INTERNATIONALIZATION OF RUPEE : A REPORT

 DOCUMENT STRUCTURE

1 :  INTRODUCTION

2 :  HISTORY OF INTERNATIONALISATION

3 : INTERNATIONALISATION OF INDIAN RUPEE

4 : COSTS AND BENEFITS OF CURRENCY INTERNATIONALISATION

5 : IMPACT OF CURRENCY INTERNATIONALISATION ON VOLATILITY OF FOREIGN                 EXCHANGE AND CAPITAL FLOWS

6 : MICRO AND MACRO ECONOMIC MEASURES

7 : CONCLUSION - LESSONS FOR INDIA

 

                                      INTRODUCTION 

          There is no well-established framework to define what is meant by internationalisation of a currency. A currency can be termed ‘international’ if it is widely accepted across the world as a medium of exchange. In practical terms, it would mean the use of the currency for invoicing and settlement of cross-border transactions, freedom for non-residents to hold financial assets/liabilities in that currency and freedom for non-residents to hold tradable balances in that currency at offshore locations. The “internationalisation” of a currency is an expression of its external credibility as the economy integrates globally.. Limited or full use of an ‘internationalised’ currency as legal tender in certain other countries is a possibility. Further, limited internationalisation within a geographical region is also possible. For example, the South African rand (ZAR) has the characteristics of an ‘international currency’ in the neighboring countries viz., Namibia, Swaziland and Lesotho.

        The main economic factors underpinning internationalisation of currency are: (a) domestic stability which makes the currency attractive as a store of value; (b) a well-developed financial system with deep and liquid markets offering participants a wide range of services and products in terms of borrowing, investing and hedging; and (c) a big size economy compared to the world output, financial markets and a significant role in trade leads the outside world to increase the demand for internationalised currency for transaction purposes, and also to consider the use of such currency when making portfolio decisions. In sum, these factors include all things which may contribute to speed, efficiency, reliability and user-friendliness of the currency.

 

                      History of  Internationlisation

The pound sterling was the first currency in modern times to assume an international currency, as a result of Britain’s dominant position in international trade and investment in the nineteenth century. However, Sterling now has only a very modest role as an international currency as compared to its position a century ago (Latter, 2000).

The US dollar owed its emergence as a major international currency initially to similar factors as did Sterling – namely the strength of the US economy and its weight in global business. The position was consolidated when the dollar was the only significant currency to remain fully convertible after the Second World War. The US dollar continues to be a dominant international currency despite changes in interest and exchange rates, Swiss Franc was at one time disproportionately important as an international currency, albeit in the rather narrow sense of being a haven for savings, rather than as a major vehicle for international trade or fund-raising. Switzerland’s record of political stability and economic prosperity was one factor leading the attractiveness of the Swiss franc, but so also was the tradition of banking secrecy.

When we come to euro there are about 60 countries with an exchange rate regime linked to the Euro, including those States that have not yet joined the Euro area. The non-EU countries that use the Euro as a reserve currency are mainly located in the EU’s neighboring regions. In most of these countries, the Euro is also the main or the sole intervention currency used by the authorities to stabilise the exchange rates of their respective currencies. The role of the Euro as a reserve currency in countries outside the Euro area has remained stable overall. In using the Euro as an issuance currency, financial institutions and corporations, mainly from mature economies (USA, UK) have taken advantage of the greater size and liquidity provided by the increasingly integrated Euro-denominated bond markets (Mersch, 2004).

The Indian rupee was regarded as an official currency of other countries, including Kuwait, Bahrain, Qatar, the Trucial States (United Arab Emirates (UAE) since 1971) and Malaysia in previous times. The Gulf rupee, also known as the Persian Gulf rupee, was introduced by the Government of India as a replacement for the Indian rupee for circulation exclusively outside the country with the Reserve Bank of India [Amendment] Act, May 1, 1959. This creation of a separate currency was an attempt to reduce the strain put on India's foreign exchange reserves. After India devalued the rupee on June 6, 1966, those countries still using it - Oman, Qatar and UAE - replaced the Gulf rupee with their own currencies. Kuwait and Bahrain had already done so earlier in 1961 and 1965, respectively.

