India and UAE have signed a pact to promote use of local currency (Rupee and UAE Dirham(AED)) for cross border transactions. It will cover all current account transactions and permitted/limited capital account transactions.
Correspondent banks are financial institutions that act as an agent on behalf of other foreign banks. Foreign banks use the services of correspondent banks when it’s not financially feasible to establish a branch in the country. For example, SBI may act as a correspondent bank for banks in UAE because UAE banks may not be willing to establish their branches in India but just want to use some services.
Mechanism
Indian exporters will make invoices in Rupees (prices of exported items will be in Rupees) and UAE exporters (to India) will make invoices in UAE Dirham. Indian importers while making payment will transfer rupee in the correspondent bank (of UAE in India i.e. SBI) and Indian exporters will be paid in Rupee from this (SBI) correspondent bank.
As the UAE exporters (to India) are invoicing in Dirham and Indian importers are making payment in Rupee, so this will lead to development of INR-AED foreign exchange market. [Right now, only few currency pairs trading are allowed in forex market… USD/INR, EUR/INR, JPY/INR etc.] Presently since there is no direct conversion/trading of INR-AED (Dirham) is there, so there is no market for INR-AED trade. But once this mechanism of payment starts then INR-AED foreign exchange market will develop. And then INR-AED will be easily convertible and then in future whether we are paying to (UAE exporters) in INR or AED will not make much difference as it will be freely convertible/tradable.
This mechanism will be used to pay for crude and other imports for which we are currently paying in dollars. This will also lead to promotion of investment and remittances between the two countries. It will be a step in the internationalization of rupee.
This will lead to protection/hedging from exchange rate risk (Rupee-dollar price variation) and will insulate the domestic economy from global shocks.
