India and Capital Account Convertibility

A Report
Sanjeev Sanyal* The Prime Ministers recent announcement has refocused attention on the issue of full capital account convertibility. The new Tarapore Committee needs to weigh the gains from removing the remaining restrictions against the macroeconomic vulnerabilities that remain. In the discussion, it has been argued that external accounts and the financial system by themselves should be able to take the stresses of free capital.
*Director, Global Markets Research, Deutsche Bank1

The government recently decided to re-evaluate the possibility of full Capital Account Convertibility. The country has steadily eased controls since 1991 but significant restrictions remain. The total removal of restrictions would end half a century of varying levels of capital controls and would be a fundamental shift in Indias exchange rate and monetary policy framework. A committee has now been set up to look into the issue. It is headed by former RBI Deputy Governor Tarapore who headed a similar committee in 1997. The new committee is expected to submit its findings by end-July. The previous Tarapore Committee had proposed a number of preconditions for full convertibility and the economy is now close to satisfying some of them. However, we think the committee should consider the issue within the context of the countrys long-term growth strategy. In particular, it needs to weigh the benefits of capital account convertibility against the loss of monetary policy independence. Experience in other emerging markets has shown that this loss of policy independence can seriously exacerbate macroeconomic stresses caused by external and internal shocks. In this report, we argue that the financial system is unlikely to be placed under serious risk in an environment of free capital flows in part because Indias foreign exchange reserves appear plentiful enough to absorb some of the external shock. However, we feel that fiscal consolidation has not progressed far enough to convince investors that a regime of full capital account convertibility would be a stable one. We think that the authorities should either embark on a major fiscal correction before convertibility or at least deliberately create a war-chest of foreign exchange reserves as a bulwark against shocks. We estimate, the Reserve Bank would currently need around USD300bn worth of reserves to provide a credible war-chest. This target level would probably be higher by the time capital controls are fully removed. We estimate the direct cost of holding the incremental stock of foreign exchange at somewhere between 0.5 per cent and 1.0 per cent of GDP. The authorities need to judge if it is worth paying this insurance premium. A factor that may mitigate the cost of accumulating reserves is that this strategy could boost export competitiveness and investor confidence, and therefore be growth-enhancing.

The opinions expressed in this paper are personal, and do not necessarily reflect those of Deutsche Bank.

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History of Capital Controls India has a long history of using capital controls as they were a key element in the countrys quasi-socialist, import-substitution economic strategy prior to 1991. They were first introduced in the late 1950s and became comprehensive and draconian by the mid-seventies. In the 1980s, controls on external borrowing, including short-term borrowing, were selectively eased. However, it can be argued that this lopsided easing of controls eventually contributed to the external crisis of 1991. The country embarked on the path of liberalization after this crisis. Industrial licensing was abolished, import quotas and tariffs were lowered and so on. As part of this effort, the authorities lowered restrictions on foreign investment flows, both for FDI and for portfolio investments. Other controls were retained but were steadily eased as the economy in general and external accounts in particular showed improvement. By the end of the decade, restrictions on current account transactions had ceased to be binding and those on foreign capital were no longer especially cumbersome. Nonetheless, controls remain on debt-creating inflows (external borrowings) and on investments abroad by residents. The highlights of this system as given below: Foreign Direct Investment: Before 1991, FDI was allowed only on a case-by-case basis. The restrictions were so severe that there very little inflow (Suzukis involvement with carmaker Maruti is a notable exception). The reforms of 1991 provided for automatic approval of a 51 per cent stake in a wide range of industries. Proposals for a higher share were considered by the Foreign Investment Promotion Board. The system was still more restrictive than it sounds as there were various other bureaucratic hurdles. Nonetheless, it was better than before. In 1996, the list of open industries was increased and the foreign limit was increased to 74 per cent in many cases. Portfolio Investment: In 1992, the authorities also decided to allow foreign portfolio investment in primary and secondary equity markets. This was open only to Foreign Institutional Investors (FIIs) who were registered with the regulators. In 1997, it was decided that foreign investors could also buy government bonds. The system was also smoothened in many ways. In recent years we have witnessed a sharp increase in FII investments into the country. Note that FII registration may remain a requirement even after removal of capital controls (for reasons of taxation, supervision and foreign ownership limits). External Commercial Borrowings (ECBs): As we have already mentioned, restrictions on external borrowings were eased in the 1980s and this may have contributed to the external crisis of 1991. Therefore, the Indian authorities remain somewhat suspicious of debt-creating sources of capital. Following the 1991 crisis, ECB restrictions were tightened and have since been eased at a very gradual pace. Despite some liberalization in recent years, there are still quite a few limitations in place. In the Appendix we have attached a RBI circular issued in August 2005 about ECBs which shows the types of controls that remain in place. We have deliberately printed the whole list in order to give the reader a sense of how capital controls are imposed in practice. Resident Outflows: The area where controls remain quite stringent is on outward remittances by resident individuals and institutions both for investment purposes and for current transactions such as foreign travel. These restrictions have been in place for decades in one form or another,
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and had fuelled black markets of various kinds gold smuggling in the seventies and eighties, the hawala system since the eighties and so on. Indian passports typically had extra pages at the back that recorded the amount of dollars purchased. During the crisis of 1991, the controls were temporarily made even more severe. They were then eased through the nineties. At present, resident Indians are allowed to buy USD25,000 worth of foreign exchange every year. The constraints on Indian institutional investment abroad have also been gradually eased. Nonetheless, these are perhaps the most serious restrictions left, and would be effectively binding in the event of a macroeconomic crisis of any kind. As one can see from the above discussion, capital controls are more liberal now than they have been in two generations. For most current account transactions and for foreign investment, they are no longer binding. Even for external borrowing and resident outflows, the restrictions are now far easier than they were in the nineties. The question now arises should the authorities take the last step and get rid of the framework altogether? In order to answer this question we need to consider the constraints placed on policy-making by free international capital movement. These constraints can be especially severe in emerging markets because of systemic rigidities. We think the new committee should take this into account when recommending a way forward. The Impossible Trinity There are a number of standard theoretical arguments in favour of capital account convertibility. Free capital accounts encourage foreign investment (and consequently technology transfers), promote the productive use of capital, allow risk-sharing across borders, and so on. There are empirical studies that support the theoretical argument for capital account liberalization2. However, it is difficult to generalize these theoretical/empirical results for a specific case. India is not choosing between a fully closed capital account and a fully open one - it has significantly liberalized its external accounts and it now a matter of trading-off the costs and benefits of removing remaining controls. Eventually, the new Tarapore Committee will have to make a judgment based on the benefits of free capital movement under normal circumstances, and the exposure to risk from external and internal shocks. After all, it has been argued that capital controls were the key reason why India did not suffer from contagion from the East Asian Crisis of 1997 despite the fact that its macroeconomic indicators were far worse that for the Crisis countries3. The Impossible Trinity condition provides a simple framework within which to assess the risks from open capital accounts. The Impossible Trinity condition states that it is not possible to simultaneously have free international capital flows, an independent monetary policy and a fixed exchange rate. This means that after removing capital controls, the Indian authorities will likely at some point have to choose between having an independent monetary (interest rate) policy and having control over the exchange rate4. This would be a major shift in policy framework. For the last thirteen years,
2

