Vijay Kumar Gaba

The Reserve Bank of India constituted an Inter Departmental Group (IDG) in December 2021 “To examine issues related to Internationalisation of INR and suggest a way forward”. The Group submitted its recommendations in October 2022; and the same have been made public last week. The following are some of the highlights of the IDG recommendations.

Terms of References

The terms of reference of the IDG were as follows -

·         To review the extant framework for use of INR for current and capital account transactions and assess their current levels;

·         To review the extant position of use of INR for transactions between non-residents and the role of off-shore markets in this regard;

·         To propose measures, consistent with the desirable degree of capital account liberalization, to generate incentives for use of INR for trade and financial transaction invoicing and denomination, official reserves and vehicle currency for foreign exchange intervention after analyzing data obtained from AD Banks on INR invoiced trading;

·         To propose measures to bring greater stability in the exchange rate of INR determined by market forces and deep and liquid market with availability of wide range of hedging products, efficient banking system and world class infrastructure with easy accessibility to both residents and non-residents;

·         To recommend measures to address concerns, if any, arising of the Internationalisation of INR;

Internationalisation of currency

“An international currency is used and held beyond the borders of the issuing country for transactions between residents and non-residents, and between residents of two countries other than the issuing country. Currency Internationalisation has thus been described as the international extension of a national currency’s basic functions of serving as a unit of account, medium of exchange and store of value. In other words, the internationalization of a currency is an expression of its external credibility as the economy integrates globally.”

Why Internationalisation?

Internationalisation of a currency helps both the government as well as the private sector the issuing currency, by—

·         allowing a country’s government to finance part of its budget deficit by issuing domestic currency debt in international markets rather than issuing foreign currency instruments;

·         allowing a government to finance part, if not all, of its current account deficit without drawing down its official reserves;

·         allowing the country’s exporters and importers to limit exchange rate risk by allowing domestic firms to invoice and settle their exports/imports in their currency, thus shifting exchange rate risk to their foreign counterparts;

·         permitting domestic firms and financial institutions to access international financial markets without assuming exchange rate risk;

·         offering new profit opportunities to financial institutions, although this benefit may be offset in part by the entry of foreign financial institutions into the domestic financial market (to the extent that the government permits it); and

·         reducing the cost of capital and widening the set of financial institutions that are willing and able to provide capital; thus, boosting capital formation in the economy thereby increasing growth and reducing unemployment.

Cost of internationalisation

The internationalisation of a currency does not happen without a cost. Besides resulting in higher volatility in the exchange rates, it usually has monetary policy implications as the obligation of a country to supply its currency to meet the global demand may come in conflict with its domestic monetary policies, popularly known as the Triffin dilemma. Also, the internationalisation of a currency may accentuate an external shock, given the open channel of the flow of funds into and out of the country and from one currency to another.

The costs also emanate from the additional demand for money and also an increase in the volatility of the demand. International currency use can also have an undesirable impact on the financing conditions.

The process of internationalisation

The IDG felt that internationalisation of INR is a process rather than an event. A series of continuous efforts would be needed to achieve the long-term goal of INR internationalisation. There is a need to build upon the small steps already taken.

Many factors play a role in internationalisation of a currency. The prerequisite for internationalisation is however “widespread use of a currency outside the issuer’s borders”. To popularize the international use of a currency, the factors like size of the economy; centrality to global trade; capital account openness, macroeconomic stability, and depth of financial markets, which provide global investors with a safe store of value, etc. are considered important.

The roadmap for internationalisation therefore includes:

·         Removal of all restrictions on any entity, domestic or foreign, to buy or sell the country’s currency, whether in the spot or forward market.

·         Domestic firms can invoice some, if not all, of their exports in their country’s currency, and foreign firms are likewise able to invoice their exports in that country’s currency, whether to the country itself or to third countries.

·         Foreign firms, financial institutions, official institutions and individuals can hold the country’s currency and financial instruments/assets denominated in it, in amounts that they deem useful and prudent.

·         Not only are foreign firms and financial institutions able to issue marketable instruments in the local currency, but the issuing country’s resident entities are also able to issue local currency-denominated instruments in foreign markets.

·         International financial institutions, such as the World Bank and regional development banks, can issue debt instruments in a country’s market and use its currency in their financial operations.

Internationalisation of the INR and capital account convertibility are processes which are both closely and symbiotically intertwined with each other.

Recommendations of IDG

In view of the IDG over the long term (5yr and above), India will achieve higher level of trade linkages with other countries and improved macro-economic parameters, and INR may ascend to a level where it would be widely used and preferred by other economies as a “vehicle currency”. The IDG recommended that keeping in mind the long run goal of inclusion of INR in IMF’s SDR basket, the following measures should be taken in the short and medium term.

Short term (upto 2yrs) measures

·         Designing a template and adopting a standardized approach for examining the proposals on bilateral and multilateral trade arrangements for invoicing, settlement and payment in INR and local currencies.

·         Making efforts to enable INR as an additional settlement currency in existing multilateral mechanisms such as ACU.

·         Facilitating LCS framework for bilateral transactions in local currencies and operationalising bilateral swap arrangements with the counterpart countries in local currencies.

·         Encouraging opening of INR accounts for non-residents (other than nostro accounts of overseas banks) both in India and outside India.

·         Integrating Indian payment systems with other countries for cross-border transactions.

·         Strengthening financial markets by fostering a global 24x5 INR market and promoting India as the hub for INR transactions and price discovery.

·         Facilitating launch of BIS Investment Pools (BISIP) in INR and inclusion of G-Secs in global bond indices.

·         Recalibrating the FPI regime and rationalizing/harmonizing the extant Know Your Customer (KYC) guidelines.

·         Providing equitable incentives to exporters for INR trade settlement.

Medium-term measures (2 to 5yrs)

·         A review of taxes on Masala bonds.

·         International use of Real Time Gross Settlement (RTGS) for cross border trade transactions and inclusion of INR as a direct settlement currency in the Continuous Linked Settlement (CLS) system.

·         Examination of taxation issues in financial markets to harmonise tax regimes of India and other financial centers.

·         Allowing banking services in INR outside India through off-shore branches of Indian banks.

The IDG discussed in detail the steps already taken by the government and RBI to achieve the larger objective. From the recommendations however it appears that the steps already taken are too small. The government needs to accelerate the process to earn the confidence of domestic and international businesses and investors to improve the acceptability of INR over the next five years. The most important step seems to be “decontrol”; something the incumbent government has not been very fond of. The volatility, opacity and subjectivity in the policy making seems to have led to erosion of faith in INR. These are perhaps the factors which prevented IDG from categorically saying that INR could be internationalised in the next 10yr or so.

Also see: Internationalisation of INR - 1