University Department of Management Sciences, Pune

SBI Quest Cure '97 Seminar on Forex Management

FROM FERA TO FEMA

Reasons For Optimism 25th April, 1997 RASHMIN SANGHVI

CONTENTS

1. 2. 3. 4. 5.

Executive Summary Paradigm shift Jurisprudence Purposes of FERA Package of laws to regulate Fx flows Consequences of the package 6. Outward Flight of capital - Past - Present 7. Rupee value - World Bank 8. Devaluation - Past - Present 9. Exports 10. Protection to RBI 11. Future Role of RBI 12. Road map to convertibility Conclusion

Page Nos. 1 1 2 3 to 4 5 5 6 6 to 7 8 9 9 to 10 11 12 12 13 14 PAGE NO. 1

1. Executive Summary
This presentation is on the following lines In the past, India needed FERA. Government of India and RBI managed our foreign exchange better than several other countries. However, today FERA is doing more harm than good. The policy of consistent devaluation of rupee is counter productive and harmful. We must move much faster towards Foreign Exchange Management Act. It is good that both GOI & RBI are serious about it. India is at such a fortunate position in terms of foreign exchange that It is possible to start revaluing the rupee ; This can only help us in controlling inflation and simultaneously achieving growth. The presentation is more on macro policy level than on technicalities of the law. Conclusion is - there is reason for considerable optimism on the FERA front. It is for the nation to exploit the available potential.

2. Paradigm Shift.
Paradigm shift means, for the same issue/problem which you want to solve, Have an entirely new model, a new structure. Be prepared to consider radically new ideas. Probably contrary to our thinking so far. Let us see some examples. 2.1 With Mr. Jyoti Basu's Marketing of West Bengal for foreign investment during the last six years, CPI is now known as "Capitalist Party of India." 2.2 How many would have even thought just ten years back - in the year 1987 that Russia would be more capitalist than India ? PAGE NO. 2

2.3 The Hypothesis that by reducing tax rates, Government gets more revenue is now accepted by the Finance Minister. And even now many people in the Income-tax department are not prepared to believe in this logic. RBI is convinced on the merits of consistent depreciation of the rupee. Can we consider the merits of appreciation of rupee ? I can give more examples. But I will only request you to have an open mind to consider some new thoughts. Reconsider some prevalent hypotheses and see them in a different light.

3. Jurisprudence.
What is a law ? 3.1 It is one of the processes by which society tries to regulate the conduct of the individual. Religion tries to do so in the name of God by giving the fear of hell and incentive of heaven. Social traditions & codes of conduct & morality try to do so by "Social" sanctions, the penalty of being "looked down upon" and incentive of "prestige". The law obtains the authority of the state. The state has the power to punish - monetary sums as well as imprisonment. It also has the power to give subsidies & incentives. Who makes the law ? How and why ? What are the limits beyond which the law can not travel ? 3.2 Consider a Co-operative Society Democracy and Co-operative Housing Society Imagine A Co-operative Housing Society called "INDIA CHS" Ltd. One member, Mr. A wants to repaint his house. The chairman and the secretary of the society send him a notice asking him not to proceed with painting without the society's prior permission. The manager goes further and advises Mr. A that "pink" colour will not be suitable. Mr. A must go for "green" colour. Courageous Mr. A will thunder "Who are you to restrain me or advise me about my home painting? You have no right whatsoever. I, and other members have elected you and made you the Chairman and Secretary to pay the common bill and to manage the sweepers of the society. I have not given you the right to rule over me." PAGE NO. 3

"The manager of course is a servant of all the members. He has no locus-standi to go beyond serving the members". This would be a micro level example of democracy functioning. Macro level functioning of democracy in India would be Where Government looks after defense, law and order ; regulates fiscal policy etc. but does not impose undemocratic and out dated laws like licensing and FERA. And the bureaucrat does not sit in judgement over the citizens' business decisions. The first reason for optimism is that GOI and RBI are proposing to dilute FERA. It is essential to have a solid dialogue so that a law, to the extent, it has become redundant, does not continue to suppress the entrepreneurs.

