Stick to the line of control

Financial Express, 27th May 2013

Just redefine foreign investments by whether or not they seek to control the company they are in

Indian capital controls are amongst the most complex in the world. In this area the Indian bureaucracy blindly marched on in the spirit of the licence permit raj of the 1970s. Today, the system has become so tangled that it is difficult to implement all the various conflicting rules in place. Simplifying the system requires implementing the UK Sinha working group on foreign investment through current initiatives such as the Sebi working group on QFI, and the Arvind Mayaram group on FDI definition.

The gentle reader is requested to read the next few tortuous paragraphs, in order to get a sense of the scale of complexity that has been constructed in the Indian capital controls. Foreign investment into India has been cut up into a maze of categories. Foreign investors are classified as: Foreign Institutional Investors (FIIs), Foreign Venture Capital Investors (FVCIs), Non-Resident Indians (NRIs), Qualified Foreign Investors (QFIs) and Foreign Direct Investors (FDI). FDI includes a sub-route involving issuing ADRs/GDRs or foreign currency convertible bonds. Sebi, RBI and the finance ministry make rules and regulations governing foreign investment. Investment by each subcategory of investors in each sector has to be continuously monitored.

The FDI framework consists of acts, regulations, press notes, press releases and clarifications, etc. The Department of Industrial Policy and Promotion (DIPP), ministry of commerce & industry, frames policy on FDI through press notes which are notified by RBI as amendments to the FEMA regulations. To bring some clarity, DIPP attempts to consolidate the various circulars on FDI in a consolidated policy statement (which has unclear legal authority). Often, it seems to get tangled in the issues with other routes of investment. While FDI is permitted up to 100% in most sectors under the automatic route, in other sectors there are sectoral investment caps.

In addition, the rules cross reference each other. For example, RBI regulations on FIIs state that an individual FII can purchase up to 10% of the equity of a company and all FIIs together can hold up to 24%. In addition, there are caps for NRIs and QFIs. The same regulations give an option to the company to raise the aggregate FII limit from 24% to the sectoral limit prescribed by the FDI policy. Similarly, when the DIPP issues press notes governing FDI limit, it states the FII investment limit should stay within the caps on foreign direct investment. In some cases, the consolidated FDI policy overrides the regulations made by RBI. In print media, the foreign investment limit is 26%, which includes the limit by NRIs/FIIs/PIOs. This means that if a company with an FDI of 20% lists on the exchanges, FIIs and other portfolio investors will be allowed to the extent of only 6%. This contradicts the RBI regulations which state that FIIs can purchase up to 24% of equity of a listed company.

Similarly, if a foreign investor invests in the same company through both the QFI route and the FDI route, the total holding of the person in such a company cannot exceed 5% of the paid up equity capital of the company, at any point of time irrespective of the sectoral cap, if any. In addition, regulations often restrict FII/NRI/QFI investments in a company at various arbitrary limits and cap their total limit to the FDI limit.

The regulatory framework is further complicated by the lack of clarity on the nature of instruments classified as FDI. As an example, if a company raises funds through the issue of ADRs/GDRs, the resultant foreign investment is considered to be part of FDI. ADRs/GDRs are largely equity instruments and investments through these do not qualify as 'control' by the foreign investors as these instruments do not give voting rights to the investors.

This tangled mess is typical of everything that India did wrong in economic policy in previous decades. Just as we have simplified industrial licensing (by eliminating it) or indirect taxation (by moving to a single rate GST), we need to drastically simplify capital controls so as to reduce transactions costs, and shift the focus of the field away from fixers to genuine investors.

In the Budget speech 2013, the finance minister announced that India will follow international best practices in defining FDI and FII. According to OECD and UNCTAD norms, a stake of less than 10% should be classified as FII. The government proposes to provide clear definitions to FDI and FII, with an aim to remove ambiguity over the two types of foreign investments.

The key step is that of clarifying the objective of the FDI/FII classification and regulations. If the objective of regulations is to prevent foreigners from taking control of an Indian company (due to national security, politics, infant industry arguments, etc) then the regulations should not take into consideration the amount of portfolio investments in the company, since such investments are not for the purpose of control of the Indian company. The regulator may choose to classify any single large investor (say, above 10) as one seeking control and bring him under the limit, but overall limits for portfolio investment do not serve this purpose.

A simple solution of redefining the different foreign investment routes is by dividing investment into two categories: investment which is related to foreign control of the Indian companies and investment which does not lead to control of an Indian company. Under this system, the FII or, say, QFI investment will not be considered for FDI limits. It will simplify both the calculation of limits for FDI and the monitoring costs. The investments which do not lead to control of the Indian company should then be subject to a uniform registration requirement with emphasis on robust KYC norms.

