Overseas Direct Investment Regulations : Anomalies in RBI’s clarification circular No. 100 dtd 25th April 2013 ?
Among the objectives of the Overseas Direct Investments Regulations, is the recognition by the Govt. of India and the RBI of such investments as important avenues for promoting global business by Indian entrepreneurs. Joint Ventures are perceived as a medium of economic and business co-operation between India and other countries. Transfer of technology and skill, sharing of results of R&D, access to wider global market, promotion of brand image, generation of employment and utilization of raw materials available in India and in the host country are other significant benefits arising out of such overseas investments. They are also important drivers of foreign trade through increased exports of plant and machinery and goods and services from India and also a source of foreign exchange earnings by way of dividend earnings, royalty, technical know-how fee and other entitlements on such investments.
This is the obverse of FDI into India which is also actively promoted by the Govt. of India.
The Regulations pertaining to Overseas Direct Investments are covered under the Foreign Exchange Management ( Transfer or Issue of any Foreign Security) Regulations 2004 and notified by the RBI vide notification No.FEMA 120/RB-2004 dtd. July 7th 2004, as amended from time to time. The recent Master Circular of RBI in this matter is dated July 2nd 2012.
The eligibility and general permissions for investments are covered under Regulations 5, 6 and 7 of the aforesaid Regulations.
An India entity desirous of establishing a WOS abroad or entering into a JV with a foreign party may follow the Automatic Route as envisaged under Reg 6 of these Regulations. In the case of those entities which are already in the Financial Services Sector, would need to follow certain prescriptions as stipulated in Reg. 5 which among others require them to obtain the approval of the concerned Regulatory authorities both in India as well as abroad to embark upon such financial sector activities.
It shall be noted that the securing of the aforesaid approval or permission from the local Regulator as required under Regulation 5 would not constitute an approval from the RBI under Regulation 7 which deals with prior approvals required by entities to undertake certain other activities in foreign jurisdictions and places certain additional conditions to be met for the grant of such approvals.
A number of Capital Market (equity as well as commodities) regulated entities have established their Wholly Owned Subsidiaries or have entered into JV arrangements overseas in order to participate on stock and commodities exchanges abroad following the procedures prescribed by the aforesaid Regulations. These entities have accordingly secured registration or license from the international regulators / stock Exchanges on the basis of them having adhered to the local requirements in India.
In the process of facilitating the overseas direct investment in the financial sector, since 2004 neither the RBI nor the Govt. of India had placed any restriction on the participation or product offerings by these entities to their respective clients in the overseas markets with regard to the investment type or class of Securities that are made available for trading by such regulated Exchanges. On the basis of these positions and in the absence of any prohibition or restriction, these overseas subsidiaries had planned and executed their business propositions and have grown their business, many of them quite substantially and with huge investments.
However, the RBI has vide a circular No.100 dtd 25th April 2013, issued a “clarification” in respect of the aforesaid Regulations to the effect that any overseas entity having equity participation of Indian parties shall not offer any products that are either linked to the Indian Rupee or to any of the indices of the Indian bourses. Violation to these provisions would attract the penal provisions under FEMA.
In the extant circular of the RBI the following terms or words have been used. We would like to delve on the application of each of them and their relevance to the matter on hand:
1. “Set-up certain structures” : While the word “set up” has been used many times in the extant Regulations, its meaning is simply to establish an entity. This could, in the present context mean the formation or establishment of a JV or a WOS by an Indian entity within the ambit of Regulation 5, 6 and/ or 7. We need not attribute any importance to the word “structures” as it only serves to complete the purpose of the words “Set up” used in the said sentence.
2. “Automatic route”: This is actually a very important attribute in the said circular as almost every JV or WOS that is formed by the Indian entities in the Financial Services Sector (other than the banks) is through the automatic route as envisaged in the said Regulations. Where a JV or a WOS is formed under Reg 7, the clarifications or directions of the said circular will not apply.
The effect of this clarification by the RBI also extends to all Stock exchanges that have been established abroad by Indian entities under the Automatic route, even though the functioning of these stock exchanges is not at all governed by the RBI.
3. “Having equity participation of Indian Parties”: the effect of these words would include a WOS of an Indian entity or the holding of even one share by an Indian entity in the foreign JV or a foreign company.
