How Progression of FERA to

FEMA has helped Indian markets

for healthy growth & decent Forex
reserves

Prepared by:

Ashish Anchaliya (03)

Jay Barchha (05)

Rahul Govil (07)

Swati Jain (09)

Vipin Kumar (11)

NMIMS
FERA TO FEMA:

Independence ushered in a complex web of controls for all external transactions through a
legislation i.e., Foreign Exchange Regulation Act (FERA), 1947. There were further
amendments made to the FERA in 1973 where the regulation was intensified. The policy was
designed around the need to conserve Foreign Exchange Reserves for essential imports such
as Petroleum goods and food grains. The year 1991 was an important milestone for the
Economy. There was a paradigm shift in the Foreign Exchange Policy. It moved from an
Import Substitution strategy to Export Promotion with sufficient Foreign Exchange Reserves.
The adequacy of the Reserves was determined by the Guidotti Rule, though the actual
implementation of the rule was modified to meet our requirements. As a result of measures
initiated to liberalize capital inflows, India’s Foreign Exchange Reserves (mainly foreign
currency assets) have increased from US$6 billion at end-March 1991 to US$270 billion2 as
on 9th November 2007. It would be useful to note that the Reserves accretion can be
attributed to large Foreign Capital Inflow that could not be absorbed in the economy. This has
been as a result of shift of funds from 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 of economic reforms a sea change
relating to the broad approach to reform in the external sector took place. The Report of the
High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan, 1993) set the
broad agenda in this regard. The Committee recommended the following:

• The introduction of a market-determined exchange rate regime within limits

• Liberalization of current account transactions leading to current account
convertibility;
• Compositional shift in capital flows away from debt to non debt creating flows;
• Strict regulation of external commercial borrowings, especially short-term debt;
• Discouraging volatile elements of flows from non-resident Indians; full freedom for
outflows associated with inflows (i.e., principal, interest, dividend, profit and sale
proceeds) and gradual liberalization of other outflows;
• Dissociation of Government in the intermediation of flow of external assistance, as in
the 1980s, receipts on capital account and external financing were confined to
external assistance through multilateral and bilateral sources.

The sequence of events in the subsequent years generally followed these recommendations.
In 1993, exchange rate of rupee was made market determined; close on the heels of this
important step, India accepted Article VIII of the Articles of Agreement of the International
Monetary Fund in August 1994 and adopted the current account convertibility. In June 2000
a legal framework, with implementation of FEMA, was put into effect to ensure
convertibility on the current account.
Capital Account liberalization approach

Globalization of the world economy is a reality that makes opening up of 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 diversification of domestic savings in a
portfolio of home assets and foreign assets and allows agents to reap the advantages of
diversification of assets in the financial and real sector. However, the benefits of capital
mobility come with certain risks which should be categorized and managed through a
combination of administrative measures, gradual opening up of prudential restrictions and
safeguards to contain these risks.

Current scenario

The main objectives in managing a stock of reserves for any developing country, including
India, are preserving their long-term value in terms of purchasing power over goods and
services, and minimizing risk and volatility in returns. After the East Asian crises of 1997,
India has followed a policy to build higher levels of Foreign Exchange Reserves that take into
account not only anticipated current account deficits but also liquidity at risk arising from
unanticipated capital movements. Accordingly, the primary objectives of maintaining Foreign
Exchange Reserves in India are safety and liquidity; maximizing returns is considered
secondary. In India, reserves are held for precautionary and transaction motives to provide
confidence to the markets, those foreign obligations can always be met. The Reserve Bank of
India (RBI), in consultation with the Government of India, currently manages Foreign
Exchange Reserves. As the objectives of reserve management are liquidity and safety,
attention is paid to the currency composition and duration of investment, so that a significant
proportion can be converted into cash at short notice.

The Foreign Exchange Regulation Act of 1973 (FERA) in India was repealed on 1st June,
2000. It was replaced by the Foreign Exchange Management Act (FEMA), which was
passed in the winter session of Parliament in 1999. Enacted in 1973, in the backdrop of acute
shortage of Foreign Exchange in the country, FERA had a controversial 27 year stint during
which many bosses of the Indian Corporate world found themselves at the mercy of the
Enforcement Directorate (E.D.). Any offense under FERA was a criminal offense liable to
imprisonment, whereas FEMA seeks to make offenses relating to foreign exchange civil
offenses. FEMA, which has replaced FERA, had become the need of the hour since FERA
had become incompatible with the pro-liberalization policies of the Government of India.
FEMA has brought a new management regime of Foreign Exchange consistent with the
emerging frame work of the World Trade Organization (WTO). It is another matter that
enactment of FEMA also brought with it Prevention of Money Laundering Act, 2002 which
came into effect recently from 1st July, 2005 and the heat of which is yet to be felt as
“Enforcement Directorate” would be investigating the cases under PMLA too.

Unlike other laws where everything is permitted unless specifically prohibited, under FERA
nothing was permitted unless specifically permitted. Hence the tenor and tone of the Act was
very drastic. It provided for imprisonment of even a very minor offence. Under FERA, a
person was presumed guilty unless he proved himself innocent whereas under other laws, a
person is presumed innocent unless he is proven guilty.
Objectives and Extent of FEMA

The objective of the Act is to consolidate and amend the law relating to foreign exchange
with the objective of facilitating external trade and payments and for promoting the orderly
development and maintenance of foreign exchange market in India. FEMA extends to the
whole of India. It applies to all branches, offices and agencies outside India owned or
controlled by a person who is a resident of India and also to any contravention there under
committed outside India by any person to whom this Act applies.

Except with the general or special permission of the Reserve Bank of India, no person can :-

• deal in or transfer any foreign exchange or foreign security to any person not being an
authorized person;
• make any payment to or for the credit of any person resident outside India in any
manner;
• receive otherwise through an authorized person, any payment by order or on behalf of
any person resident outside India in any manner;
• Reasonable restrictions for current account transactions as may be prescribed.

Any person may sell or draw foreign exchange to or from an authorized person for a capital
account transaction. The Reserve Bank may, in consultation with the Central Government,
specify:-

• any class or classes of capital account transactions which are permissible;

• the limit up to which foreign exchange shall be admissible for such transactions

However, the Reserve Bank cannot impose any restriction on the drawing of foreign
exchange for payments due on account of amortization of loans or for depreciation of direct
investments in the ordinary course of business.

The Reserve Bank can, by regulations, prohibit, restrict or regulate the following:-

• Transfer or issue of any foreign security by a person resident in India;

• Transfer or issue of any security by a person resident outside India;
• Transfer or issue of any security or foreign security by any branch, office or agency in
India of a person resident outside India;
• Any borrowing or lending in foreign exchange in whatever form or by whatever name
called;
• Any borrowing or tending in rupees in whatever form or by whatever name called
between a person resident in India and a person resident outside India;
• Deposits between persons resident in India and persons resident outside India;
• Export, import or holding of currency or currency notes;
• Transfer of immovable property outside India, other than a lease not exceeding five
years, by a person resident in India;
• Acquisition or transfer of immovable property in India, other than a lease not
exceeding five years, by a person resident outside India;
• Giving of a guarantee or surety in respect of any debt, obligation or other liability
incurred
(i) By a person resident in India and owed to a person resident outside India or

(ii) By a person resident outside India.

A person, resident in India may hold, own, transfer or invest in foreign currency, foreign
security or any immovable property situated outside India if such currency, security or
property was acquired, held or owned by such person when he was resident outside India or
inherited from a person who was resident outside India.

A person resident outside India may hold, own, transfer or invest in Indian currency, security
or any immovable property situated in India if such currency, security or property was
acquired, held or owned by such person when he was resident in India or inherited from a
person who was resident in India.

The Reserve Bank may, by regulation, prohibit, restrict, or regulate establishment in India of
a branch, office or other place of business by a person resident outside India, for carrying on
any activity relating to such branch, office or other place of business. Every exporter of goods
and services must:-

• Furnish to the Reserve Bank or to such other authority a declaration in such form and
in such manner as may be specified, containing true and correct material particulars,
including the amount representing the full export value or, if the full export value of
the goods is not ascertainable at the time of export, the value which the exporter,
having regard to the prevailing market conditions, expects to receive on the sale of the
goods in a market outside India;
• Furnish to the Reserve Bank such other information as may be required by the
Reserve Bank for the purpose of ensuring the realization of the export proceeds by
such exporter.

The Reserve Bank may, for the purpose of ensuring that the full export value of the goods or
such reduced value of the goods as the Reserve Bank determines, having regard to the
prevailing market-conditions, is received without any delay, direct any exporter to comply
with such requirements as it deems fit. Where any amount of foreign exchange is due or has
accrued to any person resident in India, such person shall take all reasonable steps to realize
and repatriate to India such foreign exchange within such period and in such manner as may
be specified by the Reserve Bank.

FEMA Rules & Policies

The Foreign Exchange Management Act, 1999 (FEMA) came into force with effect from
June 1, 2000. With the introduction of the new Act in place of FERA, certain structural
changes were brought in. The Act consolidates and amends the law relating to foreign
exchange to facilitate external trade and payments, and to promote the orderly development
and maintenance of foreign exchange in India.

From the NRI perspective, FEMA broadly covers all matters related to foreign exchange,
investment avenues for NRIs such as immovable property, bank deposits, government bonds,
investment in shares, units and other securities, and foreign direct investment in India.
FEMA vests with the Reserve Bank of India, the sole authority to grant general or special
permission for all foreign exchange related activities mentioned above.

Section 2 - The Act here provides clarity on several definitions and terms used in the context
of foreign exchange. Starting with the identification of the Non-resident Indian and Persons
of Indian origin, it defines “foreign exchange” and “foreign security” in sections 2(n) and
2(o) respectively of the Act. It describes at length the foreign exchange facilities and where
one can buy foreign exchange in India. FEMA defines an authorised dealer, and addresses the
permissible exchange allowed for a business trip, for studies and medical treatment abroad,
forex for foreign travel, the use of an international credit card, and remittance facility

Section 3 prohibits dealings in foreign exchange except through an authorised person.

Similarly, without the prior approval of the RBI, no person can make any payment to any
person resident outside India in any manner other than that prescribed by it. The Act restricts
non-authorised persons from entering into any financial transaction in India as consideration
for or in association with acquisition or creation or transfer of a right to acquire any asset
outside India.

Section 4 restrains any person resident in India from acquiring, holding, owning, possessing
or transferring any foreign exchange, foreign security or any immovable property situated
outside India except as specifically provided in the Act.

Section 6 deals with capital account transactions. This section allows a person to draw or sell
foreign exchange from or to an authorised person for a capital account transaction. RBI in
consultation with the Central Government has issued various regulations on capital account
transactions in terms of sub-sect ion (2) and (3) of section 6.

Section 7 covers the export of goods and services. All exporters are required to furnish to the
RBI or any other authority, a declaration regarding full export value.

Section 8 puts the responsibility of repatriation on the persons resident in India who have any
amount of foreign exchange due or accrued in their favour to get the same realised and
repatriated to India within the specific period and in the manner specified by the RBI.

