First, the present situation is an outcome of the RBI's insistence that foreigners not be allowed to earn a "fixed return" (through put options or otherwise) when they exit their Indian investment, unless they comply with the relatively more stringent RBI regulatory regime governing foreign debt. Prior to 2011, there was no clear regulation restricting put options. However, the RBI reportedly issued notices to several Indian companies having foreign investment, objecting to put option clauses in the shareholders' agreement signed between their Indian and foreign shareholders. In September 2011, the Ministry of Commerce and Industry categorised transactions involving put options in favour of foreigners as "debt transactions", with retrospective effect. This tainted all transactions where an Indian shareholder of an Indian company had agreed to buy the shares of its foreign shareholders at a future date for a fixed price, because none of them complied with the stringent norms pertaining to foreign debt. The ministry withdrew the circular within a month of having issued it, after reported intense lobbying.
Finally, in January 2014, the RBI issued a circular legitimising put options in favour of foreigners subject to conditions, including that the price to be paid by the Indian resident could not be pre-fixed. The circular was faulty on several grounds. First, the logic of equating all put-option transactions with debt was flawed as the rights in a put-option transaction and a debt transaction are inherently different. For instance, a put option is not backed by a security and does not give creditor-like rights upon default. Second, even if some put options conferred creditor-like rights on the foreigner, the rationale for imposing capital controls on rupee-denominated instruments was not clear, as there were no systemic risk concerns arising from put options on equity shares. There is no similar control on rupee-denominated debt instruments.
Third, retrospectively amending the RBI regulation on put options may yield some short-term benefits of allowing Indian parties to honour their contractual obligation to foreigners. But, this would not be a "reform" at all. Many individualistic Fema "reforms" are, in fact, driven by crises situations or worse, personality-driven persuasive efforts. The absence of a statement of objective underlying controls on foreign capital has created tremendous scope for rent-seeking and ad-hoc carve-outs and exemptions. Take the external commercial borrowing (ECB) policy (the norms governing the manner in which Indian companies may borrow from foreigners), for instance. Prior to 2012, the ECB policy did not allow Indian residents to borrow in foreign exchange for working capital requirements. In 2012, the policy was revised to help cash-strapped airline companies to let them borrow for working capital requirements. It is only a matter of time before another sector is cash-strapped and lobbies the authorities to similarly relax the requirement for itself.
Similarly, over the last one year, the foreign direct investment (FDI) policy in retail was "rationalised" on a couple of instances pursuant to concerns of individual foreign investors. In November 2015 and May 2016, the CEO of Ikea and Apple met with the Indian prime minister. At the meetings, they reportedly raised concerns with the local sourcing norms mandated for foreign investors intending to invest more than 51 per cent in the Indian retail sector. Both the meetings yielded changes to the local sourcing conditions for foreign investors in the FDI policy. To be sure, the relaxations were sensible, but only illustrated the frail foundations of our law governing capital controls.
The problems with Fema run deep. One, the law lacks a statement of objective for imposing controls on foreign capital, leading to a makeshift and unpredictable approach towards imposing and relaxing controls. Two, the scheme of the law allows implicit or explicit "outs" for individual transactions from virtually every regulation in the book. This creates ample scope for rent-seeking and cronyism. For example, the regulation that impedes Tata from honouring its contractual commitment to DoCoMo has no explicit "out". However, on an application made to the RBI, the central bank was reportedly keen to allow a relaxation from the regulation. Three, apart from sectoral entry barriers, the law imposes several artificial controls that are devoid of any economic rationale. Restrictions on the form of investee entities, artificial distinctions between investment routes such as the FVCI (foreign venture capital investors) and FDI routes and between instruments through which investments may be made, and special dispensations such as dispensations to NRIs, are some examples.
Several expert committees including the U K Sinha-led working group on foreign investment and the Financial Sector Legislative Reforms Commission have recommended the rationalisation of Fema. The Indian Financial Code contains a blueprint of a simplified law governing capital controls. Relaxing the RBI regulation on put options right now would be a quick hack to solve a temporary problem. However, until we fix the fundamental design of Fema, we will be treating only the symptoms, not the disease.
The authors work with the National Institute of Public Finance and Policy