4. “Offering financial products linked to Indian Rupees” : This is the first time in the scheme of things related to the Overseas Direct Investment Regulation that something is spoken of ( in the prohibitory sense) on financial products that are linked to the Indian rupee. In the same breath the circular throws up certain examples of such products like non deliverable trades involving foreign currency, which could mean the US$ or the Euro etc, the rupee Exchange rates, stock indices linked to Indian markets etc which can include the Nifty or the SENSEX). The words “Offering”, “Shall Not Offer” and “such product facilitation” used in the circular would mean and include:
1. Activities of the dealership or broking community by any name as may be referred to in different jurisdictions, in placing buy or sell orders, on behalf of their clients, in respect of financial products offered by or on recognized exchanges in any market.
2. Clearing and settlement functions of a Clearing Member including a Professional or General Clearing Member of the relevant Stock Exchange/ clearing corporation.
5. “Incidence of Product Facilitation” : In my view, this should not include any prop book deals of Brokers as they do not reflect “facilitation”. However, in view of the current thinking of the RBI in this matter, as can be sensed from the manner in which the “direction” has been worded and communicated, it would not be prudent to infer that it is the intention of the RBI to exempt the Prop book trades in respect of the said “financial products” from the provisions of this circular.
6. Upon a normal reading of para 2 of the circular, it would appear that its contents are in the nature of clarifications. However, in Para 4, there is a clear statement that contents of this circular are in the nature of “directions” that require adherence, failing which the actions of these entities will be treated as contraventions to the provisions of FEMA.
The said circular seems quite innocuous, but loaded heavily against a certain section of the brokerage community. The question is: can the basic framework of a Regulation be altered through a “Clarification” circular.
To place the entire matter in a nut shell, the contents of the said circular appear to be against commercial interests of the Indian brokerage fraternity and goes contrary to the objectives that have been set out in the preamble of the Overseas Direct Investment regulations of 2004 which read as :
“Section A – General
(1) Overseas investments in Joint Ventures (JV) and Wholly Owned Subsidiaries (WOS) have been recognised as important avenues for promoting global business by Indian entrepreneurs. Joint Ventures are perceived as a medium of economic and business co-operation between India and other countries. Transfer of technology and skill, sharing of results of R&D, access to wider global market, promotion of brand image, generation of employment and utilisation of raw materials available in India and in the host country are other significant benefits arising out of such overseas investments. They are also important drivers of foreign trade through increased exports of plant and machinery and goods and services from India and also a source of foreign exchange earnings by way of dividend earnings, royalty, technical know-how fee and other entitlements on such investments.
(2) In keeping with the spirit of liberalisation, which has become the hallmark of economic policy in general, and Foreign Exchange regulations in particular, the Reserve Bank has been progressively relaxing the rules and simplifying the procedures both for current account as well as capital account transactions. ”
The contents of this circular also appear to be weak on the legal front: The original provisions vide the “Foreign Exchange Management ( Transfer or Issue of any Foreign Security) Regulations 2004” and notified by the RBI vide notification No.FEMA 120/RB-2004 dtd. July 7th 2004 as amended from time to time extends a firm permission to every entity that is established abroad pursuant to the Indian equity participant following the prescriptions of procedure and eligibility to participate in a foreign Securities Market without any restriction or prohibition. The broking entities are business enterprises and participate in Securities trading only after obtaining regulatory permissions. The products are offered by a Securities Exchange only after obtaining Regulatory approvals. Every aspect of a product offering and facilitation go through the fine sieve of a Regulatory scrutiny and external statutory bodies cannot override the decisions of a local Regulator who alone is empowered to place restrictions on a licensee.
Again, the circular states that “It is clarified that any overseas entity having equity participation directly or indirectly shall not offer such products without the specific approval of the Reserve Bank of India given that ……..”
This is a badly drafted sentence. It just says “any overseas entity having equity participation…..” It does not say “with whom”. Therefore, as it stands, the circular would prohibit any entity including those without any Indian equity participant and unconnected or unrelated to an Indian entity, to offer such products or facilitate trading in such products. The RBI has no universal authority or jurisdiction on every entity in the world. I assume that the RBI assumes that one would read its mind and link this sentence to the earlier part of the paragraph and relate the words “equity participants” to mean “Indian parties”. This is a wrongly and hastily worded circular but I shall not spend too much time on it treating this as a sheer misadventure on the part of RBI if they fancy that they have such powers.
The same sentence then goes on to state that “ …… given that currently Indian Rupee is not fully convertible and such products could have implications for exchange rate management of the country”
This is where the RBI logic fails, the reasons being :
1. Since 2009, Currency futures ( US$/INR, Euro/INR currency pairs) are actively traded on more than 3 Indian bourses with a combined average daily volume in excess of US$ 8 Bn in the initial two years and currently at around US$4 Bn on each trading day. For the last two years Option trading in different currency pairs is also facilitated by these Indian bourses.