The duties and liabilities of the Authorised Dealers have been dealt with in Sections 10, 11
and 12, while Sections 13 to 15 cover penalties and enforcement of the orders of the
Adjudicating Authority as well as the power to compound contraventions under the Act.
NOSTRO AND VOSTRO ACCOUNTS
International accounting procedures between Local banks and overseas banks often involve
the use of nostro and vostro accounts.

A nostro (means "ours" in Latin) account is an account maintained by a Local bank with a
foreign bank that allows the Local bank to buy foreign currency. A vostro (means "yours" in
Latin) account is an account maintained by an overseas bank with a Local bank that allows
the overseas bank to purchase Local currency. The system of nostro and vostro accounts
facilitates foreign exchange dealings and settlements and allows the settlement of currency
transactions between the Country's (Local)Bank and foreign banks.

Example : When X (Buyer) a trader in Base Country wants to purchase $5000 worth of
goods by paying cash. Mr.X deposits the cash in his local bank in the country's currency for
the corresponding amount ($5000) then a swift message is sent to the corresponding bank in
the foreign country where the local bank holds a NOSTRO account requesting the bank to
make the payment to Y (Seller) in his local currency i.e. US Dollars. Thus facilitating the
trade between X & Y. IF Y wanted to buy something from X then the foreign bank would
complete the deal using their VOSTRO account in X's country
Latest Developments with regards to Nostro accounts
RBI has asked banks to reconcile & closely monitor nostro accounts

The Reserve Bank of India (RBI) has advised banks to minimize the number of nostro
accounts to have a better control over reconciliation and put in place a system of fast
reconciliation and close monitoring of pending items in nostro accounts by top management
at short intervals. Banks are also advised to leverage technology to avoid building up of such
unreconciled balances.

RBI has been receiving representations from banks expressing practical difficulties and
involvement of substantial expenditure in the elimination of outstanding entries in nostro
accounts after the lapse of certain time. RBI in it’s circular dated May 11, 2009, has reviewed
the position about reconciliation of nostro account and treatment of outstanding entries and
decided as under:

a) In respect of outstanding debit/credit entries of individual value USD 2500 and above or
equivalent in nostro accounts, banks will continue to make efforts for reconciliation.

b) In respect of outstanding credit entries of individual value less than USD 2500 or
equivalent in nostro account originated upto March 31, 2002:

(i) Banks may transfer to profit and loss account the credit balance arising out of the netting
of entries pertaining to the period prior to April 1, 1996 parked in blocked account.

(ii)The amount credited to the profit and loss account should be appropriated to the general
reserve and will not be available for declaration of dividend.

(iii) Appropriate disclosure should be made in the Notes to Accounts including the impact on
the profit and loss account.

(iv) Any future claim in respect of these entries should be honoured.

c) Banks may at their discretion, write off the unreconciled debit entries of individual value
less than USD 2500 or equivalent in nostro and mirror accounts originated upto March 31,
2002 against the provision already held in terms of the circular dated July 1, 1999.

d) All unreconciled credit entries in the nostro accounts originated on or after April 1, 2002
which are outstanding for more than 3 years may be transferred to Blocked Account and
shown as outstanding liabilities which will be reckoned for the purpose of CRR/SLR.

e) Make 100 per cent provision in respect of all unreconciled debit entries in the nostro
accounts originated on or after April 1, 2002 which are outstanding for more than two years
(instead of three years as at present).
Impact of PROGRESSION FROM FERA TO FEMA on Economy & markets

We shall discuss the impact of conversion on the following

• Rupee progress
• Exports
• imports
• FDI
• External debt
• Trade Credit
• Exports

Progress in Rupee

1950-51 to 1960-61 Rs 4.76

1980-81 Rs 7.9

1987-88 Rs12.97

1992-93 Rs 30.65

2001-02 Rs 47.68

The rupee has not been too volatile over the years. But that doesn’t mean it hasn’t depreciated
to the dollar. It has fallen from Rs 4.76 in 1950-51to Rs 47.84 on December 7, 2001-a plunge
in excess of 1000%. Now, see this in the light of the fact that the past 50 years have seen a
mere two ‘devaluation’ (in June 1966 and July 1991)
Exports-

• Items exempted under regulation 4 of FEMA 23.

• A few such cases are as under;
• Trade samples of goods and publicity material supplied free of payment
• Personal effects of travellers , whether accompanied or unaccompanied;
• Goods or software accompanied by a declaration by the exporter that they are not
more than USD 25000 in value
• By way of gift of goods accompanied by a declaration by the exporter that they are
not more than five lakh rupees in value etc
• Firms / Companies and other organisations take/export goods for exhibition outside
India without the prior approval of the Reserve Bank of India.
• Unsold exhibit items may be sold outside the exhibition/trade fair in the same country
or in a third country.
• Such sales at discounted value are also permissible.
• It would also be permissible to `gift' unsold goods up to the value of USD 5000 per
exporter, per exhibition/trade fair.

AD Banks may approve GR Form of export items for display or display-cum-sale in trade
fairs/exhibitions outside India subject to conditions.

• AD banks may consider request from exporters for granting GR approval in cases
where goods are being exported for re-import after repairs / maintenance / testing /
calibration etc. subject to the condition that the exporter shall;
• Produce relative Bill of Entry within one month of re-import of the exported item
from India.
• Where the goods being exported for testing are destroyed during testing, AD banks
may obtain a certificate issued by the testing agency that the goods have been
destroyed during testing, in lieu of Bill of Entry for import.
Import

• Section 5 of FEMA 1999

• Master Circular No.8/2009-10 dated 1.07.2009 read with AP(DIR Series) Circulars
issued thereafter.
• GOI Notification No.381 (E) of May 3, 2000 follow KYC guidelines (issued by
DBOD)

Time Limit for Settlement of Import Payments

• Remittances against imports should be completed not later than six months from the
date of shipment except in cases where amounts are withheld towards guarantee of
performance etc.
• Authorised Dealers may permit settlement of import dues delayed due to disputes,
financial difficulties etc.
• Interest in respect of such delayed payments may be permitted in terms of the
directions/guidelines on trade credit.
Foreign Direct Investment (FDI)

The entire foreign exchange market in India is regulated by Foreign Exchange Management
Act, 1999 [FEMA]. Before this act was introduced, the market was regulated by FERA or the
Foreign Exchange Regulation Act, 1947. After independence, FERA was introduced only as
a temporary measure for the purpose of regulating the inflow of foreign capital. But with the
industrial and economic development, the requirement for conservation of the foreign
currency was felt and on recommendation of Public Accounts Committee, the Indian
government passed the Foreign Exchange Regulation Act, 1973 and gradually, this act
became well-known as FEMA.

The foreign exchange market in India is regulated by the RBI through the Exchange Control
Department. The Foreign Exchange Dealers Association (a voluntary association) also
provides help in regulating the market. The Authorized Dealers (Authorized by RBI) and
accredited brokers are qualified to participate in the foreign Exchange market in India. When
foreign exchange trade is taking place between Authorized Dealers and RBI or between
Authorized Dealers and overseas banks, then brokers do not have any role to play.

The Forex market in India consists of buyers, sellers, market intermediaries & the monetary
authority of India. Mumbai [the commercial capital of India] is the main centre for foreign
exchange transactions in India. There are many other centres for foreign exchange
transactions in the country such as Chennai, Bangalore, Kolkata, New Delhi, Pondicherry and
Cochin.

FOREX concept

The flow of funds across the national boundaries happens because of the trade and personal
remittances. Inward remittances are on account of exports and remittances from Indians
working abroad. These remittances result in flow of foreign currency into the country. The
foreign funds accumulate with the Indian banks that pay out equivalent Indian rupees to the
beneficiaries of the remittances in India.

Indian banks accumulate the foreign currency funds in current accounts maintained with
banks at foreign centers such as London and New York. Thus, foreign inward remittances
result in increase in money in circulation. On the other hand, foreign outward remittances
lead to contraction of money in circulation and outflow of foreign currency from the stock
with Indian banks.

Banks having surplus foreign currency funds sells the funds to other Indian banks in
exchange of Indian Rupees. If all banks have surplus foreign currency funds they sell these to
the RBI. Balances in the foreign currency accounts of RBI become the foreign exchange
reserve of the country.
Impact on money supply

In context of the Indian financial system, the relevant factor is that the increase in foreign
currency reserves as a result of the larger foreign inward remittances, lead to increase in
money supply; finding its way into the money market and capital market through the banking
system.

Banks create credit and any inflow into the banking system gets multiplied by a factor. This
factor depends on the reserves maintained by banks. If banks maintain n average reserve of
25%, any inflow into the banking system will increase money supply four times.

Similarly, any contraction of funds available with the banks will result in a four-fold
reduction in money supply. Increase and decrease in the foreign exchange reserves of the
country impact the financial system through increase or decrease in money supply.

Foreign Direct Investment [FDI] & Foreign Institutional Investors [FII]

Another aspect of Foreign Exchange market is that apart from flows resulting from personal
and trade remittances, banks and corporate borrow funds from abroad and foreign entities
invest in Indian business entities, such as Foreign Direct Investment [FDI], foreign funds and
Foreign Institutional Investors [FII] that invest in the Indian capital markets. These flows are
large in magnitude and have a great impact on capital market and the exchange rate.

However, there is also the danger that if FIIs pull out, the stock markets could crash which in
turn can adversely impact the economy. This danger is not only on account of the impact of
share prices but also because of the impact on exchange rate, which can adversely affect
foreign trade and consequently the price level in the country.
External Debt

Major Highlights of External Debt

(i) India’s external debt, as at end-March 2009, was placed at US $ 229.9 billion (22.0 per
cent of GDP) recording an increase of US $ 5.3 billion or 2.4 per cent over the level of the
previous year mainly due to the increase in trade credits.

(ii) As per an international comparison of external debt of the twenty most indebted
countries, India was the fifth most indebted country in 2007.

(iii) By way of composition of external debt, the share of commercial borrowings was the
highest at 27.3 per cent as at end-March 2009 followed by short-term debt (21.5 per cent),
NRI deposits (18.1 per cent) and multilateral debt (17.2 per cent).

(iv)The debt service ratio has declined steadily over the years, and stood at 4.6 per cent as at
end-March 2009.

(v) Excluding the valuation effects due to appreciation of US dollar against other major
currencies and Indian rupee, the stock of external debt would have increased by US$ 18.7
billion as compared with the stock as at end-March 2008.

(vi) The share of short-term debt in total debt increased to 21.5 per cent at end-March 2009
from 20.9 per cent at end-March 2008, primarily on account of rise in short-term trade
credits.

(vii) Based on residual maturity, the short-term debt accounted for 40.6 per cent of the total
external debt at end-March 2009

(viii) The ratio of short-term debt to foreign exchange reserves at 19.6 per cent in March
2009 was higher compared to 15.2 per cent in March 2008.

(ix) The US dollar continues to remain the dominant currency accounting for 57.1 per cent of
the total external debt stock as at end-march 2009.

