Foreign Exchange Management Act (FEMA) | Financial Management

Foreign exchange in India has been regulated in one form or the other since Independence. The Foreign Exchange Regulation Act (1947) was enacted as a temporary measure to deal with an acute foreign exchange crunch in the post-World War II period. Since the foreign exchange position continued to remain precarious, this temporary measure was made permanent in 1957. In 1973, this Act was repealed and replaced by the Foreign Exchange Regulation Act (FERA), 1973. Its objective was to conserve foreign exchange resources and ensure their proper utilization.

The dreaded FERA was a rigid piece of legislation that made contravention of the provisions of the Act a criminal offence, and gave sweeping powers for search and seizure under which the person suspected of having broken any rule had to prove his innocence beyond reasonable doubt. It governed foreign exchange activities of the country up to 1999.

In the light of the LPG (liberalization, privatization, and globalization) efforts undertaken since 1991, it was felt that FERA (1973) was a draconian piece of legislation whose focus was not in keeping with the new direction given to the economy. After much deliberation, it was replaced by the Foreign Exchange Management Act (1999) or FEMA. At present, all foreign exchange activities in India are governed by FEMA.

FEMA came into effect in June 2000 and its provisions are available on the RBI’s website. FEMA differs from FERA (1973) in several aspects. The most important is in its intent. FEMA does not view foreign exchange as a scarce resource that must be conserved and hoarded, but as a mechanism through which external trade can be promoted. It is interested in the ‘orderly development and maintenance of the foreign exchange market in India’.

With these twin objectives FEMA seeks to regulate the Indian foreign exchange market. FEMA is a marked departure from FERA because the latter was focused on punitive measures on violation of its provisions, and created an atmosphere of fear, stealth and secrecy when it came to foreign exchange activities of Indian citizens. In contrast, FEMA is much more benign in its approach. It accepts the cross-border movement of funds as a necessity in an era of increased integration of world financial markets, upsurge in foreign direct investment, and liberalization of trade under the aegis of the World Trade Organization (WTO).

It does not view outflows of foreign exchange as an evil that must be checked, but rather as a reality that must be factored into the foreign exchange management process. Thus, it places greater importance management of foreign exchange than on conservation of foreign exchange. This is in keeping with the general rules regarding any asset management decision taken by business firms on a daily basis.

Asset management aims at optimal asset holdings, and on taking decisions that maximize their value. This is how FEMA must be viewed, except that the value maximization is conducted from the macroeconomic point of view.

The main differences between FERA and FEMA are given below:

Distinction between FERA and FEMA:

FERA (1973):

i. Scope applicability – In India

ii. Jurisdiction – Outside India to all citizens of India to all branches and agencies, registered or controlled by persons resident in India

iii. Objective – Conservation of foreign exchange

iv. Assumption – Foreign exchange is a scarce resource that must be protected and used with great care

v. Definition of Authorized Person – Authorized dealers and money changers

vi. Nature of Law – Imposed criminal liability for violation of provisions

FEMA (1999):

i. Scope applicability – In India

ii. Jurisdiction – Outside India to all branches, offices and agencies owned and companies and bodies corporate incorporated in India, and owned and controlled by citizens of India

iii. Objective – Management of foreign exchange

iv. Assumption – Foreign exchange is an asset that must be properly managed

v. Definition of Authorized Person – Authorized dealers, money changers, and offshore banking units

vi. Nature of Law – Imposes only civil liability for violation of provisions

Important terms and definitions under FEMA 1999 are given below:

Foreign exchange includes:

i. Foreign currency (defined as any currency other than Indian currency)

ii. Deposits, credits and balances payable in foreign currency

iii. Drafts, travellers’ cheques, letters of credit, bills of exchange, either expressed or drawn in Indian currency but payable in a foreign currency

iv. Drafts, travellers cheques, letters of credit, bills of exchange, drawn by banks, institutions or persons outside India but payable in Indian currency

Foreign security includes:

i. Any security in the form of shares, stocks, bonds, and any other instruments denominated and expressed in foreign currency

ii. Any security in the form of shares, stocks, bonds, and any other instruments denominated and expressed in foreign currency, on which return (in the form of interest or dividend) is payable in Indian currency

iii. Any security in the form of shares, stocks, bonds, and any other instruments denominated and expressed in foreign currency, in which the redemption proceeds are payable in Indian currency

A person resident in India includes:

i. A person residing in India for more than 182 days in the preceding financial year. Thus with regard to an individual, FEMA focuses on resident status, while FERA focused on citizenship.

ii. Anybody corporate registered or incorporated in India

iii. An office, branch or agency located in India, and owned and controlled by a person residing outside India

iv. An office, branch or agency located outside India, and owned and controlled by a person residing in India.

FEMA divides all cross-border transactions by persons resident in India into two categories – capital account transactions and current account transactions.

Under Section 2 (e) of the FEMA, a capital account transaction is defined as:

i. Any transaction that the RBI specifies as being a capital account transaction.

ii. A transaction that alters the assets and liabilities (including contingent liabilities) outside India, of persons residing in India

iii. A transaction that alters the assets and liabilities (including contingent liabilities) in India, of persons residing outside India

Under Section 2(j) of the FEMA, a current account transaction is one that is not a capital account transaction.

Therefore, current account transactions include:

i. Payments made for foreign trade in goods and services, current business, short-term banking and credit facilities, in the ordinary course of business

ii. Payments made for expenses incurred due to foreign travel, education, or medical needs of spouse, children and parents

iii. Remittances overseas for living expenses of spouse, children and parents

iv. Payments due as interest on a loan, or net income from investments

Under FEMA, a person resident in India is free to buy and sell foreign exchange from an authorized person, that is, a person authorized by the RBI to undertake foreign exchange transactions. An authorized person’ under FEMA includes authorized dealers, money changers and offshore banking units. An offshore banking unit is a unit located overseas that conducts banking operations with non-residents.

Many Indian banks such as State Bank of India and Bank of Baroda have offshore banking units in Bahrain, Hong Kong and Cayman Islands. By including offshore banking units, FEMA has a wider scope as FERA included only authorized dealers and moneychangers.

From the definition of current account transactions, it is apparent that FEMA gave ex post sanction to current account convertibility. At first glance it may appear that FEMA like FERA continues to emphasize outflows of foreign exchange rather than inflows, because the former are seen as requiring management while the latter are not viewed as a major concern. But this is not entirely accurate. FEMA places equal emphasis on capital account transactions, which are loosely defined as ‘altering the assets/liabilities’.

Assets and liabilities get altered in many ways, and one of them is through overseas borrowing by Indian businesses. Though this will result in an inflow of foreign exchange in the short term, it commits the business to cash outflows in the form of periodic interest payments to be made in foreign exchange, and repayment of principal, also in foreign exchange. So an external borrowing impacts future foreign exchange outflows, and this is taken cognizance of both by FEMA and by the Ministry of Finance.