vostro account of the correspondent bank of the partner country. Indian exporters, undertaking exports of goods and services through this mechanism, will be paid the export proceeds in INR from the balances in the designated Special Vostro account of the correspondent bank of the partner country.

The Rupee surplus balance accumulated in Vostro account (in case imports from a country exceed exports to that country) may be used for permissible capital and current account transactions. The balance in Special Vostro Accounts can be used for: (a) Payments for projects and investments; (b) Export/Import advance flow management; (c) Investment in Government Treasury Bills, Government securities (subject to FEMA and similar statutory provisions).

What factors have necessitated Trade Settlement in Rupee?

Global Capital Reallocation: The US Fed has been raising interest to combat domestic inflation in the US. This has led investors to shift their capital to the US (in search of higher returns in the US), depreciating major currencies with respect to the Dollar. Rupee has crossed INR 80 level vis-a-vis dollar. This has put pressure on India’s forex reserves and made imports more expensive.

Russia-Ukraine Conflict: The conflict has extended to 9 months with no end in sight. It has led to global rise in prices of commodities including food items and energy sources (oil and gas). Russia has reduced gas supply to Europe leading to rise in global prices (supply-demand mismatch).

Moreover, the sanctions imposed by Western nations on Russian firms have made it difficult for India to import oil from Russia. Russian Banks and firms have been barred from accessing global financial settlement mechanisms. Hence an alternate mechanism for trade settlement is required.

Widening Trade Deficit: Despite a historic uptick in exports, the Current Account Deficit (CAD) is projected to more than double to US$ 100 billion in 2022-23. It might approach the critical level of 3% of GDP. Higher value of US Dollar will increase India’s imports further putting pressure on CAD and forex reserves.

Imported Inflation: Since India imports almost 85% of its annual oil needs, a weaker currency increases the risk of imported inflation in India.

What are the benefits of Trade Settlement in Rupee?

Shift in Dominant Currency Paradigm: Deputy Director of IMF, Gita Gopinath, recently remarked that the International trade today is centred on the ‘Dominant Currency Paradigm’ (DCP), in which the US dollar holds predominance as the source, destination and vehicle currency. This makes trade of other countries susceptible to fluctuation in the value of US Dollar. Trade settlement in Rupee will assist lessen India’s dependency on US dollars and therefore shift in this paradigm.

Flexibility to Traders: Traders from both India and other trading countries involved in the transaction will benefit because they won’t have to pay to convert the money or worry about the variation in the exchange rate.

Circumvent Sanctions: Circumventing the SWIFT (system used by banks for payments in foreign currency) system and paying for imports in rupees would help India work around the sanctions imposed on Russia and Iran and facilitate access to cheaper oil.

Reduce Outflow of US Dollar: India runs a trade deficit (imports are greater than exports), this means more dollars are paid for imports than gained through exports. Trade settlement in Rupee will save dollar outflows. At a time when the rupee’s value is declining against the US dollar, saving dollar outflows becomes even more critical for the RBI.

Addressing the issue of US dollar Mobilisation: Traders from several parts of Africa, South America and Asia are unable to mobilise the US dollar for invoicing. The problem of mobilising the US dollar affects trades between these countries and the rest of the world. If these countries are willing to invoice exports and imports trade in Rupee, it will brighten the prospects of their bilateral trade with India.

Internationalise the rupee: A transparent and efficient framework for conducting international trade transactions in Rupee is the first step towards the path of Rupee’s acceptance as a global currency. The present status is far from Rupee becoming a reserve currency, nevertheless, this is a small first step.

Geopolitics: The move is significant in international politics because it indicates the beginning of more coordinated efforts to settle payments in non-dollar currencies among Brazil, Russia, India, China, and South Africa (BRICS), with other South Asian nations also interested. In these uncertain times, when China and Russia are creating alternative payment systems, this would strengthen the position of the Indian rupee on the international stage.

What are the challenges in Trade Settlement in Rupee?

Bilateral Trade Equilibrium: Countries whose exports to India are more than imports, will not be too enthusiastic to trade in rupees. As long as the trade is in equilibrium (exports equal to imports), the Vostro account mechanism will work efficiently. However, excess of imports over exports will lead to surplus in Vostrol account, which has limited benefit for the trading country e.g., in 2021, India’s exports to Russia were at US$ 3.3 billion while its imports from Russia were at US$ 8.6 billion. This means that international trade settlement in rupee can happen up to US$ 3.3 billion where exports and imports are equal. Beyond this point, Russia has excess of US$ 5.3 billion which gets locked in Indian Rupee. At most, they can invest in Government Securities which offer limited return.

In the above simplified transaction, the Vostro Account has surplus of INR 50 as imports are worth more than exports. If there is persistent trade deficit the surplus will keep on accumulating. Due to capital restrictions, the Russian Bank will find it difficult to withdraw this surplus (hence can’t reinvest and earn returns). 

Moreover, Rupee is not a fully convertible currency in Capital Account. Therefore, investment in government securities and bonds cannot be repatriated back to Russia.

Limited Scope: Trade settlements in rupee will be limited to countries like Russia and Iran, which are facing sanctions from the West, and Sri Lanka, which is going through an economic turmoil, and a few other immediate neighbours of India. India’s share in global trade is not significant enough and India’s dependence for import of fossil fuels, edible oils, gold etc. is quite large. It is unlikely that exporting countries will consider Indian rupee as a currency of invoicing, unless it suits their interests. The position of US Dollar as international reserve and trading currency appears too strong at present.

The US Dollar is dominant currency in International Trade. 74% of trade in Asia Pacific is invoiced in US$. Share is low in Europe where majority of trade is invoiced and settled in Euro (€).

Bilateral Exchange Rate: The international trade transactions between two countries are shaped by various factors such as political and economic relations, availability of goods, quality and competitive pricing etc. Exchange rate happens to be one of the factors in deciding trade. All elements have to be examined seriously which directly impact the landed cost for importers.

Trade Protectionism: In the prevailing global trade protectionism and geopolitical rivalries, each country wants to promote exports and reduce imports. Invoicing in Indian Rupee and not depending on US Dollar may upset India’s relationship with the US. It may also have an indirect impact on services sector for which we are dependent on developed markets like the US and Europe.

What can be done going ahead?

First, To promote rupee for international trade settlements, India needs to enhance its export competitiveness. Rise of share of Indian goods in global trade will create a demand for Indian Rupee as well and make it a more tradable currency.

Second, This should be supported by critical reforms in financial markets which include capital account convertibility, deepening financial markets coupled with large financial institutions other than the RBI to manage the large scale inflow and outflow of capital.

Conclusion

The RBI’s decision to allow trade settlement in Rupee has been welcomed by economic experts. It is expected to lead to many macroeconomic benefits like curbing CAD, reducing pressure on forex reserves etc. among others. However, there are still many challenges to wider acceptance of trade settlement in Rupee. That would be possible only in the long term by making Indian exports more competitive accompanied by financial sector reforms.

Syllabus: GS III, Indian Economy

Source: Indian Express, Mint, The Hindu BusinessLine, The Times of India, RBI