G Padmanabhan: FEMA administration - prospects and challenges
Address by Mr G Padmanabhan, Executive Director of the Bank of India, at the
Kuwait/Muscat Chapter of Institute of Chartered Accountants of India seminar, Muscat,
5 August 2014.
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Assistance provided by Mr H S Mohanty in finalising this address is gratefully acknowledged.
1. It is a great pleasure and privilege to be here today. I thank the Kuwait/Muscat
Chapter of the Institute of Chartered Accountants of India for the unique opportunity to
address its members and a cross section of Indian population in the Gulf Region. The
Institute has set high standards in professionalism and contributed greatly to the
development of the corporate business. It is heartening to note that the Institute has a large
presence in this region and that they are making important contributions to the business
world here.
2. India's engagement with the Gulf region has been civilisational, dating back to
ancient times and beyond. Located strategically, the Gulf region provided a critical trading
node between ancient Indian civilisations, predominantly the Indus Valley urban centres, and
the "Fertile Crescent" of Mesopotamia. Archaeological evidence seems to indicate a great
deal of human interactions accompanied the trade and possibly, wealthy merchants from
Indian principalities had set up base in the Gulf region, not very unlike the case today.
3. Indians have been sea-faring into distant lands from both her eastern as well as
western coast down the centuries. But systematic migration was not a phenomenon beyond
what was necessary to support buoyant and sustained trade until the colonial era when the
need of cheap labour for plantation industries lured large number of Indian labour to foreign
shores. During the 1970's, migration from India acquired a different structure which included
large scale flow of professional, skilled, and unskilled labour to support the oil-fuelled
development and construction activity in the Gulf region. Today, I understand that about six
million Indians working in the Gulf region account for about 50% of the total remittance to
India. That this magnitude of remittance has significant implications for our Balance of
Payments is undeniable. The future engagement has to traverse beyond this in greater trade,
commerce, investment and entrepreneurial ventures.
4. As you are aware, the regulatory framework for external sector transactions in India
has evolved over the years. The rather restrictive regime of the 1970's progressively yielded
space to liberalisations since the mid 1980's. The process of economic liberalisation started
in the 1990's hastened the pace of change in the regulatory framework marked by several
milestones, including market determined exchange rate of the Rupee and current account
convertibility in compliance with the obligations under article VIII of the IMF. The progress
thus far was then consolidated in framing a new regulatory framework under the Foreign
Exchange Management Act, 1999 the express objective of which was to facilitate external
trade and payments and promote orderly development and maintenance of the foreign
exchange market in India. With current account fully convertible, except only minimal
restrictions necessary to prevent a current account transaction being used as a camouflage
for a capital account transaction, the entire focus of the regulatory framework for external
sector transactions has been on the capital account transactions. We have not been able to
approach full capital account convertibility because some of the necessary preconditions
such as persistently low inflation and stable fiscal conditions have not materialised.
Notwithstanding this limitation, the capital account has been managed in a way as to meet
the needs of the economy in a non-disruptive manner.
5. Why is capital account important? Firstly, India has generally run a current account
deficit barring a couple of years a decade back mostly due to relatively benign crude prices.
A current account deficit has to be offset by a capital account surplus: it is an accounting
identity. The challenge is to generate capital flows of the desired quality and quantity. I will
come to this a little later. Secondly, the Indian economy requires investment on a massive
scale not only to sustain a high growth momentum, but also to create the physical and social
infrastructure to fulfil the needs of one and a quarter billion aspiring Indians. India has a high
rate of savings, but it is inadequate to meet the gargantuan investment needs of today.
Thirdly, as the gathering here will appreciate, Indian entrepreneurship is second to none in its
business acumen and can surely compete globally. Rather than shackling the Indian
businessmen to the domestic arena, the aim has to be to encourage them to set up shop
wherever profitable opportunities beckon them.
6. Important as the capital account transactions are, as I have mentioned above, they
also usher in potential elements of instability. There was a time when capital account
openness or convertibility was extolled as a necessary virtue to hurl the less developed
economies into a path of high growth. There were critics of this path then too, but now it is
widely accepted that capital account openness has to be approached with caution and in
certain situations, capital controls can even constitute a useful policy tool. Essentially, we are
wary of short term capital flows that usually feed asset price boom and are susceptible to
sudden stops or reversals.
7. Within this general framework, I now turn to our approach to capital account
management in some detail. As you know, capital account transactions are transactions in
assets and non-residents can hold domestic assets in three forms: equity, debt and
immovable property. Investment in equity can further be classified into foreign direct
investment and foreign portfolio investment. Similarly, flows relating to debt can be divided
into three broad groups, viz., contracted debt, marketed debt and bank deposits.
