Impact of Fema on Forex

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      Until 1992 all foreign investments in India and the repatriation of foreign capital required previous approval of the government. The foreign-Exchange regulation Act rarely allowed foreign majority holdings for foreign exchange in India. However, a new foreign investment policy announced in July 1991, declared automatic approval for foreign exchange in India for thirty-four industries. These industries were designated with high priority, up to an equivalent limit of 51%. The foreign exchange market in India is regulated by the Reserve Bank of India through the Exchange Control Department.

Initially the government required that a company¶s routine approval must rely on identical exports and dividend repatriation, but in May 1992 this requirement of foreign exchange in India was lifted, with an exception to low-priority sectors. In 1994 foreign and non resident Indian investors were permitted to repatriate not only their profits but also their capital for foreign exchange in India. Indian exporters are enjoying the freedom to use their export earnings as they find it suitable. however, transfer of capital abroad by Indian nationals is only allowed in particular circumstances, such as emigration. Foreign exchange in India is automatically made accessible for imports for which import licences are widely used.

Indian authorities are able to manage the exchange rate easily, only because foreign exchange transactions in India are so securey controlled. From 1975 to 1992 the rupee was coupled to a trade-weighted basket of currencies. In February 1992, the Indian government started to make the rupee convertible, and in March 1993 a single floating exchange rate in the market of foreign exchange in India was implemented. In July 1995, Rs 31.81 was worth US$1, as compared to Rs 7.86 in 1980, Rs 12.37 in 1985 and Rs 17.50 in 1990.

Since the onset of liberalization, foreign exchange markets in India have witnessed explosive growth in trading capacity. The importance of the exchange rate of foreign exchange in India for the Indian economy has also been far greater than ever before. While the Indian government has clearly adopted a flexible exchange rate regime, in practice the rupee is one

of most resourceful tracker of the US dollar.

The foreign exchange market in India is growing very rapidly, since the annual turnover of the market is more than $10,000 billion.  c
   

 In context of the Indian financial system, the relevant factor is that the increase in foreign currency reserves as a result of the larger foreign inward remittances, lead to increase in money supply; finding its way into the money market and capital market through the banking system. Banks create credit and any inflow into the banking system gets multiplied by a factor. This factor depends on the reserves maintained by banks. If banks maintain n average reserve of 25%, any inflow into the banking system will increase money supply four times. Similarly, any contraction of funds available with the banks will result in a four-fold reduction in money supply. Increase and decrease in the foreign exchange reserves of the country impact the financial system through increase or decrease in money supply.

 c   c c  c cc Another aspect of Foreign Exchange market is that apart from flows resulting from personal and trade remittances, banks and corporate borrow funds from abroad and foreign entities invest in Indian business entities, such as Foreign Direct Investment [FDI], foreign funds and Foreign Institutional Investors [FII] that invest in the Indian capital markets. These flows are large in magnitude and have a great impact on capital market and the exchange rate. However, there is also the danger that if FIIs pull out, the stock markets could crash which in turn can adversely impact the economy. This danger is not only on account of the impact of share prices but also because of the impact on exchange rate, which can adversely affect foreign trade and consequently the price level in the country.

_
 _   The FEMA divides transactions according to their nature - that is, as current account and capital account. The regulation of foreign exchange too varies according to the nature of transaction. Sale or withdrawals of foreign exchange on current account transactions are made free under Section 5 of the FEMA. This freedom is subject to the power of the Centre to prescribe, in public interest, reasonable restriction on current account transactions in consultation with the RBI, the regulator. In terms of Section 6, the RBI, in consultation with the Centre, specifies the permissible capital account transactions. Thus, there is no free capital convertibility, rightly so, and the extent is prescribed by the regulator. The liberal provision on current account transactions is in line with the Article IX status of India in the IMF that demands full current account convertibility. The present forex reserves of about $34 billions are sufficient to remove all restrictions on current account transactions and facilitate trade and payments. Even under the FERA regime, current account transactions were progressively liberalized since August 1994, through various notifications: including payment in foreign exchange towards dividends, investment income, commission, compensation for engagement of foreign technician, technology payments, and consultation charges and so on. In effect, liberal treatment of current account transactions, available through various notifications or circulars under the FERA, is made statutory in FEMA. Inevitably, one can expect a spate of notifications under FEMA too and the regulator will face new types of challenges in the changed scenario. The statutory expression `current' and `capital' account transactions may open up a controversy requiring the regulator's intervention and clarification. Simply put, a capital account transaction is defined to mean a transaction that alters the asset or liabilities located outside India of a resident or those of an NRI in India. In addition, Section 6(3) brings under the definition, specific types of capital transactions. A current account transaction is defined to mean one other than a capital transaction. Here,

too, certain obvious current accounts dealings, such as payments due in connection with foreign trade, interest, foreign travel, and so on, are roped into the definition and have the potential to cause misunderstandings. For instance, if a current account payment is not paid (but is `payable'), and a provision made in the books of the Indian firm, it becomes a liability. Once a liability, it amounts to a capital account transaction as per the statutory definition. This is because the term capital account transaction does not restrict itself to `long-term' assets and liabilities, but includes short-term liabilities and assets as well. Thus, a current account transaction for accounting purposes could become a capital transaction legally. Those in dire need of making a payment may have to justify them under the `other current business' set out under the definition of a current account transaction. There is greater incentive for ingenuity in interpretation, as any contravention of the FEMA is only treated as civil wrong. Likewise, if a capital account transaction is split into several seemingly current account dealings, it may escape the legislator. This apart, when public interest so demands, the regulator may bring in a restriction even on current account dealings. All these would necessitate descriptions/clarifications through a series of notifications or circulars by the regulator. The fact that there cannot be any precise definition of what is current or capital transactions contributed to the bulk of litigation under the income-tax laws. The provisions relating to the realization of export (a current account transaction covered under Section 18 in FERA) is substantially contained under Section 7 of FEMA. The new law includes export of services too. Unlike other current account transactions, exports are expressly regulated, as the full value of export proceeds should be quickly realized in foreign exchange in the larger interest of the forex reservoir. According to the estimate three years before, about $11.6 billions of forex resources were lost through over-invoicing imports and under-invoicing exports. In all other aspects, the old law of regulation is substantially retained though, of course, in a different form. The elimination of threat of penal provisions may prompt forex users to take advantage of the inherently `subjective' provisions in the operative part of the Act. In this sense, the change is a challenge to the regulator. To counter this, the regulator is bound to

accelerate the spate of circulars and clarifications. This way, the foreign exchange market continues to have more of regulation than management.