Can the rupee become a hard currency?

Writing about the prospect of the Indian rupee becoming a hard currency in the week after it depreciated against the dollar and in a year when foreign portfolio investors have pulled money out of India’s bond market might appear misplaced. Nevertheless, the rupee may be in a better position over the long haul to achieve hard currency status than the yuan. China’s top-down approach towards achieving hard currency status for the yuan has entailed mimicking the characteristics of a hard currency. On the other hand, the Indian government’s steps toward creating a formal, tax-compliant economy—although not directed at attaining hard-currency status—have laid the foundations for the rupee to evolve as an international currency.

Hard currencies are easily exchangeable, commonly used in international transactions, and generally expected to be stable in the short term. Hard currencies are also widely held as foreign exchange reserves by central banks. Yet, trying to arm-twist other countries to denominate exports and to accept one’s currency in transactions is hardly likely to make it a hard currency. Hard currencies have evolved organically as market participants have come to trust government finances and monetary policy and value deep, transparent financial markets, especially for government bonds, in those countries. Unsurprisingly, all the hard currencies, such as the dollar, the euro and the Japanese yen, are issued by developed countries which are viewed as financially and politically stable. In that light, let us consider how disparate actions of the National Democratic Alliance government over the past few years have established a robust launching pad for the rupee to become a hard currency.

One of the key differences between developed and developing countries is that the former have large tax bases, reflecting productive economies and effective tax enforcement. Large tax bases give developed countries ample fiscal capacity, which is a key underpinning of hard currencies. Firstly, modern fiat currencies are ultimately backed by the taxing power of the sovereign issuing the currency. The enforcement of the tax obligation creates a demand for the currency since taxes have to be paid in the currency. So, a large tax base ensures a natural, large demand for the currency. The currency can then take a life of its own and become loosely tethered to the taxing power.

Secondly, large fiscal capacity is essential for fostering macroeconomic and financial stability, another cornerstone of hard currencies. Limited fiscal space not only crimps the ability of the government to cushion recessions with countercyclical policies but also hampers efforts to recapitalize banks and stabilize the financial system in the event of a crisis. India’s policymakers have long bemoaned the country’s weak fiscal capacity thanks to rampant tax evasion. The combination of demonetization and the goods and services tax (GST) have dramatically expanded the tax base by bringing more individuals and businesses into the tax net. Sustained high economic growth augments fiscal capacity. Some of the reforms that have been carried out in recent years have augmented India’s potential growth in contrast to its diminution under the previous government. With economic growth, the tax base will expand exponentially as more people earn taxable incomes.

Developed countries are characterized by high levels of formalization of economic activity and a high degree of financialization of savings, both of which foster transparent and deep financial markets that allow investors in the currency a panoply of liquid investment choices. Demonetization, GST, Aadhaar and the Pradhan Mantri Jan Dhan Yojana (PMJDY) have given a big push to formalization and financialization of India’s economy.

Demonetization has clearly given a big fillip to financialization of household savings. Mutual fund inflows have experienced a substantial leap post demonetization and the trend is still going strong. The life insurance industry too has experienced a significant jump in business since November 2016. As domestic investors become a strong base, Indian financial markets will become less susceptible to the whims of international investors. Indeed, the resultant stability might make international capital less skittish. Meanwhile, there is now a growing body of evidence that the PMJDY has also contributed to a significant increase in financial savings and growth in usage of banking services.

The combination of Aadhaar and proposed laws to tighten property registration will ensure foolproof property titles and increase transparency in the real estate sector, thereby opening up the vast potential for mortgage-related financial instruments. Another far-reaching reform is the Insolvency and Bankruptcy Code (IBC). IBC will speed up bankruptcy resolution and probably lead to higher recovery rates, both of which will boost investor confidence and potentially lead to a vibrant corporate bond market. In turn, the disintermediation of credit will reduce the economy’s vulnerability to banking system instability.

One should be under no illusion that the rupee is poised to become a hard currency anytime soon. India does not yet have a fully convertible capital account. However, by 2030, when India could be a $10 trillion, middle income economy, the foundations laid today may well allow the rupee to gradually evolve into a hard currency.

V. Anantha Nageswaran and Srinivas Thiruvadanthai are, respectively, an independent consultant based in Singapore, and director of research at the Levy Forecasting Institute. Read Anantha’s Mint columns at www.livemint.com/baretalk

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