8. Of all capital flows, FDI occupies the highest tier in preference order and therefore
has the most permissive regime. In line with the FDI policy framed by the Government of
India, the only restrictions in FDI relate to investment caps in certain sectors, depending
upon our comfort with the degree of foreign control motivated by strategic or socio-economic
considerations. Reflecting the same concern, while a large majority of sectors are open to
FDI through the automatic route, a few require a prior approval. The FDI policy framework is
not exactly static and is open to review. It is evident from the Honourable Finance Minister's
recent budget speech wherein proposals to increase foreign investment ceiling in Defence
sector from 26% to 49% and also a similar increase in insurance sector have been
announced.
9. While on the subject of FDI, I want to mention two specific policy developments of
the last one year that have evinced a great deal of interest.
a. In January this year, we allowed companies to issue shares with inbuilt optionality
clause where the issuer of shares writes a put option so that the investor can exit at
the specified time by selling the share to the issuer. The key feature is that the sale
would take place not at a pre-determined price but at the "fair price" prevailing at the
time of exit. An option without a predetermined strike price may seem to be a bit of a
problem, but there is a logic behind it. Please appreciate that an equity that has a
put option at a given strike price upon exercise becomes a debt instrument and
therefore, is contrary to a policy regime where there is a great deal of control on
debt flows. However, we realise that in certain risky investments, it is natural for an
investor to be assured of a floor on the expected returns and venture capital
investment has indeed been granted that latitude. Allowing such an arrangement on
a secular basis is a matter for future policy.
b. It is a fair requirement that an asset must be sold at its fair value to an investor.
Underpricing the sale of an asset to a non-resident investor is a stratagem to dodge
tax and transfer value and accordingly the regulatory framework prescribed a
specific valuation methodology - the Discounted Cash Flow (DCF) method - for
sale of shares of unlisted companies. Surely, notwithstanding its problems, the DCF
method may be the most appropriate; but with a view to affording the investors and
investees greater freedom in carrying out their transactions, we have last month
amended the regulations to permit any internationally accepted valuation
methodology at an arm's length basis.
10. As far as portfolio investment is concerned, the access to foreign investors is fairly
well defined - the only constraint, consistent with the international norm, is that portfolio
investment by an individual investor cannot exceed 10% of the outstanding stock of a
company and the aggregate portfolio investment cannot exceed 24% or such higher limit as
may be decided by the company concerned. This is subject to the sectoral caps, wherever
applicable. Earlier this year SEBI has put in place a comprehensive regime for registration of
potential portfolio investors, which has also been notified under FEMA, 1999. An important
relaxation that I like to mention here is that RBI has dispensed with additional KYC
requirement for a bank account that a registered foreign portfolio investor has to open for the
purpose of investment. The Finance Minister, in his budget speech, has sought to address a
long-standing demand for level playing field in respect of tax treatment of foreign funds
whose fund managers are India-based. I am sure this will bring more professional
employment and income to Indian shores.
11. While on the subject of foreign investment, it is important to note about the proposed
revamping of the regulatory framework for Depository Receipts. Depository Receipts are
essentially instruments to address the home-country bias of international investing
communities and over the years has proved a useful tool for Indian companies to raise
capital abroad. With a view to further expanding the scope of these instruments, a
Government of India appointed Committee (Chairman: Shri M S Sahoo) recently looked into
the entire gamut of issues and its recommendations are being taken up for implementation.
Without going into details, the overarching principle that has guided the work of this
Committee is that whichever asset class is open to a non-resident to invest in the domestic
markets, should also be accessible to non-residents in international market through an
appropriate institutional framework and safety measures, including compliance with KYC and
other international norms.
12. As indicated earlier, the policy regime in respect of debt flows, particularly
contracted borrowings commonly known as ECB, has a pronounced bias towards long term
flows. The other restrictions at present relate to the type of lender, the type of borrower, the
end use and the cost of borrowing. It is to be appreciated that these restrictions are aimed at
controlling indiscriminate borrowing which has potential stability implications. Recognising
the large and typical borrowing needs of the Infrastructure sector, we have effected several
relaxations in this area. Even though a framework of general permission may not be in place,
we are open to the specific needs depending upon the compulsions of the borrower and the
international practice.
