ABSTRACT
Foreign Exchange Regulations are indispensable for any nation willing to engage in global trade and investment. In the case of India, the Foreign Exchange regulations had been very restrictive till 1999, with the FERA legislation imposing restrictions on every type of foreign exchange circulation in India, to the degree where Foreign Exchange transactions were thoroughly frowned on by the Indian Government.
However with the financial crisis in 1989, the Indian Government saw the need to liberalise many aspects of Indian regulations, particularly those surrounding relations with the global trade markets.To manage this, the Foreign Exchange Management Act 1999 was passed to create a more liberal Foreign Exchange regulatory environment.
The biggest change from FERA in this legislation was the reduced role of the Central Government and a smaller role of the Reserve Bank of India. Furthermore, any transaction done as a capital account or a current account transaction as defined in the FEMA legislation would not require approval from the RBI, other than the basic licences for registration.
Despite these changes, FEMA still is a conservative legislation not allowing limitless Foreign Exchange transactions as all other transactions require approval from the RBI. The RBI kept the Indian Rupee only partially convertible and not wholly as compared to many western nations along with a staggered Foreign Direct Investment withdrawal policy. These act as safety mechanisms for the stability of Indian markets and the Indian economy.
The inherent conservatism of the FEMA legislation is being questioned by experts. This research paper will analyse if FEMA has provided economic benefits and if the continued caution in Foreign Exchange legislation is a good policy in the long run.
Keywords: Forex, FEMA, RBI, liberalisation, Licence
INTRODUCTION
After the liberalisation of the economy in 1991, the philosophy of the Indian Government towards the movement of foreign currency to and from India changed. Earlier, it was seen as a highly risky idea and was kept firmly restricted by legislation.
However with the need for India to become more connected with global trading platforms, the need for forex involvement too increased. Replacing the Foreign Exchange Regulation Act (FERA), 1973, FEMA was intended to liberalise India’s foreign currency exchange, keeping in line with the attempts to make India a more open economy.
This legislation also assists with the continued development of India’s forex trading market. Furthermore, FEMA allows for a greater insight into the status of the Indian Economy. However, as compared to countries such as the United Kingdom, Germany, Japan etc, the Indian forex regulations can be relatively restrictive.
The aim of this research paper will be to delve into the economic impact of FEMA and also try to understand the reasons behind such legislation.
RESEARCH METHODOLOGY
This research paper will delve into the current provisions of FEMA and how it affects India economically. The information for this paper will be from various secondary sources in the form of, but not limited to scholarly articles, Government statistics, authentic news reports and other reliable statistics.
REVIEW OF LITERATURE
- Shyamala Gopinath, Foreign Exchange regulatory regimes in India: From control to management, RBI Bulletin, 1, 2-10, (2005)[1]: This paper covers the shift that the Indian Government made from FERA to FEMA. The author covers the various changes in the regulations of forex in India, particularly surrounding that of calculation capital and current accounts, which are an indicator of the economic health of a country. The overarching point of the author is highlighting the shift in language in the second legislation as compared to the first. The author propounds that FERA was more of a controlling legislation than a managing one i.e. it was restricting foreign exchange in India rather than establishing oversight on the same.
- R.K Patnaik, Muneesh Kapur, S.C Dhal, Exchange Rate Policy and Management: The Indian Experience, 38, Economic and Political Weekly, 2139, 2140-2151, (2003)[2]: This research paper covers the exchange rate policy change of the Indian Government by tracing its path across the years. The author covers the shortcomings of a pegged currency exchange rate, which was the case till 1992, when it was converted to a floating currency as the pegged rate system was hurting the Indian economy. Furthermore, the author highlights the various institutions and legislations developed and implemented for the continued stability of currency rates, which includes FEMA. The author concludes that Governments must select their exchange rate regimes wisely as not every regime works for every nation’s economy.
- Michael Hutchinson, Gurnain Pasricha, Exchange Rate Trends and Management in India, Monetary Policy in India: A modern macroeconomic perspective, 1, 1-12, (2015)[3]: This research paper attempts to draw a parallel between the existing foreign currency regulations and the economic status of India in the same time period. The author propounds that during the FERA regulation, the status of India’s economy and her currency were weak and also said that the term ‘weak’ has not been applicable to the Indian Rupee since the 1990s. Addressing the volatility in exchange rates, the author analyses that the external factors have a greater impact on exchange rates than supposed weak internal regulations.
