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Photo illustration by John Lyman

India wants to ditch the dollar for the rupee.

In the world of global commerce, a few hard currencies—like the dollar, euro, and pound—reign supreme. These currencies, the dollar, in particular, are the linchpins of international trade, regardless of the countries involved. Their ubiquity creates a host of challenges for developing nations, from exposure to volatile capital flows to a cycle of dependency on external debt. The typical use of a so-called “vehicle currency,” one that belongs to neither party in a trade, amplifies these vulnerabilities and imbalances.

Enter India—a major oil importer grappling with rising oil prices and a strengthening dollar. In an attempt to mitigate these challenges, India’s central bank has initiated a novel framework that allows trade invoicing and settlements between India and other nations to occur in rupee denominations. This move not only lessens foreign exchange losses but also creates opportunities for more nuanced economic partnerships. Take Russia, for example. It enjoys a significant trade surplus with India, a balance that could be funneled into investments in India’s capital markets, effectively bypassing the dollar’s hegemony.

The implications of internationalizing the rupee are manifold. For traders, it mitigates exchange rate risk and reduces dependency on the dollar, which is increasingly seen as a political risk. For India, it could open up avenues to handle budgetary deficits more strategically. An intriguing geopolitical wrinkle is the easier facilitation of trade with regimes often viewed as unstable—Russia, Iran, Sri Lanka—by sidestepping dollar-based credit lines.

Yet, a more granular examination reveals that this transition is not without its caveats. For nations exporting more to India than they import, the lure of trading in rupees may be absent. The system can sustain itself only as long as trade equilibrium exists; beyond that, the benefits diminish. Market sentiment could trigger the rupee’s depreciation, particularly as the rupee is only partially convertible on the capital account.

Another pitfall lies in India’s reliance on crude oil imports, accounting for 80% of its internal requirements. A surge in oil prices could easily unsettle the Indian forex reserves. Moreover, the unpredictability in global commodity prices, intensified by supply chain disruptions, exacerbates this vulnerability, risking devaluation of the rupee and limiting the domestic availability of dollars.

The rupee-based trade system could also have unintended consequences for India’s monetary policy. The country’s central bank might find its capacity to regulate the domestic money supply compromised, especially given that a balanced two-way trade is essential for the rupee’s stability against the dollar. Currency depreciation, coupled with levies and inflation, could make imports increasingly unfeasible, adding more complexity to the equation.

What about India’s trading partners? With nations like Bangladesh, the UK, and Turkey, India enjoys a trade surplus, but it runs a deficit with countries like South Korea, Thailand, and South Africa. The common thread is that their currencies have depreciated significantly against the dollar. Settling in rupees might be a double-edged sword, benefiting some while harming others, particularly those in the service sectors reliant on developed economies.

As India contemplates the rupee’s ascendancy on the international stage, the question becomes how to approach this with nuance and prudence. Liberalizing settlements in rupees and diminishing trade barriers are essential first steps toward full rupee internationalization. Yet, to truly make the rupee globally competitive, India must enhance its export competitiveness, tackle trade protectionism, and navigate geopolitical rivalries skillfully. Financial market reforms are also needed, including making the rupee fully convertible.

India’s endeavor to move away from dollar dependency and establish the rupee as a significant player in global trade is a complex but worthy endeavor. However, it’s crucial that this internationalization proceeds cautiously and strategically, taking into account both the promising opportunities and the daunting challenges that lie ahead.

Adisri Swain is a Research Intern at the Indian Institute of Management, Bangalore, India. Her interests lie in Development Economics, Health Policy, International Economics, and Data Analysis.