                          Internationalisation of Indian Rupee 

Internationalisation of a currency is a policy matter and depends upon the broader economic objectives of the issuing country. India, at present, does not permit rupee to be officially used for international transactions except those with Nepal and Bhutan (Bhutanese Ngultrum is at par with the Indian Rupee and both are accepted in Bhutan. The Indian rupee is also accepted in towns of Nepalese side of Nepal-India border).    Non-residents cannot hold rupee assets and more importantly, liabilities denominated in Indian rupee, beyond certain limits. Non-residents cannot hold tradable rupee balances. Similarly, restrictions have been imposed on the domestic and international banks with respect to transactions in Indian rupee. The funds in vostro accounts-accounts in Indian rupee held by foreign banks-can be used only for the purpose of transactions with Indian residents.

 The hallmark of an internationalised currency is that invoicing of tradable goods between countries is done with it. In sharp contrast, almost the entire bulk of international trade in India continues to be denominated in the US dollars. Efforts to promote invoicing in the domestic currency have met with little success in countries with currencies which are not internationalised as the trade-counterparty does not have the necessary infrastructure to hedge its exposure in international markets. India accounts for a very small proportion of the total foreign exchange market turnover in the world as compared to other countries. BIS Triennial Central Bank Survey data for 2007 shows that India’s daily average share in the total foreign exchange market turnover is 0.9 per cent as compared to 34.1 per cent of UK and 16.6$ of USA. However, India’s share in total foreign exchange market turnover has been slowly but continuously increasing. India’s share has increased from 0.1 per cent of the total foreign exchange market turnover in 1998 to 0.2 per cent in 2001 to 0.3 per cent in 2004 to the 0.9 per cent in 2007.

 The share of Indian Rupee in total currency turnover is also very small. Moreover, in case of the Indian rupee, spot transaction accounts for major part of currency turnover (42.6 per cent), while in case of both Euro and Dollar, the foreign exchange turnover is highly concentrated in foreign exchange swaps.

SUB PRIME CRISIS IN US:-Factors covering origin and distribute model of bank lending, regulatory arbitrage on non-banking financial entities, financial innovations in terms of complex financial derivatives and persisting global imbalances are considered as major factors leading to current crisis.

-Most importantly, it is argued that the combination of low real and nominal interest rates accompanied by abundance of liquidity induced by accommodative monetary policy especially in the US.

-Increased financial flows and low inflation led to a decline in interest rates across the world, thus reducing the returns from traditional assets. Banks were less worried about credit risk as the loans were subsequently sold to third parties. Hence they increased their lending volumes without caring much about the (1) quality of credit and the (2) credit worthiness of the borrower.

-The emerging economies, with their limited exposure to mortgage backed securities were initially able to sustain their growth momentum and retain the confidence of international investors. However, as the turmoil continued in the developed economies, the effect on emerging economies became unavoidable. “Emerging market economies are being affected both through real and financial channels”. Responses to large external shocks – for instance, the sharp rebound of the US dollar – once again demonstrated that feedback mechanisms due to leverage, payoff nonlinearities in “forex derivatives” and similar other reasons can lead to great volatility in financial market prices, often involving overshooting on a major scale.

In order to address the crises, countries across the globe have responded with a mix of both conventional and unconventional measures as summarized below: 

(1) In the US, authorities have supplemented their case-by-case approach that addresses points of distress as they arise, including liquidity support for banks and near-bank institutions such as broker dealers and money market funds; asset purchases to free up bank balance sheets; support for the housing market, extending deposit insurance; and restricting short selling.

- The actions taken by the U.S. authorities are intended to relieve pressures on financial balance sheets and to restore confidence: to provide a catalyst for private markets to support asset prices, open up funding, and allow the rebuilding of capital cushions. 

• In Europe, measures to improve funding have been coordinated within the euro area through the European Central Bank’s operations, and internationally dollar liquidity needs have been alleviated through swap facilities between European central banks and the Federal Reserve.

EU-wide action is also under way to improve supervisory capital requirements and other aspects of market structure. 

• Responses in other countries include- large provision of both overnight and term liquidity often against a wider pool of collateral; Policy rate cuts; Collateral swaps;
 direct or indirect purchases of illiquid assets; introduction or increase in foreign currency swap 6 lines; partial/full guarantee of bank debt; increased depositor protection; restrictions on short selling of equities; provision of capital to banks; and nationalisation of distressed financial institutions.