4. PURPOSES OF FERA.
What are the basic purposes of FERA 1) To help RBI in maintaining exchange rate stability. 2) To conserve precious foreign exchange. 3) To prevent/regulate Foreign business in India. 4.1 Exchange Rate stability. RBI has consistently devalued the rupee. Generally the rate of devaluation is difference between the rates of inflation in India and major trading partners of India. Whenever, rupee has not been devalued for a few years; there has been a sudden devaluation and the inflation differential is taken care of. When we consider the experiences of African and Latin American countries, India has managed well. Mexico, Russia and Thailand have sufferred severe shocks and their people have sufferred miserably. Compared to these countries, India has managed well. Compared to the Asian tigers, India has done poorly. However, that is on the front of economic development. As far as exchange rate stability is concerned, we have done reasonably well. 4.2 Conservation of Fx. Finance Minister Dr. Man Mohan Singh had stated, at the time of presentation of his first Finance Bill in the year 1991; that - Indian residents' black money deposited in Swiss banks alone is around $ 50 billions. PAGE NO. 4

Mr. Forbes, of the Forbes magazine had estimated in the year 1996 that Indian residents' black money held abroad (all the tax havens etc.) was around $ 150 billions. Compare these figures with GOI's external debt of $ 92 billions. It is a common knowledge that transfer of funds through the havala market is easy, convenient and fast. Premium of 10% to 15% is fairly steady. Dr. Man Mohan Singh has reiterated even in his (relatively) recent talks that if only India could succeed in attracting its black money held abroad; it would not need any foreign loans. Considering the above RBI's policies ; GOI's policies ; and Enforcement Directorate's all the actions Have totally failed in conserving foreign exchange. Sections 8, 9 and 16 of FERA have proved to be redundant and need scrapping. 4.3 Foreign Business. FERA 1947 was based on a fear. An event like - East India Company started business in India and took over India - should not be repeated. FERA 1974 was made more stringent because, cases were reported where American multinational corporations in collusion with CIA had toppled Latin American Government which was found to be inconvenient for them. However, all that fear is a matter of past. Today we are encouraging NRI and foreign investment. There is an about turn. Prime Minister, Finance Minister and several Chief Ministers make annual pilgrimage to several countries for "marketing" India and inviting foreign investments. When the highest authorities go abroad, make sincere requests and appeals to invite investment; and then the bureaucrat talks of granting a "permission" - naturally, something is seriously wrong. Section 29 of FERA needs to be totally revamped. PAGE NO. 5 We will still need this section to counter the "protective" measures adopted by some countries on reciprocal basis. We will also need to prevent foreign investments in certain sensitive areas like defense etc. Except for these, there should be a section which would enable an

authority like FIPB & FIPC to Invite Foreign investment and grant a real one window clearance.

5. Package of Laws to regulate Fx flows.

5.1 India's Fx position after independence was - we had very little foreign exchange. Our imports were more than the exports. Foreign exchange was not adequate even for essentials like medicines, defense and capital goods. How can one permit the import of luxuries ! India was dependent upon foreign aids and loans for meeting the balance of payments deficit. In the situation, Government of India (GOI) worked out the following strategy to conserve foreign exchange 5.1.1 Import Licensing. No Indian could import anything without obtaining a licence. Under the Import licensing law, GOI could permit import of some items and could ban the import of non-essential items. Gold was one such item whose import was banned. Reduction of imports would reduce the demand for Foreign exchange (Fx). Simultaneously, all exports were encouraged to increase the inflow of fx. 5.1.2 Customs Duty. Where goods were not banned for imports, very heavy customs duties were imposed. This made imports costlier, so reduced the demand for fx and simultaneously gave revenue to the Government. 5.1.3 FERA. Under FERA, GOI acquired complete monopoly over fx. It acquired the rights to take over the fx earned by all residents and to allocate the same to those who would need fx. All foreign investments by Indian residents were banned. 5.2 Consequences of the package. What has been the result of such regulations ? 5.2.1 It is said that wherever there are profits, there will be some people to do that business. If you permit the business openly, good businessmen will be in the business. They will pay taxes and abide by the law. If you prohibit the business ; the mafia will take over. They will not pay any taxes and terrorise the regulatory authority, destabilise Government also. PAGE NO. 6 5.2.2 This truism is reflected in the following facts in India Internationally, foreign exchange dealing is done by young professionals who are highly paid by the banks and other similar institutions. In India, fx dealing is done by the havala recketeer. Internationally, gold import and export is done by well respected multinationals. In India it was being done by the smuggler.

