Foreign Exchange Management Policy in India

Overview of Indian Foreign Exchange Policy

Independence ushered in a complex web of controls for all external transactions through a legislation i.e., Foreign Exchange Regulation Act (FERA), 1947. There were further amendments made to the FERA in 1973 where the regulation was intensified. The policy was designed around the need to conserve Foreign Exchange Reserves for essential imports such as Petroleum goods and food grains. The year 1991 was an important milestone for the Economy. There was a paradigm shift in the Foreign Exchange Policy. It moved from an Import Substitution strategy to Export Promotion with sufficient Foreign Exchange Reserves. The adequacy of the Reserves was determined by the Guidotti Rule, though the actual implementation of the rule was modified to meet our requirements. As a result of measures initiated to liberalize capital inflows, India’s Foreign Exchange Reserves (mainly foreign currency assets) have increased from US$6 billion at end-March 1991 to US$270 billion2 as on 9th November 2007. It would be useful to note that the Reserves accretion can be attributed to large Foreign Capital Inflow that could not be absorbed in the economy. This has been as a result of shift of funds from developed economies to emerging markets like India, China and Russia.

From Foreign Exchange Control to Management (FERA to FEMA)

In the 1990s, consistent with the general philosophy of economic reforms a sea change relating to the broad approach to reform in the external sector took place. The Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan, 1993) set the broad agenda in this regard. The Committee recommended the following:

  • The introduction of a market-determined exchange rate regime within limits
  • Liberalization of current account transactions leading to current account convertibility;
  • Compositional shift in capital flows away from debt to non debt creating flows;
  • Strict regulation of external commercial borrowings, especially short-term debt;
  • Discouraging volatile elements of flows from non-resident Indians; full freedom for outflows associated with inflows (i.e., principal, interest, dividend, profit and sale proceeds) and gradual liberalization of other outflows;
  • Dissociation of Government in the intermediation of flow of external assistance, as in the 1980s, receipts on capital account and external financing were confined to external assistance through multilateral and bilateral sources.

The sequence of events in the subsequent years generally followed these recommendations. In 1993, exchange rate of rupee was made market determined; close on the heels of this important step, India accepted Article VIII of the Articles of Agreement of the International Monetary Fund in August 1994 and adopted the current account convertibility. In June 2000 a legal framework, with implementation of FEMA, was put into effect to ensure convertibility on the current account.

Capital Account liberalization approach

Globalization of the world economy is a reality that makes opening up of the capital account and integration with global economy an unavoidable process. Today capital account liberalization is not a choice. The capital account liberalization primarily aims at liberalizing controls that hinder the international integration and diversification of domestic savings in a portfolio of home assets and foreign assets and allows agents to reap the advantages of diversification of assets in the financial and real sector. However, the benefits of capital mobility come with certain risks which should be categorized and managed through a combination of administrative measures, gradual opening up of prudential restrictions and safeguards to contain these risks.

Current scenario

The main objectives in managing a stock of reserves for any developing country, including India, are preserving their long-term value in terms of purchasing power over goods and services, and minimizing risk and volatility in returns. After the East Asian crises of 1997, India has followed a policy to build higher levels of Foreign Exchange Reserves that take into account not only anticipated current account deficits but also liquidity at risk arising from unanticipated capital movements. Accordingly, the primary objectives of maintaining Foreign Exchange Reserves in India are safety and liquidity; maximizing returns is considered secondary. In India, reserves are held for precautionary and transaction motives to provide confidence to the markets, those foreign obligations can always be met. The Reserve Bank of India (RBI), in consultation with the Government of India, currently manages Foreign Exchange Reserves. As the objectives of reserve management are liquidity and safety, attention is paid to the currency composition and duration of investment, so that a significant proportion can be converted into cash at short notice.