Weaknesses of recent moves on capital controls for outbound capital flows

by Gausia Shaikh and Bhargavi Zaveri.

On 30th September, 2016, RBI published a draft framework for allowing Indian residents to invest in overseas technology funds, for public comments. The draft framework lays down certain criteria on the basis of which RBI may allow an Indian resident to invest in offshore overseas technology funds (draft framework). We, at the Finance Research Group at IGIDR, submitted written comments on the draft framework.

Investing abroad offers Indian investors reduced risk through diversification of holdings. The Indian regulatory framework governing capital outflows is complex, fragmented and unduly restrictive, increasing the cost of investing in foreign securities and businesses. For instance, even at this advanced stage of liberalisation, it does not permit any Indian resident, except a listed company and a mutual fund (and in some cases, an alternative investment fund) to make portfolio investments (i.e. in listed securities) abroad. It defines what kinds of instruments may be invested in, caps the amount that can be invested, requires RBI approval to be obtained if the amount of outflow exceeds USD 1 billion, prescribes what kinds of instruments may be invested in, controls what the foreign investee entity can or cannot do, etc. In short, the regulatory framework has several features of central planning, which are not connected with any market failure arising from capital outflows.

Several expert committees constituted by the Central Government and RBI in the past have underscored the need to simplify the regulatory framework governing capital outflows (See the Tarapore Committee Report (2006), the Report of the Working Group on Foreign Investment (2010) and the Report of the Financial Sector Legislativ e Reforms Commission (2013)). For instance, the report of the Raghuram Rajan Committee (2008) states:

We also need to make it easier for our individuals and institutions to invest abroad. For individuals, the primary task may be to simplify procedures, and liberalize the kinds of assets and managers that can be invested in. For our institutions like pension funds, we have to convince various constituencies that a portfolio diversified across the world is safer than a portfolio concentrated only in India, and has better risk properties (for one, it retains value when the Indian economy suffers a downturn). Regulatory authorities then have to allow institutional portfolios to become broadly and internationally diversified.

Restrictions on capital outflows

The International Monetary Fund has, in its paper titled Liberalizing Capital Outflows and Managing Outflows, summarised the existing literature and understanding of capital flow measures in partially capital account convertible countries (like India) and has suggested a policy framework governing capital outflows. Among other things, the suggested policy framework makes the following recommendations:

1. In countries that have substantially liberalised their capital account, capital outflows must be managed primarily with macro-economic and financial sector policies.
2. Capital flow measures on outflows may be considered in (i) crisis or near crisis situations; or (ii) to provide breathing space while more fundamental policy adjustment is implemented. Such measures ought to be temporary in nature and must be lifted once the crisis is controlled.
3. Even when capital flow measures are imposed, they must not be residency-based. Examples of residency-based measures include measures on residents' investments and transfers abroad, restrictions on investments in financial instruments, etc.

Problems with the draft framework

In the context of the understanding summarised above, we submitted the following inputs on the draft proposal to allow Indian residents to invest in "overseas technology funds" after obtaining the approval of RBI.

Allowing Indian residents to invest in funds managed and invested abroad.

The draft framework makes an artificial distinction between what it calls 'overseas tech funds' and other funds, and then relaxes the existing restrictions on Indian residents from investing in overseas tech funds. There appears to be no economic rationale supporting a case for allowing Indian residents to invest in some kinds of funds and not others. Interventions in the policy governing capital outflows, must be supported by a consistent economic rationale linked to identified market failures. Similarly, relaxations in such policy must be crafted in accordance with sound principles of public economics.

Principles of public administration and rule of law

The draft framework gives the following reason for allowing Indian residents to invest in overseas tech funds:

Reserve Bank (sic) has been receiving references from various Indian parties to invest in Overseas Technology Funds which in turn will further invest in overseas technology startups. Such proposals generally do not meet the eligibility norms for making the overseas direct investment under the automatic route ... It is proposed that the Reserve Bank will deal with such requests under the approval route ...

The reason for relaxation is linked to repeated requests from Indian residents to invest in overseas tech funds. This perpetuates the ad-hoc nature of relaxations that has pervaded the Indian regulatory framework governing capital controls in India. On this blog, we have repeatedly written about ad-hoc measures, both restrictions and relaxations, that seem to pervade the fabric of our law governing capital controls (see, for example, here and here.). While such relaxations may bring temporary cheer to a few stakeholders, such ad-hocism is dangerous as it has bad outcomes for the overall predictability of a regulatory regime in the long run.

Moreover, by mandating Indian residents to approach the RBI for approval for investing in overseas tech funds, even where the Indian resident satisfies the criteria specified in the draft framework, the draft framework perpetuates the approval route mechanism under our regulatory regime. A mature regulatory framework governing capital outflows should leave no scope for the exercise of discretion. The criteria for allowing or not allowing investment abroad must be clearly laid out in the law. Once an Indian resident satisfies such criteria, the investment must be allowed without having to approach any authority for approval. This reduces the transaction costs of investing abroad as well as the scope for exercising ad-hoc discretion.

Lack of clarity and perpetuating central planning

For a framework so limited in its applicability to investment in a specific kind of fund, the draft framework is unclear on fundamental concepts on which it hinges. For instance, although the primary purpose of the draft framework is to regulate investment in an overseas tech fund, it does not define the concept of an "overseas tech fund" and "overseas tech start-up". To the best of our knowledge, there is no globally accepted definition of what constitutes an overseas tech fund or a tech start-up. The vagueness leaves scope for tremendous discretion and potential for abuse.

The draft framework perpetuates the culture of central planning by defining the eligibility criteria for Indian residents who may invest in overseas tech funds. For instance, it allows only listed companies in India with a profit track record and a minimum networth to invest in overseas tech funds. Similarly, it states that Indian companies which have ``long overdue export'' bills are disallowed from investing in overseas tech funds. An investment in a foreign security is an investment decision just like any other investment in the portfolio of an investor. In a mature market economy, long overdue export bills cannot be a ground for disallowing an Indian resident from investing abroad. None of these restrictions are backed by any economic rationale. The requirement of obtaining approvals from RBI for making such investments further perpetuates the central planning culture of 1990s.

Conclusion

In view of the above, we made the following recommendations with respect to the draft framework:

1. The framework must not distinguish between overseas tech funds and others. Indian investors must be given the benefit of diversifying their portfolios by allowing investment in all kinds funds managed and investing abroad. Apprehensions of round-tripping and money laundering must be dealt with under the respective taxation and anti-money laundering frameworks that already exist in India. Such apprehensions alone should not be a ground for pre-empting Indian residents from investing in diversified funds abroad.
2. The framework must depart from the central planning approach of defining eligibility criteria for Indian residents who may invest in funds managed and investing abroad.
3. The framework must lay down the criteria for allowing Indian residents to invest in funds managed and investing abroad, by incorporating them in the regulatory framework (namely, the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 or FEMA 120) itself, in a clear and precise manner. Once these criteria are complied with, there should be no requirement of further approval from RBI.

The authors are researchers at the Indira Gandhi Institute of Development Research, Mumbai.