India and Malaysia can now use Indian rupee to settle trade, says MEA

India and Malaysia can now use Indian rupee to settle trade, says MEA

Subject: Economy

Section: External Sector

What has happened?

India and Malaysia have agreed to settle trade in the Indian rupee, the Ministry of External Affairs announced on Saturday

How it will happen?

• The India International Bank of Malaysia(IIBM) has already operationalized this mechanism by opening a special Rupee Vostro account through its corresponding bank in India, Union Bank of India.

What is Vostro Account?

Vostro accounts are used to make payments in domestic currency. The opening of this account will allow Malaysia to use the Indian Rupee to settle trade payments. This move is expected to be beneficial for both India and Malaysia. It will eliminate the need for foreign exchange conversion and will reduce transaction costs. This development is also expected to lead to increased trade between the two countries, especially in areas such as textiles, automobiles, and electronics.

Why it is significant?

The announcement is seen as a decisive step towards de­dollarisation and an effort to safeguard Indian trade from the impact of Russia’s war in Ukraine and its subsequent fallout and sanctions

What is De-dollarization?

De-dollarization is a process of substituting the US dollar as the currency used for:

Trading oil and/ or other commodities

• Buying US dollars for the forex reserves
• Bilateral trade agreements
• Dollar-denominated assets

It happens when the leading central banks diversify their reserves away from the USD to other assets or currencies like the Euro, Renminbi or gold.

The USD (United States Dollar) has been the world’s dominant currency since the conclusion of the second world war. Dollar has also been the most sought reserve currency for decades, which means it is held by central banks across the globe in significant quantities. Dollar is also primarily used in cross-border transactions by nations and businesses.

This unique position not only makes the US the leader in the financial and monetary system, but also provides incomparable leverage when it comes to coercive ability to shape decisions taken by governments, businesses, and institutions.

Causes of this shift:

• The USD as a sanctions weapon-The US has for long used imposition of sanctions as a tool to achieve foreign policy and goals, which entails restricting access to US-led services in payment and financial transaction processing domain
• The emergence of China,
• Slowdown in the US economy,
• European Union’s independent policy assertion,
• Russia-US detachment, and us-china trade war
•  increasing voices from across the world to create a polycentric world and financial system in which hegemonic capacities can be muted.
• The rise of digital or cryptocurrencies at an increasing pace.

Examples

• Dedollarization emerged as a priority for Russia in 2014 in response to the imposition of Western sanctions following the annexation of Crimea that limited the ability of state firms and banks to raise financing in Western markets.
• Between 2013 and 2020, the Russian central bank halved its dollar-denominated reserves. In 2021, it revealed plans to completely ditch all dollar assets from its sovereign wealth fund and increase holdings in euros, yuan, and gold instead, thus acquiring a quarter of the world’s yuan reserves.
• China also began seeing value in this initiative after the onset of the US-China trade war in 2018 and the use of punitive financial measures by the US.
• EU members had switched to INSTEX (Instrument in Support of Trade Exchanges) which acts as a special-purpose vehicle to facilitate non-USD trade with Iran to avoid US sanctions
• The EU remains the largest investor as well the biggest trade partner for Russia, with trade taking place in euros, instead of dollars.
• Further, in recent years, Russia has also switched to settlements in national currencies with India (for arms contracts) and the two traditionally strong defence partners are aiming at exploring technology as means for payment in national currencies.

Impact

• Reduce trade volatility and risk-The “de-dollarisation” by several central banks is imminent, driven by the desire to insulate them from geopolitical risks, where the status of the US dollar as a reserve currency can be used as an offensive weapon.
• As an alternative to economic sanctions.
• Reduce demand of USD thus, relative depreciation of USD and imported inflation in the USA.
• Push to globalisation 
• Reduce3 spillover effect of economic crisis in one country to global economy

Challenges

• Finding alternatives to the dollar-currency with the right amount of availability, acceptability and stability.
• Given the psychological bias, the world will continue to prefer the USD as a “store of value” and a “medium of exchange”, fulfilling the basic functions of money.
• Sudden dumping of dollar assets by adversarial central banks will also pose balance sheet risks to them as it will erode the value of their overall dollar-denominated holdings.
• No full proof from sanctions – increasing reliance on the euro and thus greater exposure to EU sanctions;
• Finding true exchange rate-US dollar being the link currency for determining the exchange value of any two currencies
• A new international payments system that could operate as an alternative to the US-dominated SWIFT, as international trade needs a payment and financial system to take place
• Dollar’s continued primacy as the medium of exchange in international currency markets, selling euros in exchange for rubles is likely to be difficult without going through the dollar, as Iran learned a few years ago.
• Increase economic autonomy

De Dollarization and India:-India, currently among the most dollarized countries (in invoicing) and hence relatively difficult to switch to other modes given the economic and political relation with the USA. However,

• While others accumulate dollars from their earnings of trade surplus, India maintains a large forex reserve even though India imports less than it exports. In India’s case, the dollar reserves come through infusion of Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI), which reflects the confidence of foreign investors in India’s growth prospects. Thus, India is less impacted by economic sanctions of the USA.
• Just like Chinese renminbi, Indian rupee is also not yet fully convertible at the exchange markets. While this means that India can control its burden of foreign debt, and inflow of capital for investment purposes in its economy

India remains vulnerable to policy changes by other nations’ monetary policies which are beyond India’s own control. For instance, it has been often highlighted that a tightening of the US monetary policy leads to capital outflows (capital flight) from India, thus impacting India adversely.

Alternatives: Instead of switching dependence from the USD to any other currency like euro, yuan or backing currency to the ‘old gold’ will not solve the problem but repeat the crisis the global economy went through pre-Bretton Woods times.

• Currency swap agreements
• A central bank digital currency (CBDC) that bypasses the dollar-China submitted a “Global Sovereign Digital Currency Governance” proposal at the Bank for International Settlements to influence global financial rules via its digital currency, the e-Yuan.
• A global currency or an arrangement like the IMF’s SDR
• Introduction of a new Russia-China payment system, bypassing SWIFT and combining the Russian SPFS (System for Transfer of Financial Messages) with the Chinese CIPS (Cross-Border Interbank Payment System).
• National electronic payments system-like Russia’s Mir or India’s UPI