Limits of local currency trade

Internationalisation of the rupee may prove counterproductive without the necessary building blocks

Some countries are increasingly getting uncomfortable with the US dollar’s dominance. Concerns increased considerably because the US-led West weaponised the international financial system against Russia after the Ukraine invasion. Clearly, no country wants to be in such a situation. The idea of reducing dependence on the dollar thus has gained greater urgency. China, notably, has been making significant efforts in this direction, which is perhaps consistent with its broader positioning as an emerging superpower. Saudi Arabia is reportedly considering settling some of its oil sales to China in yuan. Such an arrangement is said to pose a significant threat to the position of the dollar, which dominates the global petroleum trade. China is paying in yuan for imports from Russia.

The efforts to find an alternative to the dollar, however, are not limited to yuan, or a single national currency. Foreign ministers of Brazil, Russia, India, China, and South Africa, or Brics, met last month in Cape Town where one of the important talking points was the use of alternative currencies. The idea, according to the reports, is to create a joint Brics currency. More clarity is likely to emerge after the August summit. Such a project, however, will have to overcome a variety of problems. For instance, what would be the weight of different member countries or currencies in the joint mechanism? Since China is by far the biggest economy in the group, it is likely to have a dominant position. The possible induction of other countries into the group might add complications.

Further, given the state of relations with China, it is not clear why India would want to be part of any such arrangement. If it decided to stay away from the “China-dominated” Regional Comprehensive Economic Partnership, why would it support a joint currency that will inevitably be driven by China? And if India doesn’t participate, the project may not take off. Even if it does in some form, why would other countries use Brics currency? Since its use may remain very limited, it would not provide the same kind of “exorbitant privilege” that the US enjoys because of the status of the dollar to any Brics member. In any case, China’s interest would be served better by promoting the yuan over any joint mechanism.

Having a currency that the world is willing to use and hold does bring benefits to the issuing country. It lowers transaction costs, for instance. US residents can trade in their home currency. It also reduces financing costs because the world is willing to hold dollar-denominated assets. In the given situation, the US dollar is likely to maintain its dominant position in the foreseeable future. According to the latest triennial survey (April 2022) of the Bank for International Settlements, the dollar was involved in about 90 per cent of transactions in the foreign exchange markets, followed by the euro at 31 per cent. The euro’s share, in fact, declined from the peak of 39 per cent in 2010. The yuan was at 7 per cent. Although the dollar’s position in foreign exchange reserves has weakened in recent years, it still remains dominant with about 60 per cent share.

China is a trading powerhouse with the second-largest economy in the world, but the yuan is unlikely to pose a challenge to the dollar in the near future. It is nonetheless possible that some of its trading partners and debtors may use the yuan for settling bilateral trade and holding reserves. One of the biggest obstacles for the yuan is capital controls. Besides, the functioning of markets in China is significantly influenced by the government’s interests. An open, stable, large, and liquid financial market in the US thus gives the dollar an unbeatable edge. The share of yuan in foreign exchange reserves is under 3 per cent.

India is also encouraging the use of the rupee in international trade. The Reserve Bank of India last week released a report by an interdepartmental group in this regard, which has proposed various steps, including considerable reduction in restrictions on the capital account. But given the policy and financial market constraints, the rupee is unlikely to travel too far for now. A significant opening up of the capital account would increase financial stability risks. As things stand, India runs a persistent current account deficit, and trade in the rupee will leave a surplus with trading partners, which will have to be converted into hard currency at some point. Most foreign businesses will be unwilling to take the currency risk. Russia, for instance, has accumulated large rupee funds and is reportedly looking to convert them into hard currency.

India is unlikely to gain much at this stage by pushing the rupee trade because volumes are likely to remain low. Further, internationalisation of currency is not without risks. At times of higher volatility, for instance, foreign entities may want to sell rupee holdings, which would increase the pressure on Indian currency. It is thus important to get the sequencing right in this context. Free flow of capital is a necessary condition but it alone cannot ensure internationalisation of the country’s currency. To increase the international use of the rupee, it is first important to develop the economy and financial markets with significant depth and width. Without the required building blocks, internationalisation efforts may prove counterproductive. It is worth noting that measured relaxation in capital controls has worked well for India and there is no compelling reason to hurry. China, of course, has different compulsions.