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India's central bank is nudging local banks to ask their clients to settle trade between the United Arab Emirates and India using the dirham (AED) or Indian rupee (INR) to reduce U.S.-dollar-based transactions, five sources told Reuters.

The move is part of the Reserve Bank of India's broader aim of promoting settlement in local currencies with countries with which India has a trade deficit, with the knock-on effect of boosting the rupee's global reach, three banking sources said.

India's trade deficit with the UAE was $21.62 billion in 2022/23, or 8.2% of its total deficit, government data shows. In July, the two countries agreed to facilitate trade in rupees instead of dollars.

The idea, a government source said, was to reduce the outflow of dollars on account of this trade deficit.

"The RBI has asked banks to encourage clients and corporates to initiate INR-AED trades gradually, instead of using the dollar," said a treasury official at a private bank.

An RBI official communicated this message verbally to foreign exchange dealers at a seminar this month, four sources said. This communication has not been previously reported.

None of the sources wished to be named because they are not authorised to speak to the media. The RBI and trade ministry did not respond to a Reuters email seeking comment.

The RBI may consider setting internal targets for the quantum of India-UAE trade it would like to see moved away from dollars, said the government source.

The central bank is "keen that volumes of such trades go up" and "has assured the market that they will be ready to support banks with INR-AED trades," this banker said.

While data on such cross-currency trade volumes is not publicly available, at least three bankers said the current volume is low and may act as a hurdle for corporates to pay for the entire import in dirhams.

Indeed, earlier this month, Indian Oil Corp paid Abu Dhabi National Oil Co (ADNOC) in rupees to buy a million barrels of oil.

"The RBI is telling banks to first encourage large clients and corporates to start INR-AED trades because their balance sheets are relatively stronger," another banker said.

But large corporates have, so far, been reluctant in engaging in non-dollar-denominated deals, said a banker with a state-run firm.

With smaller companies, on the other hand, bankers have pushed for such transactions by offering discounted service charges as an incentive, the banker said.