5.2.3 Import licensing created scarcities/non-availability of several products in India. customs duties created huge price differences between the International market price and the local market prices. Both togather created a huge, profitable smuggling market. Havala business complimented smuggling and completed the financial cycle. The syndicate of smugglers, mafia and havala racketeers have used a well intended legal system to carry on their business at the cost of Indian economy. 6.1 Outward flight of capital - Past. 6.1.1 India had a usurious tax system.
Maximum Marginal Rates 97% 8% 85%

Income-tax Wealth-tax Estate Duty

6.1.2 Continuously depreciating rupee was causing erosion of wealth. 6.1.3 These had ensured that every law abiding rich person would soon become a pauper. Excessively regulated economy with excessive powers of penalty, prosecution and harassment by all sorts of bureaucrats had created an anti-businessman, anti-rich atmosphere. All these had caused an outward flight of capital. 6.2 Present. 6.2.1 Tax Rates. Today, however, there is a sea-change in the atmosphere. Estate Duty is abolished. Wealthtax is as good as non-existing. And income-tax rates are quite reasonable - even before passing of the finance bill - 1997. If this finance bill is passed PAGE NO. 7

reducing tax rates to 30% and 35% (for individuals and companies respectively) ; we will have tax rates lower than the rates prevailing in western developed countries and at par with Asian Tigers. 6.2.2 Our developing economy offers growth rates higher than any that can be offered by the matured, developed economies. 6.2.3 Today, Economic circumstances clearly favour a business decision to transfer the funds to India. 6.2.4 Political uncertainty is a cause for grave concern.

6.2.5 Even if politics were to be stabilised, there would ; still be two reasons why Indian residents can not openly bring back their wealth : Tax laws ; and FERA. Under both these laws, he would be held guilty. The Voluntary Disclosure Scheme offered by Finance Bill, 1997 is not good enough. 6.3 What we need is a concrete action to assure and encourage the Indian resident. If following steps are taken, there can be great flight of capital inwards. 6.3.1 GOI and RBI should assure that they will not take market action which would cause depreciation of rupee. While it would support stability, it would not interfere if there is small, annual appreciation of rupee of upto 5% per year. 6.3.2 GOI should give a clear timetable - that if the economy behaves well, within three years rupee will be made fully convertible. 6.3.3 A good, whole hearted amnesty should be given for past offences with winding up of the enforcement directorate. These steps alone can create a significant return of Indian residents' black money held abroad. When Indian residents will be convinced that investing in India is more profitable, NRIs will soon follow. These will then be followed by foreign investment. Total annual inward flow of funds can well exceed U.S.$ 10 billions. It can offset the balance of trade deficit. Massive investment in infrastructure and industry ; and intense competition are two factors which can meet the existing Indian shortages and eventually create exportable surplus. this alone can be a fundamental assurance for good stability in trade balances. PAGE NO. 8

7. Rupee Value - World Bank.

7.1 Consider World Bank's Development Report for the year 1995. The report gives details of GNP per capita of several countries converted into U.S. $ by two different methods. Table 1 on page 162 gives the GNP converted at market exchange rates Indian per capita GNP is reported at U.S. $ 300. Table 30 on page 220 gives the GNP converted at PPP exchange rates - and the Indian GNP is - U.S. $ 1220. In all these statistics, considerable degree of assumptions are built in. Hence they can be used only as a rough guide.

The rough guide says that the market exchange rate values rupee at one fourth its PPP rate.
In other words, if the market rate is the PPP rate should be Or if the market rate is the PPP rate should be Rs. 36 per Dollar, Rs. 9 per Dollar. Rs. 60 per Pound, Rs. 15 per Pound.

This sounds unbelievable. So let us see another example 7.2 What may be the income of a peon or a clerk in India where he can live a lower-middleclass standard of living ? One may estimate - say Rs.2000 per month. With this salary, his family can live a subsistence level existence in Bombay. In U.S.A., the lowest paid peon would earn at least $ 1000 per month. This salary would translate into Indian rupee

at market rate, into Rs.36,000 per month; at PPP rate, into Rs. 9,000 per month.

Can anyone say that a person earning Rs. 36,000/- per month would live at subsistence level in Bombay ? Which rate is more realistic ? Rs.9 per dollar or Rs.36 per dollar ? (Monthly family expenditure is another way of saying that similar baskets of goods are valued in different currencies and compared.)

PAGE NO. 9

8.1 Devaluation.
The Past. GOI found that devaluation of rupee was very profitable. Every devaluation meant that 8.1.1 imports became costlier. Indians would import less. Less demand for foreign exchange. Where import is unavoidable, and people would import; at the same rates, customs revenue increased.