(Co-authored with Radhika Pandey of NIPFP)

How do you prevent rupee trades?

Financial Express, 10th May 2013

Even if Indian firms stop offering such overseas trades, the market will continue to thrive

In a recent circular, the Reserve Bank of India (RBI) prohibited Indian entities owning foreign entities that facilitate trading in offshore rupee derivatives. Since the rupee is not a convertible currency, it cannot be traded outside India. Trading in rupees derivatives, even when it is in non-deliverable products, which may not technically be trading the rupee, constitutes a violation of the Foreign Exchange Management Act (FEMA). RBI feels that such trading makes the job of managing the rupee harder.

While RBI does not have regulatory jurisdiction over foreign exchanges that offer platforms for such trades, FEMA gives it jurisdiction over entities even those outside India if they are owned or controlled by a person residing in India. Indian entities facilitating offshore markets require its permission. According to the present law, those entities which, fully or partly, own businesses that offer such products need to take permission from RBI. Today, such firms have three choices. Either those derivative products must not be sold any more, or the businesses have to exit their participation in the ownership of those exchanges, or they must receive RBI's permission to continue the facilitation of offshore rupee derivative products. While at one level this appears is an attempt to curb the growth of the rupee market for hedging and speculation, the real issue lies in the legal framework of capital controls.

The first is the question of the path to capital account convertibility. As long as the rupee is not convertible, i.e cannot be bought and sold in foreign markets, and as long as RBI is required to administer FEMA, issuing and enforcing such regulation is part of RBI's responsibilities. While the usual arguments can be made about the need for RBI to encourage growth of the market, their usefulness in today's context are limited. Unless there is move towards convertibility, and unless the present FEMA is repealed, RBI, with the responsibility to see that it is not violated, will have to enforce it. Within the present framework of non-convertibility and the present regime of capital controls, a violation of FEMA is an offence under the law. If the law is changed to make the rupee fully convertible and RBI is required to administer that law, such a regulation would not be feasible. For the time being, Indian companies participating in such activities are required to operate within the legal boundaries of FEMA.

Today, the arguments for making the rupee convertible are stronger than before. As India integrates both on account of trade and financial flows with the rest of the world, it needs to move to allowing the currency to trade abroad. This can be done in limited ways and in a slow and cautious manner. China has already started pushing ahead on making the remnimbi international. In a recent agreement with Australia, China will allow Australia to hold 5% of its reserves in remnimbi. India can start the same with neighbouring countries that have a large share of trade with India. Countries in the neighbourhood that peg to the Indian rupee and which are holding convertible currencies as reserves should be able to hold Indian rupees. Such a move can be done by agreements and treaties until India ultimately repeals FEMA.

But let us say India chooses to keep the legal framework for capital controls in place. Then, there is a need to address the manner in which financial sector laws are administered. Under the present FEMA, RBI is not required to carry out consultations with stakeholders or show a cost-benefit analysis of why a regulation should be issued. In the recently-drafted Indian Financial Code (IFC) proposed by the Financial Sector Legislative Reforms Commission (FSLRC), the regulator would be required to show what will be achieved by the regulation. In this case, for example, it is well known that there exists a large offshore market for Indian rupee derivatives. Offshore markets for the rupee exist in Singapore, Hong Kong, London, Dubai and Bahrain. A report by the City of London on NDF markets for BRICS currencies shows that in London the rupee NDF market is the fastest growing among BRICS currencies. Between April 2008 to April 2012, NDF trading volume in the Indian rupee has increased from $1.5 billion to $5.2 billion, an increase of almost 250%.

RBI should adopt the practices of reasoned order for issuing regulation and showing a cost-benefit analysis at its own initiative even before the IFC becomes law. In a cost-benefit analysis, RBI will need to show the impact of the regulation. It will have to show by how much it will be able to reduce the size of the NDF market, thereby making its job of rupee management easier.

At first blush, greater benefits from the present regulation are not obvious. Even if Indian companies withdraw from equity participation in the exchanges on which NDF trades take place, the market will continue to thrive, keeping rupee management difficult. Also, since RBI has moved to a flexible exchange rate, the benefits from curbing the size of the market are limited.

If the cost-benefit analysis does not show greater costs but, say, RBI has other concerns, such as those of money laundering, it should not be able to issue regulations under the powers given to it under FEMA. It should then have to issue them under the Prevention of Money Laundering Act. At the same time, it would need to develop the supervisory capacity to examine the books of financial firms to uncover how the money laundering was undertaken. Today, such supervisory capacity is lacking, and given that regulators do not have to give the rationale and cost-benefit analysis of their regulations, they may have the incentive to use a nuclear option of banning such activities rather than carefully supervising them.

