Indian Economy | Trade Reforms and Foreign Exchange Management act (FEMA) 1999 Download PDF
Foreign Exchange Regulation Act (FERA)
Trade reforms as a part of opening of the Indian Economy have their genesis in repealing of the foreign exchange regulation act (FERA) 1973, which was restrictive and had regulations on foreign exchange transactions. As an inward-looking economy, with strong insulation from the rest of the World, FERA was to discourage foreign currency in domestic economy, and if required, be specific and thus need for regulations.
Under FERA, there were very limited transactions which were permitted and that too after seeking approval there were a large number of transactions in the negative list or that transactions could not be done. Cross-border inflows and outflows were also restricted, in line with the levels of insulation of the economy.
Ail foreign-owned companies were designated as FERA companies. Similar to their counterparts in the domestic sector, MRTP companies under a similar act known as MRTP act. These companies in terms of their respective acts had to be closely monitored and regulated for fears of exploitative and unethical practices.
Foreign exchange regulation act also vested powers to try out criminal cases of violations in foreign exchange regulations. Thus, towards greater openness, and as a part of major trade sector reforms FERA was repealed and a new foreign exchange management act (FEMA) enacted in 1999, through which regulations paved way to management of foreign exchange transactions.
Foreign exchange management act was more liberal in allowing transactions without restrictions and dramatically pruned the negative list of foreign exchange transactions. The basic idea was to ‘permit rather than the earlier regime to ‘prevent’. It also eased restrictions on cross-border capital flows especially foreign investment providing a clear signal of lowering of insulation.
In tandem, the then EXIM policies had already lowered peak-level customs duty to facilitate greater imports into the country. With the dismantling of both the MRTP as well as the FERA acts, nomenclature of FERA companies, MRTP companies were also discontinued. With a strong focus on management of foreign exchange, trying out of criminal offenses was entrusted to a separate newly created enforcement directorate (ED). Thus, FEMA essentially covers three broad areas which are as follows:
(1) Rupee convertibility.
(2) Setting up of a separate ED for trying out criminal offenses in foreign exchange.
(3) Borrowings by the corporate sector.
Like the reforms in the industrial sector, replacing of FERA with FEMA is seen as a major aspect of trade reforms signifying relaxations on inflows and also greater openness of the Indian Economy. It is not only replacing ‘regulations’ with ‘management’, but a paradigm shift in the government’s outlook towards foreign currency. The other major areas of trade sector reforms are in the areas of foreign investment policy and also exchange rate determination, which are discussed in the subsequent sections.
What is the generic meaning of convertibility? Convertibility, as a concept, goes with open economies and little relevance in the era of closed economies. The meaning of convertibility is to treat foreign currency, no different from the home currency for transaction, investment and saving purposes whether in the domestic economy or overseas.
Convertibility is linked to absence of restrictions from the government of conversion of one currency into another and also in its end use domestically or internationally. Or coming back to ‘why’ mentioned in the beginning. If the government/RBI does not ask why foreign currency is required or foreign currency, freely, available across the counter, like home curren¬cy, is what is know as a convertible currency/economy. More specifically convertibility is also about the following:
Freedom to residents to maintain homq currency or foreign currency denominated by bank accounts.
Freedom to residents to remit outside the country.
Freedom to residents to invest in the global stock markets.
Freedom to domestic companies to borrow funds either from the domestic or from the international markets.
Freedom to companies to issue shares/bonds in overseas markets subject to their regulatory compliances.
Freedom to domestic companies for global operations and also to. acquire companies overseas.
Freedom to do transactions in any currency.
Freedom to invest globally.
Freedom to exchange currencies like commodities across the counter.
Most of the larger economies such as US and Europe have convertible currencies, which can be freely exchanged with other currencies, without any restrictions and can also be used for transaction and other such purposes as mentioned above.
Why is convertibility important for open economies?
(1) With increased openness, increased trade and capital flows, absence of convertibility is seen as a hindrance to smooth inflows and outflows, resulting in avoidable delays in conversion, besides increasing transaction costs of conversion.
(2) A convertible currency is acceptable in a non-convertible economy (USD in India) but a non-convertible currency is not acceptable in a convertible economy (Rupees in the US).
