Foreign Exchange Management Policy in India

Independence ushered in a complex web oI controls Ior all external transactions through a
legislation i.e., Foreign Exchange Regulation Act (FERA), 1947. There were Iurther
amendments made to the FERA in 1973 where the regulation was intensiIied. The policy was
designed around the need to conserve Foreign Exchange Reserves Ior essential imports such as
Petroleum goods and Iood grains. The year 1991 was an important milestone Ior the Economy.
There was a paradigm shiIt in the Foreign Exchange Policy. It moved Irom an Import
Substitution strategy to Export Promotion with suIIicient Foreign Exchange Reserves. The
adequacy oI the Reserves was determined by the Guidotti Rule, though the actual
implementation oI the rule was modiIied to meet our requirements. As a result oI measures
initiated to liberalize capital inIlows, India`s Foreign Exchange Reserves (mainly Ioreign
currency assets) have increased Irom US$6 billion at end-March 1991 to US$270 billion2 as on
9th November 2007. It would be useIul to note that the Reserves accretion can be attributed to
large Foreign Capital InIlow that could not be absorbed in the economy. This has been as a result
oI shiIt oI Iunds Irom 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 oI economic reIorms a sea change relating
to the broad approach to reIorm in the external sector took place. The Report oI the High Level
Committee on Balance oI Payments (Chairman: Dr. C. Rangarajan, 1993) set the broad agenda
in this regard. The Committee recommended the Iollowing:
O The introduction oI a market-determined exchange rate regime within limits
O Liberalization oI current account transactions leading to current account convertibility;
O Compositional shiIt in capital Ilows away Irom debt to non debt creating Ilows;
O Strict regulation oI external commercial borrowings, especially short-term debt;
O Discouraging volatile elements oI Ilows Irom non-resident Indians; Iull Ireedom Ior
outIlows associated with inIlows (i.e., principal, interest, dividend, proIit and sale
proceeds) and gradual liberalization oI other outIlows;
O Dissociation oI Government in the intermediation oI Ilow oI external assistance, as in the
1980s, receipts on capital account and external Iinancing were conIined to external
assistance through multilateral and bilateral sources.
The sequence oI events in the subsequent years generally Iollowed these recommendations. In
1993, exchange rate oI rupee was made market determined; close on the heels oI this important
step, India accepted Article VIII oI the Articles oI Agreement oI the International Monetary
Fund in August 1994 and adopted the current account convertibility. In June 2000 a legal
Iramework, with implementation oI FEMA, was put into eIIect to ensure convertibility on the
current account.
Capital Account liberalization approach
Globalization oI the world economy is a reality that makes opening up oI 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 diversiIication oI domestic savings in a portIolio oI home assets
and Ioreign assets and allows agents to reap the advantages oI diversiIication oI assets in the
Iinancial and real sector. However, the beneIits oI capital mobility come with certain risks which
should be categorized and managed through a combination oI administrative measures, gradual
opening up oI prudential restrictions and saIeguards to contain these risks.
Current scenario
The main objectives in managing a stock oI reserves Ior any developing country, including India,
are preserving their long-term value in terms oI purchasing power over goods and services, and
minimizing risk and volatility in returns. AIter the East Asian crises oI 1997, India has Iollowed
a policy to build higher levels oI Foreign Exchange Reserves that take into account not only
anticipated current account deIicits but also liquidity at risk arising Irom unanticipated capital
movements. Accordingly, the primary objectives oI maintaining Foreign Exchange Reserves in
India are saIety and liquidity; maximizing returns is considered secondary. In India, reserves are
held Ior precautionary and transaction motives to provide conIidence to the markets, those
Ioreign obligations can always be met. The Reserve Bank oI India (RBI), in consultation with the
Government oI India, currently manages Foreign Exchange Reserves. As the objectives oI
reserve management are liquidity and saIety, attention is paid to the currency composition and
duration oI investment, so that a signiIicant proportion can be converted into cash at short notice.