Further, RBI should engage with the entities to indicate to them not to participate in businesses that result in a violation of the law. This would offer greater business certainty and lower risks in case of those arising from difficulties in the interpretation of the law.

Some chit chat

Indian Express, 08th May 2013

To protect investors, make the formal financial system more accessible and attractive

News of investors losing their life savings in Ponzi schemes like Saradha has become recurrent in recent times. It seems that as long as the real estate sector was booming, these schemes were able to survive as new money kept coming in. But with employment and incomes growing slowly, finding new investors to pay off old ones might have become more difficult. It should not be surprising if many more such schemes collapse in coming days.

Chit funds alone attract millions of investors. It is estimated that registered chit funds have collected Rs 300 billion worth of deposits. The real story apparently lies in unregistered funds, who, it is estimated, have collected Rs 30 trillion. This is nearly half of the Rs 64.8 trillion held in commercial banks (in February 2013). But while all chit funds may not be fraudulent, the danger of some being so, given the weaknesses in regulation, is very high.

The origins of India's unregulated financial system lie in the poor and outdated financial regulatory system that India has clung on to. The banking regulator is proud of the fact that there have been no bank failures, no complex derivatives and the banking system survived the global crisis - a system, it claims, that offers an example for the world to learn from. The sad reality is, however, that as much as half the Indian population does not have access to this banking system. Even those who have access often find it unattractive. Interest rates paid to depositors have been pushed down through years of policies of administered interest rates and lack of competition in banking. Regulatory requirements for priority sector lending and holding of government bonds have further resulted in lower returns. The result is low or negative real interest rates for depositors.

This is fertile ground for unscrupulous individuals. A Ponzi scheme like Saradha can be set up. The law does not require all financial service providers to register with any single regulator. If a firm says it is a collective investment scheme, it is required to register with SEBI and be regulated by it. If it claims to be a chit fund, it is regulated by state governments. If it says it is a private company taking deposits for its business, it must be regulated by the registrar of companies as Sahara has claimed it should be. If it takes public deposits, it should register as a non-banking financial company and be regulated by the RBI. It may actually register with no one, as Saradha didn't.

If any one regulator finds out a company is guilty of fraudulent practices and tries to stop its activities, it has to approach other regulators. The financial firm, in the meanwhile, can go to court, claiming the regulator has no jurisdiction over it, as in the case of Sahara. It can continue to collect money. The regulator has to prove in a court of law that the firm was indulging in activity that is under its jurisdiction, and then, during the long delays in courts, watch helplessly as thousands more get duped by the firm. Section 11AA of the SEBI Act, under which SEBI has been acting, defines "collective investment schemes" in terms of principles that identify such schemes. It, however, includes exemptions for institutions such as chit funds, nidhis and cooperative societies.

Will passing a more stringent law, as the West Bengal legislature has done, solve the problem? Do state governments have the capacity to regulate financial firms? Even if some well-governed state governments are able to regulate chit funds, the regulatory capacity of other state governments can be quite limited. Perhaps the way forward should be that state governments with weak regulatory capacity choose to hand over powers of such regulation to the Centre.

But even after that is done, institution-based regulation would continue to provide legal cracks in the system for unscrupulous firms to slip through. To address this issue, the Indian Financial Code (IFC), proposed by the Financial Sector Legislative Reforms Commission, suggests that the definitions of financial products and services be broad and principle-based, with no statutory exemptions. All kinds of deposit-taking and investment schemes, including chit funds, are covered by the proposed definitions. For example, a deposit, in the draft law, is defined as a contribution of money, made other than for the purpose of acquiring a security, which may be repayable at the demand of the contributor. As a consequence, anyone in the business of accepting deposits or managing investment schemes would need to get authorisation from the regulator. The IFC proposes two regulators. Under the proposed law, either a financial firm must obtain a bank licence from the RBI, or it must register with the Unified Financial Agency (UFA), the regulator of all financial firms and activities other than banking. This would eliminate the legal tussles over jurisdiction seen today. In addition, the IFC proposes powers of investigation and prosecution for the financial regulators to prevent further fraud.

But it is not sufficient to give regulators the powers to catch criminals. The origin of the problem, that is, the inaccessible and unattractive formal financial system, also needs to be addressed. Today, regulators have an incentive to ensure there is no failure of the financial firms they regulate, leading to over-regulation. Saradha depositors may be paid by a West Bengal tax on cigarettes, and SEBI may be given additional powers to prosecute. But beyond this legal patchwork, India needs a comprehensive legal framework for financial regulation if it is to protect investors and reduce such fraud in future.