13. The policy regime in respect of Rupee denominated marketable securities - both
sovereign and corporate debt - has undergone change over time mainly by way of
consolidation and expansion of limits. At present, foreign portfolio investors are allowed to
invest up to USD 25 billion in dated government securities and an additional USD 5 billion is
available to the long term investors. Similarly, a limit of USD 51 billion is available for
investment in corporate debt. As a conscious policy stance, we have been trying to nudge
the foreign portfolio investors towards investing in long term papers. It is to be appreciated
that investment in short dated papers, treasury bills and commercial papers are essentially
volatile and constitute interest rate play. This is not in sync with our policy imperative.
Accordingly, we have mandated last month that all fresh investment upon sale or redemption
of existing investment in sovereign debt has to be necessarily in government dated security
of a minimum residual maturity of 3 years. There is no lock in period and no restriction on
selling the bonds to residents irrespective of their residual maturity.
14. Let me state in this context, brief details of a pilot initiative taken last year. We were
approached by IFC for floating a rupee denominated paper in international market with a
view to investing the proceeds in the Indian markets. IFC was permitted to issue USD one
billion worth of such papers, which it has executed successfully. Subsequently, Asian
Development Bank has also been permitted to float a similar issue of USD 500 million.
Because of capital account restrictions, we had earlier been averse to the idea of such rupee
linked offshore bonds abroad because of its potential impact on domestic currency and debt
markets. The permissions to IFC and ADB are essentially testing the waters, as it were, and
the future view on such floatation will depend on the experience.
15. Overseas direct investment is an inalienable part of India's progressive integration
with the world economy. Apart from the quest for profitable business opportunities, overseas
presence enriches the Indian corporate in adapting itself to global competition and imbibing
the best management practice. It is also expected to serve the strategic interests of the
economy as well. With this in view, the regulatory regime has been fairly encouraging. For a
capital-scarce economy like India, the cumulative overseas investment position at about
USD 140 billion is no small achievement. At the height of Rupee volatility last year, as a
purely temporary measure, RBI had reduced the "automatic route" investment limit from
400% of the Indian company's net worth to 100% - a measure mistakenly dubbed by some
as capital control. Even when the restriction was in force, RBI's approval was not denied to
any productive venture. This measure was rolled back once the markets stabilised.
16. It is a matter of some concern that the overseas investment has not been yielding as
much return as should be expected. The need for deployment of the surplus generated in
expansion activities is well recognised. But in reality, tax arbitrage also plays an important
role which needs to be addressed.
17. Recognising the benefit of asset diversification for the domestic investor, the
regulatory regime permits an individual to invest abroad in any asset class, including in real
estate, up to USD 125,000 per year. Though a major part of the remittance under this
category is made for various current account transactions simply because of the ease of
procedure, the route nevertheless does enable the domestic individual to own foreign asset
in her portfolio. To deal with the home country bias of the Indian investor and also to make
the ownership of foreign security easily accessible, we have permitted Indian Depository
Receipts under FEMA since 2009. Ironically, the only IDR floatation we have had till date has
been predominantly invested in by the FIIs! In this context, I may mention that the Sahoo
Committee that I had mentioned earlier also suggested exhaustive revamping of the
regulatory framework for IDR. The Finance Minister too, in his budget speech, has proposed
a liberal and ambitious Depository Receipt scheme styled Bharat Depository Scheme
(BhDR). I am sure this is going to give a quantum fillip to the Indian capital markets.
18. Speaking here before an assembly of predominantly non-resident Indians, I shall be
failing in my duty if I do not mention the foreign exchange framework as it relates to the NRIs.
At the outset, I must pay my encomium to Indian Diaspora for its support to the Indian
economy in its moments of need. It is the buoyant remittances from the hardworking Indians
that provided the first glimmer of hope during the gloomy 1970's when the acute foreign
exchange crisis almost stalled the Indian development story. As I have mentioned earlier, it
still provides a much needed support to India's Balance of Payments.
19. The regulatory framework for foreign exchange has also always recognised the
contributions of the Diaspora. In the early stages when the access to the Indian economy
was rather restrictive for non-residents, the NRIs enjoyed a preferential regime in investment,
bank deposits, etc. With gradual opening up of the Indian economy and financial
liberalisation, some of the preferential treatment has become superfluous but still many
remain. For instance, an NRI individual can invest up to 5% of the outstanding stock of a
company through the portfolio investment scheme and has unlimited access to the debt
securities at par with a resident Indian.