- Sumit Majumdar, Foreign exchange legislation transformation and enterprise demography in India, 25, Journal of Law and Economics, 39, 40-54, (2007)[4]: The author covers the legislative changes seen in the foreign exchange regulations of India and its impact on the presence or absence of foreign firms and organisations in India.The author concludes that after 1991, when the liberalisation legislations came into effect, the number of foreign firms in the nation has been on a consistent rise and even took a sharp increase after FY 2001-02. The author also concludes that with the removal of FERA and the implementation of a more accommodative FEMA in 1999, India became more financially viable for foreign organisations.
FEMA
In order to facilitate foreign trade and payments, the Foreign Exchange Management Act (FEMA) was legislated in 1999. FEMA was introduced with the intention of regulating the forex inflow and outflow, which would positively affect India’s economic growth, particularly in global trade.
Features of FEMA
In 1999, FEMA was introduced, repealing the FERA legislation. As previously mentioned, FERA emphasised more on controlling Foreign Exchange, however FEMA was more focused on managing the same.
This can be most clearly seen in Sections 5 and 6 of FEMA[5], which allow for current and capital account transactions respectively.
Current Account transactions allow for payments related to business activities, foreign trade and short-term banking. Current Account is also how countries analyse their import and export figures and are a part of the Balance of Payments of a country.
Capital Account transactions involve money-related assets and debt between nations. Section 6(2b) also puts restrictions on the amount of foreign exchange which may be permissible for the given transactions.
These two features of FEMA set it apart from its predecessor in regulation, as it allowed for the greater use of Foreign Exchange in Indian markets, without crippling restrictions that caused the financial crisis of 1989.
However the biggest change that FEMA made was the shift in the punishments for penalties. While FERA made every penalty a criminal offence, FEMA has turned them to civil offences, thus reducing the punishments and almost entirely removing a prison sentence.
COMPARISON WITH FERA
FEMA acts as the regulation for the continuation and growth of external trade and to act as a regulation for the forex market in India. This was an improvement over its predecessor, FERA, which was more restrictive and did not allow much scope for growth.
FERA created the template for a large Government intervention in foreign currency exchanges in India and made trading in the same very restricted as was given under Section 8 of FERA[6].
Some tone of the legislation also hints at the intention with which the Government passed the same. The legislation approaches Forex trading and payments with the philosophy, ‘everything was prohibited unless specifically permitted’.
The penalties differ drastically in the two legislations, with FERA having a prison sentence for almost every offence, while FEMA provides for fines for relatively minor offences as given under Section 13 of FEMA[7].
Another aspect of foreign exchange regulations that was changed in FEMA was the sweeping authority of the Government. Section 11[8] of FERA restricted asset holding by non-residents and Section 15[9] allowed for the Central Government to seize foreign exchange if the holder is found to be holding more currency than the stipulated amount or in case of failure of compliance with procedures.
ECONOMIC DAMAGE
As one can expect, keeping stringent regulations on foreign exchange will not result in economic growth. Throughout the 1970s and 1980s, India’s Forex market was nonexistent due to the severe restrictions on possessing foreign currency, with the Forex reserves of India dwindling from $6 Billion in 1980 to $3 Billion in 1989[10]. These are clear signs that the FERA legislation was not assisting with growth and was in fact detrimental to the same.
As the Liberalisation of 1991 changed the overall tenor of the economic policies of the Indian Government, so did their approach to Foreign Exchange. The Government no longer viewed foreign exchange as an instrument to be restricted, but one that can be used to foster greater growth for India, with trade payments being the primary advantage.
Economic ramifications of FEMA
The biggest change that FEMA brought was the shift from a restrictive regulatory environment to an incentivising one. The Capital and Current Account regulations allow for greater oversight in Foreign Exchange being brought in and taken out of India via transactions. However, the Reserve Bank of India plays a crucial role in enforcing FEMA and placing other laws that complement the same.