(x) India’s foreign exchange reserves provided a cover of 109.6 per cent to the external debt
stock at the end of March 2009 as compared with 137.9 per cent as at end-March 2008.
1. Stock of India’s External Debt as at end-March 2009

(i) India’s external debt, as at end-March 2009, was placed at US $ 229.9 billion (22.0 per
cent of GDP) recording an increase of US $ 5.3 billion or 2.4 per cent over the end-March
2008 level mainly due to the increase in trade credits. (Table 1 and Chart 1).

Table 1: External Debt Outstanding

(US $ billion)
Total Variation
External Debt Over corresponding Quarter Over Previous Quarter
of Previous year
At end of Amount Per cent Amount Per cent
1 2 3 4 5 6
March 2007 171.3 33.2 24.0 10.9 6.8
June 2007 182.3 37.3 25.7 11.0 6.4
September 2007 195.6 45.0 29.9 13.3 7.3
December 2007 206.0 45.6 28.4 10.4 5.3
March 2008 224.6 53.3 31.1 18.6 9.0
June 2008 223.6 41.3 22.6 -1.0 -0.5
September 2008 223.5 27.9 14.3 0.0 0.0
December 2008 229.3 23.3 11.3 5.7 2.6
March 2009 P 229.9 5.3 2.4 0.6 0.3
P: Provisional

Source: Ministry of Finance, Government of India and Reserve Bank of India.

2. Valuation Changes

(i) the valuation effect reflecting the appreciation of the US dollar against other major
international currencies and Indian rupee resulted in a decline in India’s external debt by US
$ 13.4 billion. This implies that excluding the valuation effects, the stock of external debt as
at end-March 2009 would have increased by US $ 18.7 billion over the level at end-March
2008.

3. Components of External Debt

(i) By way of composition of external debt, the share of commercial borrowings was the
highest at 27.3 per cent as at end-March 2009 followed by short-term debt (21.5 per cent),
NRI deposits (18.1 per cent) and multilateral debt (17.2 per cent) (Table 2).

(ii) The long-term debt at US$ 180.5 billion and short-term debt at US$ 49.4 billion
accounted for 78.5 per cent and 21.5 per cent, respectively, of the total external debt as at
end-March 2009.
Table 2: External Debt by Component
(US $ million)
Item End- March
1991 1998 2004 2005 2006 2007 2008 2009 P
1 2 3 4 5 6 7 8 9
1. Multilateral 20,900 29,553 29,297 31,744 32,620 35,337 39,490 39,566
(24.9) (31.6) (26.2) (23.9) (23.6) (20.6) (17.6) (17.2)
2. Bilateral 14,168 16,969 17,277 17,034 15,761 16,065 19,701 20,587
(16.9) (18.1) (15.5) (12.8) (11.4) (9.4) (8.8) (9.0)
3. IMF 2,623 664 0 0 0 0 0 0
(3.1) (0.7) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0)
4. Trade Credit 4,301 6,526 4,697 5,022 5,420 7,165 10,358 14,604
(5.1) (7.0) (4.2) (3.8) (3.9) (4.2) (4.6) (6.4)
5. ECBs 10,209 16,986 22,007 26,405 26,452 41,443 62,337 62,676
(12.2) (18.2) (19.7) (19.9) (19.1) (24.2) (27.8) (27.3)
6. NRI Deposits 10,209 11,913 31,216 32,743 36,282 41,240 43,672 41,554
(12.2) (12.7) (28.0) (24.6) (26.3) (24.1) (19.4) (18.1)
7. Rupee Debt 12,847 5,874 2,720 2,302 2,059 1,951 2,016 1,527
(15.3) (6.3) (2.4) (1.7) (1.5) (1.1) (0.9) (0.7)
8. Long-term Debt (1to 1,07,21 1,15,25 1,18,59 1,43,20 1,77,57
7) 75,257 88,485 4 0 4 1 4 1,80,514
(89.8) (94.6) (96.0) (86.7) (85.9) (83.6) (79.1) (78.5)
9. Short-term Debt 8,544 5,046 4,431 17,723 19,539 28,130 46,999 49,373
(10.2) (5.4) (4.0) (13.3) (14.1) (16.4) (20.9) (21.5)
1,11,64 1,32,97 1,38,13 1,71,33 2,24,57
Total (8+9) 83,801 93,531 5 3 3 1 3 2,29,887
(100.0)(100.0)(100.0) (100.0) (100.0) (100.0) (100.0) (100.0)
P: Provisional
IMF: International Monetary Fund; ECBs: External Commercial Borrowings; NRI: Non-
Resident Indian
Note: Figures in parentheses are percentage to total external debt.
Source: Ministry of Finance, Government of India and Reserve Bank of India.

(iii) The rise in external debt stock was mainly due to the increase in trade credits which rose
by US$ 4.2 billion over its level at end-March 2008.

(iv) The short-term debt increased by US$ 2.4 billion as at end-March 2009 mainly on
account of rise in short-term trade credits (Table 3 and Chart 2).

(v) Outstanding NRI deposits at US $ 41.6 billion as at end-March 2009 declined by US $ 2.1
billion over the level at end-March 2008 mainly due to valuation effects as there was positive
inflows under NRI deposits during 2008-09.
Table 3: Variation in External Debt by Components
Item External debt outstanding Absolute variation Percentage variation
at the end-of (US $ million) (per cent)
(US $ million)
Mar 07 Mar 08 Mar 09P Mar 07 Mar 08 Mar 07 to Mar 08
to to Mar 08 to
Mar 08 Mar 09 Mar 09
1 2 3 4 5 6 7 8
1. Multilateral 35,337 39,490 39,566 4,153 76 11.8 0.2
2. Bilateral 16,065 19,701 20,587 3,636 886 22.6 4.5
3. IMF 0 0 0 0 0 0.0 0.0
4. Trade Credit 7,165 10,358 14,604 3,193 4,246 44.6 41.0
5.Commercial
Borrowings 41,443 62,337 62,676 20,894 339 50.4 0.5
6. NRI Deposits 41,240 43,672 41,554 2,432 -2,118 5.9 -4.8
7. Rupee Debt 1,951 2,016 1,527 65 -489 3.3 -24.3
8. Short-Term Debt 28,130 46,999 49,373 18,869 2,374 67.1 5.1
Of which:
(i) Short-Term Trade Credit 25,979 43,162 45,975 17,183 2,813 66.1 6.5
Total Debt
(1 to 8) 171,331 224,573 229,887 53,242 5,314 31.1 2.4
Memo Items
A. Long-Term Debt (1 to 7) 143,201 177,574 180,514 34,373 2,940 24.0 1.7
B. Short-Term Debt 28,130 46,999 49,373 18,869 2,374 67.1 5.1
P: Provisional
Source: Ministry of Finance, Government of India and Reserve Bank of India.
(vi) The level of approvals of ECBs during 2008-09 (April-March) was significantly
lower at US$ 18.4 billion as compared to US$ 31.0 billion during 2007-08. As a
result, gross disbursements for 2008-09 were lower at US $ 13.4 billion than that
of US$ 28.8 billion during the previous year (Table 4).

Table 4: External Commercial Borrowings

(US $ million)
Year Approvals# Gross Amortisation* Interest* Total ECB Debt
Disbursement* Servicing Outstanding
1 2 3 4 5 6 (4+5) 7
1990-
91 1,903 4,252 2,004 1,410 3,414 10,209
1995-
96 6,286 4,252 3,868 1,380 5,248 13,873
2000-
01 2,837 9,621 5,378 1,695 7,073 24,408
2001-
02 2,653 2,684 4,107 1,456 5,563 23,320
2002-
03 4,235 3,505 5,019 1,167 6,186 22,472
2003-
04 6,671 5,225 8,045 2,119 10,164 22,007
2004-
05 11,490 9,084 3,571 959 4,530 26,405
2005-
06 17,175 14,343 11,584 3,015 14,599 26,452
2006-
07 24,492 20,257 3,814 2,583 6,397 41,443
2007-
08 PR 30,954 28,784 6,119 3,652 9,771 62,337
2008-
09 QE 18,364 13,377 6,439 3,962 10,401 62,676
PR : Partially Revised ; QE: Quick Estimates.
*: Revised; based on Balance of Payments data.
# : Based on date of agreement of the loan which may differ from the date of granting the
loan registration number by the RBI. Ceiling on ECB approvals is fixed on the basis of the
latter, which may either be after or before the date of agreement of the loan. Hence, there
may be some difference between the amount shown under approvals in the table and the
amount of ceiling fixed for a particular year.
Note: Disbursements during 1998-99 and 2000-01 include RIBs (US$ 4.2 billion) and
IMDs (US $ 5.5 billion), respectively. Debt service payments during 2003-04 and 2005-06
include redemption of RIBs and IMDs, respectively.
4. Currency Composition

(i) The currency composition of India’s external debt is generally disseminated in terms of
major foreign currencies such as US dollar, Japanese Yen, Euro, Pound Sterling, Special
Drawing Rights (SDR) and the domestic currency i.e., Indian Rupee.

(ii) The US dollar continues to be the dominant currency accounting for 57.1 per cent of the
total external debt stock as at end-March 2009, followed by the Japanese yen (14.2 per cent),
Indian rupee (13.2 per cent) and SDR (9.2 per cent) (Table 5 and Chart 3). The share of Euro
has been at around 4 per cent in the recent years.

Table 5: Currency Composition of External Debt

(Percentage share in total external debt)
As at end March
Currency 2004 2005 2006 2007 2008 2009 P
1 2 3 4 5 6 7
US Dollar 40.5 48.0 49.2 51.4 54.4 57.1
SDR 15.5 14.2 13.7 11.9 10.0 9.2
Indian Rupee 22.7 19.6 18.9 18.6 17.5 13.2
Japanese Yen 11.6 10.5 10.9 11.5 12.0 14.2
Euro 5.8 4.6 4.4 3.9 3.6 4.1
Pound Sterling 3.4 2.6 2.6 2.4 2.2 1.9
Others 0.5 0.5 0.3 0.3 0.3 0.3
Total 100.0 100.0 100.0 100.0 100.0 100.0
P: Provisional
Source: Ministry of Finance, Government of India and Reserve Bank of India.
5. Instrument-wise Classification of External Debt

(i) The instrument-wise classification of India’s external debt as at end-March 2009 reveals
that ‘loans’ accounted for 51.8 per cent of total debt outstanding as compared to 49.5 per cent
as at end-March 2008 (Table 6).

(ii)The group ‘currency and deposits’ and ‘trade credits’ together accounted for 50.6 per cent
of the total non-Government debt as at end-March 2009 as against 52.6 per cent as at end-
March 2008.

Table 6: Instrument-wise Classification of External Debt Outstanding

(US$ million)
Sr. No. Borrower End-March 2008 End-March 2009
1 2 3 4
A. Government (1+2) 56,947 54,856
1. Short-Term 615 939
(i) Money Market Instruments 615 939
2. Long-term {(i)+(ii)+(iii)} 56,332 53,917
(i) Bonds and Notes 2,300 963
(ii) Loans 52,740 51,680
(iii) Trade Credits 1,292 1,274
B. Monetary Authority 1,115 764
1. Short-term 1,115 764
(i) Currency and Deposits 1,115 764
C. Non-Government (1+2) 1,66,511 1,74,267
1. Short-Term {(i)+(ii)} 45,269 47,670
(i) Money Market Instruments 2,107 1,695
(ii) Trade Credits 43,162 45,975
2. Long-term {(i)+(ii)+(iii)+(iv)} 1,21,242 1,26,597
(i) Bonds and Notes 18,302 17,018
(ii) Loans 58,484 67,310
(iii) Currency and Deposits 43,672 41,554
(iv) Trade Credits 784 715
Total External Debt (A+B+C) 2,24,573 2,29,887
Source: Ministry of Finance, Government of India and Reserve Bank of India.