20. For the large number of Indian migrant workers, remittance home is extremely
important. Over the years, we have enabled multiple channels to provide easy and efficient
remittance facility both for the remitter and the receiver. Apart from the traditional banking
channel, the exchange houses and money transfer service agents have been handling the
large volume of remittances. If KYC requirement at both ends is sometimes viewed as
onerous, we must bear in mind that we live in difficult times and measures like KYC is a price
we pay for the safety and security of our society. At the same time we took a series of
measures towards electronification of the payment systems in India. Today payment to India
and across India happens in matter of seconds in a safe and secure manner. Secondly, we
are proactively enabling alternate payment methods so that you are not required to carry or
use physical cash.
21. I understand that acquisition of immovable property is a very important concern for
not only the Non- Resident Indians - I mean Indian citizens residing abroad - but also
Persons of Indian Origin. I wish to make it clear that the regulatory framework is pretty liberal
inasmuch as it permits both NRIs as well as PIOs to acquire any immovable property except
agriculture property, plantations or farmhouse. The acquisition however is required to be
funded through the banking channel, which is a fair stipulation. While there is no restriction
on NRIs for sale, gift or otherwise transfer any property so acquired, PIOs can sell the
acquired properties only to resident Indians. There is also a restriction on NRIs/PIOs
acquiring property in India jointly with their spouse if she/he is neither resident in India nor an
NRI nor a PIO. Such cases require prior approval of RBI and of late, there has been an
increase in number of such cases. This is an issue that requires examination in consultation
with the Government of India. In fact, I have directed an comprehensive review of FEMA 21
before I embarked on this trip.
22. Let me mention in passing the problem of gold, as I realise the gulf region provides
perhaps the largest gold market with an Indian connection on the western side. The control
on gold imports was imposed with a view to getting an immediate handle on the burgeoning
current account deficit. The insatiable Indian appetite for gold is well known. It had probably
been further whetted by persistent inflation on the one hand and increased prosperity on the
other. Thus restriction on gold import provided a much needed immediate reprieve for
restoring the imbalance in the current account. But it is well recognised this cannot be a long
term measure lest it engenders undesirable consequences. It will be a challenge to blunt the
lure for gold, but it has to be faced in the medium to long term.
23. So far, I have attempted to paint a broad-brush picture of our approach to the
management of India's external sector. The narrative has been fairly simple: gradual opening
up of the capital account with a cautious eye on the potentially disruptive impact of unbridled
capital flows like what countries in several regions have faced in the past and may be facing
now, as we talk. Notwithstanding the straightforward approach, the devil is in the detail, as
they say. From my vantage position, I cannot really say that the regulatory regime that a
foreign investor seeking to engage with the Indian markets faces is as simple or transparent
as one would wish it to be. There are many reasons for the complexity of the regulatory
regime that obtains today. Let me mention just two. First, the external factors have changed
rapidly in the past. The post-Pokhran II sanctions during the closing years of the last
millennium and early years of this millennium; the global liquidity glut and unprecedented
capital inflows of 2006-07; the global financial crisis and its aftermath - all these events
elicited regulatory response to deal with the fallouts. The responses varied depending not
only upon the external factor, but also the state of the economy. Secondly, the regulatory
regime has often to respond to the way market participants exploit the gaps and even benign
relaxations to game the regulatory regime to their advantage, against the spirit of the game.
Be that as it may, the fact remains that there is an urgent need today to make the regulatory
regime simple, transparent and easily comprehensible. The Government of India and we in
the RBI are making efforts at several levels to address this issue and I am sure that soon we
shall make progress in this regard.
24. In this complex world of international business, the need for professional expertise
cannot be overemphasised. It has been rightly said that the foundation of the modern society
owes as much to Luca Pacioli, the 15th century Franciscan Friar who perfected the double
entry book-keeping, as to anyone else. The development of the post-industrial-revolution
corporate sector would not have been possible but for the efforts of competent, diligent and
credible accounting professionals. Rapid economic development is a revolutionary necessity
for India today, so that the aspirations of one and a quarter billion Indians can be realised.
This process requires growing integration with the global economy: in trade and commerce
as well as in finance and investment. I am sure the profession of chartered accountants shall
play the role of a facilitating catalyst in this endeavour. Having said this, I would also like to
call upon the professionals to equip themselves to render correct advice within the letter and
spirit of FEMA to avoid compounding complications later. This is important to facilitate
speedier enablement of simpler procedures that are less intrusive.
25. Let me end by reiterating that we are open to receiving suggestions to make FEMA
administration more user friendly, particularly from an important stake holder like the NRI
community.
Thank you for your patience.