- A flexible exchange rate in many cases served as a safety valve. The scale of forex intervention was unusually large; in several cases, however, intervention was designed to minimize the effect on the process of price formation in the forex market.

-The volatility of portfolio flows (and market prices) was magnified by abrupt adjustments by banks and other financial firms in the main centers. One aspect of the adjustments was deleveraging (or attempted deleveraging) of major international banks, hedge funds and so on. Another was a reduction of resources devoted to market-making in often illiquid markets.

-because foreign institutional and retail investment in local bond and equity markets was typically channeled through major international banks willing to work continuously make markets in such instruments, the sharp cut-back of trading desks has major implications. The crisis has also raised new questions about measures of reserves adequacy. Countries that, by conventional criteria, have more than ample reserves were hit very hard. Possible reasons include the accuracy of simple measurements of underlying forex exposures from short-term external debt (in particular, allowing for exposures through derivatives) and the flight of domestic capital. One simple prescription that central banks should use foreign exchange reserves to address these pressures did not prove to be fully realistic. Explanations put forward for the impracticality of that prescription include the assertions that any too-rapid drawdown of reserves under exchange market pressure would risk sending a signal of vulnerability to the market; that a crisis heightens uncertainty about the future, so reserves should be managed; and that selling large volumes of reserves puts additional strain on the markets for local currency bank funding. In view of the unfolding of the crisis, the focus of the policy maker is on maintaining adequate liquidity in the economy and facilitating growth. In recent months, growth estimates for the economy have consistently been revised downwards and we have recorded net outflow of capital 7 from the country. Consequently, foreign exchange reserves have depleted and the external value of the Indian rupee has been declining.

          Costs and Benefits of Currency Internationalisation 

 Benefits of Internationalisation: May promote growth by facilitating greater degree of integration both in terms of foreign trade and international capital flows. Other important benefits are - savings on foreign exchange transactions, reduced foreign exchange exposure, economies of scale and seigniorage. On seigniorage, it must be mentioned that the USA which enjoys considerable advantage on this account ensures that there are sufficient quantity of US banknotes, of the right denominations, available for external shipment and that the distribution channels operate efficiently.

However, the policy maker needs to be cautious, as internationalisation of the domestic currency has several disadvantages. A major problem with the internationalisation of a currency is that it can increase the issuing country’s vulnerability to external shocks, given the freedom to residents as well as non-residents with respect to the flow of funds in and out of the country and from one currency to another. If large amounts of domestic currency are held by non residents, particularly at offshore locations, any expectation that the currency is vulnerable due to weak fundamentals, can turn out to be self-fulfilling and can lead to a sell-off resulting in a sharp fall in the value of the currency. A potential risk of internationalism is the withdrawal of short-term funds and portfolio investments by non-residents. Moreover, currency internationalisation has an impact on the effectiveness of various monetary policy instruments. For example, the effectiveness of open market operations as an instrument for influencing interest rate and money supply is likely to reduce in an environment where residents and non-residents are free to buy and sell domestic currency. This is more likely to happen in countries where the market for government debt is neither very large nor liquid.

Impact of currency internationalization on volatility of foreign exchange and capital flows                                        

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.

In the context of choosing an exchange rate regime, the weight of experience seems to be tilting in favour of intermediate regimes with country-specific features, without targets for the level of the exchange rate, the conduct of exchange market interventions to ensure orderly rate movements, and a combination of interest rates and exchange rate interventions to fight extreme market turbulence. In general, emerging market economies have accumulated massive foreign exchange reserves as a circuit-breaker for situations where unidirectional expectations become self-fulfilling. Moreover, the impact of greater exchange rate volatility has been significantly different for reserve currency countries and for developing countries. For the former, mature and well developed financial markets have absorbed the risks associated with large exchange rate fluctuations with negligible spillover on to real activity. Consequently, the central bank does not have to take care of these risks through its monetary policy operations. On the other hand, for the majority of developing countries, which are labour-intensive exporters, exchange rate volatility has had significant employment, output and distributional consequences, which can be large and persistent. In recent months, the exchange rate of the Indian rupee has moved over a wide range. The Reserve Bank only attempts to contain volatility but does not target any level of exchange rate, which is mainly market determined. The volatility in the exchange rate impacted the traders and also the capital flows in the economy. In the present situation of global uncertainty, any further attempt towards capital account convertibility or internationalization of the currency may not be appropriate for our economy.

