Context

In the backdrop of the western sanctions on Russia, the Reserve Bank of India (RBI) has put in place a mechanism to facilitate international trade in rupees.

Background

• Recent geopolitical dynamic is creating a significant impact on the economies of several nation, leading to decline in their forex reserve.
• Russian invasion on Ukraine has push the price of crude oil in the international market to its all-time high.
• Western sanctions on Russia and economic crises in several nations have impacted the international trade.
• In the backdrop of these situations India has launched a mechanism to settle payment system for imports and exports in terms of Indian domestic currency, i.e., Rupee.

Analysis

Rupee settlement system for International trade:

• Banks acting as authorized dealers for such transactions would have to obtain prior approval from the regulator to facilitate this.

Nostro and Vostro Accounts: Nostro and vostro are terms used to describe the same bank account; these terms are used when one bank holds the money of another bank. They are used to distinguish between the two sets of accounting records kept by each bank. Nostro comes from the Latin word for "our", as in "our money that is deposited in your bank". Vostro means "your" as in "your money that is deposited in our bank".

• All exports and imports under the invoicing arrangement may be denominated and invoiced in rupees.
• The exchange rate between the currencies of two trading partner countries can be determined by the market.
• Exporters and importers can now use a special Vostro account linked to the correspondent bank of the partner country for receipts and payments denominated in rupees.
• These accounts can be used to make payments for projects and investments, manage the flow of advances on imports or exports, and invest in Treasury bills under the Foreign Exchange Management Act of 1999 (FEMA).
• Also bank guarantee, set-off of export receivables, export advance, utilization of surplus, approval process, documentation etc. related aspects would be included in FEMA rules.

Essentiality of the move:

• The rupee is at an all-time low against the dollar.
• The mechanism is intended to facilitate trade with sanctioned countries.
• Payments became a pain point for exporters immediately after the outbreak of the Russia-Ukraine war, especially after Russia was cut off from the SWIFT payment gateway.
• As a result of the Trade Facilitation Mechanism, we see an easing of payment problems with Russia.

Key Concept Currency Convertibility: Convertibility is the ease with which a country's currency can be converted into gold or another currency through global exchanges. A convertible currency allows a government to pay for goods and services in a currency that may not be the buyer's own.

• The move would also reduce the risk of forex volatility, especially with respect to the Euro-Rupee parity.

Key fact Convertibility of Rupee: In order to face a serious deficit in the current account of the balance of payments, the Government of India introduced partial convertibility of the rupee from 1 March 1992. Under this system, 60 percent of foreign exchange earnings were convertible in rupees at the market exchange rate and the remaining 40 percent were at the officially fixed exchange rate. Capital account convertibility refers to the similar liberalization of a country's capital transactions, such as loans and investments, both short-term and long-term.

• We see this as the first step towards 100% convertibility of the rupee.
• It will also help stabilize the rupee.

What will be positive implications on Indian Economy?

• It will boost India's exports and currency: This move would boost the growth of global trade with an emphasis on exports from India (eg tea exports) and support the growing interest of the global business community in the domestic currency.
• Speeding up transactions with sanctions-hit Russia: India's trade with Russia in 2021-22 was $13.1 billion.
• Final Settlement in Indian Rupees: As per the existing provisions of the Foreign Exchange Management Act, the final settlement must be made in free currencies except for Nepal and Bhutan. Now, if RBI approves, final settlement for all countries can be in Indian Rupee.
• Save foreign exchange and reduce trade deficit: Because India imports more than it exports. It will boost forex flows and as a step to stabilize the rupee.
• It will help build better relations with Russia: The opening of the trade route shows the importance of Russia as India's trading partner in the face of growing pressure from Western countries to sever ties.
• Can be used for other neighboring countries as well: Several countries including Iran, Sri Lanka and some in Africa and Latin America are facing shortage of ? forex. As such, the new mechanism will help India promote its exports in these countries.

What does this means for exports?

• Several countries including Sri Lanka and some in Africa and Latin America are facing forex shortages.
• As such, the new mechanism will help India promote its exports.
• It will also help buy discounted oil from Russia, which now accounts for 10% of all imported oil.

How will this impact the trade deficit?

• The gap between India's exports and imports widened to record highs.
• This puts pressure on the current account deficit, which some economists estimate would nearly double to more than 3% of GDP in FY23.
• The RBI's decision may not benefit the foreign account immediately, but in the medium term demand for dollars may fall.
• This is partly because it can take time to open new Vostro accounts between banks.

What are major issues associated with this system?

• A similar Vostro account set up to trade with Iran has dried up as India has been stopped from buying oil from Iran due to US sanctions.
  • Exporters said the payment problem in the Iranian market was limiting them from filling the gap left by Sri Lanka, which is in the midst of a severe financial crisis.
• Western countries could put pressure on India not to allow any such mechanism.

Conclusion

The new settlement system of payments in term of rupee, will pave the way for India to boost up the exports from India. This move will also be beneficial for world south diplomatic policy for India. Along with elimination of the expected concerns India needs to focus on unprecedented emerging economical threat, internal security and money laundering challenges.