FEMA creates a welcoming environment for foreign investors, which is done through Foreign Direct Investment (FDI). FDI’s are a direct way of acquiring foreign exchange and require an easy regulatory environment for it to flourish. The previously mentioned removal of criminal charges from the Foreign Exchange regulation helped in mending the image of investing in India, as FERA was viewed as ‘too draconian’ for foreign investors to comfortably invest in India, who are more accustomed to a loosely regulated market such was European markets or the United States.
RBI was given the power to regulate FEMA, which reduced the direct role of the Central Government, allowing greater investments. Furthermore, the FDI restrictions were lifted, allowing 100% FDI in high priority areas and in automatic routes.
Sectoral caps have also been introduced under the FEMA regime, as few sectors that have been deemed to be imperative from the perspective of national security, are not allowed FDI via the automatic route.
For example, an entity engage in private banking can receive FDI only up to 74% of its share capital, with 49% of the same falling under automatic route, with the remainder requiring Government approval[11].
The FEMA regime has relaxed the regulation on the amount of foreign exchange being held by a citizen and its usage in transactions. The FERA legislation mandated zero transactions outside the approval of the Central Government as given under Section 8[12]. However the FEMA legislation provides outer limits for transactions in foreign currency without approval from the RBI and not the Central Government in some specific cases.
The exceptions are primarily current account transactions, which are deemed to be day-to-day transactions under Foreign Exchange Management (Current Account Transaction) Rules, 2000.
The Liberalised Remittance Scheme (LRS) introduced in Schedule III of the Foreign Exchange Management (Current Account Transaction) Amendment Rules 2015, allows for resident individuals to remit amounts up to $250,000 without prior permission from the RBI.
The immediate benefits of a liberalised FDI policy can be seen by tracing the amount of Foreign Investment in India after enacting and enforcing the legislation. In 1999, the FDI in India was $2.17 Billion and after the FEM CAT Rules of 2000, the FDI stood at $5.13 Billion. 10 years later in 2010, the FDI stood at $27.40 Billion[13], which was a 534% increase and as of 2023, the FDI stands at ~$70 Billion[14].
The implementation of FEMA has also lent a boost to the Forex reserves of India over the two decades of the legislation’s existence. In 1999, India’s Foreign exchange Reserves were recorded at $29 Billion and as of 2024, the Forex Reserves are estimated at $640 Billion. Much of this growth can be attributed to liberal Foreign Exchange legislations such as FEMA, that made it easier for foreign investors to invest in India, due to a reduced penalty level, along with regulations that were aimed to incentivise trading of Foreign Exchange along with greater investment in the Indian economy.
FINANCIAL STABILITY
As previously discussed, FEMA was an improvement over the FERA legislation, which was restrictive and did not allow for a good environment for growth to take place. FEMA, as mentioned, made Foreign Exchange transactions easier for internal and foreign parties in the Indian markets along with an easier form of maintaining Balance of Payments for the Indian economy.
However, promoting greater Foreign exchange transactions is not the only purpose of the FEMA legislation. This act of Parliament is also aimed at providing stability to India’s trade with nations by regulating the inflow and outflow of Foreign Exchange in the same.
Furthermore, FEMA also aims to provide stability to India’s financial markets by regulating the flow of Foreign Exchange to and from the nation, which would have an impact on India’s Forex reserves and the valuation of the Rupee itself.
In contrast to previous Foreign Exchange Regulations, FEMA not only allows for the entry of Forex in Indian markets, but allows for their exit as well, keeping in line with the Foreign Exchange policies after the 1991 liberalisation.
One of the biggest aspects of this can be seen in the restrictions FEMA has placed on the withdrawal of FDI from almost every sector.
The biggest restriction to the FDI exit is the lock-in period. The Lock-in Period is mandated as per FDI tranche listed and implemented by the RBI. This mandate is applicable to all convertible shares and debentures, which would be the non-debt and debt instruments used for investment in a particular industry or sector by a foreign entity.
While there is no single legislation which mandates the lock-in period, notifications such as the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 provide for a minimum 1 year lock-in period for foreign investors, while in sectors such as construction and defence mandate a 3 year lock-in period[15].
