Jan 31, 2016

A case for trade invoicing in INR

Should it matter whether the international trade invoices are quoted in INR or USD?
A simple thinking says it shouldn't. When buying/selling a good or service we mentally convert the currencies in the head or a calculator and it doesn't matter much. Like an inch or millimetre, they seem to be just units with a floating (or fixed or pegged or whatever) conversion ratio. It appears that it is not so. It does matter, and with profound consequences.

Today, over 97% of India's exports are invoiced in freely convertible currencies (FCCs) mainly in USD. INR is not yet an FCC due to restrictions on movement and convertibility in capital account. The realisation of export proceeds in India need to be in FCCs as mandated by FEMA and the master circular on exports and imports. While para 2.52 of India's foreign trade policy allows export invoicing in INR, in addition to FCCs, the trade prefers quoting invoices and contracts in USD, Euro and other FCCs. It appears that it is a bad policy. A better policy might be to make it mandatory to quote all the invoices in INR.

There is an interesting working paper by Gita Gopinath hosted at NBER website. Some of the results discussed therein have profound consequence on the way we think about exchange rate effects on macroeconomics. And about how invoicing currency has a significant link with exchange rate pass-through, trade balance and imported inflation. Let me summarise some of the key takeaways, in applied sense. 

I had blogged earlier about how exchange rate has a lag effect of around a year and a half in India. A depreciation of INR today helps our exports with a lag of more than a year. It turns out that one of the reasons for this delayed pass-through is 'not' invoicing in INR. If we quote our trade in INR, the pass-through delay will reduce drastically. Empirical data, as quoted in the paper, supports this view. Therefore, if we want to take advantage of currency depreciation in boosting exports, a better way is to quote all our invoices in INR. A corrigendum of the pass-through effect is also that trade balance adjustments happen through exports in countries that quote in domestic currencies, and through imports in countries that quote in foreign currencies. Therefore, India would try to adjust it's trade imbalance through control of imports, whereas US would work through exports. That's an important point to ponder about.

Secondly, prices are sticky in their currencies of invoicing. This leads to a situation where INR depreciation leads to markup profits for exporters/windfall gains, and pain to importers (and vice-versa for appreciation). India being a net importer, it hurts as it imports inflation. Invoicing in INR won't do this. US is insulated from currency swing effects on domestic inflation as most of its trade is quoted in USD. Imported inflation stabilisation would become much easier if we decide to quote mandatorily in INR.

Now, if that's true, we have some further points to ponder about.

First, would it be sensible to force our trade to quote exclusively in INR, irrespective of currency of realisation? An amendment to FTP/FEMA might achieve this but a better way of going about it would be to internationalise our currency by making it fully convertible, and thus more acceptable as an invoicing currency. While the path to full convertibility is long, we might think of amending FTP/FEMA to make invoicing in INR mandatory for all goods and services. This, after careful consideration.

Secondly, we need to realise that while we quote in USD, a currency depreciation is not helping much, and the export boost has a significant lag of more than a year. Therefore, a competitive devaluation of our currency is not in good interest, given that it might import inflation. So, to that extent I stand corrected from an earlier post that recommended rupee devaluation.

PS: I have assumed hedging both ways or none, therefore, the points hold even with hedged currency exposure.