(3) It is seen from the global perspective as a growing stature of the home currency gaining global acceptability.
(4) It reflects greater transparency in the foreign exchange transactions in the domestic economy.
(3) It is seen as the growing maturity and strong macro-economic fundamentals of an economy and their ability to withstand adverse global fallouts.
(6) It is also believed as a way to attract foreign investment.
(7) It is a reflection of the confidence of the government that convertibility will not result in outflows from the economy.
(8) Economies with convertible currencies have greater levels of efficiency, provide depth to the financial sector and are seen as globally competitive.
(9) Convertibility allows testing of strengths of economies in their bid to global integration.
(10) It is also about dispelling the ‘fear’ factor, the fear of‘what if’ from the minds of the government.
(11) Most large open economies, as mentioned earlier, such as US and Europe have convertible currencies.
What could be the possible fallouts of convertibility?
(1) All the crisis-ridden economies in the past had complete convertibility and that
convertibility exposes economies and makes them vulnerable, especially in adverse global circumstances. „
(2) One of the biggest dangers of convertibility is known as the fear of infamous ‘Dutch disease’, coined during 1977 following the discovery of oil in The Netherlands. There was a surge inflows resulting in currency appreciating adversely affecting their manufactured exports and slow down of the economy.
(3) The stance of the monetary policy changes to managing inflows and outflows,
managing what is referred as the ‘impossible trinity’ of open capital account, exchange rate and independent monetary policy. The central bank can at best manage two but not all three. .
(4) Large inflows can create issues of liquidity and result in inflationary pressures besides affecting the growth.
(5) The fear factor mentioned above is the apprehension of flight of capital from the country, which can be very de-stabilizing in nature for the economy.
(6) It is a one-way journey offering no scope of experimenting or going back. Also having begun the journey it will also have to be completed. It cannot be abandoned mid¬way. This is because over a period of time, it will not be possible te prevent leakages despite having controls on capital flows.
What can be the basic preconditions to convertibility? It is difficult to lay down a set of defined preconditions to convertibility. It is qualitative in nature, differs from economies to economies and is also about the confidence levels of the government on its own people and the state of the economy.
However, based on the experience of other countries having convertible currencies and also of the crisis-ridden economies, some key fundamentals to convertibility are as follows:
(1) Economies should be on sustained upward growth trajectory.
(2) Exports should be showing signs of buoyancy and moving away from primary to manufactured goods.
(3) Inflation levels should be ‘manageable’. Economies should have the confidence on their ability to be able to effectively manage inflation through appropriate policy tools.
(4) Interest rates should be globally aligned i.e., the inflows and outflows should be interest rate ‘neutral’. –
(5) Current account deficit should be supported by capital inflows or high current account deficit should not lead to external borrowings.
(6) ‘Manageable levels’ of fiscal deficit. The government should be resolved at lowering the levels of fiscal deficit and should have initiated fiscal consolidation.
(7) Economies should have the confidence of servicing the external debt through export earnings.
(8) The financial sector especially banking should have strong balance sheets, mature, com¬petitive and have the depth to assess and mitigate risks. They should be following pruden¬tial lending, not overexposed and a balanced asset portfolio in terms of their risk appetite.
(9) Economies should have initiated economic reforms, greater openness towards a competitive, efficient, market-determined and productive domestic economy.
What is the status of convertibility in India? India’s effort at convertibility has been cautious, well-calibrated, well thought out and gradual, beginning since 1994. It is not necessary to map the journey or the chronological ordering but that there has no fallouts in the journey so far. The present status is thus ‘complete convertibility on the current account’ in the balance of payments of the India. But not capital account convertibility (CAC). Convertibility on the current account implies that for export and import of goods and services, transactions in foreign currencies are unrestricted and do not have any restrictions either from the RBI or from the government.
Restrictions on Current Account Transactions
With regard to other transactions on the current account they are also unrestricted except
for the following which are restricted:
(1) Outward remittance of prize money earned out of game shows, lottery, betting, racing, etc., is not permitted.
(2) For outward tourism, an Indian resident can freely take up to USD 10,000 per visa holder in a calendar year should more be required prior authorization of RBI would be required.