During the lock-in period, investors are not allowed to fully divest their share and are required to maintain their majority shares wherever applicable. The RBI however, has provided exceptions for the same in areas such as Special Economic Zone registered entities, investors in hospitals, educational institutions and investments by Non Resident Indians.
Another mandate that exists for FDI exit is the 50% completion requirement. This is applicable for specific sectors only, such as real estate. In this mandate, foreign investors can only exit after the completion of either 50% of the project which would be decided beforehand.
After the exit conditions are met, the investors can only divest their share by sale in the open market only with express permission from the RBI. Such restrictions are imposed to protect the interests of Indian investors and sectors.
This is a form of staggered FDI exit mandated by the parliament and the RBI. It has been the understanding and mandate of the Indian Government and Central bank, that an immediate drop in FDI will result in an unstable financial situation in either a particular sector or the Indian Economy in general if the amount becomes large in amount.
Another important restriction that has been imposed in Foreign Exchange transactions in India, is surrounding the convertibility of the Indian Rupee.
Also known as Capital Account Convertibility, this means the conversion of one currency into a foreign currency based on the exchange rates at the time and back into the original currency for the purposes of a capital account transaction.
Section 6 (2) of FEMA[16] allows the RBI and the Central Government to make amendments and additional legislations dealing with capital account transactions in India which includes the convertibility of the Indian Rupee.
From 1994, the Indian Rupee was technically ‘convertible’ as it was a floating currency and was on the global Forex Market. However, the RBI made a clear distinction and announced that the Indian Rupee would be a partially convertible currency, with a ratio of 40% Foreign exchange earnings traded at official rate and 60% at the market determined rates.
Despite many attempts made by the IMF and western nations, who already had fully convertible currencies, the traditional faction in the Indian Government refused to allow the same. The wisdom of this decision came to light in 1997.
In 1997, the South East Asian Financial Crisis hit the global financial markets. Among the other realities of many of the nations being administratively weak and corrupt, the reality of nations such as Indonesia, Malaysia and Thailand’s regulations being ineffective in managing this crisis also became clear, with the Indonesian rupiah falling 80% in value, with the damages borne by the economies of Russia and Brazil alike.
However, India and China were not as drastically affected by this crisis, despite rumours about the Indian Rupee collapse being imminent. The basic structural difference between the Indian Rupee and the currencies of the South East Asian countries was the convertibility of the same[17].
Currencies such as the Indonesian Rupiah were fully convertible, keeping in line with the IMF’s guidelines and what was the monetary policy of western nations as well. However, after the 1997 financial crisis, the IMF grudgingly admitted that their prescriptions aggravated the South East Asian Financial Crisis.
Furthermore, India and China staved off the deadlier effects of the financial crisis as the restriction on their capital account convertibility insulated them from the same.
SUGGESTIONS
FEMA was introduced as a liberalisation tool for Foreign Exchange transactions in India, changing from the previous FERA legislation which aimed to curb any and all Foreign exchange transactions.
Despite this legislation helping the economy as previously mentioned in this paper, there are still aspects that need to be altered.
FEMA reduced many bureaucratic hurdles in Forex transactions, yet it still has many complex regulations that are expensive to medium and small scale businesses in terms of finances and time.
FEMA allows for appeals to tribunals and the courts in cases of a dispute. However, The decision-making process of the tribunal in many cases is opaque to say the least and has the potential to cause loss of trust with foreign investors.
RBI policies surrounding FDI exit from India in the form of staggered withdrawals along with the partial convertibility of the Indian Rupee. While serving as an important tool in providing financial stability, is also hampering the potential growth of the Indian Economy.
This can be seen in the slowdown of FDI inflow, which dropped to $44 Billion in FY 2023-24, from $66 Billion in 2020. While the global economic slowdown is an important factor for this drop in FDI, many hurdles in the existing legislation cannot be fully ignored as a contributing factor.
CONCLUSION
With increased globalisation in South East Asia, the need for the Indian Government to undo certain restrictive policies in aspects such as Foreign Exchange restrictions became important.
In doing so, the Foreign Exchange Management Act, 1999 was introduced to regulate and manage Foreign Exchange in the country instead of curtailing its circulation. The primary reason for doing this was to help the growth of the Indian Economy by providing smoother ways for inflow and outflow of Foreign Currency in Indian Markets.
