The two-decade gap

Indian Express, 6 September 2010

The U K Sinha report has recommended cleaning up of India'a capital control regime, bringing in principles of transparency and rule of law to an opaque system of regulations that have become a maze over the years. Proposed changes include a single window for portfolio investment, an applelate body for decisions made under FEMA and changes in regulations that smart lawyers help investors find ways around.

Under British rule, India had full capital account convertibility. Shortly after investment, comprehensive capital controls were brought in, and the dreaded FERA criminalised violations of capital controls. In the crisis environment of the early 1990s, the Foreign Institutional Investor (FII) framework was invented. This was a difficult time for policy makers given that there was a crisis and a lack of knowledge about how an open economy functions.

When the FII framework was setup in the early 1990s, at first, tiny sums of money came in. The framework had flaws, and more importantly, the domestic capital markets were not ready. It took ten years to setup SEBI and NSE, to do dematerialisation, to launch derivatives trading and close down `badla'. By the early 2000s India was ready to accept foreign investment, and then the numbers galloped ahead. Through this entire period, numerous small changes were made to the framework of capital controls. These incremental changes were well intentioned in that they aimed to solve specific problems.

By March 2009, listed companies had foreign capital of Rs.3.6 lakh crore - an enormous sum of money by any standard. Foreigners are bearing both business risk and currency risk in investing in Indian companies. This risk capital has enabled building factories, giving jobs and increasing India's GDP. Today, roughly a fifth of the stock of equity capital in listed companies is from foreigners. While this lags what other emerging markets have achieved, it is a respectable achievement.

Events like the India's nuclear tests, the election of a left supported government in May 2004, the Satyam scam and the Gujarat riots caused turmoil in stock markets but foreign investors had divergent views. While some sold shares to leave India, others treated this as a chance to buy cheap. On the whole, foreign investors have not been fair weather friends - the exits from India under stressed conditions have been modest. Foreign investors have not acted in a herd - on most days, foreign buying and foreign selling, put together, is more than 20 times bigger than the net foreign buy. Foreigners are just like locals in that they have divergent opinions about what to buy and what to sell.

Today, we have 20 years of experience with how foreign investors behave. We also have 20 years of accumulated incremental changes to law, which has yielded a mess. A variety of transactions require complicated gymnastics in order to navigate the complexity of the law. This benefits lawyers, but hurts everyone else.

In the last 20 years, we have also learned modern principles of financial regulation, about the rule of law. Rule of law requires clarity of drafting subordinated legislation, a requirement that government produce reasoned orders for every action, a requirement that orders be placed on websites for transparency and to ensure equal treatment, and an appeals procedure. Many of these features are now everyday reality with SEBI, but are mostly absent with capital controls.

Another important change that has occurred in recent years is that after the 9/11 attacks, the world has become much more concerned about being able to track terror finance. The FII framework involved a registration at SEBI, but this registration process is inadequate when compared with present thinking, and given India's new membership of the Financial Action Task Force (FATF). Regulations need to change in the new environment.

A recent report led by U. K. Sinha at the request of the Ministry of Finance addresses these issues. First, the report calls for bringing about high quality rule of law in the field of capital controls. It asks that SEBI and RBI come up to high standards on the problems of well drafted subordinated legislation, acting only in writing, producing reasoned orders, placing reasoned orders on a website, and giving aggrieved parties the ability to appeal at SAT, or a similar appelate body.

The second big idea of of the report is to replace the existing multiple frameworks (FII, FVCI, etc) through which financial flows come into India by a single framework which is termed `QFI'. Under the QFI the foreign investor would have to perform one KYC with an Indian bank and another KYC with an Indian depository participant. After this, he would be able to transact on the Indian securities markets and engage in other kinds of financial flows. The QFI framework simultaneously brings India up to the post-9/11 world in terms of safety, and removes the considerable legal complexity and overhead which has crept up in recent years.

A key feature of the QFI framework is that the capital controls regime would no longer distinguish between the kinds of vehicles through which capital comes into India. Under the QFI framework, the Indian capital controls would identically treat a pension fund or an insurance company or a venture capital fund that buys shares in an Indian company. The present attempts at distinguishing between vehicles increases costs for foreigners. In addition, they are futile: the foreign investor who is prohibited from doing work under one garb has to merely repackage his money into a different garb and then come into the country.

Much more is needed to be done in terms of moving India forward towards greater capital account openness. The Sinha report is valuable in that it replicates the present realities - the facts on the ground - by a cleaner legal framework. It upholds the rule of law, is a part of building India into a modern market economy, reduces legal risk, clarifies the picture in the eyes of foreigners, and reduces payments to lawyers.

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