Why India and China can’t settle bilateral trade using their respective currencies?

Trade between India and China must be settled in dollars and not in their respective currencies. The non-convertibility of the yuan and the rupee is to be blamed for it.

Among other things, a large current account deficit – result of the nation’s import bill far exceeding its export earnings – is responsible for the rupee hitting a new low every now and then.

And massive oil imports, in large part, can be blamed for the yawning current account deficit. Being a dollar denominated commodity, the government needs to purchase substantial dollars using the rupee, thereby dragging down the latter’s value.

The counter the situation, one option before it is to stem the loss of dollars caused by the other merchandise imports.

In fact, if sources are to be believed, the government is already mulling over the option – it is planning on some imports from China to be settled in yuan, the official Chinese currency.

But why can’t the trade between the two nations be settled in their own currencies, you may wonder. Common logic, after all, dictates that to buy Chinese products you need the yuan. Similarly, to buy Indian merchandise, China simply needs to use our national currency the rupee.

Now, here’s the twist.

The currencies of the two nations are not directly convertible. This means trade between them needs to be settled in dollars and not in their respective currencies.

To elaborate further, both the yuan and the rupee are not fully convertible like the dollar. While the yuan is non-convertible, the rupee is partially convertible.

To understand how it works, we try and answer a few basic questions first.

What is a non-convertible currency?

A non-convertible currency is one which cannot be easily exchanged for another currency owing to restrictions placed on it by the government. It is mostly used in domestic transactions.

Naturally, a non-convertible currency is not openly traded in the forex market, such as the traditional spot or forward currency markets (in a spot market financial instruments or commodities are traded for immediate delivery, whereas in the future market it is traded for delivery at some future date at a price set earlier).

However, one has the option to gain exposure to non-convertible currencies through non-deliverable forward (NDF) contracts. As the name suggests, those are forward contracts in which underlying currency is not delivered on expiration date of the contract at the earlier locked exchange rate. Instead profit or loss is settled by making a net payment in a convertible currency.

Why do certain nations choose to make their currencies non-convertible?

The truth of the matter is, they do not have much of a choice in this respect.

What comes to play is the impossible trinity, also referred to as the unholy trinity (a wordplay on holy trinity). It is a policy trilemma which allows policymakers of a country to choose only two out of three policies. The three policies are as follows:

  • Allow free movement of capital across a nation’s borders
  • An independent monetary policy
  • A fixed exchange rate with another currency

Here’s a scenario to help you understand better:

Say, a nation pegs its exchange rate against the US dollar, and it allows the free movement of capital across it borders.

Now, if under inflationary circumstances, it hikes interest rates above those set by the central bank of the US called Federal Reserve, it is tantamount to exercising the third policy as well.

Once that is done, the economy would automatically see inflow of foreign capital with investors parking their money in the nation’s fixed income assets which now offer higher interest rates. They would sell the dollar to buy the national currency to invest in those. It would drive up the value of the national currency. Subsequently, the peg with the dollar would break.

On the other hand, if interest rates are slashed below the federal funds rate, the local currency would see its demand lessen and as a result would see its value erode.

Thus, the nation cannot have an independent monetary policy, if it opts to manage the exchange rate of its currency, and also allow its free movement across the borders.

Instead, it is obliged to shadow the monetary policy of the nation with whose currency it has pegged its own.

Nations across the world have opted for different combinations in this trinity. The US, for example, has an independent monetary policy but no capital controls. Hence, it has a flexible exchange rate. On the other hand, countries in the EU have a stable exchange rate but no independent monetary policy.

What makes Chinese yuan non-convertible and the Indian rupee partially convertible?

Since China manages the exchange rate of the yuan and has an independent monetary policy, it cannot allow capital to flow freely across the borders as it would affect the peg. This is considered as China’s trilemma. So, now the Chinese yuan is one of the most prominent non-convertible currencies.

The Indian rupee on the other hand is partially convertible since there is a degree of control over its movement across its borders. There are caps on personal transfer of money out of the country; there are limits placed on foreign currency borrowing by domestic firms; there are limits on overseas investment for domestic companies as well.

Such restrictions make it difficult to convert the currencies into one another for the purpose of trade. Dollar being freely convertible is used to settle trade between the two nations. This also ratchets up transaction and hedging costs.

To solve the issue, China and India, both beleaguered with plummeting currencies, could be considering settling some of their trades in local currencies. In this manner, India could directly receive its own currency, the rupee for pharmaceuticals, oilseeds and sugar exports to China.

Already, Iran and India are already considering settling bilateral trade in the respective currencies, owing to the US threatening sanctions against Iran.