6. Short-term Debt

(i) The short-term debt has become an important component for measuring the liquidity and
refinancing risks. In the recent years, efforts have been taken to expand the coverage of short-
term external debt. The data on short-term debt now includes suppliers’ credit up to and
above 180 days, FII investments in Government debt, investment by foreign central banks
and international institutions in Treasury Bills and external liabilities of central banks and
commercial banks.
(ii) Short-term debt by original maturity has increased over the period mainly because of the
increase in trade related credits due to growing imports. The share of trade related credits in
total short-term debt increased from 91.8 per cent as at end-March 2008 to 93.1 per cent as at
end-March 2009 (Table 7).

Table 7: Short-Term Debt by Original Maturity

(US $ million)
End-March
Components 1991 2001 2005 2006 2007 2008 2009
1 2 3 4 5 6 7 8
A Short-Term Debt 8,5443,628 17,723 19,539 28,130 46,999 49,373
a) NRI Deposits (up to 1 year
maturity) @ 3,577957 0 0 0 0 0
b) FC (B&O) Deposits (up to 1
year maturity) 167 0 0 0 0 0 0
c) Trade Related Credits # 4,8002,671 16,271 19,399 25,979 43,162 45,975
(i) Above 6 months and upto 1year 2,2672,671 7,529 8,696 11,971 22,884 23,346
(ii) Upto 6 months 2,5330 8,742 10,703 14,008 20,278 22,629
d) FII Investments in
Government Treasury Bills & other
instruments 0 0 1,452 140 397 651 2,065
e) Investment in Treasury
Bills by foreign central
banks and international
institutions etc. - - - - 164 155 105
f) External Debt Liabilities of: - - - - 1,590 3,031 1,228
(i) Central Bank - - - - 501 1,115 764
(ii) Commercial Bank - - - - 1,089 1,916 464
27,91 1,18,9 1,57,0 1,90,6 2,57,7
B Imports (during the year)* 5 57,912 08 56 70 89 2,94,587
C Trade Credits to Imports (%) 17.2 4.6 13.7 12.4 13.6 16.7 15.6
@: Short-term deposits of less than one-year maturity under FCNR(A) were withdrawn with
effect from May 15, 1993,
such deposits under FCNR(B) and NR(E)RA were withdrawn effective October 1999 and
April 2003, respectively.
#: Data on short-term Trade Credits of less than six months in respect of suppliers’
credit and FII investment in debt papers are included since end-March 2005.
*: On balance of payments basis.
Source: Ministry of Finance, Government of India and Reserve Bank of India
7. External Debt by Residual Maturity

(i) While external debt is generally compiled in terms of original maturity, analysing the
external debt, in particular short term debt in terms of residual maturity is important from the
point of view of foreign exchange liquidity management and to ascertain the total foreign
exchange outgo on account of debt service payments in the immediate future.

(ii) The ‘short-term debt by residual maturity’ comprises the repayments due under medium
and long-term debt by original maturity during one year reference period along with the
short-term debt with original maturity. The balance constitutes the long-term debt by residual
maturity. Based on residual maturity, the short-term debt accounted for 40.6 per cent of total
external debt as at end-March 2009. The ratio of short-term debt by residual maturity to
foreign exchange reserves worked out to 37.0 per cent at end-March 2009 (Table 8).

Table 8: Residual Maturity of External Debt Outstanding as at End-March 2009

(US $ million)
Short- Long-term Total
term (2) to (5)
Components Up to one 1 to 2 2 to 3 More than 3
year years years years
1 2 3 4 5 6
1. Sovereign Debt (long-term) 2,603 2,924 3,015 45,376 53,917
2. External Commercial Borrowings 9,189 10,839 14,521 50,494 85,043
(including trade credit)
3. NRI deposits {(i)+(ii)+(iii)} 32,108 4,465 3,757 1,224 41,554
(i) FCNR(B) 9,944 2,085 1,075 107 13,211
(ii) NR(E)RA 18,649 2,015 2,041 865 23,570
(iii) NRO 3,516 365 641 252 4,773
4. Short-term Debt* 49,373 - - - 49,373
(Original maturity)
Total (1 to 4) 93,273 18,228 21,293 97,093 229,887
Memo Items
Short-term debt
Residual maturity as per cent of total
debt 40.6
Short-term debt
Residual maturity as per cent of
Reserves) 37.0
* Also includes short-term component of sovereign debt amounting to US$ 939 million.
Note: Residual Maturity of NRI Deposits is estimated on the basis of the Survey conducted by
the Reserve
Bank on NRI deposits outstanding as on March 31, 2009.
Source: Ministry of Finance, Government of India and Reserve Bank of India
Graphical representation:
Merchandise:

The graph shows merchandise data (in US $ ‘000) over the period of 2009-2010. It shows
how merchandise debit and credit increase over the years’ time. And hence net merchandise
too increases over the period.

Foreign Investment:

The graph shows Foreign Investment (in US $ ‘000) over the period of 2009-2010. It shows
how Foreign Investment credit increase over the years’ time. There’s a steep growth in FI
debit. The net Foreign Investment shows decline over the given period.
Loans:

The graph shows Loans (in US $ ‘000) over the period of 2009-2010. It shows how Loans
credit increase over the years’ time. It also shows how Loans debit increase over the years’
time and then decrease. There’s a steep growth in Loans credit. The net Foreign Investment
shows almost constant growth over the given period.

Current Account:

The graph shows total current account (in US $ ‘000) over the period of 2009-2010. It shows
how total current account debit increase and then steeply decrease and total current account
credit increase over the years’ time. The net total current account shows decline over the
given period.
Banking Capital:

The graph shows banking capital (in US $ ‘000) over the period of 2009-2010. It shows how
banking capital debit decrease and banking capital credit decrease and then steeply increase
over the years’ time. The net banking capital shows growth over the given period.

Overall Balance:

The graph shows overall balance (in US $ ‘000) over the period of 2009-2010. It shows how
overall balance debit and credit increase over the years’ time. Debit and credit data are almost
same. The net overall balance shows growth over the given period.
Total Capital Account:

The graph shows total capital account (in US $ ‘000) over the period of 2009-2010. It shows
how total capital account debit and credit increase over the years’ time. The net total current
account shows constant growth initially and then steady growth over the given period.
TRADE CREDIT

Some Highlights of FEMA

It prohibits foreign exchange dealing undertaken other than an authorized person;

It also makes it clear that if any person residing in India, received any Forex payment
(without there being a corresponding inward remittance from abroad) the concerned person
shall be deemed to have received they payment from an unauthorized person.

There are 7 types of current account transactions, which are totally prohibited, and therefore
no transaction can be undertaken relating to them. These include transaction relating to
lotteries, football pools, banned magazines and a few others.

FEMA and the related rules give full freedom to Resident of India (ROI) to hold or own or
transfer any foreign security or immovable property situated outside India.

Similar freedom is also given to a resident who inherits such security or immovable property
from an ROI.

An ROI is permitted to hold shares, securities and properties acquired by him while he was a
Resident or inherited such properties from a Resident.

The exchange drawn can also be used for purpose other than for which it is drawn provided
drawl of exchange is otherwise permitted for such purpose.

Certain prescribed limits have been substantially enhanced. For instance, residence now
going abroad for business purpose or for participating in conferences seminars will not need
the RBI's permission to avail foreign exchange up to US$. 25,000 per trip irrespective of the
period of stay, basic travel quota has been increased from the existing US$ 3,000 to US$
5,000 per calendar year.

Buyers’ /Supplier's Credit

Trade Credit has been subjected to dynamic regulation over a period of last two years. Now,
Reserve Bank of India (RBI) vide circular number A.P. (DIR Series) Circular No. 24, Dated
November 1, 2004, has given general permission to ADs for issuance of Guarantee/ Letter of
Undertaking (LoU) / Letter of Comfort (LoC) subject to certain terms and conditions . In
view of the above, we are issuing consolidated guidelines and process flow for availing trade
credit

Definition of Trade Credit: Credit extended for imports of goods directly by the overseas
supplier, bank and financial institution for original maturity of less than three years from the
date of shipment is referred to as trade credit for imports.

Depending on the source of finance, such trade credit will include supplier's credit or buyers
credit, Supplier's credit relates to credit for imports into India extended by the overseas
supplier, while Buyers credit refers to loans for payment of imports in to India arranged by
the importer from a bank or financial institution outside India for maturity of less than three
years.

It may be noted that buyers’ credit and suppliers’ credit for three years and above come under
the category of External Commercial Borrowing (ECB), which are governed by ECB
guidelines. Trade credit can be availed for import of goods only therefore interest and other
charges will not be a part of trade credit at any point of time.

Amount and tenor : For import of all items permissible under the Foreign Trade Policy
(except gold), Authorized Dealers (ADs) have been permitted to approved trade credits up to
20 million per import transaction with a maturity period ( from the date of shipment) up to
one year.

Additionally, for import of capital goods, ADs have been permitted to approve trade credits
up to USD 20 million transactions with a maturity period of more than one year and less than
three years. No roll over/ extension will be permitted by the AD beyond the permissible
period.

All in cost ceiling: The all in cost ceiling are as under: Maturity period up to one year 6
months LIBOR +50 basis points. Maturity period more than one year but less than three years
6 months LIBOR* + 125 basis point for the respective currency of credit or applicable
benchmark like EURIBOR. SIBOR, TIBOR, etc.

Issue of guarantee, letter of undertaking or letter of comfort in favor of overseas lender: RBI
has given general permission to ADs for issuance of guarantee / Letter of Undertaking (LOU)
/ Letter of Comfort (LOC) in favor of overseas supplier, bank and financial instruction, up to
USD 20 million per transaction for a period up to one year for import of all non capital goods
permissible under Foreign Trade Policy (except gold) and up to three years for import of
capital goods. In case the request for trade credit does not comply with any of the RBI
stipulations, the importer needs to have approval from the central office of RBI.

FEMA regulations have an immense impact in international trade transactions and different
modes of payments. RBI release regular notifications and circulars, outlining its clarifications
and modifications related to various sections of FEMA
Emerging markets face hot money influx:
In the post-crisis era, the flow of international capital has taken on new features. FDI has
decreased from 80 percent to 50 percent of net international capital flows. The gap is being
filled by short term capital flows to emerging economies.

International hot money

Since the U.S., EU and Japan slashed interest rates, higher rates in emerging economies have
become a magnet for arbitrageurs. Net capital inflows to Asia reached $35 billion in 2009,
and the 2010 figure will be higher. Emerging markets have become the target of international
hot money, causing asset bubbles in real estate and stock markets. In 2009, India's Sensex
Index increased by 81 percent, the Brazilian BOVESPA index surged by 82.7 percent, and
the Russian RTS Index rose by an astonishing 128.8 percent. In Indonesia, Philippines,
Thailand, Vietnam and Argentina stock market indexes rose more than 60 percent, while the
Dow Jones only managed 18.8 percent.

