Explained: RBI’s new mechanism to settle trade transactions in rupees

The Reserve Bank of India (RBI) has put in place a new mechanism to settle international trade in rupees, as the local currency faces increased pressure following Russia’s invasion of Ukraine and falls to a record low against the dollar.

The central bank it has decided to put in place an additional arrangement for invoicing, payment, and settlement of exports and imports in rupees in order to promote growth of global trade with emphasis on exports from India and to support the increasing interest of the global trading community in rupees.

Why did the RBI put in place this new mechanism?

For one, the rupee has been under pressure since the beginning of this year as central banks worldwide—especially the US Federal Reserve—tighten monetary policy to control inflation. This has led to an exodus of foreign capital from India, with net sales by foreign portfolio investors from India’s equity and debt markets crossing $30 billion.

As a result, the rupee has weakened against the dollar, from around 74 to the greenback to more than 79 currently.

In addition, the move to facilitate trade settlement in rupees could allow Indian companies to bypass certain international sanctions against Russia after its invasion of Ukraine. Since companies can no longer pay Russia in US dollars to buy commodities such as crude oil and fertilizers, an alternative mode of payment was necessary.

While there was talk also of the Indian authorities considering a rupee-ruble trade system, the RBI’s new mechanism goes a step further.

What exactly is the new mechanism?

According to the RBI, the broad framework for cross-border trade transactions in rupees under the Foreign Exchange Management Act (FEMA) of 1999 will have three components:

Invoicing: All exports and imports under this arrangement will be denominated and invoiced in rupees.

Exchange rate: The exchange rate between the currencies of the two trading partner countries will be market determined.

Settlement: The settlement of trade transactions under this arrangement shall take place in rupees as per a specified procedure.

So, what is this procedure and how will trade transactions be settled under the new mechanism?

Before putting in place this mechanism, authorised dealer banks will require prior approval from the RBI’s foreign exchange department. The authorised banks can open the so-called Rupee Vostro Accounts.

For settlement of trade transactions with any country, such banks in India will have to open Special Rupee Vostro Accounts of correspondent banks of the partner trading country. The authorised bank maintaining the special Vostro Account will have to ensure that the correspondent bank is not from a country in the FATF Public Statement on High Risk and Non Co-operative Jurisdictions.

Indian importers undertaking imports through this mechanism will make payment in rupees. This will be credited into the Special Vostro account of the correspondent bank of the partner country, against the invoices for the supply of goods or services from the overseas seller.

Similarly, Indian exporters will be paid the export proceeds in rupees from the balances in the designated Special Vostro account of the correspondent bank of the partner country.

How else can the new system benefit exporters?

Indian exporters can receive advance payment against exports from overseas importers in Indian rupees through the new mechanism. However, before allowing any such receipt of advance payment against exports, Indian banks will have to ensure that available funds in these accounts are first used towards payment obligations arising out of already executed export orders or export payments in the pipeline.

In addition, the RBI has allowed setting off export receivables against import payables in respect of the same overseas buyer and supplier with facility to make or receive payment of the balance of export receivables or import payables.

Will banks be able to issue guarantees under the mechanism?

Yes, banks will be able to issue a bank guarantee for trade transactions undertaken through this arrangement, subject to adherence to FEMA provisions.

What happens to any surplus balance in banks’ vostro accounts?

The RBI said that the rupee surplus balance held can be used for permissible capital and current account transactions in accordance with mutual agreement. The balance in Special Vostro Accounts can be used for payments for projects and investments, export or import advance flow management, and investment in government treasury bills and government securities.