Incubating a non-dollar architecture

After two years of intense negotiation, the BRICS leaders finally launched the New Development Bank on July 15 at the Sixth BRICS Summit in Fortaleza, Brazil. The bank’s focus will be on infrastructure and sustainable development projects through loans, guarantees, credits and equity investments. The decision to share the initial subscribed capital of $50 billion and the resulting voting rights equally, reflects a commitment by the five countries to view each other with equity^[1].

The launch of the bank will now give the BRICS five confidence to experiment with other geoeconomic ambitions. Chief among them is the desire to conduct trade in local currencies. Russia is moving to denominate its energy assets in roubles, China is pushing for the renminbi to become the global currency of choice for trade payments, and India was creatively using rupee accounts to hold payments for Iran after the U.S. and EU imposed financial sanctions on Iran.

Can the mandate of the new bank be extended to incubate a non-dollar financial architecture for emerging countries? If so, what would the design look like?

In its most basic form, this architecture would need three components, one each to support trade, settlements and investments in the local currencies of the five countries– rupees, rouble, renminbi, rial, rand.

1. A mechanism that enables trade in local currencies. Since none of the five currencies are global reserve tender, the respective central banks will have to make their currencies available to the group. Article 24 of the BRICS bank does provide for financing of projects in local currencies^[2]. However, for enabling trade, the bank will have to enable currency swaps between the central banks or activate the Multilateral Agreement on Extending Credit in Local Currencies signed at the 4^th BRICS Summit in New Delhi in 2012^[3].

China has been experimenting with such swaps bilaterally to push for greater use of the renminbi. It has swaps with 21 countries including Russia and Brazil, denominated in renminbi worth up to RMB 2,600 billion ($420 billion) and is encouraging partner countries to pay for their imports from China in renminbi^[4]. Brazil has been experimenting with conducting trade with Argentina in rial and pesos through an agreement inked in 2008^[5].

India has three swaps to its credit – Bhutan ($100 million), SAARC ($2 billion), Japan ($50 billion). However, these swaps are denominated in dollars and earmarked only as a line of reserve for partner countries during a balance-of-payment crisis; it is not for enabling trade payments^[6]. When the rupee was depreciating rapidly against the dollar in 2013, New Delhi scurried to set up a task force to study how trade in local currencies can be enabled, and also indicated that it may sign currency swaps denominated in rupees with 23 countries^[7]. However, no definitive measures were announced.

2. A mechanism for settling local currencies. Since trade payments will be made in five local currencies, a new settlement system will have to be created, as dollar-based transactions are ultimately cleared by the Federal Reserve of the U.S. There are no provisions in the bank for this yet but there are two models that can be built on – Asian Clearing Union and RMB Trade Settlement Scheme.

The Asian Clearing Union (ACU) was established in 1974 to encourage trade between India, Iran, Pakistan, Myanmar, Bangladesh, Nepal, Bhutan and Maldives. It provided a system for the members to settle trade in their local currencies. At its peak in the 1980s, ACU cleared up to 84% worth of trade amongst its members^[8]. Since then, its usage has dropped mostly due to western pressure against Myanmar (until the 2010 reforms) and Iran but it is a workable model for settling trade in non-dollar currencies.

China experimented with settling trade in renminbi between foreign traders and mainland China enterprises by launching the RMB Trade Settlement Scheme in 2009 in Hong Kong^[9]. The success of that experiment has enabled it to extend renminbi clearing and financial services to Singapore, Germany, Taiwan and the UK, proving that the use of a non-dollar currency is possible.

3. A mechanism to invest ‘surplus’ local currencies. Since trade is not perfectly balanced between the BRICS, it is likely that some countries will be left with the surplus currency of another country even after payments have been cleared through the clearing union. For instance, India has a $36 billion annual trade deficit with China. Even if 50% of it were settled through the clearing union, China will still be left with, $18 billion worth of rupees.^[10] This surplus can be settled in dollars, as ACU currency does with surpluses left over from trade between its members.

An alternative strategy would be for India to have China hold rupees in an interest-bearing financial product such as government securities or corporate bonds in India. This will enable the rupees to be re-invested into the Indian economy. Foreign ownership of rupees has its risks but the capital may help avoid Indian businesses take on foreign loans to finance their operations.  It is a strategy the United States has successfully pursued over many decades. For instance, in the 1970s the U.S. convinced the Gulf countries not to launch their own currency but denominate oil in dollars and invest the money through financial products in the U.S. markets. The U.S. did the same with China which was accumulating dollars, convincing it to hold its reserves in the US financial markets. Today, the U.S. remains a trade deficit country but it is able to attract dollars back into its economy and recycle the capital into global opportunities with higher returns for itself. Of course, the U.S. has built deep and sophisticated markets to support its financial statecraft, which no other country in the world has yet replicated.

At the moment, Article 19 of the bank only has a provision to facilitate access to international capital markets for project financing^[11]. This will have to be expanded to support investments in local currency financial products. China has launched the Renminbi Qualified Foreign Institutional Investor Program (RQFII) to attract RMB raised by investors offshore, back into China’s onshore securities markets^[12]. HSBC and Fullerton Fund have already launched financial products to use this option. This is in addition to the renminbi-denominated bonds that Nigeria, Australia and Japan have bought to convert their reserves into renminbi.

India can provide similar financial products – without having to announce full capital account convertibility. Today, sovereign wealth funds and foreign central banks can invest in Indian government securities. But there is a limit of $10 billion and it can only be done in U.S. dollars as it brings in valuable foreign exchange^[13].  The RBI also heavily regulates rupees-based accounts. It only recently allowed foreign institutions to open accounts where they can park rupees earned from the sale of assets in India until their next investment^[14]. For enabling investments in rupee instruments, much more deregulation would be required.

Some Indian government officials remain concerned that foreign ownership of the rupee is an eerie reminder of the Rupee Trade Agreements signed in the 1960s with eastern European countries. It negatively affected India’s exports and eventually partner countries refused to hold rupees when its value depreciated^[15]. However, the Indian economy, financial markets, technical infrastructure, regulatory supervision, and geoeconomic heft are far more sophisticated now. To expect the same risk is being over-cautious and reflects the pessimism that India will remain a trade deficit nation in the future. Even so, BRICS bank can always enforce limits on the surplus holdings as Keynes had originally suggested when designing the IMF. Businesses too are reluctant to switch to multi-currency architecture because it will cost to create the supporting technical, legal and regulatory processes. They also fear losing the West as a valuable source of investment and finance, in case the West retaliates.

China can build the alternate architecture just by itself and for itself. If that happens, a renminbi-based geoeconomic architecture could be as unfair as the existing dollar-based architecture – so it is even more important to build a multilateral architecture.

The only way to ensure that each country’s interest is protected is through smart economic diplomacy. Otherwise, the larger financial eco-system will not be willing to join this experiment with the BRICS bank.

Akshay Mathur is the Geoeconomics Fellow and Head of Research, at Gateway House: Indian Council on Global Relations, Mumbai.

An edited version of this article was first published by the Financial Times.

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