The benefits of the same could be easily seen by tracing the Foreign Direct Investment rates along with India’s Forex reserves before and after the implementation of the FEMA legislation.
However FEMA was not only tasked with giving a boost to Foreign Exchange transactions in Indian markets, but also to provide stability to Indian financial markets and the economy by extension. The staggered FDI outflow policies by the RBI prevent the immediate withdrawal of large amounts of Foreign Currency which would cause a market collapse and the partial nature of convertibility of the Rupee ensured that the Indian Economy did not see the same result as did many Southeast Asian nations during the financial crisis of 1997.
This was the result of the sway the conservative forces held in India’s policy making levels. Their restraint in not following the IMF’s guidelines staved off a heavy financial loss. However this conservatism cannot continue until further notice. The drop in FDI rates and an increasing demand by foreign investors to further liberalise India’s Foreign Exchange Regulations indicate the need to change certain restrictions in the same to maintain a continued supply of Foreign investment in the nation.
Name: Jay Pandya
College: Kirit P. Mehta School of Law, NMIMS University
[1] Shyamala Gopinath, Foreign Exchange regulatory regimes in India: From control to management, RBI Bulletin, 1, 2-10, (2005)
[2] R.K Patnaik, Muneesh Kapur, S.C Dhal, Exchange Rate Policy and Management: The Indian Experience, 38, Economic and Political Weekly, 2139, 2140-2151, (2003)
[3] Michael Hutchinson, Gurnain Pasricha, Exchange Rate Trends and Management in India, Monetary Policy in India: A modern macroeconomic perspective, 1, 1-12, (2015)
[4] Sumit Majumdar, Foreign exchange legislation transformation and enterprise demography in India, 25, Journal of Law and Economics, 39, 40-54, (2007)
[5] Foreign Exchange Management Act, 1999, § 5,6, No. 42 Acts of Parliament, 1999 (India)
[6] Foreign Exchange Regulation Act, 1973, § 8, No. 46, Acts of Parliament, 1973 (India)
[7] Foreign Exchange Management Act, 1999, § 13, No. 42, Acts of Parliament, 1999 (India)
[8] Foreign Exchange Regulation Act, 1973, § 11, No. 46, Acts of Parliament, 1973 (India)
[9] Foreign Exchange Regulation Act, 1973, § 15, No. 46, Acts of Parliament, 1973 (India)
[10] India Budget, https://www.indiabudget.gov.in/budget_archive/es2000-01/app6.1-B.pdf (Last visited June 10 ,2024)
[11] Radhika Ghaggar, Abhishek Kalra, Abhay Singh, Chandni Ochani, India: Foreign direct investment regulations, Global Competition Review (Dec 6, 2022), https://globalcompetitionreview.com/guide/foreign-direct-investment-regulation-guide/second-edition/article/india
[12] Foreign Exchange Regulation Act, 1973, § 8, No. 46, Acts of Parliament, 1973 (India)
[13] Macrotrends,https://www.macrotrends.net/global-metrics/countries/IND/india/foreign-direct-investment#:~:text=Data%20are%20in%20current%20U.S.,a%2027.17%25%20increase%20from%202019. (Last Visited on June 12, 2024)
[14] Economic Times, https://economictimes.indiatimes.com/industry/services/property-/-cstruction/indias-fdi-steady-at-70-9-billion-in-fy24-inflows-more-than-doubled-in-the-construction-sector/articleshow/110733686.cms?from=mdr (Last Visited on June 12, 2024)
[15] Foreign Direct Investment- Pricing Guidelines for FDI instruments with optionality clauses, Reserve Bank of India,https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=8682&Mode=0#:~:text=(a)%20There%20is%20a%20minimum,three%20years%20has%20been%20prescribed). (Last Visited on June 13 2024)
[16] Foreign Exchange Management Act, 1999, § 6(2), No. 42, Acts of Parliament, 1999 (India)
[17] Rashmin Sanghvi & Associates, https://www.rashminsanghvi.com/articles/foreign-exchange-law/archives/fema-1999/taxmans-guide-to-foreign-exchange-management-act-1999-convertibility-of-rupee.html (Last Visited on June 13 2024)