Answer:

Introduction:

The establishment of a Local Currency Settlement System (LCSS) between India and the United Arab Emirates (UAE) aims to stimulate cross-border transactions in their respective domestic currencies, INR (Indian Rupee) and AED (UAE Dirham). This landmark move seeks to strengthen bilateral trade ties, mitigate foreign exchange risks and minimize dependency on third-party currencies such as the US Dollar.

Body:

Significance and Potential Benefits of the Local Currency Settlement System:

• Promotion of Bilateral Trade: 
  • With bilateral trade reaching around $85 billion in FY23, the LCSS would facilitate a more predictable trading environment, thereby encouraging growth in trade between India and the UAE. 
  • The reduction of transaction costs and settlement time through the use of domestic currencies would stimulate commerce, especially in sectors like crude oil, where India is a significant importer from the UAE.
• Reduced Dependence on Third-Country Currencies: 
  • This move serves as a strategic step in internationalizing the Indian Rupee and lessening reliance on the US Dollar, protecting the domestic economy from global economic shocks and exchange rate volatilities.
• Risk Management: 
  • As the LCSS covers all current account transactions and permitted capital account transactions, it equips both nations with better tools to hedge exchange rate risks, potentially limiting losses for exporters.
• Development of an INR-AED Foreign Exchange Market: 
  • The LCSS would enable the formation of an INR-AED foreign exchange market, promoting investments and remittances between the two nations and creating a new sphere of financial interactions.

Challenges and Considerations:

• Exchange Rate Fluctuations: 
  • Even though the LCSS provides tools for hedging, significant fluctuations in the INR and AED could pose financial risks to both countries.
• Trade Imbalance: 
  • India has a trade surplus with the UAE, potentially leading to an oversupply of Indian Rupees in the UAE market, which could depress its value if not properly managed.
• Regulatory and Operational Complexities: 
  • The establishment of LCSS involves addressing various operational and regulatory issues, which could be a complex and time-consuming process.
• Market Liquidity: 
  • The liquidity of the INR-AED pair might not match that of pairs involving globally dominant currencies like USD, which might impact the speed and cost of currency trades.

Conclusion: 

The establishment of a Local Currency Settlement System between India and the UAE is a transformative step in bilateral relations, poised to boost trade and economic cooperation while reducing dependency on third-party currencies. However, its success hinges on the effective management of potential challenges and ensuring balanced benefits for both parties. The experiences of this LCSS could also offer insights for similar arrangements with other nations, further enhancing India’s economic resilience and global trading partnerships.