Stimulus packages, economic recovery and the inflow of foreign capital have caused a real
estate boom in emerging economies. Brazil began to surge in 2009; real estate in Brasilia is
now $6600 per square meter on average; in Moscow the average is $5320; in New Delhi it is
$1400.

Vietnam and India are facing inflationary pressures. The forecast growth rate for the
Vietnamese economy this year is 8.2 percent, while the CPI is expected to reach 10.8 percent.
The wholesale price index in India has reached an 11-year high.

Why is hot money flowing into emerging countries?

Loose monetary policy is the financial platform for international hot money. Interest rates in
major Western countries are almost zero, and capital is flowing into stock markets and real
estate. The capital markets of emerging countries have become the destination of choice for
excess liquidity.

Industrialization and urbanization in the emerging economies have contributed to the surge in
asset values, providing a further spur to international arbitrageurs.

Exchange rate mechanisms in emerging economies lack the flexibility to react to the
excessive hot money inflows. Most emerging countries still have exchange controls and lack
the auto-adjustment function of free-floating exchange rates.
Negative impact

Hot money has several negative impacts. The inflow of foreign capital increases pressure on
the domestic currency to appreciate. In countries with floating exchange rates, this can have a
huge impact on the national economy. Countries with fixed exchange rates, on the other
hand, have to make costly interventions in the currency markets. Inflows and outflows of hot
money disrupt macroeconomic policies and make an independent monetary policy virtually
impossible.

By early 2009, the international hot money was already active and predatory in the
commodity markets, even before the economic recovery began. Hot money in commodities
drives up prices, causing bubbles and cost-push inflation in emerging economies. Hot money
flowing into capital and real estate markets causes property bubbles and distorts investment
and consumption patterns. Finally after realizing its profits, hot money rapidly withdraws and
the flow of capital reverses direction, inflicting even more serious damage on emerging
countries.

Reasons for Inflow into India on a high:

India has been becoming a hot destination for foreign capital to be parked in its economic
environment. The major reasons which have been identified for this shift towards India has
been due to the following reasons

Inward Consumption Based Growth:

India’s economy is consumption oriented when compared to other emerging markets. India’s
export contributes less than 15% to its $1.2T GDP. The IT outsourcing services and back
office has garnered most of the business media coverage; however, these industries have less
than 8% contribution to the GDP and employ less than 5 million people. This is an indicator
of growth by internal production and consumption. It is less reliant on exports. Quite
contrarily, these technology services perform better in recession, because it is all about
optimizing operational cost.

Conservative Central Bank:

Its Reserve Bank (ie central bank) has very conservative monetary policy, which is why we
did not see failure of the banks (or banking system) during recent financial meltdown. There
were no widespread bank bailouts.

Transparency:

It has democratic governance which on many occasions slows down the decision making
progress, but provides better transparency (relative to Russia and China). As of today, its
currency is freely convertible for trading goods and services, but there are certain restrictions
for international asset acquisition. However, it has a pragmatic roadmap to allow its currency
to fully float with market dynamics. In 2007 and 2008, when Dollar dropped against Indian
Rupee, Indian export started becoming uncompetitive.
Government Stimulus Driven Growth is Less: The Indian market has rebounded in line with
other emerging markets like China or Brazil. An earlier fear of bubble seems to be a just – a
fear. It’s economy indicator suggest it is back of growth. The key in this rebound is; not much
is being supported by government driven expenditure or public infrastructure projects. In fact,
it continues to stumble on its infrastructure.

Finally, India can boast that its government is run by a bunch of prominent economists (with
political and public support). The architect of Indian economic reforms, who laid down the
path for reforms 18 years ago, is now at its helm as a prime minister. It is always good to
have a non-political leader who is not only an economist, but someone who knows how to
execute it in the complex state like India. Therefore, I continue to believe that on long 10+
year time horizons my dollars are (a) relatively safer; and (b) provide above average returns
in Indian markets. I do not expect to be a smooth ride. There will be time period when
markets will crash, but it will eventually come out stronger.

Due to the above mentioned reasons, India finds itself in a favourable position, where a lot of
foreign capital is getting attracted. The inflows have been in the forms of FII and FDI
mainly, and have been the reason for the appreciation of Rupee against dollar.

The pumping in of money has heated the debate regarding management of “Hot Money” by
the Reserve Bank of India. The RBI has not initiated any capital control measures to curb the
inflow. Which many economists think might prove to be a mistake. On the other hand, other
emerging economies like Brazil, Vietnam have enacted capital control measures, forcing
foreign investors to park their funds in India, thereby further increasing the capital flow to
India.
Impact of the appreciating Rupee on exporter’s mindset:
Indian exporters are overwhelmingly in favor of a fixed currency exchange rate as a recent
currency gyration due to the Greek Contagion has made their lives very difficult. In a survey
done by India’s Business association FICCI, 88% of the respondents wanted the Indian
Currency Rupee to be fixed as they were suffering from big losses due to appreciation.
Euro’s 20% depreciation against the US Dollar has resulted in massive problems for
exporters all over the world. India with 25% of its exports going to the European Union faces
similar problems. The exporters want India’s Central Bank the RBI to changes its Currency
Policy from free floating to fixed for exporters. Note China has a fixed dollar Yuan currency
peg at a much depreciated value. This has led to increasing international pressure on China
to revalue the yuan as its swelling Forex Reserves and huge Trade Surplus leads to global
imbalances

The Reserve Bank of India is not likely to oblige as its currency handling has been quite
successful so far. RBI has intervened only to slow down rapid changes without interfering in
the Rupee finding its market determined rate. RBI has a policy of not intervening to prevent
either appreciation or depreciation resulting in the Rupee trading in a wide band of Rs 38-52
over the last Three years. Note Exports form a relatively smaller percentage of India’s GDP
and so exporters have little influence over India’s currency exchange rate. Unlike countries
like China and Japan which are heavily dependent on exports, India is not inconvenienced too
much by Rupee appreciation. Caught off guard by recent appreciation of the rupee,
particularly against the euro, the majority of the exporting firms surveyed by FICCI want the
Reserve Bank to peg a fixed currency exchange rate. They took a cue from China, which has
pegged a fixed rate of yuan against the US dollar. “At least for exporters, the central bank
should give a facility like that in China of a fixed exchange rate. This would enable them to
focus on managing their business and save them from the trouble of managing currency
movements,” it said. An overwhelming 88 per cent of the 278 exporting firms participating in
the survey, said the sudden appreciation in rupee has affected their margins. They lost on
account of forward contracts that were booked to hedge currency rise
China state of Yuan:
China recently announced a series of measures to protect its economy against a possible
devaluation of the US dollar by decoupling the Asian currencies from the American currency
and using the Chinese yuan to gain access to raw materials from South America, the
Caribbean and, most importantly, Russia.

The Chinese government has serious reasons to be alarmed. As the financial crisis deepens
and the US debt multiplies to unprecedented levels, the possibilities of the US dollar failing
to maintain its privileged position as the world reserve currency are very real.

Under such a scenario, China has much to lose. Its economy has been built around exports to
the US, and the Chinese government holds $744 billion in US Treasury bonds, whose value
would fall should the dollar be devaluated.

So far, the 21 percent gain of the yuan against the dollar since the Yuan’s fixed exchange rate
was scrapped in 2005 has eroded China’s reserves as well as exporters’ profits. This was a
factor in February’s 25.7 percent fall in exports in February.

The leaders of the Chinese Communist Party are aware that China lacks a domestic market
capable of supporting the growth levels it needs to avoid mass unemployment. The jobless
rate among China’s 225 million rural migrant workers has already reached 10 percent.

With a million college graduates from 2008 yet to find a job, another 6 million will join the
labor market this year. The Chinese leaders fear that unemployment could lead to social
unrest, threatening the wealth and privileges they have carved out for themselves since China
opened itself to the world market.
Towards full convertibility of the yuan
Concerns over the stability of the US dollar led China in March 2008 to lobby the Group of
20 for the adoption of a “super-sovereign reserve currency.” This move, China feels, is
necessary, all the more so since the yuan cannot be a reserve currency today because it is not
fully convertible.

To redress this problem, China has embarked on a program to ensure that the yuan gains full
convertibility in the not-too-distant future and is thereby in a position to compete with the
dollar at some point for the role of world reserve currency.

The measures announced so far represent “baby steps toward liberalization of China’s capital
account and internationalization of the renminbi,” said Tim Condon, head of Asia research at
ING Group NV in Singapore. (Renminbi is another name for the yuan.)

Condon added, “Access to renminbi is not going to be an issue. China is using its financial
might to hedge any risk it might face in terms of supplies of central raw materials for its
growth and demand in other markets for its products.”

In a series of statements, the Chinese government has expressed its commitment to make the
yuan a fully convertible currency. “China’s State Council said last week it allowed yuan
settlement for international trade in Shanghai and four cities in Guangdong province—
Guangzhou, Shenzhen, Zhuhai and Dongguan—to promote global use of the currency and
protect companies from swings in the dollar,” reported Bloomberg News on April 9.

Other steps include the decision by the People’s Bank of China, approved in November 2008,
to provide currency swaps for 650 billion yuan ($95 billion) to Belarus, Hong Kong,
Indonesia, Malaysia, South Korea and Argentina. Last month, a similar arrangement with
Jamaica was announced.

Bank Indonesia Deputy Governor Hartadi Sarwono told Bloomberg News last month that a
100 billion currency swap will enable Indonesia to buy Chinese goods using yuans for the
first time.

China is also moving closer to eliminating the remnants of Hong Kong’s previous status as a
British protectorate. Hong Kong will become the first city outside mainland China to start
settling trades in yuan. In addition, China plans to allow Hong Kong companies to issue debt
in yuan. Hong Kong had been accepting payments in yuan since 2004 to attract tourists from
the mainland.

“It will reduce foreign exchange risks for companies, create more business for Hong Kong
banks and diversify use of yuan funds,” Donald Tsang, chief executive of Hong Kong said at
a press briefing last month, according to Bloomberg News. “The policy has already been
approved. It’s almost here.”

With these actions, China plans to protect its exports to Hong Kong, Macao and the ASEAN
nations, which reached $402.7 billion in 2008, a substantial 20 percent of China’s total
trading volume. This is a sufficiently large volume to make a statement to the world on the
benefits of trading with China in yuans, rather than US dollars.

Latin America is another case in point. China is stepping in to fill a vacuum left in the region
by a US in financial turmoil. A $10 billion currency swap will allow Argentina to purchase
Chinese goods without using its depleted US dollar reserves.

The Argentina deal came as a direct challenge to US dictates in the region. The Argentina-
China currency swap was announced a few weeks after the US approved $30 billion in swaps
each to Mexico and Brazil, but was unwilling to extend a line to Argentina, which has yet to
clear its defaulted Paris Club debt.

