Context: 

The Government’s announcement of a long-term road map for further internationalization of the rupee can turn out to be a positive exercise.

About Internationalization of Rupee:

• Internationalization of Rupee refers to the process of increased cross-border transactions of Indian currency, especially in import-export trades followed by other current account transactions and then capital account transactions. 

Indian Currency in Gulf Region:

• In the 1950s, the Indian rupee was legal tender for almost all transactions in the United Arab Emirates (UAE), Kuwait, Bahrain, Oman and Qatar, with the Gulf monarchies purchasing rupees with the pound sterling. 
• In 1959, to mitigate challenges associated with gold smuggling, the Reserve Bank of India (Amendment) Act was brought in, enabling the creation of the “Gulf Rupee”, with notes issued by the central bank for circulation only in the West Asian region. 
• Holders of the Indian currency were given six weeks to exchange their Indian currency, with the transition happening smoothly.

Benefits of Internationalisation of Rupee:

• Limited exchange rate risk
• Lower cost of capital due to better access to international financial markets
• High seigniorage benefits
• Reduced requirement of foreign exchange reserves.
• Ability to insulate from payment disruptions caused by events like the Russia-Ukraine war.

Implications of Internationalisation:

• The internationalization 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.
• India will need to run continuous current account deficits in order to provide more and more liquidity needed by an expanding world economy, making it increasingly indebted over time.
• There could be conflicts of interest between short-term domestic and long-term international economic objectives. 

Learning From China’s Experience:

• Initially, China allowed the use of  Renminbi outside its borders for current account transactions and select investment transactions.
• By 2009, China signed currency swap agreements with countries like Brazil, the United Kingdom, Uzbekistan, and Thailand.
• Central banks, offshore clearing banks, and offshore participating banks were permitted to invest excess RMB in debt securities.
• The Shanghai Free Trade Zone, launched in September 2013, facilitated free trading between non-resident onshore and offshore accounts.
• Over time, the  Renminbi gained international recognition and achieved reserve currency status, with its share of international reserves reaching approximately 2.88% by Q2 2022.

Efforts to Internationalize Rupee: 

• The Reserve Bank of India (RBI),in 2022, allowed the settlement of foreign trades between partner countries in Indian currency. 
• It was announced in the backdrop of continuous weakening of rupee against the US dollar and the sanctions put on Iran and Russia by the United States on the use of their currency for transactions.
• Foreign Trade Policy 2023 also aims to push towards internationalization of Rupee in foreign trades.
• India had the rupee arrangements with Bhutan and Nepal for a long time and recently Sri Lanka decided to formally include the rupee as a designated foreign currency.

Challenges to Internationalize Rupee:

• Market Depth and Liquidity: The depth and liquidity of the Indian rupee market are not yet comparable to major global currencies like the US dollar or the euro. 
• Regulatory Framework: The regulatory framework governing foreign exchange transactions, capital flows, and financial markets in India needs to be further liberalized and streamlined to support the internationalization of the rupee.
• Economic Stability: The stability of the Indian economy, including factors such as inflation rates, fiscal discipline, and overall economic growth, plays a crucial role in enhancing the credibility and attractiveness of the rupee in international markets.
• Investor Confidence: Factors such as political stability, policy predictability, and investor-friendly reforms contribute to creating a conducive environment for global investors.

Way Forward: 

Many reforms can be pursued to internationalize the rupee such as:

• Rupee Convertibility: Rupee must be made more freely convertible, with a goal of full convertibility by 2060 – letting financial investments move freely between India and abroad. This would allow foreign investors to easily buy and sell the rupee, enhancing its liquidity and making it more attractive.
• Focus on Liquid Rupee Bond Market: The RBI should pursue a deeper and more liquid rupee bond market, enabling foreign investors and Indian trade partners to have more investment options in rupees, enabling its international use. 
• Encourage Transaction in Rupee: Indian exporters and importers should be encouraged to invoice their transactions in rupee — optimizing the trade settlement formalities for rupee import/export transactions would go a long way. 
• Currency Swap Agreements: Additional currency swap agreements (as with Sri Lanka) would further allow India to settle trade and investment transactions in rupees, without resorting to a reserve currency such as the dollar.
• Tax incentives: Additionally, tax incentives to foreign businesses to utilize the rupee in operations in India would also help.

News Source: The Hindu

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