Backstage Theatrics of Economical Apparatus
India’s post-independent economic regime was governed by the principle of self-reliance, growth, modernisation and social justice. Colonial exploitation induced the State to reduce foreign interference in India’s economic decisions.
After independence, the Foreign Exchange Regulation Act, 1947 was implemented in consonance with the five-year plans with minor structural changes.
Indian Government approached towards the resurrection of economic growth by adopting the fundamentals of mixed economy. The State emphasised on the development and protection of domestic Indian industries with a wider State control over the operations of the businesses. Imports and investment in key industries from foreign countries were discouraged to reduce the dependence on the foreign countries except oil and petroleum. The public and private spheres were demarcated and were regulated by State.
India aimed import substitution and developed the national economy to become self-reliant. In this regard, the Nehru-Mahalanobis Model was constructed to capitalise heavy industries. This “creation of assets” was imperative to form basic infrastructure of other industries. But the assumption of a closed economy transformed into “export pessimism”. Private industrialists were reluctant to capitalise on emerging industry due lack of funds and incentives to encourage investment. So, the concentration of power and wealth in the hands of the State manifested the socialistic pattern.
The second five-year plan and the Industrial Policy Resolution of 1956 underpinned the licence raj system.
(a) The categorisation of the industries into three schedules paved the way for the “system of licensing” by the virtue of the Industries Development and Regulation Act (IDRA), 1951. The repercussions of “licence raj” impacted the growth and expansion of private sector and investment as big industrialists juxtaposed with budding or prospective industrials misused the system. On the other hand, the foetus industries bore the brunt of the red-tapism and strict licence compliances with respect to region, capital, expansion and production.
(b) Imports were subjected to high tariff rates and quotas to protect the domestic industries. Foreign Direct Investment (FDI) was allowed on mutually advantageous agreements without any financial participation. It means on one hand; they restricted the participation of the foreign exchange in the national economy. On the other hand, India endeavoured to attract the foreign investments in lieu of capital and technology. For instance, strategic industries like power, oil, petroleum, mining, banking and airlines sought technical and financial assistance from Russia, Germany and the United Kingdom.
However, due to shortage of foreign exchange, the prices rose by 30% with growth at a staggering rate of 4.3%. The bureaucratism and the State capitalism coupled with sheer ignorance of the interplay of market forces curtailed the flow of foreign exchange in India. In addition to it, the public borrowings were pegged at a low rate of interest further restraining the savings.
The focus of the State remained on the mobilisation of savings and investment even at the cost of generation and facilitation of investment. The State behaved as a conservative parent to protect the domestic industry like an infant instead of giving opportunity and incentivising the development in an open economy.
Subsequently, the failure of the third five-year plan led to the devaluation of money and inflationary recession. This ongoing foreign exchange crisis facilitated the liberalisation of FDI in the manufacturing sector to finance the foreign exchange. The private foreign investment showed some increment in 1959. Companies like Cadbury Chocolates, Tube Investments, Reckitt and Coleman, Horlicks, Pfizer, Parke-Davis, Otis Elevator, Coke, Pepsi, Vicks, Nestle, Siemens, Pharmacia, Hoechst, BASF entered India.
However, this brief timeline of FDI inflow had ramifications which subdued private investment in India.
(a) Firstly, local industries bore the brunt of technological development. It failed to keep pace with the budding competitiveness from both foreign industries and domestically sound industries in terms of capital, technology, managerial skills and entrepreneur skills.
(b) Secondly, the concessions and incentives which initially profited and attracted the foreign companies led to the outflow on account of remittances of dividends, profits, royalties and technical fee abroad on account of servicing of FDI.
(c) Thirdly, the oil crisis of 1973 worsened the geo-political scenario and adversely impacted the supply of oil due to rise in the prices from $3 per barrel to $12. The oil crisis severely impacted the balance of payments, ultimately leading to taking immediate action in order to conserve the foreign exchange.
Conservative Approach to Foreign Exchange Mechanism in India
The above panoramic view of the economic regime necessitated the legislation of the Monopolies and Restrictive Trade Practices Act, 1969 (MRTP) and the Foreign Exchange Regulation Act, 1973 (FERA). The objective of FERA was to conserve and regulate the foreign exchange within the country in the backdrop of paucity of foreign exchange. It was to ensure proper utilisation of foreign exchange resources in the economic development of India. It aimed at boosting the capital market by regulating the foreign exchange reserves and placing restrictions on profits of MNC’s and helped local businesses to raise capital.
(a) Clause 29 of FERA restricted the establishment of a place of business and acquisition of undertaking in India subject to the permission of RBI. Ownership was pegged up to 40% which required prior permission for sale and pricing of shares.
The provisions of FERA were implemented according to the regulatory framework by the Department of Industrial Development.
