There has lately been some talk of internationalising the rupee - making it an acceptable currency for trade, investment and savings globally, just the way the dollar is. The International Finance Corporation (IFC), a World Bank arm which invests mostly in poorer countries, will be the first to test the market for rupee bonds overseas this week. In 2005, it was the IFC, which along with ADB, raised Chinese yuan denominated bonds.
The rupee bonds for a total of $1 billion mark the beginning of the internationalisation of the currency. But it is bound to take years to establish the rupee's credibility in the international market. Global investors who buy rupee bonds will surely be looking for a good return on their investment. If there is depreciation of the rupee against the dollar, they are going to lose a chunk of their money. As it happens, the rupee has been sliding precariously against the US dollar. Just a month ago, it was in its worst-ever situation, dropping to nearly 69 against the dollar despite all measures to prop it up.
Whether a currency can be successfully internationalized depends a lot on its stability. The failure of the euro to replace the US dollar is relevant here. The dollar, despite few setbacks, is still very strong in the global marketplace. In India at present, a weak domestic economy, a vulnerable currency, large trade and current account deficits and only partial convertibility of rupee so far make the chances of successfully internationalizing the currency slim.
India has been running a trade deficit - the excess of imports over exports - for a long time, resulting in net outgo of foreign exchange. In 2012/13, the trade deficit widened to $191 billion. There is also a current account deficit (CAD), which means that the trade deficit is not adequately covered by capital inflows such as FII and FDI flows, remittances, etc. The CAD was $ 87.8 billion in 2012/13, which was 4.8 per cent of the GDP. The acceptable level for CAD is 2.5 per cent of GDP.
There is also a bigger issue of quality of capital inflows. In India, speculative FII inflows are the mainstay, while FDI inflows have been slow because of governance issues, policy delays and infrastructural problems.
How big a global trader a country is also matters. India's share of global trade, especially exports, is less than three per cent whereas China has a 12 per cent share in exports. As against India's trade and current account deficits, China has a current account surplus of over USD $ 500 billion. The Chinese currency is also pegged to the dollar, which leaves it no scope for sharp depreciation or appreciation. The rupee-dollar exchange rate, on the other hand, is market determined and has always seen heavy volatility. Both the RBI and the government have to take defensive action when the rupee depreciates because the country does not have enough dollar reserves in its arsenal to defend the rupee by selling dollars in the market. In the past, they have resorted to unpopular measures such as hiking the import duty on gold (to cut imports) or raising the short term interest rates to avoid money being used for speculation on the currency market. India's foreign exchange reserves, currently at $292 billion, can cover only about seven months of the import bill.
The onshore market for hedging foreign currency risk is also in a nascent stage. For example, India allowed trading in currency futures of the dollar-rupee only five years back. Today, exporters are allowed to rebook only 50 per cent of their cancelled forward contracts. Similarly, importers, if they cancel a forward contract, are allowed to rebook only 25 per cent of it. Thus there are many restrictions. Many foreign banks, or corporate houses with an overseas presence, trade on rupee-dollar forwards in the overseas non-deliverable forward (NDF) market. There is even evidence of the NDF market influencing the movement of Indian currency, when it depreciated to nearly 69 last month.
To encourage rupee internationalization, RBI Governor Raghuram Rajan has said that, as trade expands, the RBI will push for more settlements in rupees. "This will also mean that we will have to open our financial markets more, for those who receive rupees to invest them back. We need to continue on the path of steady liberalisation," he said. Clearly cross border trade has to expand and further liberalization of the market for foreigners to participate in it has to take place to achieve internationalization of rupee. There are today restrictions upon FIIs on investing in the Indian debt market. Corporate houses too are not allowed to freely raise money overseas through external commercial borrowings and other debt routes.
The first step to promoting rupee internationalization is to encourage corporate houses and PSUs to raise dollar denominated loans to create a presence and also credibility in the international market. The government could also do that with a sovereign debt issue. The next logical step would be to test the market for rupee bonds. In the meantime, India should build forex reserves by raising a dollar denominated sovereign bond issue or quasi bond issue by government owned companies in the international market. And if the rupee stabilizes and manages to withstand events like the forthcoming tapering off of quantitative easing in the US, or sudden outflows of FII funds, the internationalisation of rupee should kick off in earnest.