Steps needed to boost local currency settlement in UAE dirham and Indian rupee

Almost two years have passed since the Local Currency Settlement Agreement between India and UAE. The United Arab Emirates was the first country with which India signed the Comprehensive Economic Partnership Agreement (Cepa) as well as a Local Currency Settlement (LCS) Agreement. The LCS agreement was signed in July 2023, though both countries started discussions and negotiations one year back in the year 2022. 

However, the LCS has not picked up to the expectations despite concerted efforts of both the central banks, while Cepa has seen good progress. The less-than-expected performance not only required soul searching but also efforts to address some of the concerns raised by parties on both sides of the spectrum. After signing the first LCS agreement with the UAE, India has signed three more LCS agreements with Sri Lanka, Maldives, and Indonesia. 

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The mechanism of settlement is very simple — exporters can receive the export proceeds in dollars or other major currencies, the local currency of the importing country, and in the currency of the exporting country. However, the US dollar has dominated the trade settlements. This effort is not aimed at de-dollarisation but arranging settlement in bilateral trade or even trilateral trade in the respective currencies of countries involved. 

The process is as follows — 

Indian exporter - export to UAE - invoice in UAE dirham - payment in UAE dirham - UAE dirham credited in a bank account in UAE.

UAE exporter - export to India - invoice in Indian rupee - payment in Indian rupee - Indian rupee credited in a bank account in India.

However, the invoicing and settlement can be in any respective currencies of two countries i.e. invoicing for export to India can be in UAE dirhams too, and export to UAE can be in Indian rupees too. But the objective of the LCS is to encourage the trade partners of the respective countries to deal in partner countries’ local currencies too, away from US dollar.

A few problems and hurdles mentioned by the United Bank Federation of UAE and other stakeholders were addressed by the Reserve Bank of India. However, there have been many other concerns that still need to be resolved.

On January 14, 2025, to promote the use of the Indian Rupee (INR) in cross-border transactions, the Reserve Bank of India amended some of the regulations of the Foreign exchange Maintenance Act (Fema). Two major changes were:

1. The Foreign Currency Accounts (FCA) Amendment allowed Indian exporters to maintain FCAs with banks outside India for all export transactions (goods and services) and receive advance payments for goods/services to be exported by them.

2. Persons resident outside of India (PROI) are permitted to open Special Non-Resident Rupee (SNRR) Accounts for all ‘permissible current and capital account transactions’ with authorised dealer (AD) banks in India as well as their branches outside of India. They can do same (opening INR account) with UAE banks also.

The first and foremost clarification is that the LCS doesn’t include only trade transactions, but also retail business, thus giving a chance to the NRI customers and Indian businesses alike outside India, means providing them banking in INR with permitted transactions. Thus, NRIs can open INR accounts outside India in local banks which can offer interest also for those accounts.

A major problem faced by the LCS arrangement is the trade deficit between India and the UAE. The trade balance is in favour of the UAE which has naturally raised the issue of the use of surplus rupee because of trade settlement. While the Reserve Bank of India is working on various suggestions of banking partners in UAE, it brought out a welcome change that the balance in INR in foreign countries can also be used for payments of proceeds with third countries having LCS arrangements with India. For example, payments for the tea import to the UAE can be made in INR to Sri Lanka which has an LCS agreement with India.

Another positive development brought out by RBI is that foreign banks have been allowed to invest INR surplus in permissible current account transactions, with the only clause that they must register as Foreign Portfolio Investor (FPI) in India. Thus, they can invest in Indian equity and stock markets and other permissible investments.

A misconception exists in the business fraternity and even individuals also that settlement through LCS will require an additional or different set of documents which is wrong. LCS also operates with the same set of documents which otherwise is required for US dollar transactions. 

Despite these steps taken by central banks, there are still a few pain points that need to be addressed to popularise local currency settlements. Besides the trade deficit, another concern is the ready availability and maturity of the forex market for the two currencies.  As of now, there is no active treasury market for quotes in forward and future markets, as well as currency and interest derivatives. A free market quote without referring to the US dollar is important to develop confidence and sentiment.

Despite efforts of two governments and two central banks, small players and exporters are not very clear about the mechanism and benefits as well as LCS itself. There is a need for more promotion, clarification, and sessions about the benefits of this mechanism.

There is a demand for the establishment of a bilateral line that should be enabled by the central banks of the two countries in their respective currencies for settlement of trade as well as permitting the drawing in case of need to make it more flexible and practical.

The effort should be to encourage those companies which are having offices and subsidiaries, associate companies, or joint ventures to operate in local currencies as they are present on both sides and settlement, as well as overall natural hedge, will be efficient and effective for them. In this regard moving Indian exporters to LCS will be practically easy as payment in Dirham which is pegged to dollars will be easily acceptable and even in rupee those companies having a presence in India and UAE will help in settling transactions easily and cost-effectively. Some of the sectors like gems and jewellery, gold and textiles can help in popularising the local currency settlements. 

The writer is Chief Executive Officer, State Bank of India, DIFC, Dubai.