Demystifying FEMA - Part 2

PART – 2

Capital and Current Account Transactions and the Rules of Convertibility

Transactions in foreign exchange can be divided either into current account transactions or capital account transactions. Persons resident in India are free to buy or sell foreign exchange for any current account transaction except for those transactions for which drawl of foreign exchange has been prohibited by Central Government, and drawl of foreign exchange is prohibited for all capital account transactions except for those for which drawl of foreign exchange has been permitted by the central government. Central government has the authority to regulate all the current account transactions, and, for this, it has issued Foreign Exchange Management (Current Account Transactions) Rules, 2000 (“Rules”). For capital account transactions, RBI has the authority to regulate these transactions, and, for this, it has issued various regulations depending upon the nature of the transactions.

CAPITAL ACCOUNT TRANSACTIONS

Section 2(e) of Foreign Exchange Management Act, 1999 (“The Act”) defines a Capital Account Transaction as a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India.

While reading this definition, distinction between “assets” and “goods” should be kept in mind. An asset is supposed to give returns in future whereas goods are meant for immediate consumption. Domicile of assets/liabilities involved in capital account transactions always remain in foreign country. Few examples of capital account transactions: -

·         Buying immovable property outside India.

·         Buying shares in a foreign company.

·         Borrowing from a foreign bank.

CURRENT ACCOUNT TRANSACTIONS

Section 2(J) of The Act defines Capital Account Transaction as a means a transaction other than a capital account transaction. Such transaction includes,

1.      Payments due in connection with

·         Foreign trade, (Export/Import)

·         Other current business

·         Services, and

·         Short-term banking and credit facilities in the ordinary course of business; (Though it is creating liabilities outside India, these types of transactions will be treated as current account transactions because these arising out of ordinary course of business and their short term nature.)

2.      Payments due as (Return on Investment)

·         Interest on loans and

·         Net income from investments

3.      Remittances for living expenses of parents, spouse and children residing abroad, and

4.      Expenses in connection with

·         Foreign travel,

·         Education and

·         Medical care of parents, spouse and children.

Goods Vs Assets

·         A, an importer in India, imports clothes to sell in India.

In this situation, clothes involved are goods, and the domicile of these goods gets changed when these clothes come to India. A will sell these clothes without adding further value to them.

·         A, a manufacturer, imports a machine for manufacturing goods.

In this situation, though the machine is an asset for the manufacturer but it will be considered goods falling in current account transactions because after import the domicile of the machine will change. It will come to India after import therefore not altering any assets/liabilities outside India provided the machine was purchased on cash basis i.e. not on credit.

Return on Investment (ROI)

Interest on loan, dividend on shares etc. are the returns on investment. While calculating Return on Investment (ROI) in financial management, capital gain also gets included in the computation of ROI, but for current account transactions’ purpose, capital gain is not to be included in ROI. This distinction is necessary to keep in mind because various regulations issued by RBI allow investment on repatriable and non-repatriable basis. The condition of repatriability applies on the capital amount, and the return generated on investment in the form of interest and dividend will always be freely repatriable because these fall in category of current account transactions.

Example – Collaboration Agreements

There are two types of collaboration agreements with non-residents: First – Financial, and Second – Technical/Trademark, collaboration agreements. In Financial Collaboration Agreements (FCAs), non-residents invest money into India thus creating assets in India. Therefore, FCA falls into capital account transactions. On the other hand in Technical/Trademark Collaboration Agreements (TCAs) rights to use technologies or trademarks get transferred from non-resident to residents. In return, non-residents get payment of royalties for the use of such technologies or trademarks. Royalties are income in nature, and their payments do not result in creating assets or liabilities outside India, so TCAs has to comply with the requirements of the Current Account Rules. Remittance of salary, dividend, rent, interest, royalty etc., all are current account transactions.

CONVERTIBILITY

Convertibility implies freedom to draw foreign exchange for the purpose of capital and current account transactions. The rules of convertibility of current account transactions are different from that of capital account transactions. The rules depends upon various economics’ considerations. One principle to keep in mind to appreciate these rules is that foreign investors are good weather friends.

Current Account Convertibility

India has full current account convertibility in the sense that all current account transactions are permitted except those which have specifically been prohibited. The rules has divided these transactions into three categories.

• ·       The transactions on which there are no restrictions;
• ·        The transactions on which maximum cap has been prescribed; and
• ·   The transactions which are completely prohibited – foreign exchange cannot be drawn for betting and gambling purpose.

