Rupee Internationalisation Requires Ambitious Domestic Liberalisation
Shankkar Aiyar | 24 July 2023, 07:52 AM IST
Japan envisaged it in 1980s, Korea tried it in 1990s, China is at it. India, forecast to be third largest economy, aspires to it. India will need to scale up trade, deepen financial markets and attain ratings which investors trust. The big challenge for the rupee is not global but the strong political consensus for weak reforms.
You could call it the rite of passage. Nations build on popular aspirations to journey past milestones. One such milestone for any rising economic power is the internationalisation of their currency. This month an inter-departmental group of the Reserve Bank of India presented a pathway for the “internationalisation of the rupee”.
Timing matters in the germination of hope. India overtook Britain to emerge as the fifth largest economy in 2022 and is projected to be the third largest economy by 2031. The promise of potential scaffolds a billion aspirations. The RBI’s report merits applause for catalysing a conversation and attention for illustrating the distance to be covered.
Every major economy, barring the Deutsche Mark, has passed through this roundabout. The Soviet Union tried to create an alternate universe but could impose the rouble only on Soviet bloc countries and the idea crash-landed after the attempts in 1950. The parade of currencies seeking internationalisation in recent years include the Japanese yen, the Korean won, Chinese renminbi (yuan), the Australian and Canadian dollars besides the Singapore dollar.
In the 1970s, following the Nixon Shock, the Japanese government charted a plan to internationalise the yen. In December 1980, Japan overhauled the Foreign Exchange and Foreign Trade Control law to promote cross-border monetary flow. In 1983, following the visit of U.S. President Ronald Reagan, the Yen Dollar Committee was established and a series of reforms were undertaken to internationalize the Yen.
In the early 1990s, buoyed by rising trade and expansion of growth Korea stepped up on the global stage. It made the won tradeable, enabled issue of convertible bonds for foreign investors, and initiated linking of the won to a basket of currencies among other measures to join the OECD. Even as that was unravelling, the euro arrived in 1999 representing the ambition of member countries of the European Union to host a reserve currency.
It was not long before China, spurred by the expansion of its GDP, joined the race in the new millennium. It opened up domestic capital markets in 2003 and followed up with a range of measures including issue of Dim Sum bonds, currency-swap arrangements with countries, installation of capital account liberalisation over the limited geographical domain of Shanghai Free Trade Zone, launch of offshore market avatars and the Cross Border Inter-bank Payment System.
History reveals that the promise of potential is while necessary is not sufficient. China, for instance, is the second largest economy with a near total domination in global trade. Yet it has struggled to fulfil its ambition. What makes a currency truly international is its ability to deliver as as a medium of exchange, as a unit of denomination or pricing and as a store of value. And the U.S. dollar articulates this well.
Data from Bank of International Settlements spells out that the dollar accounts for nearly 90% of all forex transactions — the average turnover on one side of trade is around $ 6.6 trillion and makes it the most traded currency in the world. In contrast, the Euro accounts for 31%, yen for 17%, British pound sterling for 13%, Chinese Renminbi for 7%, Australian and Canadian dollar for 6% and the Korean Won for 2 per cent.
The U.S. dollar is the preferred denomination for global trade. Over 96% of trade in the Americas, 74% in Asia Pacific and 79% in the rest of the world is invoiced in dollars. It is also the preferred destination of foreign exchange reserves. Over 59% of global foreign exchange reserves is parked in dollars, 19.7% is in euros, 5.47% in yen, 4.8% in pound sterling, 2.5% in renminbi and 2.4% in Canadian dollars. Pertinently, China stores nearly a third of its reserves in U.S. dollars.
It is important to place India in the landscape of geo-economics. A critical indicator of confidence is sovereign rating. Ratings are based on assessment of economic heft, strength of governance, fiscal stability and vulnerability to events. As per Moody’s, United States is rated AAA, Japan is rated A1, China is rated A1, the United Kingdom is at Aa3, South Korea is rated Aa2, Australia and Canada enjoy AAA ratings. India is rated Baa3. That rating is the tenth and the lowest in the investment grade bracket.
The standing of an economy is illuminated by earnings from international trade and the flow of inward investments. India accounts for a very small share of global trade — the world’s top five exporters are China at $3.3 trillion, United States at $1.7 trillion, Germany at $1.6 trillion, the Netherlands and Japan at $840 billion and $756 billion. Trade rests on competitiveness and access to markets. China has over 18 trade agreements including RCEP and ASEAN, the US has agreements with 20 countries, the EU has deals with 70 countries, Korea has 21 FTAs with 59 countries.
