In a future multi-polar world, the rupee is well placed to acquire ‘global currency status’ as technology and policy measures make it more efficient to trade in cross currencies. More than 60 entities across 18 countries were granted approval to set up Rupee Vostro accounts last year. The idea is to act as offshore rupee settlement conduits. Policy makers are also using light-touch regulatory environments, such as the GIFT City, to help foreigners hedge their rupee risk by making it easier for them to get in and out of INR-denominated assets. Increasing the issuance of offshore INR-denominated assets (masala bonds) will also help foreigners hedge their rupee risk efficiently.
The INR currently has a 2 per cent market share in global FX markets, proportional to its share in global trade, remittances, and FDI flows. As the size and importance of India in global trade and cross-border capital flow increases, the global market share of the INR is bound to rise in proportion. For currencies such as the British pound, Australian dollar, Canadian dollar or the Swiss Franc, their global FX market share is disproportionately higher than their share in global cross-border forex flows.
A hypothetical example using the rupee would be India paying for Malaysian edible oil in INR. These offshore INR holdings are then used by commercial banks in Malaysia to buy manufactured goods from Germany. In turn, German commercial banks use their INR holdings to facilitate purchase of textiles, chemicals and pharmaceuticals from India. While the rupee is making its global trip, its value is proactively protected using INR-denominated assets by global commercial banks.
It is easy and convenient for global commercial banks to place their trust in a single currency like the US dollar for global transactions, which is why nearly 90 per cent of cross-border FX trade has a USD leg. Technology could break this single currency convenience barrier.
According to IMF projections, for the next five years, India’s inflation differential is expected to narrow against developed markets and turn positive against certain EM currencies. Based on inflation differentials, it is not disadvantageous for Russia, Sri Lanka, Kenya, Nepal and Bangladesh to hold INR. The INR’s value has to be predictable, therefore, reducing hedging costs.
Traditionally a currency’s value has been determined by its metallic weight. In a fiat currency world, the weight of the rupee is determined by policy credibility, more specifically in macro-economic management. Credibility around policymakers efforts to ensure 4 per cent inflation would anchor expectations in financial markets. A fast growing economy led by investments will place huge demands on capital. Policymakers have a choice: lower domestic cost of capital through sustained focus on (1) 4 per cent inflation target; (2) making it easier to bring in foreign capital; and (3) allowing a bit more upward articulation in the rupee (appreciation) to improve financial conditions.
Policy credibility fortified on the back of these actions, apart from supply-side reforms and fiscal consolidation, should take the 10 year G-sec towards 6 per cent handle and give the rupee more weight as a global currency.
The writer is ED – Economist, Institutional Equity Research, Axis Capital Limited