According to the rules by the Ministry of Industry, in order to protect small-scale industries, technical and financial foreign collaboration was not considered where indigenous technology was fully developed. Foreign collaborations were only permitted in highly export oriented or sophisticated technological industries. However, it had to fulfil the export obligations by exporting a certain minimum part of annual turnover.
Foreign equity was allowed up to 74% in industries which complied with 60% of export obligations. On the other hand, firms producing goods using highly sophisticated technology for domestic use up to 75% were allowed to have foreign equity by 74%. Foreign firms were permitted to set up industries in the “core” and “heavy industries” except for industries reserved for the public sector. High priority industries which required highly advanced technology and large investments were given automatic permission with foreign equity allowed up to 51%. The decisions related to payments and foreign exchange vested with the RBI. Permissible range of royalty payments and technology transfer agreements were specified for different industries. Foreign investors were barred in trading and industries dealing with consumer goods.
As a result, the manufacturing sector, particularly chemical and metal-based industries, food and beverages industries attracted the foreign direct investment.
It has been observed that business either follows the law to the letter or leaves the country or negotiates or takes pre-emptive action to comply with the regulatory framework of the foreign ownership. Such reaction is imperative to determine the behavioural changes in international business when the legislative regime becomes regulatory in nature.
(a) In response to the legal regime, big companies such as ITC, Ponds, Colgate-Palmolive diluted their foreign equity through public shares. Coca-Cola and IBM decided to leave the Indian territory because they did not want to disclose the secrets behind their products’ formula.
(b) According to the RBI annual report 1977-1978, around 54 companies out of 841 cases had wound up.
(c) Some companies negotiated with the Government to avoid divestment. The deliberations and tactics made by the business houses rendered the implementation of FERA tardy.
(d) Hindustan Unilever diversified its business by revamping the operations in a technologically advanced fashion along with increasing exports sales in the 1970’s. On the other hand, the business of ITC which was susceptible to Indianisation due to the nature of its business, diluted equity in order to raise funds for diversification in new product lines and businesses.
The implication of the responses of business is significant to understand how the implementation of FERA deviated from the objective of its formation. FERA failed in restricting the activities of the MNCs in India. Moreover, the decrease in foreign reserves due to dividend payments accounted for only 4% on which restrictions of FERA were imposed while the major account of flow of foreign exchange (85%) was constituted by imports itself.
The regulatory regime in pursuit of conserving the scarce foreign exchange, thus divorced itself from generating funds of investment from external sources. RBI was the sole authority to grant approvals and permissions to the dealers as well as rate of foreign exchange. Any violation would invite a criminal obligation with the offender being at sole mercy of the Enforcement Directorate.
The gap between the intent of FERA and actual implementation manifested the reasons behind the failure of the “regulative” and “prohibitive” legislative framework for FDI in India.
(a) Firstly, the foreign companies who were directed to dilute their share of equity to transfer the ownership to Indians became “domestic” enterprises. Such industries were granted licences which gave them an opportunity to diversify and expand. The capital generated from such dilution of equity was used to establish industries in which they were prohibited earlier as “foreign enterprise” displacing the small-scale enterprises.
(b) Secondly, the companies diversified and expanded by technological collaborations. So the additional royalty payments, technical fees, raw material import bills led to the outflow of foreign exchange.
(c) Thirdly, the myopic view in the generation of savings for investment by the public sector is the failure of the planning process. Instead, the savings were consumed by the public sector due to which the State had to borrow not only to meet the revenue expenditure but also to finance the deficit and investment.
(d) Fourthly, due to financial repression, the nationalisation of banks and restrictions of the capital market further hindered the growth of the economy.
(e) Fifthly, the reservation of the public sector and domestic industries led to the failure in the development of the domestic industries.
Due to these reasons, the gap between the public revenue and expenditure widened. This led to increased borrowing from IMF (International Monetary Fund) in the form of SAP (structural adjustment program). The economic and industrial landscape in India shook the international confidence and credit rating. The apparent mismanagement of the public sector and repercussions of FERA led to the liberalisation in industrial and trade policies. The pre-1991 liberalisation was at infancy stage which underpinned the formulation of the New Economic Policy, 1991 (NEP). The disequilibrium of the balance of payments (reduction in foreign exchange reserves) led to the structural reformation known as New Economic Policy, 1991.
FEMA (Foreign Exchange Management Act) as Protagonist of the Economic Liberalisation
NEP, 1991 centered around the reduction of State interference in the economy and delicensing of major industries without any investment limits. On the proposed recommendations of the Tarapore Committee, construction of a proper legislative framework was suggested. According to the recommendations, it was necessary to design a legislative framework compatible with “facilitative” or “liberal” ideas of structural reforms. The financial liberalisation came as a tool to promote and facilitate industrialisation in a mixed economy.