(3) For education abroad and overseas medical treatment expenses up to USD 1,00,000 is unrestricted and beyond requires prior authorization from the RBI.
(4) All foreign currency payments made to foreign artists in India, and that required for cultural tours overseas require prior authorization of Ministry of Finance, Government of India.
Apart from the above transactions, the remaining transactions in the current account are unrestricted. It needs to be understood and absence of convertibility does not imply that transactions cannot be done but such transactions require prior authorization from either the RBI or the government.
Capital Account Convertibility (CAC)
In the status on convertibility it was mentioned above that presently India does not have CAC. CAC has been driven in India based on recommendations of various experts committee from time-to-time, but the most notable has been the Tarapore Committee recommendations. The committee had given a road map of‘fuller’ convertibility which is easing of restrictions on the capital account but not complete removal of all restrictions on the capital account over a period of time. However, the committee has remained silent on the issue of‘full’ convertibility.
In terms of the recommendations made, the government has, however, gone ahead with the easing of restrictions on the capital account as under:
At present, all inflows in foreign currency, irrespective of the nature, are completely convertible. For example, ‘that there are no restrictions either by the government or RBI, on any kind of inflows, or their reversal as outflows’. Then what kinds of outflows on the capital account are restricted? Outflows arising out of conversion of rupees into foreign currency by Indian residents, Indian companies, Indian financial institutions for overseas transactions.
Even here, recently, the government has considerably eased restrictions on such transactions on the capital account which are as follows:
(1) Indian residents can freely remit up to USD 2,00,000 in a financial year overseas without any restrictions, for any investment purpose. Except that it should not be remittance of prize money earned. However, in view of the recent rupee turbulence it has been brought down to USD 75,000.
(2) Indian residents can open foreign currency accounts in India for foreign currency earned for services rendered overseas. Such accounts are known as foreign currency Indian residents FC(IR) accounts.
(3) Indian mutual fund managers can invest up to USD 5 billion in global stock markets.
(4) There has also been considerable relaxation to Indian companies to borrow overseas which are discussed in the next section.
What do the above imply that even without having CAC, rupee is virtually’ convertible except that it is not ‘formal’ declaration. This means that the government today has a choice of going back and can choose to re-impose restrictions on these kinds of transactions at
Should the government then press the accelerator and go for full convertibility?
(1) At present, there are no apparent compulsions for the government to announce complete convertibility, as the purpose of attracting foreign inflows is being served especially in the last two years and India’s stature globally is not affected even without complete convertibility.
(2) Further, China has broken the myth of inflows linked to convertibility and that openness not possible without convertibility or that convertibility and global competitiveness go together.
(3) Chinese economy is the fastest growing and expanding economy of the world, with robust exports, sitting on a trade surplus and globally competitive.
(4) China has seen sizeable inflows into their economies of over USD 500 billion in the last two decades and if Hong Kong is included it will go over USD 1 trillion, all without any convertibility.
(5) Definitely Chinese experience has diluted the importance and relevance of convertibility for open economies.
(6) Even India despite not having CAC, particularly after 2007, there has been sizeable inflows including foreign direct investment as can be seen in the section on Foreign Investment discussed subsequently.
(7) However, over a period of time with a more balanced global economy, from the present unbalanced, favouring Asian economies, convertibility would eventually be seen as maturity, resilience of economies with strong macro-fundamentals allowing smooth integration within the global economy.
(8) Lack of convertibility also allows for leakages, conversion of good money into bad money, a hindrance to the increasing cross-border flows. As openness of economies increases it only raises transaction costs of conversion.
(9) India unlike China, fortunately has initiated the journey, but even with no apparent compulsions of completing the journey, at some time would have to complete it as the controls would become ineffective or outflows finding a way around the controls.
(10) Full convertibility of the Indian rupee can be delayed, but is inevitable and the only issue is by when?
External Commercial Borrowings
A major aspect of FEMA and trade reforms is also the easing of restrictions on the private corporate sector to borrow from the international market especially for paying for its imports and saving on the transaction cost of converting rupees to foreign currency for import of goods. This is known as external commercial borrowings (ECBs) which is similar to domestic borrowing except that they are in foreign currency from the overseas market.