The reason of full convertibility is that these transactions does not result in ownership of non-residents into country’s assets. These transactions do not result in building capital assets, and therefore generating employment. Full convertibility for current account transactions facilitates free flow of goods and services among the countries thus facilitating unhindered trade. Though, these transactions do affect the value of rupee depending upon the demand and supply of rupee and foreign currencies from importers and exporters.

Capital Account Convertibility

India has partial capital account convertibility in the sense that all capital account transactions are prohibited except those which have specifically been permitted. India applies restrictions in the form of caps, repatriation, lock-in period, minimum capitalisation etc. on capital account transactions. Non-residents become the owner of the assets in the home country, generate employment, and build capital assets. In nut shell, these transaction are form of investment made by foreign investors in home country. Foreign investors will remain invested so long as they get desired returns on their investment. These transactions have far deeper and comprehensive impact on the economy than the current account transactions. Depending on the effects of each type of transaction, there are different restrictions on every capital account transaction.

Example - Investment in Equity Shares

Equity shares are assets and their ownership results in capital gains, voting rights, management’s rights etc. A non-resident can buy Equity shares of an Indian company either under Portfolio Investment Scheme (PIS) or Foreign Direct Investment scheme (FDI). Under FDI scheme, a non-resident can directly acquire management’s rights besides voting rights. The power to control management i.e. composition of board of directors is the threshold for degree of restrictions. Investment under FDI scheme results into setting up or expansion of business thus creating employment, infrastructure, assets etc. On the other hand, investment under PIS (generally, equity shares listed on stock exchange), non-residents acquire only voting rights. Investors under PIS are not interested into managing the company rather they are interested into the company’s profit. Since there is no new business and employment from these investments thus investment under PIS have little impact on country’s economy, there is easy convertibility for these types of transactions subject to the maximum limit of foreign investment allowed in that sector.  Thus convertibility for transactions under PIS is much easier than under FDI.

Why there is no Full Capital Account Convertibility (FCCA)?

Capital Account Convertibility has been defined by RBI as the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rate of exchange without any sort of intermediation of law or regulations. A, an Indian resident has shares in an Indian company, and he wants to buy shares in a foreign company by selling shares in the Indian company. So for that, A will sell shares in the Indian company, and, in exchange, he will get Indian money. Now, A will buy foreign money by giving Indian money to purchase the shares in the foreign company, assuming there is FCCA in India.

FCCA was one of the main reason of Asian financial crises of 1997. Due to FCCA, companies in Thailand borrowed heavily from foreign countries for unproductive business purposes. This borrowing led to debt to GDP ratio beyond 160 % of the GDP of Thailand. The level of debt spooked the investors which resulted in capital flight from Thailand. Investors dumped assets of Thailand and converted into assets of foreign country, and since there was FCCA, the conversion happened in very short span of time. This resulted in major devaluation of the baht, currency of Thailand, because of higher demand of dollar and abundant supply of baht. India and China were remained unaffected due to tight capital control measures. Even now, Indian companies are not allowed to borrow from outside India (ECB) for unproductive purposes i.e. not for operational expenditure, and only for Capital expenditure.

In past, FCCA has been contemplated by Indian authorities, and to study the possibilities and the measures to be taken to facilitate FCCA, a committee was setup under the chairmanship of S.S. Tarapore, a former deputy governor of RBI. The committee recommended various measures to achieve macro-economic stability before facilitation of FCCA. The report included recommendations on lower targets for inflation, fiscal deficit etc. Recently, during European Union sovereign debt crises, Portugal, Ireland, Greece, and Spain (PIGS countries) were on the verge of default due to higher fiscal deficit before these were bailed out by central bank of European Union. The most important part for macro-economic stability is the lower level of debt in comparison to GDP of the country. The real devil is not the level of debt, but the ability to service that debt. As noted earlier, India, to make sure productive use of ECBs for proper service of the debt, has prohibited use of ECBs for operational activities. Macro-economic stability is very important before facilitation of FCCA.

At current juncture, India can achieve some macro-economic stability in next few years. Consumer Price Inflation (CPI) is below 6%, which is at par with the expectations of RBI. India’s fiscal deficit is improving with govt. hopeful to achieve the fiscal deficit target of 4.1% of GDP in current financial year. Tarapore committee recommended fiscal deficit target should be below 3% of the GDP which India should be able to achieve in next two financial year. Both, lower level of inflation and fiscal deficit encourage RBI to reduce the prevailing interest rates in the country therefore giving fillip to the economic activities with lower cost of capital. This will not only attracts foreign capital, but also make sure it stays into the country.

This part concludes here with understanding of capital and current account transactions and their rules of convertibility. Next part will be focused on the foreign portfolio investors. This part will have discussion of Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000 (FEMA 20).