                           
                                Micro and macro measures

In the banking sector, the macro prudential analysis is based on both backward looking indicators such as

(1)Balance sheet profitability asset liquidity.

(2)capital adequacy which identify major risk facing the banking sector.

In today’s scenario banks have become mere originators of loans and distribution of risk.

(1)First, availability of Information Technology has reduced the cost.

(2)Secondly, Financial innovation which has a great impact on risk management in the volatility market (over the counter market) OTC.

The role of effective financial regulation and supervision had underscored the need for strengthening of role of oversight advanced financial markets. Traditionally, financial surveillance has placed relatively more emphasis on banking regulation, the idea being the banks are trustees of public money. In the context of recent activities, it is important to recognize and to understand the transmission of risk information through various segments of financial market in order to protect the credit market.

In the derivatives market, forward contracts have the greater risk and volatility in the prices may cause due to irregularities in the situations that occur. The regularities should process in a effective and efficient manner to provide credit risk management to either parties in the derivatives market. New regularities should been implemented to ensure the investors capital protection and the trust-worthiness in the credit market.

A number of steps have been taken by Reserve Bank of India with a view to mitigate liquidity risk:

 (1) Participation in the unsecured overnight money market has been restricted to banks.

(2) Limits imposed on banks’ interbank liabilities.

(3) Asset-liability guidelines have been framed.

(4) Liquidity support to SPV’s (special purpose vehicles)

Detailed guidelines have been issued by the reserve bank on the implementation of the basel II framework covering all three pillars. Minimum CRAR of 9 per cent has been described.

It is now recognised that the current microeconomic-driven prudential regulatory framework, including basel

II is procyclical which further worsens the impact of crisis on institutions.

Successively, additional prudential regulations with respect to exposures to specific sectors such as real estate, housing loans to individuals and consumers credit have been imposed on the lines of dynamic provisioning. Furthermore, the supervision of non bank finance companies (NBFCs) have been tightened with a view to reduce regulatory arbitrage vis-à-vis the banking sector.                                    

                            Conclusion - Lessons for India 

 The initial effect of the crisis on India was muted, as was the case with most emerging economies. Capital flows were increasing till September- October 2007. There was a negligible effect on Indian banks and financial markets because of limited exposure to complex derivatives, as also due to low presence of foreign banks in India (and Asia for that matter). There was however, some increase in volatility of capital flows and commodity prices. As second round effects, India experienced a mild reversal in capital flows, slowdown of external commercial borrowings (ECB) and some pressure on the exchange rate. Still the impact was not significant. Growth was projected at 8 to 8.5 per cent and inflation continued to be the major worry of policymakers. However, the crisis gradually intensified, effectively after the collapse of Lehman Brothers in September 2008. The main channels through which India has been affected are (a) a reversal in capital flows (FIIs, ECB, short-term trade credit), (b) crash in the stock market which has hit investor confidence, affected valuation, and has led to the drying up of equity capital, and (c) slowdown in exports. As external funding dried up, pressure has mounted on domestic resources. Our current problems are – capital outflow, drawdown of reserves, pressure on exchange rate and corresponding liquidity crunch. Hence the Reserve Bank of India faces the responsibility to increase liquidity and maintain money supply at adequate levels. The Bank has taken several steps to ensure this.

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 rupees bonds. There are indications to believe that Indian rupee is gaining acceptability in other countries. However the size of the country in terms of GDP, volume of trade as also the turnover in the foreign exchange market when compared with global dimensions, is small. The Indian rupee is rarely being used for invoicing of international trade. Therefore, internationalisation of the rupee is still a distant objective of policy makers in India.

                                   

BIBLIOGRAPHY

1:  Mersch, Y. (2004), The International Role of the Euro , available at www.bcl.la

2: Mohan R, (2006). Monetary and Financial Responses and Global Implications.

3: BIS. (2009).Capital Flows and Emerging Market Economies

4: IFC move to internationalise the rupee is symbolic at best – business.indiatoday.in

     

5: Article - Currency Internationalisation : Reserve bank of india

DBR Vasishtha