Relevance: GS-2: Effect of policies and politics of developed and developing countries on India's interests
Key Phrases: Diversifying its Foreign Currency Reserves, Vostro Accounts of Banks, Market Determined Exchange Rate, India’s vulnerability to Dollar Strength, Exchange Rate Volatility, Internationalising the Rupee, Bilateral Messaging Platforms
Why in News?
- The Reserve Bank of India has recently given permission to Indian importers and exporters to settle their transactions in the rupee.
- It is a significant step towards reducing India’s dollar dependence and diversifying its foreign currency reserves.
Key highlights of the new Settlement Mechanism:
- The settlement mechanism needs the involvement of only the trading partner country and its banks.
- It enables invoicing of all exports and imports in rupee and settlement at a market determined exchange rate.
- Indian banks have been allowed to open special rupee Vostro accounts of banks of the partner trading country.
- All payments made by Indian importers and receivables of Indian exporters will be channelled through these Vostro accounts.
- This process has already been tested while paying for crude oil imports from Iran in rupee.
How will the model work?
- To settle trade transactions with any country, banks in India will open Vostro accounts.
What is a Vostro Account?
It is an account that a correspondent bank holds on behalf of another bank.
- For example, the HSBC Vostro account is held by SBI in India of correspondent bank/s of the partner country for trading.
- Indian importers can pay for their imports in rupee into these accounts.
- These earnings (from imports) can then be used to pay Indian exporters in Indian rupee.
How does the current system of payment work?
- As of today, if a company exports or imports, transactions are always in a foreign currency (excluding with countries like Nepal and Bhutan).
- So in the case of imports, the Indian company has to pay in a foreign currency (mainly dollars and could also include currencies like pounds, Euro, Yen, etc.).
- The Indian company gets paid in foreign currency in case of exports and the company converts that foreign currency to rupee since it needs rupee for its needs, in most of the cases.
What are the reasons for this move by the Central Bank?
- The countries showing diplomatic and economic autonomy are cautious of
using US-dominated global financial systems on account of:
- US’s weaponization of trade
- imposition of sanctions
- exclusion of Russia from SWIFT (Society for Worldwide Interbank Financial Telecommunication)
- The US dollar, the world's reserve currency, can see a steady fall in value in the current environment as leading central banks seek to diversify their reserves away from it and into other assets or currencies such as the Euro, Renminbi, or gold.
- The role of the US dollar as a reserve currency can be used as an offensive weapon at a time when there is a need to insulate the Central Banks of the countries from geopolitical risks.
- The US has for the long used imposition of sanctions as a tool to achieve foreign policy and goals, which entails restricting access to US-led services in the payment and financial transaction processing domain
- The concept is necessary in a multipolar world in which each country seeks economic autonomy in the realm of monetary policy.
- The rise of digital or cryptocurrencies at an increasing pace.
What will be the benefits of transactions in the Indian Rupee?
- Easier trade Transactions with Russia:
- This will immediately make the processing of trade transactions with Russia easier, the long term benefits of which are likely to be more significant.
- Enabling Mechanism for Bilateral Agreements:
- The settlement of all international trading transactions in the Indian currency provides an enabling mechanism to enter into bilateral agreements with all willing trading partner countries to implement a different method of trade settlement.
- Reduction in Trade Deficit:
- If the number of countries with whom such deals are signed expands, it could ease the burden on India’s exchange rate and external account.
- India’s trade deficit has expanded considerably in the last two decades.
- Reduced Vulnerability of Indian Rupee:
- While structural changes in the composition of the country’s import and export basket are the best way to address this imbalance, settling external trade in the rupee reduces India’s vulnerability to dollar strength and the exchange rate volatility caused by domestic demand for the dollar constantly outpacing supply.
- Internationalisation of Rupee:
- This is also a definitive step towards internationalising the rupee and an attempt to hedge against the overarching dominance of the US dollar.
What are the Issues in the diversification of Currency?
- Heavy reliance on dollar trade makes diversification difficult.
- The payment mechanism suggested by the RBI may have to be adjusted based on the preferences of other major trading partners, as some countries may prefer trade settlement in their domestic currency.
- These hurdles can be mastered once there is the will to increase the use of the rupee.
Way Ahead:
- Creation of bilateral messaging platforms could be the way to avoid difficulties arising from future geopolitical tensions.
- The RBI has also stated that surplus money held in these Vostro accounts (of foreign banks in India) can be used for permissible capital and current account transactions.
- With India’s imports being higher than exports, these accounts will have surpluses.
- These funds can be channelled into infra projects, government securities, and treasury bills, as directed by the RBI, thus helping the economy.
Source: The Hindu BL
Mains Question:
Q. The Reserve Bank of India has recently given permission to Indian importers and exporters to settle their transactions in the rupee. Discuss the reasons for the move as well its significance for the Indian economy. (250 words).
