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Decoded: How the rupee trade settlement is tied to India’s trade deficit and forex reserves

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. The ongoing pressure on the Rupee and its decline against the dollar pushed the Indian central bank to put in place a mechanism earlier this week to allow international trade in rupees.

To be clear, this is not the first time that the Reserve Bank of India (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. Now, the Russia-Ukraine war and the subsequent sanctions have provided RBI with another opportunity to push for trading in rupees.

Since India is a net importer – with its imports exceeding exports by over $87 billion (about ₹6.87 lakh crore) in 2021-22 – and the value of Indian rupee has been declining consistently, RBI’s latest decision to allow international trade in rupees is expected to reduce the pressure on India’s forex reserves.

Why would other countries want to trade with India in rupees and not dollars?

RBI’s move would reduce the outflow of US dollars and shore up demand for the rupee. This would allow the central bank leeway to conserve its forex reserves and deploy it to keep the rupee stable.

But why would any country switch to using the Indian rupee for its trades with India, especially when the US dollar acts as a common point for all countries, thanks to its status as the world’s reserve currency?

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: the US dollar has been going through a phase of strength against most currencies in the world. Here is a snapshot of how some currencies have performed against the US dollar in the past one year:

The US dollar’s strong 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.


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