As an outcome, Foreign Exchange Management Act, 1999 (FEMA) was enacted to facilitate external trade and payments and to promote orderly maintenance of foreign exchange market in India. In simpler words, FEMA was enacted to remove the hindrances in the inflow of FDI in India. The role of FEMA was to make the business environment conducive to globalisation and to facilitate the incoming of foreign direct investment in India. It governed the liberal aspect of cross-border transactions in the integration of the economies.
(a) Any violation of FEMA, 1999 now attracted civil liability instead of a criminal one as in FERA, 1973. FERA was portrayed as a draconian act and an impediment to the growth of investments in India. The decriminalisation of FERA was a manifestation of a calibrated approach to make the foreign exchange regulations an effective legislation.
(b) NRI and OCB were given the permission to invest 100% in the high priority areas.
(c) The distinction between the role of RBI and Central Government was made. The power to regulate the provisions of FEMA act vested with the RBI viz. Section 47, FEMA, 1999.
The FDI processes post 1991 were classified into automatic and governmental routes.
(a) The automatic routes allowed up to 51% FDI to the industries provided in Industrial Policy Resolution, 1991 after informing the RBI. Government route provided for Foreign Investment Promotion Board (FIPB). FIPB is a single window clearance mechanism for proposals which are not conventionally permitted under the automatic route. It was an amicable process with speedy and transparent mechanism divorced from the red-tapism to encourage FDI in India.
India’s agreement to the status and obligations of International Monetary Fund (IMF), Article VIII provides: … that members shall not impose or engage in certain measures, namely, restrictions on the making of payments and transfers for current international transactions, discriminatory currency arrangements, or multiple currency practices, without the approval of the Fund.
(a) This opened the gates for the market determination of the foreign exchange rate and paved the way for the current account convertibility in 1993.
(b) Since 1993 significant developments took place such as substantial increase in foreign exchange reserves, growth in foreign trade, rationalisation of tariffs, current account convertibility, liberalisation of Indian investments abroad, increased access to external commercial borrowings by Indian corporates and participation of foreign institutional investors in our stock markets.
(c) At the same time, capital account convertibility (CAC) was not initiated due to the prospective ill-effects of CAC in the backdrop of low foreign exchange reserves and disequilibrium in the balance of payments in India.
(d) Adding to the miseries of the Indian economics, the crisis of Mexican and East Asia in 1997 hampered the capital inflow in a liberal capital market. It highlighted the significance of the capacity of the developing economy to prudentially regulate the capital inflow. The newly liberalised economy of India was thus cautioned by the repercussions arising out of the reversed capital inflow.
(e) Consequently, the liberalisation of the capital accounts were effectuated cautiously. They realised the obligations of IMF were not to be construed mechanically, instead, must be subject to certain amount of control and procedural regulations.
Foreign direct investments in India are regulated by Section 6(3)(b) and Section 47 of FEMA, 1999 read with Foreign Exchange Management (Transfer or Issue of a Security by a Person Resident Outside India) Regulations, 2000.
The enactment of FEMA was a tool of the phased liberalisation after 1999 to facilitate convertibility of the capital account transactions. Unlike its predecessor, FEMA did not put an umbrella prohibition on the inflow current account and capital account transactions. Instead, it facilitated the inflow of foreign capital and investments, except some reasonable restrictions in the interest of the public view. Capital account transactions, although liberalised to a certain extent, were regulated by RBI to limit the class of transactions which are to be permitted governed by the Foreign Exchange Management (Permissible Capital Account Transactions) Regulations, 2000.
By the virtue of Section 2 of FEMA, the transactions which are explicitly permitted by the RBI in consultation with the Central Government are allowed except:
(a) transactions involving debt instruments; and
(b) durawall of foreign exchange for payments due on account of amortisation of loans or not depreciation of direct investments in the ordinary course of business.
It can be concluded that the transformation in the legislative regulatory framework from a socialist economy to mixed economy is a “gradualist” approach. The systematic structural reform was fundamental in the growth dynamics of capital inflow in India. The amalgamation of the private and public sector had a colossal implication on the investment climate. The participation in the financial globalisation accelerated growth by developing a competitive environment.
The de jure status of FEMA facilitated the robust inflow of investment in the period of economic liberalisation. The enactment of FEMA divorced itself from the conventional skepticism of socialist economy and robustly complemented the macromanagement of foreign exchange flow.
The transition from FERA to FEMA was a fundamental key to create the accessibility to the Indian market for foreign investors. The dawn of FEMA not only succeeded in facilitating the FDI but also generated ample opportunities of economic growth and development.
*Bhumesh Verma is Managing Partner at Corp Comm Legal and can be contacted at email@example.com. **Namrata Singhal, Third year BBA LLB student, Student Researcher and can be contacted at firstname.lastname@example.org
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