Are BRICS Countries Bailing on the Dollar?

At the last BRICS summit held in March in New Delhi, development banks of the participating countries agreed on a proposal to extend credit in local currency for trade, project financing and infrastructure projects.

So far, no clear mechanism on how they will extend local currency credit has been announced. Some financial gurus even dismiss the BRICS agreement as purely symbolic. Yet banks in London, New York, Tokyo and Singapore would be wise to take a second look at what now could be the most significant agreement in international finance since the euro.

BRICS countries make up a massive trade bloc. Current intra-BRICS trade stands at $307 billion; it is set to reach $500 billion by 2015. Within BRICS, China is the dominant country, exporting $135 billion in goods and services a year to its partners. India imports $50 billion annually from China and Chinese goods account for 11.8% of India’s total imports, increasing their share of the Indian market by 2% in just four years.

As trade increases, China could move swiftly to provide renminbi for importers of Chinese goods.

At this time, China facilitates payment in renminbi through a central bank liquidity swap. Since 2009, 16 countries have exchanged local currencies for a total of 1.6 trillion renminbi; more are in line to participate–Japan and Great Britain are rumoured to be in queue. But after the Delhi meeting, China’s BRICS partners may leapfrog and be next on the list.

From BRICS, Russia is currently the only country that swaps its currency with China–India, Brazil, and South Africa should take note.

Four factors make a central bank liquidity swap particularly important. First, BRICS countries are losing purchasing power because of depreciation against the dollar.

The dollar accounts for 40% of global foreign exchange trade. But it’s getting harder for BRICS to buy dollars. Brazil has seen its currency depreciate by over 16% since February 2012 and the Indian rupee fell to an all-time low of 56.51 to the dollar on Thursday, losing more than 20% of its value in the last 12 months. India is paying more for dollars than it has done in over a decade.

Second, following the 2008 financial crisis, rupee-dollar exchange rate volatility has increased by as much as 50%, making it difficult to predict the cost of dollars.

This uncertainty places India in a tough situation, given rising prices for key commodities such as crude oil, a slowdown in capital inflows and a current account deficit now at a decadal high of 4% of gross domestic product (GDP). India isn’t alone–Brazil and South Africa face the same problem as their currencies have seen deviations of 25% to the dollar. Their current account deficits too are high, at -2.1% and -3.4% of gross domestic product, respectively.

Third, there is an opportunity to save on transaction costs, which can cost Indian business up to 1-2% of a deal. Vladimir Dmitriev, chair of the Russian development bank, suggested in the BRICS summit agenda that countries will save up to 4% by entering into these agreements, saving on transaction costs, financing fees and currency fluctuations. Quick math shows that at full potential, BRICS countries save $12.3 billion a year in banking services. India could save a whopping $2.3 billion.

Lastly, a central bank liquidity swap will benefit small business. With the credit rating agencies such as S&P downgrading India, small- and mid-cap companies are struggling to get dollar loans at reasonable interest rates. Drawing on a swap line from China, the Reserve Bank of India (RBI) can offer attractive loans to businesses through the Export-Import Bank in renminbi to finance Chinese deals without having to worry about inadequate dollar supply.

There is geopolitical risk in this, however.

In the late 1950s, India entered into a similar currency agreement with the former Soviet Union largely for arms deals. But India ran up a trade deficit and from 1955-76, Russia accumulated upwards of $350 million in non-convertible rupees.

As a result, Russia sought a strategic advantage from its poorer trading partner. India’s signature commodities such as tea were re-exported by Russia to Western markets, shrinking India’s market share with key trading partners. Moscow even petitioned for naval base rights. Prime minister Indira Gandhi refused, believing that the quid pro quo would threaten regional security.

As with the Soviet Union then, so is the possibility with China now; India’s trade deficit with China is estimated to reach $60 billion by 2014-15.

In negotiating its rupee relationship with Russia, H.V.R. Iyengar, governor of RBI (1957-62), wrote to prime minister Jawaharlal Nehru warning him of the dangers of such currency arrangements. Nehru ignored him, declaring that “political compulsions far outweigh economic considerations”.

India’s motives now are economic. BRICS swaps save money on imports by freeing India from currency fluctuations and reducing the cost of funds. The key for India will be to negotiate favourable terms of agreement. Only then will India’s economic advantages outweigh the geopolitical risks of such a deal.