Flow of investment capital matters. The top five destinations for foreign direct investment are the United States, China, the United Kingdom, Netherlands and Singapore. Between 1990 and 2022, the U.S. has received $10.4 trillion in FDI, China $3.8 trillion, UK $2.7 trillion, the Netherlands $2.6 trillion and Singapore $2.3 trillion. In 2022, India received $49 billion of the $662 billion which flowed into developing countries as foreign direct investment.
Convertibility under current and capital account matters as investors prefer easy entry and exit. Japan has had capital account convertibility since the eighties and Korea since the nineties. China, to use the phraseology of the International Monetary Fund, has a relatively closed capital account (in a de jure sense). India has current account convertibility and is only partially open under the capital account.
Total capital account convertibility is a tough ask for nations which must borrow to build, face deficits and must navigate local costs of global cycles. The challenges are illustrated in two RBI reports — Committee on Capital Account Convertibility released in 1997 and Committee on Fuller Capital Account Convertibility released in 2006 — both chaired by former RBI Deputy Governor Savak Sohrab Tarapore.
In a recent paper, Barry Eichengreen and others examine if China could internationalise the RMB without full capital account convertibility. The big question is whether individuals and institutions would be able to freely buy and sell the renminbi. And this necessitates a more open deeper, predictably priced RMB-backed by dollar reserves. While China may push for internationalisation of RMB with Chinese characteristics, Eichengreen and his co-authors conclude, “We do not foresee RMB internationalization as supplanting dollar dominance”.
The emerging shift in context is critical. Currently India, as the fastest growing large economy, has global attention. India, according to Invesco Global Sovereign Asset Management Study 2023 “has now overtaken China as the most attractive Emerging Market”. The study further states that India is a better story in terms of business and political stability, demographics, and friendly environment for sovereign investors. A parade of foreign portfolio investors and funds are “overweight” on India.
Temporal allure is welcome but what matters is sustained interest. The RBI report for internationalisation of INR moots a phased glide path for the internalisation of the rupee. This includes short-term measures for trade arrangements, integration of payment systems, fostering inclusion of rupee instruments in bond indices, medium-term steps for deepening the financial markets, harmonisation of taxation and INR services via offshore banking.
The recommendations are good but not enough. The internationalisation of a currency is enabled by a combination of factors — size of the economy, the centrality to global trade, capital account openness and depth of financial markets assuring the investors safe and liquid store of value.
Key to success is the ability to walk the charts, design and execute policy to bridge the gap between potential and reality. In 2022, Thought Capital had reviewed the long-pending list of structural issues hindering realisation of potential — liberation of agriculture, freeing of land and labour, cleaning up the power sector, monetisation of land and assets, privatisation of public sector enterprises and a viable programme for leveraging the multiplier effect of urbanisation. All of these reforms are stalled at the level of state governments.
Internationalisation calls for consistent credible conditions. Even in the limited sphere of India’s financial markets, arbitrary twists and turns haunt residents and investors. The unpredictability of the regulatory landscape — whether it is conditions imposed on remittances, on use of instruments of credit, taxation on startups funded by private equity, stop and start regulations and limits on investment in overseas equities through mutual funds — reflects lack of confidence in the resilience of the economy to weather investment cycles.
The status of the U.S. dollar, as the reserve currency, is no accident and is an outcome of proactive policy responses. The U.S. dollar is the third reserve currency following the Dutch guilder (aka Florin) and the “cable” aka British Pound.
In 1945, the U.S. blunted the challenge of a multinational currency and clearing house mooted by John Maynard Keynes and E F Schumacher. As Robert Aliber said, these currencies became international “neither by Act of Congress nor Act of God, but because they meet various needs of foreign institutions” more effectively than others.
The hegemony of the U.S. in geopolitics and the U.S. dollar in geo-economics is sustained by the size of its economy. The U.S. emerged as the largest economy in the 1920s. Recorded data shows by 1930 US GDP was well over $100 billion. The U.S. economy, now well over $25 trillion in size, has retained the top slot for nearly a century.
The biggest challenge in the quest for internationalisation of the rupee is not global but domestic. It is the strong political consensus for weak reforms. This must be dismantled for India to live up to its potential and harvest the much-promised demographic dividend. The internationalisation of the rupee demands domestic liberalisation so that the rupee is internationalised first in India for Indians.
Shankkar Aiyar, political-economy analyst, is the author of ‘The Gated Republic –India’s Public Policy Failures and Private Solutions’, ‘Aadhaar: A Biometric History of India’s 12-Digit Revolution’; and ‘Accidental India’.
You can email him at shankkar.aiyar@gmail.com and follow him on Twitter. This column was first published here. Previous columns can be found at Thought Capital.
