Contributed by: Priyanka Chandran, CFA
The threat to the USD as an international currency in the wake of the financial crisis, emergence of currencies such as the EUR and more recently the RMB which has been accepted in the International Monetary Fund (IMF) basket as a reserve currency raise many questions. These pertain to the evolution and development of internationalization of a currency along with the policy interventions necessary to promote this end. In light of these events, the progress made by the Indian Rupee and the merit to make the currency more international is worth contemplation.
The argument for internationalizing Rupee include benefits availed by any currency which is internationalized. These include currency gains for importers and exporters, lower borrowing costs for domestic borrowers and financial institutions and benefit of seigniorage for the government. But the bigger argument for the internationalization of Rupee lies in the progress of the Indian economy. Literature suggests that economic size, the sophistication of the domestic financial market and stable macroeconomic policies (especially low inflation) ought to be important determinants of currency internationalization, and empirical evidence is generally supportive (Chey, 2013). India has made a lot of progress against some of the parameters which was also evident in the evolution of international currencies over the last century, including the rise of the U.S. dollar in the 1920s and 1930s, the Japanese yen, Deutsche mark and the Euro more recently. This further builds a case for internationalization of INR
Some of the preliminary steps which have already been taken by Reserve Bank of India to liberalize the foreign exchange markets and develop the bond markets include allowing cancellation and rebook of foreign contracts, introduction of INR billing, increasing the FII debt limit, allowing issuance of INR bonds etc. However, some of the other steps which RBI could take in this direction could be as follows:
Liberalization of Currency Market: These would include allowing cancellation and rebook of FX contracts for foreign institutional investors (FII), relaxing trading restrictions for domestic and foreign banks by allowing them to trade in exchange traded contracts forwards and options for their own books and developing a deeper options market.
Deregulation and Deeping of Bond Markets: CRISIL estimates that India will need approx USD 650 billion for infrastructure till 20201. Use of Corporate Bonds for the LAF, developing Exchange Driven markets for Interest Rate Swaps etc could help.
Increased trade flows in the currency: While RBI has a guideline in place to support exports in INR, from a more strategic point of view, it makes sense for India to have local currency invoicing arrangements mostly with countries with which it enjoys a surplus in bilateral trade. A local currency swap arrangement with countries from whom India imports will only encourage more imports.
Having said the above, the roadmap to internationalization of Rupee also has many challenges. China, runs large current account surpluses but India has generally been a current account deficit country. In view of the large current account deficit, the exchange rate of the rupee is susceptible to the influence of large capital movements, especially during crisis periods. Strong and deep bond and currency markets along with robust regulatory and settlement systems would need to be in place. Further to denominate the trades in a common currency other than USD with the adjoining countries in Asia a certain degree of financial market integration is essential. Asian countries have not yet shown the degree of integration as displayed by Europe. There is a definitely more scope for greater cooperation.
While India has a long way to go towards that road, Internationalization is not an inevitable consequence of financial liberalization, nor can a government guarantee that the steps it takes to liberalize its country’s capital account will lead inevitably to internationalization. Yet the macroeconomic situations of India do demand efforts in this direction and internationalization may lead to strengthening of the domestic financial system and enrich the menu of financial assets available to domestic and international investors.