India must prepare to curb volatility risk of international rupee: RBI Deputy Governor

Subject : Economy

Section: External Sector

Concept :

India needs to gear up to manage the inevitable volatility that will emerge in the foreign exchange market as the country progresses further towards internationalisation of the rupee, a deputy governor at RBI said recently.

Currency volatility

Currency volatility is the frequency and extent of changes in a currency’s value.
It is measured by calculating the dispersion of exchange rate changes around the mean, expressed in terms of daily, weekly, monthly or annual standard deviations.
The larger the number, the greater the volatility over a period of time.
Currency volatility occurs when there are rapid changes to the exchange rate of a currency pair in a short period of time.
So, if the US Dollar began to rise and drop in value compared to Rupee, this would be classed as currency pair volatility.

Internationalisation of Rupee

Internationalisation of the rupee is a process that involves increasing use of the local currency in cross-border transactions.
It involves promoting the rupee for import and export trade and then other current account transactions followed by its use in capital account transactions.
As far as the rupee is concerned, it is fully convertible in the current account, but partially in capital account.
- Current and Capital account are the two components of Balance of payments.
- While the current account deals mainly with the import and export of goods and services, the capital account is made up of the cross-border movement of capital by way of investments and loans.
Need :
- Excessive dependence on dollars combined with global inflation and economic crises has led to the depreciation of the rupee to an all-time low. If the rupee is internationalized, India would not have to depend on US Dollars for its trade.
- RBI has allowed domestic traders to settle their import-export bills in rupee.

Advantages of Internationalization:

Appreciate currency value: It will improve the demand for the rupee in international trade.
Mitigate exchange rate volatility: Rupee-denominated payments can help reduce price volatility associated with dollars.
Making significant savings in Indian foreign reserves.
Circumvent sanctions: Improving acceptance and trade in rupees can help India to diversify its trade basket by circumventing restrictions and sanctions imposed by the west.
Improve its standing as a global economic power

Associated risks

Impact on monetary policy: The internationalization of the rupee will limit the country’s ability to create a monetary policy specific to its local economic demand.
The Indian economy will become more susceptible to international economic fluctuations.
Managed currency has been utilized to protect the economy from damages during the economic crises of 1980 and 2008. It may not be the case anymore.
The outflow of Hot money: Complete internationalization of currency will expand the risk of hot currency (highly prone to sudden outflows) to capital assets.
For example, east Asian crisis in 1997.