Background

When Russia first attacked Ukraine this year, countries across the world chose to sever ties with Russia. Russia was left alone and couldn’t engage in trade with other countries the way it used to. Russia, the biggest oil producer in the world, was locked out of many markets and had nowhere to sell its oil. That’s when they found a new trading partner in India who accepted Russia’s offer and bought oil at a deep discount. However, the problems didn’t end there for Russia. US, EU, and the UK had also imposed sanctions on Russian banks from accessing the ‘Society for Worldwide Interbank Financial Telecommunication (SWIFT) network. SWIFT is a Belgium-based globally secure interbank system that is well-accepted and near universal. The network assures payments across banks and countries and facilitates the movement of goods and services. However, Russia was locked out of this system. And that’s when, India and Russia agreed to deal in Rupees and Rubles, a historic move!

The dollar is the de-facto currency for international trade. Trade across the world, irrespective of the countries involved, happens majorly in US dollars. India’s 86% of imports are in dollars, while we merely buy 5% of our imports, from the United States. So, when India helped Russia, we made a special exception. And now it seems, that the exception is set to become a rule. The Reserve Bank of India (RBI) has announced to permit settlement of International Trade in Indian Rupees. This means we can bill in Rupees and maybe also import paying Indian Rupees. Of course, this will take time to settle and become the norm, however, the move has been made and the Rupee is set to travel to foreign countries. In this article, let’s understand how International Trade Settlements will work in Indian Rupees and what made the Reserve Bank of India resort to such an option.

How do international trade settlements work?

During the second world war and thereafter, the United States served as the main supplier of arms and weapons. In those days, international trades were settled with gold, under the gold standard. With huge exports, the United States became the owner of the majority of the gold in the world. This made the dollar a more reliable currency than any other in the world, as it was backed by a huge reserve of gold. The United States started paying countries in its currency, by printing more of it, backed by Gold, instead of using the Gold reserve. Economies around the world started maintaining their reserves in USD, as it was as dependable as Gold. Later, the United States delinked their currency from the gold standard, however, this didn’t affect the currency and even today, an approximate 59% of the global central bank reserves are in the United States. Now, please note, that the reserve here doesn’t consist of paper currency, as international trades are merely settled through banks and not an exchange of currencies. The balance, in simple words, is maintained as an account balance in a bank account in the United States. Thus, India has a bank account in the United States where all transactions happen in USD and the balance would be in USD. Similarly, most countries maintain their bank account in the United States, as it is the de-facto currency for trade.

Today, when countries import and export goods and services they have to make payments in a foreign currency. For example, if an Indian buyer enters into a transaction with a seller from Germany, the Indian buyer has to first convert his rupees into US dollars. The seller will receive those dollars which will then be converted into Euros. These trades are facilitated by banks in the United States. So when India imports oil from Germany, they would ask Germany to furnish their bank account details, the bank account that they have in the United States, maintained to receive and pay for international transactions. India would then deposit dollars in that USD account of Germany, out of its USD account. Later, Germany can use the USD balance in their account to pay for trades around the world. Since most trades occur in US dollars, rich countries have a huge stockpile of balance in their bank account in the US. And so did Russia. Russia may not be an ally of the United States, but it too had a huge chunk of its reserve as a balance in the US bank account. So, when the country was banned from the SWIFT network and international trade, it could not use the balance in its US bank account. This is where trade settlement in rupees comes in. Instead of paying and receiving US dollars, why not just bypass and pay or receive in our currencies?

How will international trade settlements in Rupee work?

If we try to bypass the USD, things do get a little complicated. Consider, a Russian oil exporter who wants to export oil to India. To bypass USD, they will have to maintain an account in India, so that when India makes a payment in Rupee, it will get deposited in Russia’s Rupee account maintained in India. This account is known as Rupee Vostro, in which the payments, receipts and balance would be in Rupee. Once the trade is completed, the Russian banks will organise to convert the Rupees at a foreign exchange rate, and pay the Russian company in Rubles, since the Rupee balance won’t be of any use to the Russian company. Thus, the Russian banks will ultimately own Indian Rupees in an Indian account. Now, the banks also do not have any other use for the Indian Rupee balance, unless there’s another trade of reverse nature. So, in another trade, if an Indian Wheat exporter wants to export wheat to Russia, he could get paid in Rupees through this balance. Now, if there are excess rupees just lying idle in the Vostro account, the bank can also invest them into Indian government bonds and earn interest on it. All this seems fine and workable until we bring in more currencies.

