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 Unless there is move towards convertibility, and unless the present FEMA is repealed, RBI, with the responsibility to see that it is not violated, will have to enforce it.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.