8.1.2 Exports become more competitive, and profitable. so exporters would export more and India would get more foreign exchange. 8.1.3 Debt servicing became costlier. But India was continuously borrowing more than repaying. So, why worry ? 8.1.4 IMF, world Bank, U.S.A. and the Aid India consortium were constantly pressurising India to devalue its rupee. Apparently, every devaluation of rupee was keeping everyone happy. So why not ? 8.2 Devaluation. The present. An economic calculation may be good in one situation, at one time. When the circumstances change, the policies must change. In the book "Rethinking the future", Mr. Rowan Gibson says"Future will not be a continuation of the past". In the past, you have driven along a road. It does not mean that the same road will continue in future. In fact, the road stops here, today. There is no further road. You have to make new road and you have to make your own map. What succeeded in the past may not succeed today or tomorrow. Consider a few examples. 8.2.1 In June, 1991 the rate of Indian rupee Vs. U.S. $ was Rs. 18 per dollar. Today, the rate is Rs. 36 per dollar, and the external debt is $ 92 billions.
U.S. $ Billions External Debt in April, 1997 92 Rs. Billions Market Rate 3,312 Rs. @ Constant Rate 1,656.

PAGE NO. 10 Because of devaluation, Government has sufferred a loss of Rs. 1,656 billions. Assuming @ 5% Debt Servicing cost, India is spending extra Rs. 83 billions on this count alone. Compare this with our budgetary deficit of Rs. 69 billions. (For the year 96-97, as per the budget presented on 28th Feb., 1997.) 8.2.2 Imports. Assume, a commodity X has the international price of $ 10. India is importing that commodity worth $ 1 billion a year. At market price, India is paying Rs. 36 billions a year. At PPP price, India would have paid only Rs. 9 billions a year.

The undervalued rupee causes extremely high cost of imported goods like crude oil. It is a strong reason for the Indian economy being a high cost economy. Many of our exports are import intensive. When we devalue the rupee, we cause cost-push inflation; hence our exports become uncompetitive; hence we need a devaluation - which causes inflation. We are in a vicious cycle. Devaluing for exports is bleeding India. Only way out is start revaluing the currency. 8.2.3 Foreign Investment. Foreign Investors want their return on investments NET of Indian taxes, Cost of Risks and Red tapism, and Depreciation of rupee. Consistent depreciation of rupee means a consistent erosion of his investment, and discourages foreign investment. What is loss to a foreign investor is also a loss to the Indian investor. That is clearly one of the reasons why Indian rich people have stored their wealth outside India. If, instead of depreciating, the rupee starts appreciating, the return on investment increases tremendously making India an attractive place for investment. Devaluation of currency causes outward flight of capital. Revaluation of currency (supported by fundamentals) causes Inward flight of capital. PAGE NO. 11

9. Exports.
No country can survive in the long run without exports paying for imports. However, there can be phases in the growth cycle of a nation - when foreign investments can pay for trade deficit. At present, some of the exports are deeply hurting India. 9.1 Where is the exportable surplus in India ? When we export the goods, price of the same commodity in India goes up. Potatoes and onions have gone beyond the reach of the common man. Export is the main culprit. Export causes inflation. This is basic economics that we learn at college. 9.2 Without creating exportable surpluses, when we want to export goods; we have to create

an artificial situation. That is bound to cause huge abnormalities, necessitate huge subsidies and bleed the national economy. 9.3 Because the exporter is assured of a continuously declining rupee and his consequent profits; he does not try to export high tech-goods with value addition. He is selling away commodity goods at throw - away prices. He does not create a brand image abroad. The only strategy is, -"sell cheap". Exporting Iron ore, cotton and yarn is one series of examples. Even in Computer Software exports we are largely doing "body shopping". If the exporters are put on notice that rupee will start appreciating, there will be a tremendous scare. If rupee really appreciates, the weak and the inefficient commodity/body traders will be wiped out. The real entrepreneur with capacity to make value addition will come up. 9.4 It is open knowledge that in case of most exporters, the foreign buyer knows Indian cost sheet fully. The foreign buyer pays only that price which gives bare minimum profits to the Indian exporters. Now assume that we are exporting goods worth Rs. 36 millions. We will get foreign exchange of U.S. $ 1 million. If the exchange rate were nearer the PPP rate of Rs.9 = $1; we would have got probably $ 4 millions. It is also possible that the export would not have taken place. The issue is, we are exporting by under - cutting. We are not exporting by value addition. In the process, the exports where we have some strength is also thrown away at cheap price.

PAGE NO. 12

10. PROTECTION to RBI.

10.1 Liberalisation of economy - has increased competition. Several Indian industrialists have cried hoarse and asked for protection under one guise or the other. Government has not listened to their appeals and gone ahead with liberalisation. Message is clear. "You have been provided crutches for too long a time. You must learn to face normal "free" and "competitive" world that prevails abroad. No more crutches." 10.2 One of the tasks of the Central Government and Central Bank of any country is : To maintain stability of its currency.

