On July 5, 2023, the RBI released the “Report of the Inter-Departmental Group (IDG) on Internationalisation of INR”, which was submitted to it nine months ago in October 2022. Apparently, the release was strategically timed as two days earlier, on July 3, 2023, it was revealed that Indian refiners had started paying for Russian oil in Chinese Yuan from June 2023 – raising the spectre of India ending up internationalising Yuan, rather than Rupee.

Seemingly, the idea of releasing the report is to convey that the RBI is doing its bit to internationalise Rupee (in trade settlements) but not a word is said about the problems India is facing in paying for Russian oil after the US and Europe sanctions made payment in USD difficult or that Russia is not keen to accept payment in Rupee (the rupee trade with then USSR dates back to 1950s) or in UAE Dirham – in which Indian refiners were forced to pay more than five months ago. More than a year of the India-Russia talks for Rupee settlement was going nowhere and was abandoned in May 2023.

The latest revelation says that the Indian Oil Corp (IOC), India’s biggest buyer of Russian oil, became the first public sector entity to pay for Russian oil in Yuan; two of the three private refiners are also doing the same but it is not known since when. The amount of Yuan payment may be small at present but is likely to grow fast as India’s reliance on cheap Russian oil is huge – up from 2% of the total import before the Russia-Ukraine war to 46% in May 2023 – and for other reasons which would be clear soon.

Challenges to internationalising Rupee

Indian refiners paying in Yuan is a real tragedy because the IMF had identified and listed Indian Rupee along with Chinese Renminbi (Yuan is the currency unit), Brazilian Real, Russian Ruble, and South African Rand “as the key emerging market currencies with the potential for internationalisation” as the IDG report says.

In 2023, the IMF’s forex reserve or SDR (Special Drawing Right) basket has five currencies: USD (43.38%), followed by Euro (29.31%), Renminbi (12.28%), Japanese Yen (7.59%), and British Pound Sterling (7.44%). Indian Rupee is conspicuous by its absence.

What determines SDR (reserve currency) allocations or international trade settlements?

While the two primary determinants are (i) the large size of the economy (GDP) and (ii) the large share of global trade, the IDG identifies four “pre-requisites” for internationalisation of currencies: (iii) deep and liquid financial and forex market (iv) currency convertibility and credible commitment to an open capital account (v) wide use of currency in private sector transactions and (vi) macroeconomic and political stability.

Of the six, India fits the bill in two (fifth largest economic, macroeconomic, and political stability) and needs to work on the rest. Its global trade has remained stuck below 2% (1.6% in 2020) for several decades, Rupee is not fully convertible, its financial and forex market isn’t deep or liquid enough, its unstable currency policy (demonetisation of high-value notes in 2016 and withdrawal of Rs 2,000 notes while keeping it a legal tender) and progressive devaluation of Rupee (vis-à-vis USD) in the past few years is unlikely to encourage big private corporate entities and HNIs to rely exclusively on Rupee transactions.

The current situation is ideal for an alternate currency to emerge though because of the new geoeconomic fragmentation resulting from the Russia-Ukraine war (the US and Europe on one side and Russia, and China on the other, along with other countries in their camps) and the economic distress (high inflation, high-interest regimes) in the US and Europe have opened up the field for other currencies to challenge the hegemony of USD and Euro – which Yuan is more likely to mount.

What if Russia and China demand Yuan payment?

Indian refiners paying in Chinese Yuan for Russian oil presents a new setback for Rupee because India’s dependence on Russian weapons is also very high – 45% of the total during 2017-2022 – followed by France (29%) and the US (11%).

What if all non-oil trade with Russia is sought to be settled in Yuan?

According to the Ministry of Commerce and Industry, Indian imports from Russia skyrocketed from $9.9 billion in FY22 to $46.2 billion in FY23 (mainly due to oil) while its export fell from $3.3 billion to $3.1 billion during the same time – leading to a sharp jump in the trade deficit from -$6.6 billion to -$43.1 billion in one fiscal. Even if Russia demands payment in Russian Ruble the sharp rise in trade deficit and continued dependence on cheap Russian oil would dent Rupee.

More importantly, what happens if China demands payment in Yuan?

According to the Ministry of Commerce and Industry, import from China has risen by 40% in the past five fiscals (from $70.3 billion in FY19 to $98.5 billion in FY23), export has fallen by 8.6% in the same period – taking the trade deficit higher by 55.3% (from -$53.6 billion to -$83 billion). In FY19, the trade deficit with China was 29% of India’s total trade deficit – which has grown to 31.6% in FY23.

Yuan is fast emerging as a serious challenge to the dominance of the US dollar. Many countries, like Brazil, Bangladesh, and Argentina have already started settling trade in Yuan instead of USD; Yuan has replaced USD in China-Russia trade. It has helped China set up global offshore Yuan markets in Singapore, London, Paris, Hong Kong, and Luxembourg. Besides, in April 2023, Yuan overtook USD to become the most-used currency in China’s cross-border transactions.

These are troubling signs. China is not just (i) the second largest economy after the US but also (ii) the global leader in manufacturing (28.7% of global manufacturing output in 2019, as against 16.8% of the next in the list, the US) (iii) the global leader in the export of goods (14.3% of the global share in 2020, as against 8.1% of the second leader, the US and (iii) also the global technology leader – leading in 37 of 44 “crucial technology fields spanning defence, space, robotics, energy, environment, biotechnology, artificial intelligence (AI), advanced materials and key quantum technology areas” because it has established “stunning lead in high-impact research”.

India may be the fifth largest economy, but its share in global manufacturing output is 3.1% (in 2019), its share in export of goods is 1.6% (in 2020, as per the Economic Survey of 2022-23), and doesn’t count in technological innovations – all key factors to make a currency to grow to global significance.

Hence, India’s dependence on China will continue to grow in the foreseeable future – for importing manufacturing goods, intermediaries, raw materials, and also technology transfers. Under the circumstances, Rupee isn’t able to stand up to the Yuan. Irrespective of how far Rupee and Yuan have devalued vis-à-vis USD in recent times, the fact remains that at current prices one USD is equivalent to 7 Yuan in contrast with 83 Rupee.

India’s share of global trade has to rise

There is yet another stumbling block for Rupee.

One of the primary roadblocks for Rupee to grow in international stature is India’s poor share in global trade (1.6%). The pie is unlikely to grow because India has (i) erected import barriers that dampen exports and (ii) chasing bilateral FTAs – individual countries with relatively smaller shares of global output and trade – while the rest of the world is converging with mega multilateral FTAs like the RCEP, IPEF, and CPTPP. Members of these mega trade blocs contribute the most to global GDP and trade.

As Fortune India argued earlier, the biggest challenge for India to boost its exports is to integrate with global value chains (GVCs), which is virtually impossible if mega trading blocs are shunned. There is no evidence that bilateral FTAs benefit more than multilateral FTAs or that India’s earlier trade regimes failed to expand trade because of unfair practices or discriminations (it was more because of poor products and bad governing standards) and none of the three reports cited to justify renegotiations of bilateral FTAs supported import substitution.

These are some of the fundamental issues that should engage the RBI and FinMin.

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