The Central Bank of Sri Lanka (CBSL) recently said that it was awaiting the Reserve Bank of India’s (RBI) approval to classify the Indian rupee (INR) as a designated foreign currency in Sri Lanka.

Sri Lanka has made this request from the RBI to facilitate and promote trade and tourism in the SAARC region including India.

After India approved Sri Lankan request to designate the INR as a foreign currency, Sri Lankans can now hold USD 10,000 worth of Indian rupees in a physical form.

Sri Lankan residents will now be able to convert the INR into another currency and to enable this, Sri Lankan banks must sign an agreement with an Indian bank to open "INR nostro accounts" which means the accounts that banks hold in a foreign currency in another bank.

According to the media reports, all current account transactions including exports, imports, and remittances can be undertaken between Lankan residents and non-residents.

Transactions between Sri Lankans can only be done through banking channels and only for permitted activities, bankers said. While this arrangement was approved by India a few months ago, the Central Bank of Sri Lanka was yet to notify the rupee as a designated foreign currency.

However, INR is still not a legal tender in Sri Lanka. Currently, there are 15 designated foreign currencies in Sri Lanka; they are Australian Dollar, Norwegian Kroner, Canadian Dollar, Pound Sterling, Chinese Renminbi (Yuan), Singapore Dollar, Danish Kroner, Swedish Kroner, Euro, Swiss Franc, Hong Kong Dollar, Thai Baht, Japanese Yen, United States Dollar and New Zealand Dollar.

Designating INR as a legal currency in Sri Lanka will provide the country much needed liquidity support to help it tide over its economic crisis amid inadequate dollar liquidity.

The decision is also in accordance with the Indian government’s efforts to popularize the Indian Rupee among Asian nations and reduce dollar dependence.

The RBI has put in place a mechanism to settle international trade in rupees “in order to promote growth of global trade with emphasis on exports from India and to support the increasing interest of the global trading community in the rupee.”
The RBI mechanism is expected to facilitate importers and exporters to avoid rules that prevent the use of a global currency such as the US Dollar for trade with certain countries. After Russia attacked Ukraine, several countries had imposed sanctions on Russia. Indian companies which were looking for alternative modes of payment for imports can make use of the new mechanism.

However, this move has also gained in significance in the backdrop of the recent economic upheaval in Sri Lanka where one Sri Lankan rupee equals 0.22 Indian rupee.
The currency swap has the potential to draw foreign investors who will be attracted by the stability of a substitute currency and show greater willingness to be paid in INR rather than the domestic currency LKR, which might be subject to losses on foreign exchange markets. Further, with a foreign currency, the economy is unlikely to face a balance of payments crisis when speculators take flight and sell domestic currency.

Meanwhile, University of Colombo Faculty of Arts Department of Economics Senior Lecturer and Attorney-at-Law Dr. Shanuka Senarath has told the media that the move to substitute LKR with the INR in certain segments of the economy had a good side as well as a bad side.

Recalling what took place over the past few years, Dr. Senarath stated that whenever Fitch and Moody’s rating agencies downgraded Sri Lanka, the Government was swift to criticise these ratings instead of looking at ways to solve the economic issues pointed out by them.
“The Government always tried to shoot the messenger, instead of trying to understand the message. This has made us look like jokers in front of the international market. We have lost our recognition. In a way, substituting the LKR with the INR might keep our economy alive,” he added.

However, according to him, if the Government were to permit the INR being used within the local economy, the country might partially become an Indian state, with the repercussions left to the imagination.

“For example, the euro is economically beneficial for countries transacting with it because the exchange rate stability is smoother. In terms of the euro, it is a totally different situation. In Sri Lanka, our situation is different. We are not doing this because of trade here,” Dr. Senarath stated.
However, there are several major benefits involved in a substitution. Under this move, a government cannot print foreign currency to create inflationary pressures. This provides an incentive to deal with inflationary pressures – such as cost-push factors and supply constraints.

Foreign investors will be attracted by the stability of a substitute currency and show greater willingness to be paid in dollars or in our case in INR rather than the domestic currency LKR, which might be subject to losses on foreign exchange markets. Further, with a foreign currency, the economy is unlikely to face a balance of payments crisis when speculators take flight and sell domestic currency.