To control inflation and to stabilise exchange value of its currency. This task has to be achieved by appropriate economic and fiscal action, and by market intervention. That is how it is done in the "free" and "competitive world". However, when a Government and its Central Bank are unable to stabilise their currency through market forces, they run for the crutches. They pass laws providing that no body can deal in foreign exchange, that those who are permitted to deal in foreign exchange must deal at the rates prescribed by the Central Bank (Section 8 of FERA); that no one can take any foreign exchange out of the country (Sections 8,9,16 of FERA) and so on. Indian Government is preparing to remove these crutches. That is reason for optimism. The industrialists have a right to say - 'that the Government which is asking the industry to walk without crutches; should itself also walk without the crutches'. If sections 8,9 and 10 are modified/deleted from FERA, both, the Government and the Central Bank won't need crutches. We will see this issue later.

11. Future role of RBI.

11.1 In future, the role of RBI has to be similar to that of Central Banks world over. It is not RBI's function to sit in judgement over several business decisions to be taken by the businessmen - Indian as well as foreign. In a fast moving economy, one can not expect that for several business decisions, the businessman has to go to RBI and take a "prior permission". This is the bottleneck in expanding Indian economy. PAGE NO. 13 RBI has to act like SEBI. Businessman can go ahead and do his business. There will be prescribed guidelines and regulations for business. It will be expected that the businessman will follow these guidelines. There will be no question of taking prior permissions. If anybody violates the guidelines, RBI/enforcement directorate will strike just as SEBI or police may strike a violator of law. 11.2 Fx gamblers world over can cause violent fluctuations in exchange rate and can cause grave damage. India will need a modern version of Section 8 and the relevant powers to curb speculation and gambling in Indian rupee for some time. When the Indian economy is more liberalised ; the financial markets are deepened and well connected globally and RBI has some comfortable reserves so that it can take effective market steps ; then Section 8 can be scrapped. One can not passively wait for these to happen. Effective, positive action has to be taken to create such an environment. GOI and RBI are already taking actions in this direction.

12. Road Map to Convertibility.

Let us notice a paradox. We all want huge amount of foreign investment. However, when Fx starts flowing in, rupee starts appreciating. Siezed with the idea that rupee must depreciate and not appreciate ; RBI starts buying dollars by selling rupee in the market. Excess supply of rupee resources causes inflation. The paradox is - we want fx inward flow. It is basic economics again that when money supply flows in, other things remaining same, inflation will increase. How to have more fx inflows without causing inflation is a dilemma. RBI had tried by paying off some of the debts, by asking GDR issuers to keep their GDR proceeds abroad and so on. Now consider another position. We want that the international confidence in the Indian rupee increases. This is a must before the rupee goes fully convertible. If GOI were to announce following time table, what would happen : 12.1 From 1st July, 1997 - all funds held in India by all NRIs and foreigners will be treated as fully repatriable. They can take back all their funds including NRO account funds without asking for any permission from anyone whatsoever.

PAGE NO. 14 Imagine the tremendous morale boost which will occur. all the apprehensions and negative thoughts that the NRIs have about India will give place to a confidence in India. I believe that such a time table would cause more inward flight than outward flight of funds. 12.2 Next step towards convertibility : All permissions and procedures for NRI business and investment in India may be cancelled from 1st July, 1997. An NRI can do any business or investment that an Indian can do. As far as FERA is concerned, there will be no restrictions. All other laws will apply just as they apply to Indian residents also. 12.3 Implement the proposal mooted in the budget. For all residents, investment abroad for businesses upto U.S. $ 15 millions would require no permission whatsoever. Simply file a declaration and go ahead. 12.4 On a date, which will not be beyond 31st December, 2000 ; FERA will be scrapped. Indian residents will be able to bring in or take out any amount at their will. All past violations would cease to be violations of FERA as the law itself will be scrapped. The enforcement directorate would be completely wound up. Conclusion

The amount of interest this time table itself will generate, will start inward flow of funds which will make FERA redundant. We have been treating convertibility as on "end" in itself. RBI has stated that when certain conditions will be achieved then only rupee will be made convertible. However, we can consider convertibility itself as a "means to achieve the targets of comfortable reserves and growth in the economy. There are thousands and thousands of mega rich NRIs staying in politically unstable countries. They are constantly on the look out for a safe and stable place to invest. They have a distrust of India on account of FERA and continuous depreciation of rupee. With the above steps, a positive sentiment will be boosted. Success of FERA liberalisation depends upon several factors including political stability. What is discussed here is only a part of the total economic policy. A liberalisation, when there is a serious political instability has to be restrained. However, as soon as reasonable stability is achieved ; rupee can be made fully convertible. I am optimist that GOI will implement these steps even before 31st December, 2000. All of us would breathe economic freedom and enjoy consequent prosperity.

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