Will Indian rupee depreciate further?

Indian rupee is falling quite aggressively compared to US dollars. In 1995, it was approximately 31, 32. In approximately 2008, it used to trade around 43 ,44. And now in 2022, Rs1 is equal to Rs80. Indian rupee has has breached 80 against the US dollar. It’s a record low. Now let me show you a very interesting comparison with the Sri Lankan rupees and US dollar. Something very similar happened. That right From 2003 onwards, sri Lankan rupee had been losing steam compared to US dollar. And the value of Sri Lankan rupee kept on depreciating, depreciating depreciating.

 And poof in 2022, when the Sri Lankan economy blew up, there was a significant mismatch between US dollar and Sri Lankan Rupee.

Now let me tell you another key data point which has to do with India’s forex reserve. Approximately 14 months back, India’s forex reserves stood at roughly $600 billion. But over the last 14 months, this number has started to get lower and lower. So again, the natural question comes that are we going to meet Sri Lanka fate? Because even in Sri Lanka, the forex reserves felt quite aggressively.

So the short answer is no, because RBI tells us that we have ten months of working capital left, that whatever money India needs in order to procure any type of commodities, anything that India exports, we can do it by using the current set of foreign reserves, at least for the next ten months. But here is the specific problem and why RBI is so worried.

So first and foremost, the world is very uncertain. We don’t know what is going to happen in the Russia Ukraine crisis or even more countries will get into the war. The inflation problem is becoming more and more severe in the US. FIIs are withdrawing money out of India. Nothing to panic. As of now, the extent of withdrawal is not that high. But if there are more uncertainties that prevail in the world, then of course emerging economies like India will get hit and our existing foreign reserves can get depleted very soon. So here is a master stroke by RBI and they have instituted something called a Rupee settlement system.

Ruppee settlement system 

So what exactly is rupee settlement system and what is its primary objective? The primary objective of rupee settlement system is to stabilize the falling of Indian rupees. How would they exactly do it? So it’s economics 101 and here is how it works. The price of INR actually depends on the supply of INR and the demand of INR, wherever these two curves meet, determines the price of Indian rupees. Right now, there is less demand of INR compared to the supply of INR. And as a result, Indian rupees has been falling quite aggressively. So RBI’s plan is fairly simple. So as to increase the demand of rupees, why not play with the supply curve? Simply because of the fact that this supply is entirely controlled by the government and they are not bothered about the supply per se, but they are very much bothered with the demand of Indian rupees. And the core objective of Rupee settlement system is to boost up the demand of INR. Now how exactly will this play out and what is the broad mechanism here?

The broad mechanism or the core objective

is that let other countries across the world trade with India and Indian rupees. Right? Now what happens is that if you are buying oil from Russia, then we have to pay them in US. Dollars. Now, because of the fact that a lot of countries have become anti US. Especially countries like China and Russia, and it is assumed that they would want to trade with India in INR rather than US. Dollars or would want to trade with India in some other currency, and RBI has come up with a timely framework. So let us say quickly understand how exactly will this system work? And it comprises of four specific steps. 

How will settlement system work

So the first step is that the countries that want to trade with India, they will express interest in terms of adopting this system. Step two would be that there would be a Nostro and a Vostro account that will be open.

What does these two terms mean?bRather than getting into the technicalities in? Very simple, easy to understand words mean. And I will use an example here that let’s say that India wants to trade with Russia. So foreign banks or Russian banks will open their account in India and this is called as Vostro account. Similarly, Indian banks will open their account in Russia and these would be called as Nostro accounts. And in both these accounts, local parties will maintain their local reserves or local currencies. So step three would be that both the countries would start trading. And here let us pick an example. So let’s say that I’m a manufacturer of fur coat and there are hardly any fur quotes in Russia. So I will export as an Indian to Russia my fur coats. Now, since I have exported my fur coats to Russia, I am supposed to be paid because I’m an exporter. And in what currency would I have been paid? I would have been paid in ruble’s, because that is the Russia’s local currency. But what ends up happening in this rupee settlement system is that the payments are deposited in Russia’s India’s bank account. Now from step four that a series of exports and imports take place over a period of time. And at the end of the period, both India and Russia will tally their accounts. And if it turns out that India has exported more than Indian traders are supposed to be paid and they get paid in what they get paid in INR. So instead of me getting Guble, I will get paid in INR. If I am an exporter of Indian goods and if I am an importer of goods, then I will pay in INR. So by using this mechanism we have been able to successfully increase the demand of INR both for exporters and importers.

Now you might ask that what are the specific advantages of having this system and will this system be actually successful?

Advantage of settlement system 

So, there are a few key points that you need to understand. First and foremost, the primary advantage is that this arrest, the fall of Indian rupees and falling Indian rupees has become a cause of concern over the last few months. So this definitely helps with curtailing the fall of Indian rupees. The second key advantage of this system for India and other countries is that we will become less dependent on the US. US is witnessing a lot of inflation related challenges. There are a lot of problems with their politics as of now and a lot of negative things are happening in their economy. So from that perspective, if the world decoupled itself from the US dollar, it might be a more resilient move. Unfortunately, majority of the trade in the world depends on US dollars. So we can’t completely decouple from the US dollar, but we can definitely reduce our dependence and therefore this rupee settlement system is a step in the right direction. The third key advantage for India comes from international relations and security viewpoints. the emergence of developing nations in contribution to GDP across the world. So, from this perspective, it is very clear that the dominance of emerging economies is increasing as a percentage of world trade. So if India’s rupee settlement systems get adopted at a world scale, it can be a game changer for emerging economies like India and India can act as a galvanizing force and can become a unity force which brings several nations together, especially in South Asia. Fourth and final advantage is that it definitely improves and boost up our forex reserve. Again, we will use India and Russia example. According to the data you can clearly see that both imports and exports have been clearly gone up. And if both the countries start engaging as per the local currency, it will strengthen the ties and it will reduce the dependence of India and Russia on the US. 

How effective  this system will be? 

 Will India become a game changer and will show the light to the world? The short answer unfortunately is no. Right now, majority of the trade that happens in the world happens in USD, Japanese yen and Euros. And the dominance of these currency is just too high for a new system to come in and get replaced by. So therefore, it is unlikely that India’s rupee settlement system is going to be a game changer per se, at least in the short term secondary related point has to do with international relations and international affairs. Right now the US is grappling to its own challenges. Therefore a lot of countries, for example India, China, Russia, they might want to move away from the US. But even international relations are very cyclical and there might be a point when US will strengthen or we will be in a bull phase in the economy and then every country would start aligning back to the US. Now comes the third point that in order for the system to be successful, this needs to be adopted by the trading country as well. For example, we talked about India and Russia. This system will only gain scale when both the countries agree to it. Their is a  list of trading partners for India. We trade with a lot of countries and but not all the countries will come aboard on this system. Why? Because they do not want to miss the US and they don’t want to take Panga with the US. So from that particular perspective, this entire scheme is a good scheme to begin with, but it’s adoption really depends not just on India, but on other countries as well and to what extent the US falls behind in the economic race.