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Context

The Reserve Bank of India has announced an arrangement for the country’s traders to settle imports and exports in rupees.
This move is aimed at promoting growth of global trade with emphasis on exports from India and to support the increasing interest of the global trading community in the Indian Rupee.

Background: Russia-Ukraine War

India is a trade deficit country, meaning it imports more than it exports.
This forces the country to maintain large forex reserves since world trade still occurs in US dollars.
This is not the first time that the RBI has allowed international trade in rupees – the sanctions on Iran a few years ago resulted in the two countries trading in rupees instead of dollars.
The Russia-Ukraine war and the subsequent sanctions have provided RBI with another opportunity to push for trading in rupees.

US Dollar: The Global Currency

The U.S. dollar has been the world’s dominant currency since the end of World War II.
Roughly half of the international trade, international loans, and global debt securities are denominated in USD.
The USD became the official reserve currency of the world in 1944. The decision was made by a delegation from 44 Allied countries called the Bretton Woods Agreement.
Despite the challenges faced by the US economy due to fiscal and external deficits of the 1980s, the dollar’s share of global reserves remained steady and reserves even grew as time progressed.
The dominance of the dollar is backed by strong and highly credible institutions, deep markets and the fact that it is freely convertible.
Almost 40% of the world’s debt is issued in dollars. As a result, foreign banks need a lot of dollars to conduct business. This became evident during the 2008 financial crisis.

What is the Rupee Settlement System?

Banks acting as authorized dealers for such transactions would have to take prior approval from the regulator to facilitate this.
All exports and imports under the invoicing arrangement may be denominated and invoiced in Rupee.
Exchange rate between the currencies of the two trading partner countries may be market determined.
Exporters and importers can now use a Special Vostro Account linked to the correspondent bank of the partner country for receipts and payments denominated in rupees.
These accounts can be used for payments for projects and investments, import or export advance flow management, and investment in Treasury Bills subject to Foreign Exchange Management Act, 1999 (FEMA).
Also, the bank guarantee, setting-off export receivables, advance against exports, use of surplus balance, approval process, documentation, etc., related aspects would be covered under FEMA rules.

Nostro and Vostro Accounts: Nostro and vostro are terms used to describe the same bank account; the terms are used when one bank has another bank’s money on deposit.They are used to differentiate between the two sets of accounting records kept by each bank.Nostro comes from the Latin word for “ours,” as in “our money that is on deposit at your bank.”Vostro means “yours,” as in “your money that is on deposit at our bank.”

Why such a move?

Trade facilitation: This will also facilitate trade with countries like Russia which are facing sanctions.
FOREX savings: India imports more than it exports so the country will also save foreign currency under the new arrangement.
Rupee appreciation: The rupee is at a historic low against the dollar. It will also help stabilize rupee.
Mitigating war impact: Payments had become a pain point for exporters immediately after the Russia-Ukraine war broke out, especially after Russia was cut off from the SWIFT payment gateway.
Convertibility easing: We see this as a first step towards 100% convertibility of rupee.
Energy security: It will also help buy discounted crude oil from Russia, which now accounts for 10% of all imported crude.
Export promotion: As such, the new mechanism will help India promote its exports.

Which countries would prefer this system?

War mongering Russia: For now, it looks like trade settlements in rupee will be limited to countries like Russia and Iran who are facing sanctions from the West
Bankrupt Sri Lanka: SL is going through economic turmoil and India has been consistently extending lines of credit to SL.
Immediate neighbors: Other countries may include immediate neighbors of India.

Rupees over Dollars: Why countries would prefer Rupees?

At a very simplistic level, this is like two Indians deciding to use an alternative mode of exchange that they have come up with, instead of using rupees.
In other terms, this is similar to the barter system.
The main reason for countries to want to trade with India in rupees is this:

USD has been going through a phase of strength against most currencies in the world
Strong USD performance has essentially made imports expensive for most countries
Sri Lanka, which is going through one of its worst economic crises in decades, is a glaring example of a country in which the economy has come to a halt due to a drastic fall in forex reserves

While the Sri Lankan Rupee has declined over 83 percent against the US Dollar, its fall against the Indian Rupee has been lower at 70 percent.
So instead of paying 83 percent more to make purchases in USD, Sri Lanka can pay in Indian Rupees and save some money.

Challenges

Trade surplus countries’ preference: The question that RBI and the Indian government will have to answer is this – why would countries with a trade surplus with India want to trade in rupees?
Negative trade balance: China had a $73-billion trade surplus with India in 2021-22 – that is, Indian imports from China exceeded its exports to China by $73 billion.
Idle money lying useless: If China were to trade with India in rupees, it would have Indian rupees worth $73 billion (about ₹5.77 lakh crore) sitting idle in its Rupee Vostro accounts in an Indian bank.
Few countries interested: Countries whose exports to India are more than imports, will not be too enthusiastic to trade in rupees, especially if the difference is huge as in the case of China.

Way forward

In a multipolar world where Free Trade Agreements (FTAs) are frequent, undermining the dollar’s dominance seems prominent.
This has been the dream of governments that have looked uneasily at US global primacy, and formed coalitions.
It is predicted that the sanctions against Russia has foreshadowed the decline of the dollar as the reserve currency.

Conclusion

No doubt! This move wouldn’t kill the dollar.
A currency’s dominance depends on demand of the currency and India would need to export stuff to create that demand.
If all the nations in the world stop using dollars only then it would fall.