As the Argentine daily, La Nación, put it, the yuan swap was a “historical agreement with
China to eliminate the US dollar on commercial exchanges.” For China, it represents the
prospect of increasing its exports to a region where it already occupies the position of second
trading partner after the US. Surely, other Latin American countries will follow closely the
progress of this deal.

As China consolidates its influence among the ASEAN nations, moves to eliminate any
vestiges of the British occupation of Hong Kong, and opens long-term relations with Latin
America countries, it is significant that the steady steps taken by China to decouple its
currency—and exports—from the US dollar have not received the attention they deserve in
the American media. So far, economic analysts, speaking through American newspapers and
cable news programs, have focused their commentary on what is happening to the US public
debt, the ups and downs of the New York Stock Exchange and President Obama’s attempts to
rescue Wall Street.

These are important aspects of the world crisis. But it is an illusion to think that these
developments can be understood while leaving China out of the analysis. In reality, the
measures to establish full convertibility of the Chinese yuan are highly correlated with
developments in the US.

The far-reaching consequences, including the challenge to the US dollar, implicit in making
the yuan fully convertible were dealt with on the Asia News web site (January 1, 2009). It
noted: “If, after a trial period, China makes its currency convertible, the consequence is that
importing countries must have reserves of yuan. To get them, central banks around the world
will have to divest themselves of US assets and Treasury bonds. The euro has a rather limited
role in Asian exchange.”

Maurizio d’Orlando, the chief economic analyst for Asia News, explained the relationship
between yuan convertibility and the US dollar in a series of articles published on the Internet
over the past six months. He wrote: “The massive levels reached by the foreign debt of the
United States and the excessive and unjustified devaluation of China’s yuan are two high-risk
factors for the world economy and stability.”
The huge US debt is threatening the US dollar’s position in the world. The unthinkable has
become a possibility: that the US government may become insolvent, unable to borrow to
cover its debt.

The American media has thus far not dared to analyze the future of the dollar. Because it
strictly adheres to looking at the world from the point of view of the profit interests of the
American ruling class, it finds it all but impossible to consider such a possibility. Having
grown accustomed to seeing the US make others behave the way the US wants, the media
lives in a state of denial. Nevertheless, there is mounting statistical data pointing in the
direction of the possibility of insolvency.
US Debt:

In an article written in December 2008, Maurizio d’Orlando examined the explosion of US

debt. He wrote that it “grew from $6.9 trillion as of 31 December 2003 to $13.4 trillion as of
31 December 2007. This is internationally circulated currency.”

The rate of growth of the debt has increased since the financial crisis began in the summer of
2007. The US public debt stood at $10.6 trillion, or 76.6 percent of gross domestic product
(GDP), at the end of 2008. “Adding the Paulson plan and the rescue package for Fannie Mae
and Freddie Mac (but not counting that for AIG), the ratio jumped to 118 percent,” wrote
d’Orlando.

He continued: “If the figures published by Bloomberg are correct—$7.74 trillion in rescue
packages—we arrive at about $23.3 trillion of public debt, for a ratio of 169 percent of GDP.
In just a short period of time, the public debt of the United States has almost doubled or
tripled. Whatever the case may be, it is far too high.”

“We can nonetheless roughly assume,” d’Orlando noted, “that a breaking point is quickly
coming up, because if we add up US public debt and spending commitments in health care
(Medicaid and Medicare) and pensions (Social Security), we get to 429.27 percent of GDP.”

An International Monetary Fund (IMF) study found that when the foreign-owned public debt
of a country reaches 60 percent of GDP, that country faces the risks of a major monetary
crisis. By the end of 2007, the ratio of US foreign-owned debt stood at 61.8 percent, up from
54.4 percent the previous year.

Even if one sets aside US commitments to Medicare, Medicaid and Social Security, its
current public debt, at least 118 percent of GDP, implies that its foreign-owned debt stands at
73 percent of GDP, far above the 60 percent limit calculated by the IMF.

The only reason the IMF’s 60 percent limit does not apply to the US is that the US dollar
remains the world reserve currency. Were the US dollar to lose its uniquely privileged
position in world trade, the result would be nothing less than catastrophic.

It must also be borne in mind that Asian investors, especially the Japanese and Chinese, are
the main foreign investors in US financial assets.

What are the alternatives for the US? Monetary policy reached a dead-end the day Federal
Reserve Chairman Ben Bernanke set the federal funds interest rate at zero. The fiscal plans
launched by the Obama administration—including the many rescue schemes offered to
banks, insurers and auto makers—still do not satisfy Wall Street, and more may be allotted to
bail out the banks. Most market practitioners consider the bottom of the financial crisis hasn’t
been reached yet.

There is a real risk that fiscal policies alone won’t work either. As Washington runs out of
options, the next measure available to the government is a massive devaluation of the US
dollar. That would have the effect of exporting the crisis to other countries, and would
unquestionably raise calls by major US competitors to replace the dollar with another
currency or basket of currencies as the world reserve currency.
Undervaluation of the yuan
For trade between China and the US, a devaluation of the US dollar is equivalent to an
appreciation of the yuan. Asia News estimates that the yuan is undervalued by 55.5 percent.

“Currently,” writes Asia News, “because the exchange rate is controlled by the People’s
Bank of China, the US dollar is worth about 6.8798 yuan.... If we applied the same
relationship between China’s GDP in current dollars (6.04 percent of world GDP) and
China’s GDP at purchasing power parity (which is 10.78 percent of World GDP), a US dollar
should be exchanged at 3.821 yuan (hence the latter is undervalued by 55.54 per cent).”

A yuan appreciation of such magnitude—or a similar massive devaluation of the US dollar—

would bring about a collapse of Chinese exports. Factories would have to shut down and lay
off workers. This would cause social upheavals and threaten the power of the Chinese
Communist Party and the cast of corrupt individuals who have enriched themselves by
seeding capitalism in China. Equally affected would be foreigners who have at stake billions
in direct investments in China.

Asia News writes, “Seen as the world’s workshop, China is a great success, but if we
consider the amount of human resources, capital and raw materials used with regards to GDP
growth per unit, then its system of production appears very inefficient. What is more, China’s
yuan devaluation in 1994 led right to the 1998 Asian crisis. For Asia, that crisis was the price
to pay for China’s transition from Communism to a market economy, the equivalent in some
ways to the 1989 collapse of the Berlin Wall.”

Asia News summarized the relationship between China and the US in the following way:
“Globalization is based on an unbalanced economic model. So far, public and private
consumption in the United States have driven world demand. US consumers made export-
driven growth in many countries possible.

“The absurdity of this method lies in the fact that producers get underpaid and are forced into
saving in order to provide credit for those who do not produce and could hardly afford to buy.
Workers in China, Brazil and India get starvation wages to produce goods tailor-made for the
US (and Western) market, whilst US consumers are unable to generate corresponding
resources and value.

“In fact, the trend for the US GDP is negative since the third quarter of 2000 when calculated
on the basis of inflation as calculated prior to the Clinton era. Yet US consumers have been
pushed, flattered and funded to live above their means, almost forced to buy every kind of
goods. This is why there is a solvency problem.”

In fact, consumers in the US have been forced to assume an ever bigger and more
unsustainable burden of debt while their wages steadily eroded as a result of corporate and
government policy.

The steps taken by China to decouple its exports from the US dollar and increase its influence
in emerging markets are strong indications that the financial crisis is evolving toward a new
stage in which the major countries will use their currencies, economic and political muscle,
and military might to carve out a larger share in a new division of the world economy.
Rupee Yuan Trade Platform:
There have been recent discussions on the Rupee Yuan trade platform being strengthened
sand the dollar peg. A new currency arrangement between India and China is desired by the
local banks in light of the recent currency row. A simpler and less expensive mechanism is
sought that would bypass dollar and allow trade payments in local currency between the
international giants.

Since the Indian rupee and Chinese yuan are largely non-convertible currencies, export and
import transactions between the two countries have dollar pegs. The rupees that an Indian
buyer pays his bank for Chinese import, are converted into dollars which in turn is converted
into yuan with the help of other banks for paying the Chinese seller.

The spiralling trade relations between India and China could prove to be a reason to move
forward in this direction as otherwise, it takes 2-3 days to complete a transaction due to
difference in time zones and involves additional operational costs.

“A direct yuan-rupee trade would cut transaction time, in fact the transactions could become
real time. Also, the transaction cost would be lower,” said Aditya Puri, managing director and
CEO of HDFC Bank, which is one of the domestic institutions that mooted the idea.

He said that the HDFC Bank team which recently visited China felt that Chinese authorities
may be open to the suggestion. A bilateral trade using local currencies would require Indian
banks opening yuan nostro accounts, which can be used for yuan trades, in Hong Kong or the
mainland. This would need regulatory approvals from both countries

The proposal could benefit the India-China trade. It’s one of the most important trade
corridors. Any means to facilitate that from a trade or a trade finance perspective would help
both India and China. In an effort to internationalise the currency, China has permitted
limited trading of yuan in the Hong Kong offshore market for trade and certain capital
account transactions.

Also, in recent times it has entered into special currency arrangements with various countries.
Last year China struck a ‘currency swap’ agreement with Brazil that allows payment for
imports from China in yuan and imports from Brazil in the lira. It has also signed pacts with
Malaysia, Argentina, South Korea, Belarus and Singapore. Across markets the deals were
interpreted as China’s efforts to internationalise the yuan and slowly pave the way to help
yuan eventually replace dollar as the world’s reserve currency.
Discussion on the possibilities of Rupee, Yuan being the next World
Reserve Currency
Indian rupee and Chinese yuan are potential alternatives to US dollar for global transactions
which has received a severe beating after the global financial crisis, says an RBI study.

The study, authored by RBI director Rajiv Ranjan and assistant advisor Anand Prakash, said
the yuan and the rupee are "natural contenders" among emerging market currencies for
international currency status. However, China is "far from ready" to achieve the global
reserve currency status at the moment, while India needs to meet "all the necessary
preconditions...before (it) could proceed further," it said.

Internationalisation of rupee would also require India to make the rupee fully convertible.
This means that rupee could be exchanged against other currencies freely. There are currently
curbs on such convertibility so far as capital accounts like stocks are concerned.

"The Indian rupee is rarely being used for invoicing of international trade," the study pointed
out. It further said that "India has so far followed a calibrated approach towards capital
account liberalisation.

India, at present, does not permit the rupee to be officially used for international transactions,
except those with Nepal and Bhutan, though there are indications of the Indian rupee gaining
acceptability in other countries." The study noted that the strength exhibited by the rupee in
recent months and continued good performance of the Indian economy have raised the issue
of greater internationalization of its currency and India needs to proactively take steps to
increase the role of the domestic currency in the region.

The study also cautioned the Government over the risks associated with "internationalising"
the rupee as it would increase sharp volatility in the forex markets. "There are, however,
problems associated with internationalisation of the rupee as it could increase volatility of its
exchange rate," the study said.

Withdrawal of short-term funds and portfolio investments by non-residents could also be a

major potential risk of internationalisation of the rupee, it added.