What would happen when all countries start working on a direct basis? There would be so many Nostro accounts with balances from several countries and banks wouldn’t like the same, as this would hinder their business. Of course, the Central Bank in the other country can arrange for inter-bank settlement between its banks to knockoff opposite balances and maintain a net balance for the country, however, that would still be a huge amount, especially if the trade deficit (net imports of the country) is huge. India already has experience in operating alternate payment mechanisms to settle dues in rupees instead of dollars when India and the USSR agreed on a similar arrangement. However, India’s balance of trade was skewed with the imports from Russia far exceeding the exports. Our rupee balance in USSR account kept increasing and the arrangement was finally terminated in 1992, and even then, it took a long time to encash the rupee balance. India also had a rupee-rial payment mechanism when Iran faced economic sanctions. It worked well to some extent until the United States placed more sanctions.

While it seems troubling based on past experiences, times have changed considerably. India’s GDP is higher than Russia’s, and also its credit rating, although India still has a trade deficit with Russia. India imported worth INR 64,623 crore in 2021-22, while exported only INR 23,658 crore. The possibility of the rupee balance ballooning similar to the past attempt still exist. However, the current version does not allow utilisation of the excess balance for investment in government treasury bills. This might control the quantum of such trades, as agree to enter such transactions only if they have counter arrangements to ensure there is no idle balance. How fruitful this arrangement in Rupee would turn out is something that only time can tell us. However, there are certain benefits which seem obvious based on the timing of this latest move.

Why does the RBI want to settle international trades in Rupees?

The first and obvious reason that most people would have guessed based on the timing of the announcement – is the falling value of the Indian Rupee. The Indian Rupee has lost its value by far and has reached its all-time high. While a weaker Rupee is great news for exporters who are now earning more than usual, and doing nothing new, merely because of the higher foreign exchange rate, it’s not the complete story. India is a net importer of goods, with a huge trade deficit. Therefore, losing the value of the rupee means paying more for imports and being a net importer Indian economy is paying a huge bill with every passing day. This is, in turn, triggering inflation in the domestic markets with a higher cost of inputs imported from other countries. Meanwhile, foreign investors aren’t looking to park their money in India as our economy isn’t exactly booming either. This is the reason why there is a lesser demand for the Indian Rupee and thereby, weakening the currency.

The second reason for the RBI’s move is strategic. Russia attacked Ukraine and faced the economic wrath of the world. If India were to carry out any such attacks, or if diplomatic relations with the United States turn sour for any other reason, India would risk and jeopardize its economy. India needs to reduce its dependency on the United States and this move is in the right direction, from that perspective. However, it all depends on how other countries perceive the option and whether they agree to this new arrangement, or how successfully India implements such arrangement. The recent Ukraine-Russia crisis and sanctions on Russia have been a real eye-opener for most countries and India has struck when the iron is hot.

The third reason for RBI’s move can be owing to the recent success in such transactions with Russia whereby the central bank may have considered expanding such transactions to a few more countries. The thing is, India’s trade deficit has expanded to a record USD 26.2 billion in June 2022 and is only expected to only rise further. This would mean the Indian rupee is going to tumble down further. The government has already hiked import duties on gold and imposed export duties on petroleum products, on this backdrop. However, that may not be sufficient. Strengthening the rupee is of paramount importance to India right now and thus, even if India manages to divert a little portion of its trade to Rupee-based settlement, it could save a lot in Dollars and strengthen the currency thereby. India already allows payments in Rupees to Nepal and Bhutan and can expand this to a few more neighbouring countries. Another reason for the move could be Sri Lanka’s low foreign exchange reserves. Sri Lanka is in no position to settle its payment with India in foreign currency and therefore, India can follow a trade settlement with Sri Lanka in Rupee to help the neighbouring country in desperate times.