Globalisation has made trading very easy. Today, you can buy and sell goods to anyone in any part of the world. When the USD became a global reserve currency as a result of the Bretton Woods Agreement in 1944, it also meant that the USD was used as an exchange currency to buy and sell goods across the globe. This gives the United States a lot of power in the global financial system.
However, of late, the United States has been using this dominance as a tool to punish its adversaries. This is usually done through sanctions. In simple terms, the United States bars the sanctioned country from trading using the US dollars. The rationale behind this is that the country on which sanctions have been imposed can’t trade internationally, which cripples their economy and forces the country to roll back whatever measures they have been undertaking which harms the US and its allies. But, in order to understand how countries can trade without the USD, we need to first understand how the international payments system works in the first place.
All international payments happen through a network called the Society for Worldwide Interbank Financial Telecommunication a.k.a SWIFT. It’s a vast messaging network for banks and other financial institutions to quickly, accurately, and securely send and receive information, such as money transfer instructions. Let’s understand how an international transfer is facilitated through this network.
Let’s take a hypothetical example. Mr. Rakesh wants to import batteries worth ₹10,00,000 from Mr. Will in China. Since it’s an international transfer, the currency of exchange is the USD. Now, an important fact to remember while transacting in the USD is that it can be transferred between American banks only. Hence, almost every bank in every country of the world has an account in an American bank. This enables their customers to transfer money internationally. Here’s how Mr. Rakesh can pay for his import to Mr. Will.
The SWIFT network now facilitates more than half of the world’s international payments. The founding member countries of this system belong to the US, the UK, and other European countries. Hence, those countries who don’t share good economic and political relationships with these countries are usually cut off from SWIFT as part of the sanctions imposed on them. This means, the balance of the local bank’s dollar holding account (the American bank) is frozen and the local banks are removed from the SWIFT network when they are sanctioned by the west. This subsequently makes it difficult for the sanctioned country to import and export goods. Countries like Iran, Russia, North Korea are subjected to such sanctions.
Now you may wonder, is there an alternative solution to this? After all, countries like Iran and Russia still manage to keep their economy afloat. The answer to this lies in a concept known as the Vostro account. A Vostro account is a bank’s bank account held by a foreign bank. Let’s explore how a country can trade with another country and settle the transaction in their local currency:
Let’s assume Ajay wants to export wheat worth ₹1,00,000 to Mr. Sheikh in Iran.
In this process, when a trader wants to import, it is important for the trader’s local bank to have a Vostro account in the exporter’s local bank so that the trade can be settled in local currency.
As per RBI’s notification dated 11th July, 2022, Indian traders can settle their trade in Indian rupees. Ever since Russia invaded Ukraine, western countries have made it difficult to trade with Russia as it has been removed from the SWIFT network and its Dollar accounts in the US have been frozen. India and Russia’s bilateral trade stands roughly around $13 billion, making it important for India to explore the Rupee-Ruble trade (using Vostro account).
India is not unfamiliar with this payment mechanism. India had such a mechanism in place in the past when it used to buy oil from Iran. However, it had to stop after America imposed sanctions on Iranian oil. But now, countries like Russia, Iran and Venezuela want to trade with India using this method as it does not involve the Dollar (all these countries come under the American sanctions) and as per RBI’s notification, if the Indian trader can settle the trade in rupees, this will increase the demand for INR which will help in maintaining a healthy forex rate.
On the flipside, if India starts settling payments with these countries using this mechanism, it may upset the US, with whom India’s bilateral trade is currently more than $119 billion. Additionally, going ahead with this plan may send a huge political message that India is getting closer to Russia and distancing itself from the West, which frankly, India cannot afford to do. And it’s not just India who is exploring this path. Earlier this year, China had proposed to the Saudi government to buy the Saudi crude oil in Yuan. It wanted Saudi Aramco to release yuan-denoted forward contracts, given that China buys approximately 25% of Saudi oil exports.
This system would be very complex for all countries to adapt to, as a local bank needs to have a Vostro account in practically every country in which it has economic relations. This would increase costs for the banks, but if the West starts imposing such sanctions on all the countries it dislikes, other countries will have no other choice but to explore this route.
Just because the US and Europe do not have good relations with a country like Iran or Russia, it does not mean that other countries should also have bad relations with them. Every country should put its national interest first and make decisions accordingly. Countries walking down this path must also understand that they will be walking on a diplomatic tightrope as trading activities with an economy put under sanction by the West are a risky business. Countries should make sure that they still maintain good relations with the US and Europe — the most powerful economies in the world — and make sure that they take the best decision concerning their national interest.
By Nikhilendra Mithanthaya, TYBFM