Outlining the difficulty in positioning the Indian currency as a global reserve, the study said
that unlike China, which has a large current account surplus, India has a significant trade and
current account deficit. Current account balance broadly relates to exports and imports of
goods and services and investment income from global trade.

The idea of "internationalising" the rupee and the yuan was mooted, after the global financial
crisis and the weakening dollar threw open the debate on alternative global currency.
However, the study also said that it is quite unlikely that the dollar will lose its predominance
as the global reserve currency in the foreseeable future.
"The current crisis has, however, thrown open the debate on the need for a new global reserve
currency in case the US economy fails to make a significant turnaround and the weakness of
the US dollar persists," it added.
Case Study:

FERA Violations by ITC

ITC was started by UK-based tobacco major BAT (British American Tobacco). It was called
the Peninsular Tobacco Company, for cigarette manufacturing, tobacco procurement and
processing activities. In 1910, it set up a full-fledged sales organization named the Imperial
Tobacco Company of India Limited. To cope with the growing demand, BAT set up another
cigarette manufacturing unit in Bangalore in 1912. To handle the raw material (tobacco leaf)
requirements, a new company called Indian Leaf Tobacco Company (ILTC) was incorporated
in July 1912. By 1919, BAT had transferred its holdings in Peninsular and ILTC to Imperial.
Following this, Imperial replaced Peninsular as BAT’s main subsidiary in India.

By the late 1960s, the Indian government began putting pressure on multinational companies
to reduce their holdings. Imperial divested its equity in 1969 through a public offer, which
raised the shareholdings of Indian individual and institutional investors from 6.6% to 26%.
After this, the holdings of Indian financial institutions were 38% and the foreign collaborator
held 36%. Though Imperial clearly dominated the cigarette business, it soon realized that
making only a single product, especially one that was considered injurious to health, could
become a problem. In addition, regular increases in excise duty on cigarettes started having a
negative impact on the company’s profitability. To reduce its dependence on the cigarette and
tobacco business, Imperial decided to diversify into new businesses. It set up a marine
products export division in 1971. The company’s name was changed to ITC Ltd. in 1974. In
the same year, ITC reorganized itself and emerged as a new organization divided along
product lines. In 1975, ITC set up its first hotel in Chennai. The same year, ITC set up
Bhadrachalam Paperboards. In 1981, ITC diversified into the cement business and bought a
33% stake in India Cements from IDBI. This investment however did not generate the
synergies that ITC had hoped for and two years later the company divested its stake. In 1986,
ITC established ITC Hotels, to which its three hotels were sold. It also entered the financial
services business by setting up its subsidiary, ITC Classic

In 1994, ITC commissioned consultants McKinsey & Co. to study the businesses of the
company and make suitable recommendations. McKinsey advised ITC to concentrate on its
core strengths and withdraw from agri-business where it was incurring losses. During the late
1990s, ITC decided to retain its interests in tobacco, hospitality and paper and either sold off
or gave up the controlling stake in several non-core businesses. ITC divested its 51% stake in
ITC Agrotech to ConAgra of the US. Tribeni Tissues (which manufactured newsprint, bond
paper, carbon and thermal paper) was merged with ITC.

By 2001, ITC had emerged as the undisputed leader, with over 70% share in the Indian
cigarette market. ITC’ popular cigarette brands included Gold Flake, Scissors, Wills, India
Kings and Classic.
Allegations:

A majority of ITC’s legal troubles could be traced back to its association with the US based
Suresh Chitalia and Devang Chitalia (Chitalias). The Chitalias were ITC’s trading partners in
its international trading business and were also directors of ITC International, the
international trading subsidiary of ITC. In 1989, ITC started the ‘Bukhara’ chain of
restaurants in the US, jointly with its subsidiary ITC International and some Non-Resident
Indian (NRI) doctors. Though the venture ran into huge losses, ITC decided to make good the
losses and honour its commitment of providing a 25% return on the investments to the NRI
doctors. ITC sought Chitalias’ help for this.

According to the deal, the Chitalias later bought the Bukhara venture in 1990 for around $1
million. Investors were paid off through the Chitalias New-Jersey based company, ETS
Fibers, which supplied waste paper to ITC Bhadrachalam. To compensate the Chitalias, the
Indian Leaf Tobacco Division (ILTD) of ITC transferred $4 million to a Swiss bank account,
from where the money was transferred to Lokman Establishments, another Chitalia company
in Liechtenstein. Lokman Establishments made the payment to the Chitalias. This deal
marked the beginning of a series of events that eventually resulted in the company being
charged for contravention of FERA regulations.

During the 1980s, ITC had emerged as one of the largest exporters in India and had received
accolades from the government. This was a strategic move on ITC’s part to portray itself as a
good corporate citizen’ earning substantial foreign exchange for the country. In the early
1990s, ITC started exporting rice to West Asia. When the Gulf war began, ITC was forced to
withdraw rice exports to Iraq, which resulted in large quantities of rice lying waste in the
warehouses. ITC tried to export this rice to Sri Lanka, which however turned out to be a
damp squib because the rice was beginning to rot already. There were discussions in the
Colombo parliament as to the quality of the rotting rice. This forced ITC to import the rice
back to India, which was not allowed under FERA.

There were a host of other such dubious transactions, especially in ITC’s various export deals
in the Asian markets. The company, following the Bukhara deal, had set up various front
companies (shell or bogus companies) with the help of the Chitalias. Some of the front
companies were Hup Hoon Traders Pvt. Ltd., EST Fibers, Sunny Trading, Fortune Tobacco
Ltd., Cyprus, Vaam Impex & Warehousing, RS Commodities, Sunny Snack Foods and
Lokman Establishment, the one involved in the Bukhara deal. These front companies were
for export transactions. It was reported that ITC artificially hiked its profits by over-invoicing
imports and later transferring the excess funds as export proceeds into India. Analysts
remarked that ITC did all this to portray itself as the largest exporter in the country.

In 1991, ITC asked all its overseas buyers to route their orders through the Chitalias. The
Chitalias over-invoiced the export orders, which meant they paid ITC more than what they
received from overseas buyers. For instance, in an export deal to Sri Lanka, ITC claimed to
have sold rice at $350 per ton – but according to ED, the rice was actually sold for just $175
per ton. ITC compensated the difference in amount to the Chitalias through various means
including under invoicing other exports to them, direct payments to Chitalia companies and
through ITC Global Holdings Pte Ltd. (ITC Global), a Singapore-based subsidiary of ITC.
ITC Global was involved in a number majority of the money laundering deals between ITC
and Chitalias.

However, by 1995, ITC Global was on the verge of bankruptcy because of all its cash
payments to the Chitalias. It registered a loss of US $ 16.34 million for the financial year
1995-96, as against aprofit of US $1.7 million in 1994-95. The loss was reportedly due to the
attrition in trade margins, slow moving stock and bad debts in respect of which provisions
had to be made.

It was also reported that ITC Global incurred a loss of $20 million on rice purchased from the
Agricultural Products Export Development Authority (APEDA), which was underwritten by
the Chitalias. By the time this consignment was exported to S Armagulam Brothers in Sri
Lanka through Vaam Impex, another ITC front company, there was an acute fall in
international rice prices. The consignee (S Armagulam Brothers) rejected the consignment
because of the delay in dispatch. Following this, ITC bought back that rice and exported it to
Dubai, which was against FERA.

This resulted in huge outstanding debts to the Chitalias, following which they turned against
ITC and approached BAT complaining of the debts and other financial irregularities at ITC in
late 1995. BAT, which was not on good terms with Chugh, reportedly took this as an
opportunity to tarnish his reputation and compel him to resign. BAT appointed a renowned
audit firm Lovelock and Lewes to probe into the irregularities at ITC. Though the audit
committee confirmed the charges of financial irregularities at ITC during the early 1990s and
the role of the Chitalias in the trading losses and misappropriations at ITC during the year
1995-96, it cleared Chugh of all charges. Chugh agreed to resign and BAT dropped all
charges against him. He was given a handsome severance package as well as the ‘Chairman
Emeritus’ status at ITC. However according to industry sources, though the Chitalias were on
good terms with ITC, it was BAT, which instigated the Chitalias to implicate the top
management of ITC. BAT reportedly wanted to ‘step in as a savior’ and take control of ITC
with the active support of the FI nominees on the board, which had supported ITC before
charges of unethical practices surfaced.

Meanwhile, the Chitalias filed a lawsuit against ITC in US courts to recover their dues. They
alleged that ITC used them to float front companies in foreign countries in order to route its
exports through them. They also alleged ITC of various wrongdoings in the Bukhara deal.
These events attracted ED’s attention to the ongoings at ITC and it began probing into the
company’s operations. ED began collecting documents to prove that ITC had violated various
FERA norms to pay the NRI Doctors.
FERA Violations

The ED found out that around $ 83 million was transferred into India as per ITC’s
instructions on the basis of the accounts maintained by the Chitalia group of companies.
According to the ED officials, the ITC management gave daily instructions to manipulate the
invoices related to exports in order to post artificial profits in its books. A sum of $ 6.5
million was transferred from ITC Global to the Chitalias’ companies and the same was
remitted to ITC at a later date. Another instance cited of money laundering by ITC was
regarding the over-invoicing of machinery imported by ITC Bhadrachalam Paperboards Ltd.,
from Italy. The difference in amount was retained abroad and then passed to the Chitalias,
which was eventually remitted to ITC.

The ED issued charge sheets to a few top executives of ITC and raided on nearly 40 ITC
offices including the premises of its top executives in Kolkata, Delhi, Hyderabad, Guntur,
Chennai and Mumbai. The charge sheets accused ITC and its functionaries of FERA
violations that included over-invoicing and providing cash to the Chitalias for acquiring and
retaining funds abroad, for bringing funds into India in a manner not conforming to the
prescribed norms, for not realizing outstanding export proceeds and for acknowledging debt
abroad TABLE II

Overview of FERA Violations by ITC

ILTD transferred $4 million to a Swiss bank account. The amount was later transferred to
Lokman Establishment, which in turn transferred the amount to a Chitalia company in the
US.

ITC also made payments to non-resident shareholders in the case of certain settlements
without the permission of the RBI. This was against Sections 8(1) and 9(1)(a) of FERA;

ITC under-invoiced exports to the tune of $1.35 million, thereby violating the provisions of
Sections 16(1)(b) and 18(2);

ITC transferred funds in an unauthorized manner, to the tune of $0.5 million outside India by
suppressing facts with regard to a tobacco deal. This was in contravention of Section a (1)
read with Section 48;

ITC acquired $0.2 million through counter trade premium amounting to between 3 and 4 per
cent on a total business of 1.30 billion, contravening Section 8(1);

The company had debts to the tune of 25 million due to over-invoicing in coffee and cashew
exports during 1992- 93 to the Chitalias, contravening Section 9(1)(c) read with Section
26(6); G. K. P. Reddi, R. K. Kutty, Dr. E. Ravindranath and M. B. Rao also violated the
provisions of Sections 8(1), 9(1)(a), 9(1)(c), 16(b), 18(2) and 26(6) read with Section 68 of
FERA.

