The recent decision by the International Monetary Fund to include the Chinese renminbi in the Special Drawing Rights basket and announcements by the Reserve Bank of India (RBI) allowing Indian companies to issue offshore rupee-denominated ‘masala’ bonds have triggered discussions on whether India is ready to ‘internationalize’ the rupee.
In popular discussions, rupee internationalization is often seen as a goal in itself. The notion that there needs to be a specific agenda for internationalizing the rupee is wrong.
To explain this proposition, it is necessary to understand what is an international currency. Rupee will be an international currency if non-residents are willing and able to trade in it and invest in rupee-denominated assets. For example, a Russian importer must be able (and willing) to invoice and pay for her imports from South Africa in rupees. Similarly, a UK resident must be able (and willing) to invest her savings in rupee-denominated bonds or shares. In these cases, non-residents take risks in the rupee as a currency.
The willingness and ability to transact and invest in a currency depend on three prerequisites. First, the issuing country must have sufficient scale, both in terms of nominal gross domestic product and volume of international transactions. For instance, while China is a $10.36 trillion economy, India is roughly at $2 trillion. For India to attain sufficient scale, the economy needs to grow at a sustainable average rate of 7-8% for the next five years or so. India’s current share of global trade is also relatively small and the bulk of it is invoiced in US dollars. Improvements in scale are linked to macroeconomic fundamentals, which cannot be changed through an internationalization-driven agenda.
Second, the value of the currency must be stable over time. A currency is considered stable when the general level of prices does not vary too much. Stability has multiple aspects: macroeconomic, financial and political. On macroeconomic stability, earlier this year, India undertook an important reform in the form of the Monetary Policy Framework Agreement that formally lays down inflation targeting as the objective of monetary policy in India. The proposed Monetary Policy Committee (MPC) Bill, if introduced and passed, will complete this reform by institutionalizing an accountable and transparent decision-making framework for monetary policy.
Not much progress, however, has been made on financial stability. The banking system continues to be overburdened with burgeoning non-performing assets. None of the attempts undertaken so far by either the RBI or the government to resolve banks’ asset quality problems seems to be yielding expected results. Improving financial stability will need urgent reform of the banking system and strengthening banking regulation.
In terms of political stability, the fact that India is a democracy, like issuers of most international currencies in the 19th and 20th centuries, goes in its favour. Democracy and associated checks and balances on the executive, instil confidence in foreign investors about the policy credibility of the government, thereby imparting stability to the national currency.
Stability is often confused with a managed currency that does not exhibit volatility. This is wrong. A currency is deemed stable when its value reflects underlying market forces. If market forces cause a currency to fluctuate, then artificially managing its price does not make it stable. One way to look at this problem is to think of administered prices. There was a time in India when prices of commodities such as steel and diesel were controlled and exhibited no volatility. Today, these prices freely fluctuate in response to supply and demand conditions. That is how a currency market should work as well.
Third, the currency must be liquid. A currency is liquid if significant quantities of assets can be bought and sold in the currency, without noticeably affecting its price. This requires depth in financial markets, a large stock of domestic currency-denominated bonds and adequate options to hedge currency risk exposures. India lacks a deep, liquid and well-functioning corporate bond market. Hedging opportunities for foreign investors are limited. On the exchange side, RBI and Securities and Exchange Board of India (Sebi) control the kind of currency derivative products that can be offered by exchanges, mandate underlying exposure requirements to buy those products and set position limits. Off exchange, there are entry barriers on who can offer and trade in currency derivative products, and on what conditions. Extensive regulatory reform is required to create a deep market that will offer foreign investors suitable hedging options.
Liquidity has been historically found to be less in countries that have capital controls. A large base of foreign investors adds to the liquidity in the domestic market. India has one of the least open capital accounts among emerging economies. Relaxing capital controls to attract foreign investor participation is crucial for enhancing rupee liquidity.
To conclude, any conversation on rupee internationalization dehors structural reforms is futile. Scale, stability and liquidity can be achieved through strong economic fundamentals and a process-driven regulatory environment. These, by themselves, are important policy goals to achieve for India. It is possible that once these are achieved, the rupee will come to be accepted as an international currency.
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