It also allows the corporate sector to take advantage of the interest rate differential between the domestic and international rates of interest. A key aspect of interest rates on ECBs is that they are linked to London inter-bank offer rate (LIBOR) a market- determined rate of interest, at which global banks lend to each other and the floor 1 level of interest and bench mark for global interest rates. The mark up over LIBOR
is usually in ‘basis points (bps)’. A 100 bps mark up implies 1 per cent over the ‘ LIBOR.
Who decides the mark up for ECBs? The mark up is in terms of the sovereign rating of countries first and then the companies given by the international rating agencies such t as Moody’s, Standard & Poor and Fitch. Normally a company’s rating cannot be better than the sovereign rating and it is invariably the country’s rating which decides the mark up. These rating agencies arrive at ratings of economies based on well-defined objective parameters. The ratings is in a scale comprising of two broad categories one—as ‘investment’grade, economy has good fundamentals and can be considered as investment grade with minimum to moderate risk and the other—‘speculative’ grade which is, economy can be considered for investment but that the risk is high.
The higher up on the scale implies less risk and thus a lower mark up and the lower down the scale there is high risk and mark up accordingly is much higher. At present, the rating of India by the three rating agencies is a low of one notch above the last in ‘ investment grade which is, India is considered ‘marginally as investment grade’. Why such a low rank by international-rating agencies?
(1) First and foremost is because of the high fiscal deficit. The combined fiscal deficit of 1 the center and states put together over 10 per cent. Such high levels are unsustainable in the long-run.
(2) High levels of public debt (all liabilities of Central and State Governments) to GDP ratio of over 70 per cent.
(3) Such high debts are trigger points of an internal crisis like it happened in Greece and Ireland.
(4) Near absence of fiscal consolidation.
(5) Slowing down of the reform process.
Even though the government has protested against the rating given to India, but these agencies are known for their independent and unbiased thinking. The most important aspect is that these ratings have global acceptability and the basis for deciding the mark up for ECBs besides also influencing overseas investment decisions.
At present, RBI under FEMA has allowed companies to raise ECBs up to USD 750 , million under the automatic route which is not requiring approval of RBI. All ECBs under automatic route or also subject to maturity period stipulated by RBI and have ‘end use’ restrictions i.e., the purpose of ECBs has to be declared and it is to be ensured that the proceeds are used only for the declared end use by the company.
There is also a restriction that the proceeds have to be parked overseas and will not be allowed to be converted into rupees for bringing it back into the domestic economy. There is presently an overall country level ceiling of USD 35 billion for ECBs. The only issue with ECBs is that only reputed companies can access the ECB route. The amount raised as ECBs are reflected in the external debt of the country.
American Depository Receipts (ADRs) and Global Depository Receipts (GDRs)
There is yet another route through which Indian corporate sector can raise foreign currency denominated funds which is through issuance of ADRs and GDRs. In the absencel of convertibility, Indian companies cannot access the global capital market by issuance of shares just as they can be in the domestic market. To enable companies to access global markets, companies can issue shares, but instead of selling in the overseas market directly can off-load the shares to an international depository.
This depository on the strength of underlying shares held by it in the capacity of a custodian, would issue depository receipts and sold, just like shares in the overseas market.
These receipts are akin to a share, have similar features but are not shares as it does not confer voting rights to the holder of these receipts. They can be listed and traded at the global stock markets just like the shares. Such receipt issued in the US is known as ADRs and elsewhere as GDRs.
Most of the reputed Indian companies are enjoying listing at the global stock markets through the ADR route. This mechanism also allows domestic companies to test international markets for their inherent strengths, competitiveness and global acceptability. All ADRs and GDRs offering are not on the automatic route and require prior approval of Ministry of Finance, Government of India.
Foreign Currency Convertible*Bonds (FCCBs)
Foreign Currency Convertible Bonds also known as foreign currency convertible notes (FCCNs) are quasi-debt instruments issued by Indian companies in foreign currency which may or may not have a coupon and principal payment option or the option of they be converted into shares at a pre-determined rate at the discretion of the investor.
At present, FEMA allows issuance of FCCBs by Indian companies subject to amount and minimum maturity stipulation under the automatic route. Thus, the Indian private corporate sector can access the international market either as ECBs or ADRs or FCCBs or a combination of all.