Strength and opportunity: What rupee going 'international' will mean

It may seem a distant dish but the Reserve Bank of India’s decision Monday to allow trade to be settled in rupee has stirred a pot of debates around the potential internationalisation of India’s currency. What would internationalisation entail? 'Business Standard' explains.

What does currency internationalisation mean?

National currencies are termed ‘international’ when they fulfill two criteria. First, they can trade beyond their immediate national borders. Second, they can be accepted as media of exchange for trade even when the nation of their origin is not involved in the transaction. For instance, the United States (US) need not be part of a trade transaction between an Indian and a Singaporean merchant, nor does the trade need to take place on American soil, for the US dollar to facilitate this transaction.

A fully internationalised currency such as the US dollar, can be used in the invoicing of trade in goods and services, as well as dividend payments, foreign direct investments and more. Such an arrangement requires full convertibility of the currency on current as well as capital account transactions.

Is the Indian rupee convertible?

The rupee is partially convertible. It attained current account convertibility in the early- through mid-1990s. This means the rupee can be converted to any foreign currency at existing market rates, easing financial transactions for the export and import of goods and services, for any amount.

The rupee remains capital account non-convertible. This means, that while there are provisions at present for bringing in foreign capital or taking out domestic money, the central regulators impose a stringent system of checks and balances, including ceilings, approvals etc. on such transactions. Moreover, the regulators, including RBI, swing in from time to time to control the rupee’s exchange rates, instead of leaving it completely at the mercy of the market forces.

What if rupee becomes fully convertible?

Capital account convertibility will allow local financial assets held in rupee to be converted into foreign financial assets and vice-versa. This entails several opportunities as well as challenges.

Opportunities

The Committee on Capital Account Convertibility (CAC), or the S Tarapore Committee, established by the RBI to present a roadmap towards full rupee convertibility, listed three major benefits in its 1997 report. Indian businesses will be able to issue foreign currency-denominated debt to Indian investors, and it will be easier to offer gold-based deposits and loans with higher, even uncapped, limits.

Further, full capital account convertibility will open up India’s markets to global investors, businesses, and trade partners. Such convertibly provides easy access to capital for different businesses and sectors.

Increased involvement of global players will bring in new strategic partnerships, direct investment opportunities, and ultimately, employment opportunities. This will also ensure a more diverse set of foreign goods and services available in domestic markets, as well as FDI investments in currently restricted sectors such as insurance, retail etc.

Local businesses will also benefit from easier access to foreign loans at comparatively lower interest rates. While now Indian companies apply for ADR/GDRs, post-internationalization, they’ll be able to raise equity capital from overseas market, a more direct route.

Challenges

The biggest challenge for a full capital account convertibility is the high levels of currency volatility that often follow such a move. Without regulatory controls, and with exchange rates subject to market forces, opening up the market to high levels of foreign capital flows from a large number of global players, can cause rapid devaluation in the currency as well as inflation in forex rates. The South African Rand, one of the more volatile international currencies, is a prime example.

Rand’s volatility also exemplifies how socio-political factors such as corruption, employment rate and political volatility can prove to be major players in determining the post-full convertibility performance of a currency. These factors, along with India’s burgeoning population and restrictive bureaucracy, can also play spoilsports for the rupee.

Moreover, leaving the exchange rates at the mercy of market forces can lead to mounting foreign debt burdens. While the full convertibility of the rupee encourages business to easily raise foreign debt, repaying them back will become harder if the currency against which the trade is being conducted, let’s say the USD, appreciates. Since the US dollar remains one of the most oft-used currency for global transactions, and the rupee is considerably weaker against the dollar, the possibility of such foreign debt burdens is quite real.

With full currency convertibility, the country’s bond market will also be more susceptible to market risks. With a fully convertible currency, foreign trade in the currency will primarily be channeled through government bonds. However, for instance, if internal unrest causes Russia to pull out of the Indian bond market, the prices of bonds will fall drastically, interest rates will rise up, and government borrowings will become costlier.    

Is India ready?

The answer is: Not yet. RBI governors have traditionally maintained that full convertibility is a process rather than an event. And it’s a long process. India still needs to establish basic infrastructural provisions for maintaining low levels of non-performing assets, fiscal consolidation, and efficient monitoring of financial organizations and businesses.

Also crucial are manageable current account deficits (CAD). Unlike China, which runs large current account surpluses, India has primarily remained a current account deficit country. Major CADs imply the exchange rate of the rupee will remain susceptible to the influence of large capital movements, especially during crisis periods.

In FY 21-22, RBI reports have mapped India’s current account balances (CAB) from a moderate surplus in Q1 to moderate deficits in Q3. In fact, India’s CAD again decreased to US$ 13.4 billion (1.5 per cent of GDP) in Q4 from US$ 22.2 billion (2.6 per cent of GDP) in Q3. While this might seem a favorable movement in the short run, widening trade deficits and the rapidly strengthening dollar could reverse these trends in the next quarter.