2. Hundreds of traders on behalf of their clients trade on these products.( hedging or just speculating)
3. The Dubai Gold and Commodities Exchange (DGCX), which was jointly promoted by the UAE Govt. and an Indian entity in 2005, had introduced trading in Futures Contracts in the US$/ INR currency pair about two years ahead of the Indian bourses. Initially, the trading was lack luster but since the last two years, on an average, the daily volumes are around US$1Bn with active participation of many brokers in Dubai.
4. From the available data it can be seen that the prices on the INR/US$ Futures contracts at DGCX is almost a mirror image of that prevailing in the Indian markets till the closing time in India. Post the closure of Indian Markets, while the prices hardly deviate, the volumes surge as the trading in Gold and silver in the US markets ( CME ) take off and the Indian Gold traders in Dubai continuously seek to hedge their INR/US$ and Gold price exposure till the closure of the US markets. DGCX is the only Exchange that is available to them for the combined hedge after the Indian Markets close at 5pm.
5. The RBI is well aware of the operations of the Non Deliverable Futures market in the US$/ INR currency pair in Singapore for the last three decades. NDFs are forward transactions used by market participants to hedge non-convertible currencies. This is purely an OTC market with no rules, regulations and price bands or even reference prices but used by every international banker for all large remittances (investments) into India. The daily volume in this NDF market is a few Bn $s worth. Strangely, since July 2011, the clearing house/ corporation of the Singapore Stock Exchange has started offering its services to settle the obligations of the Singapore NDF market, thereby lending credence to a unregulated and unrecognized market. The RBI is aware of this market. Trading on this market is 100% by international operators. The prices on this market are markedly at large variance to the prices available at the Indian and Dubai currency Futures Markets. But yet, the RBI makes no noise about this market.
6. Recently the CME and ICE, the two large markets in the US (and the world) have introduced trading in the Futures contracts of US$/ INR currency pairs. Though not very active, there are many international brokers who participate in these contracts and the product is available for a large volume game, much larger than what happens in the Indian markets.
7. In stating the reasons or the objectives to prohibit the Indian linked overseas entities/brokers from participating in or facilitating trading on INR linked currency contracts, no data, ie, empirical data on the basis which such decision was taken was not communicated to the market participants.
8. In the same clarification circular, an attempt is made by the RBI to prohibit Indian linked entities in participating in any product linked to any Stock indices of any Indian Exchange. This is quite strange as all trading in all such international Exchanges are denominated in US$ terms. The CME had, about a year ago initiated trading on the NIFTY Futures and it is openly available for trading by the international brokers and investors though in US$ terms. In fact NIFTY futures is also traded on the Singapore Stock Exchange since 1998 in US$ terms. Theoretically speaking, the prices of such Index Futures on these international markets can have major implications on the home country index ( SENSEX or NIFTY) but the RBI does not seem to be worried about that as the players would not be Indian entities !
9. In the absence of any analysis and the publication of the resultant findings on any empirical data on the INR/US$ Futures prices prevailing in the DGCX market visa vis the prices on the Indian markets, the statement of RBI on the possible adverse and unmanageable impact the participation by Indian related entities (in financial products like the US$/ INR contracts) will have on the exchange rate management shows that either the RBIs Exchange rate management capabilities are weak and they lack competence to operate in an open and competitive environment OR there is something more than the eye can see.
1. In my view, the principle of estoppel would apply in this case as the RBI has always held out that the Indian financial market community can establish overseas ventures and participate in all products that are offered by international bourses and permissions were never withheld from applicants desirous of establishing subsidiaries or JVs abroad ( read Dubai) to seek membership of the DGCX where the Futures contracts in US$/ INR pairs were on offering since 2007. Curbs cannot be applied in the middle of the game.
2. It needs to be examined whether the basic character of certain Regulations can be set side or completely altered through a clarification circular.
The RBI could be queried on the application of this circular.
However, the effect of this circular of the RBI is:
1. About 150 Indian brokerage houses that have established their WOS or have entered into JVs with others in Dubai and taken up the Membership of DGCX will need to wind up their operations in Dubai. They stand to lose all their investments overnight.
2. Trading on DGCX will no longer be attractive as more than 90% of its trading volumes are attributable to the INR/US$ Futures contracts.
3. Enterprise valuation of DGCX will take a huge beating and the value of the DGCX shares will get drastically eroded.
The timing of this “clarification” by the RBI appears to have been executed with surgical precision to annihilate a certain section of the Capital Market participants in India.
Joseph H Bosco
Karamel Knowledge Ventures Pvt Ltd.
May 20th 2013
(The contents of this article are the author’s personal views and not that of the Company)