(Source: ICMR)
The ED also investigated the use of funds retained abroad for personal use by ITC executives.
Though the ED had documentary proof to indicate illegal transfer of funds by top ITC
executives, nothing was reported in the media. The top executives were soon arrested. In
addition, the ED questioned many executives including Ashutosh Garg, former chief of ITC
Global, S Khattar, the then chief of ITC Global, the Chitalias, officials at BAT and FI
nominees on ITC board.

Meanwhile, the Chitalias and ITC continued their court battles against each other in the US
and Singapore. ITC stated that the Chitalias acted as traders for ITC’s commodities including
rice, coffee, soyabeans and shrimp. ITC accused the Chitalias of non-payment for 43
contracts executed in 1994. ITC sued the Chitalias seeking $12.19 million in damages that
included the unpaid amount for the executed contracts plus interest and other relief.
Following this, the Chitalias filed a counter-claim for $55 million, accusing ITC of
commission defaults (trading commission not paid) and defamation.

In August 1996, the Chitalias indicated to the Government of India and the ED their
willingness to turn approvers in the FERA violation case against ITC, if they were given
immunity from prosecution in India. The government granted the Chitalias, immunity under
section 360 of the Indian Criminal Procedure Act, following which the Chitalias were
reported to have provided concrete proof of large scale over-invoicing by ITC mainly in the
export of rice, coffee and cashew nuts. In another major development, a few directors and
senior executives of ITC turned approvers in the FERA violation case against the company in
November 1996. A top ED official confirmed the news and said that these officials were
ready to divulge sensitive information related to the case if they were given immunity against
prosecution, as granted to the Chitalias.

The same month, the High Court of Singapore appointed judicial managers to take over the
management of ITC Global. They informed ITC that ITC Global owed approximately US $
49 million to creditors and sought ITC’s financial support to settle the accounts. Though ITC
did not accept any legal liability to support ITC Global, it offered financial assistance upto
$26 million, subject to the consent and approval of both the Singapore and Indian
governments.

In December 1996, most of the arrested executives including Chugh, Sapru, R. Ranganathan,
R K Kutty, E Ravindranathan, and K.P. Reddi were granted bail. ITC sources commented
that BAT instigated the Chitalias to sue and implicate its executives. BAT was accused of
trying to take over the company with the help of the financial institutions (FIs), who were
previously on ITC’s side. In November 1996, BAT nominees on the ITC board admitted that
BAT was aware of the financial irregularities and FERA violations in ITC. However, BAT
authorities feigned ignorance about their knowledge of the ITC dealings and charges of
international instigation against ITC.

According to analysts, ITC landed in a mess due to gross mismanagement at the corporate
level. Many industrialists agreed that poor corporate governance practices at ITC were
principally responsible for its problems. They remarked that nominees of the FI and BAT
never took an active part in the company’s affairs and remained silent speculators, giving the
ITC nominees a free hand. R.C. Bhargava, Chairman, Maruti Udyog, said, “It is difficult to
believe that FIs and BAT nominees had no idea of what was going on. The board members
have many responsibilities. They need to ask for more disclosures and information.” Few
industry observers also commented that ITC followed a highly centralized management
structure where power vested in the hands of a few top executives

However, some other analysts claimed that problems associated with India’s legal system
were equally responsible for the ITC fiasco. Subodh Bhargava, Vice-Chairman, Eicher Group
remarked, “The root cause for a case like ITC to occur is the complexity of laws in our
country and the continuing controls like FERA. We have to admit that the limits imposed on
industry are not real and, therefore, every opportunity is sought to get around them. This
leads to different interpretations of the law and so legal violations occur”
The Aftermath – Setting Things Right

Alarmed by the growing criticism of its corporate governance practices and the legal
problems, ITC took some drastic steps in its board meeting held on November 15, 1996. ITC
inducted three independent, non-executive directors on the Board and repealed the executive
powers of Saurabh Misra, ITC deputy chairman, Feroze Vevaina, finance chief and R.K.
Kutty, director. ITC also suspended the powers of the Committee of Directors and appointed
an interim management committee. This committee was headed by the Chairman and
included chief executives of the main businesses to run the day-to-day affairs of the company
until the company had a new corporate governance structure in place.

ITC also appointed a chief vigilance officer (CVO) for the ITC group, who reported
independently to the board. ITC restructured its management and corporate governance
practices in early 1997. The new management structure comprised three tiers- the Board of
Directors (BOD), the Core Management Committee (CMC) and the Divisional Management
Committee (DMC), which were responsible for strategic supervision, strategic management,
and executive management in the company respectively.

Through this three-tiered interlinked governance process, ITC claimed to have struck a
balance between the need for operational freedom, supervision, control and checks and
balances. Each executive director was responsible for a group of businesses/corporate
functions, apart from strategic management and overall supervision of the company

However, the company’s troubles seemed to be far from over. In June 1997, the ED issued
showcause notices to all the persons who served on ITC’s board during 1991-1994 in
connection with alleged FERA violations. The ED also issued notices to the FIs and BAT
nominees on the ITC board charging them with FERA contravention. In September 1997, the
ED issued a second set of show-cause notices to the company, which did not name the
nominees of BAT and FIs. These notices were related to the Bukhara restaurant deal and the
irregularities in ITC’s deals with ITC Global.

In late 1997, a US court dismissed a large part of the claim, amounting to $ 41 million,
sought by the Chitalias from ITC and ordered the Chitalias to pay back the $ 12.19 million
claimed by ITC. The Chitalias contested the decision in a higher court, the New Jersey
District court, which in July 1998 endorsed the lower court’s order of awarding $ 12.19
million claim to ITC. It also dismissed the claim for $ 14 million made by the Chitalias
against ITC. The judgment was in favor of ITC as the US courts felt that the Chitalias acted
in bad faith in course of the legal proceedings, meddled with the factual evidence, abused
information sources and concealed crucial documents from ITC. Following the court
judgment, the Chitalias filed for bankruptcy petitions before the Bankruptcy Court in Florida,
which was contested by ITC.

In early 2001, the Chitalias proposed a settlement, which ITC accepted. Following the
agreement, the Chitalias agreed to the judgement of the Bankruptcy Court, which disallowed
their Bankruptcy Petitions. As a part of this settlement ITC also withdrew its objections to
few of the claims of Chitalias, for exemption of their assets. However, ITC’s efforts to
recover its dues against the Chitalias continued even in early 2002. The company and its
directors inspected documents relating to the notices, with the permission of the ED, to frame
appropriate replies to the notices. It was reported that ITC extended complete cooperation to
the ED in its investigations.

However, the ED issued yet another show-cause notice (the 22 notice so far) to ITC in June
2001, for violating section 16 of FERA, in relation to ITC’s offer to pay $ 26 million to settle
ITC Global’s debts (under section 16 of FERA, a company should take prior permission from
the RBI, before it can forgo any amount payable to it in foreign exchange). ITC replied to the
showcase notice in July 2001, stating it did not accept any legal liabilities while offering
financial support to ITC Global. On account of the provisions for appeals and counter-
appeals, these cases stood unresolved even in early 2002. However, ITC had created a 1.9
million contingency fund for future liabilities.

Although the company went through a tough phase during the late 1990s, it succeeded in
retaining its leadership position in its core businesses through value additions to products and
services and through attaining international competitiveness in quality and cost standards.
Despite various hurdles, the company was a financial success, which analysts mainly
attributed to the reformed corporate governance practices. What remains to be seen is
whether the company would be able to come out unscathed from the various charges of
unethical practices against it.
Case Study on FEMA: RBI slapped Rs.125 crore on Reliance Infrastructure

The Reserve Bank of India (RBI) has asked the Anil Dhirubhai Ambani Group firm, Reliance
Infrastructure (earlier, Reliance Energy), to pay just under Rs 125 crore as compounding fees
for parking its foreign loan proceeds worth $300 million with its mutual fund in India for 315
days, and then repatriating the money abroad to a joint venture company. These actions,
according to an RBI order, violated various provisions of the Foreign Exchange Management
Act (FEMA)

In its order, RBI said Reliance Energy raised a $360-million ECB on July 25, 2006, for
investment in infrastructure projects in India. The ECB proceeds were drawn down on
November 15, 2006, and temporarily parked overseas in liquid assets. On April 26, 2007,
Reliance Energy repatriated the ECB proceeds worth $300 million to India while the balance
remained abroad in liquid assets.

It then invested these funds in Reliance Mutual Fund Growth Option and Reliance Floating
Rate Fund Growth Option on April 26, 2007. On the following day, i.e., on April 27 2007,
the entire money was withdrawn and invested in Reliance Fixed Horizon Fund III Annual
Plan series V. On March 5, 2008, Reliance Energy repatriated $500 million (which included
the ECB proceeds repatriated on April 26, 2007, and invested in capital market instruments)
for investment in capital of an overseas joint venture called Gourock Ventures based in
British Virgin Islands.

RBI said, under FEMA guidelines issued in 2000, a borrower is required to keep ECB funds
parked abroad till the actual requirement in India. Further, the central bank said a borrower
cannot utilise the funds for any other purpose.

“The conduct of the applicant was in contravention of the ECB guidelines and the same are
sought to be compounded,” the RBI order signed by its chief general manager Salim
Gangadharan said.

During the personal hearing on June 16, 2008, Reliance Energy, represented by group
managing director Gautam Doshi and Price waterhouse Coopers executive director Sanjay
Kapadia, admitted the contravention and sough compounding. The company said due to
unforeseen circumstances, its Dadri power project was delayed. Therefore, the ECB proceeds
of $300 million were bought to India and was parked in liquid debt mutual fund schemes, it
added.

Rejecting Reliance Energy’s contention, RBI said it took the company 315 days to realise
that the ECB proceeds are not required for its intended purpose and to repatriate the same for
alternate use of investment in an overseas joint venture on March 5, 2008.

Reliance also contended that they invested the ECB proceeds in debt mutual fund schemes to
ensure immediate availability of funds for utilisation in India.
“I do not find any merit in this contention also as the applicant has not approached RBI either
for utilising the proceeds not provided for in the ECB guidelines, or its repatriation abroad for
investment in the capital of the JV,” the RBI official said in the order.

In its defence, the company said the exchange rate gain on account of remittance on March 5
2008, would be a notional interim rate gain as such exchange rate gain is not crystallised.

But RBI does not think so. “They have also stated that in terms of accounting standard 11
(AS 11), all foreign exchange loans have to be restated and the difference between current
exchange rate and the rate at which the same were remitted to India, has to be shown as
foreign exchange loss/gain in profit and loss accounts.

However, in a scenario where the proceeds of the ECB are parked overseas, the exchange rate
gains or losses are neutralized as the gains or losses restating of the liability side are offset
with corresponding exchange losses or gains in the asset. In this case, the exchange gain had
indeed been realised and that too the additional exchange gain had accrued to the company
through an unlawful act under FEMA,” the order said.

It said as the company has made additional income of Rs 124 crore, it is liable to pay a fine of
Rs 124.68 crore. On August this year, the company submitted another fresh application for
compounding and requested for withdrawal of the present application dated April 17, 2008,
to include contravention committed in respect of an another transaction of ECB worth $150
million. But RBI said the company will have to make separate application for every
transaction and two transactions are different and independent and cannot be clubbed
together.