For a short survey of the literature see Liberalizing Capital Flows in India: Financial Repression, Macroeconomic Policy and Gradual Reforms by Kenneth Kletzer, IPF 2004, Brookings/NCAER. 3 Foreign Inflows and Macroeconomic Policy in India by Vijay Joshi and Sanjeev Sanyal, IPF 2004, Brookings/NCAER. 4 Some economists argue that this implies corner solution either a fixed exchange rate or independent monetary policy. We feel that in practice the choice is closer to a continuum. The main requirement is that exchange rate and monetary policies are consistent.

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the India authorities have pursued an exchange rate policy that is loosely based on targeting the Real Effective Exchange Rate. In contrast, domestic interest rates and liquidity were managed to target inflation, the governments borrowing needs and general financial conditions. Despite the steady easing of controls, the remaining capital controls provide enough friction that the authorities can take advantage of the extra degree of freedom in the event of an external/internal shock. In the event of a serious external or internal economic shock in the post-convertibility world, the authorities would find that monetary policy is being forced to move in sync with the macroeconomic needs of the rest of the world (perhaps more precisely the US). Unless the deficit has been sharply reduced, fiscal policy would likely be in no position to make up for the loss of monetary policy independence because fiscal resources are already tied up. Indeed, free capital movement could exacerbate the fiscal situation in various ways rising interest rates could add to the public debt service burden and actually force a contraction in other expenditures at a time that the economy is slowing sharply. In turn, such dynamics can trigger vicious cycles with the slowing economy generating lesser tax revenues and adding to government funding needs that cannot be met because the banking system has been rendered illiquid by capital outflows. It is under such circumstances that capital controls provide the extra degree of freedom by restricting capital outflows. Indeed, during the East Asian Crisis of 1997, Malaysia imposed capital controls precisely in order to gain this extra degree of policy freedom. Old Tarapore Committee on CAC The problem of the Impossible Trinity is well known to the Indian authorities and this is why they have taken such a gradualist approach to removing capital controls. In 1997, the first Tarapore Committee laid out a number of preconditions for full capital account convertibility: a reduction in the central government deficit to 3.5 per cent of GDP, inflation in the 3-5 per cent range, Gross NPAs for banks at 5 per cent of advances and the cash reserve requirement down at 3 per cent. The committee had recommended that these targets be achieved by 2000 but it is only now that they appear within striking distance. As we will discuss in the next section, the NPA level is now close to the target. Inflation too is running below 5 per cent although it has shown a tendency to float out of this range from time to time (see chart 1). The cash reserve requirement is still at 5 per cent although we feel that it can be lowered to the targeted 3 per cent in the medium-term. Even the target for the central government deficit seems achievable (it stood at 4.1 per cent of GDP this financial year). This is probably why the authorities are feeling confident enough to push for full convertibility. Nonetheless, we feel that it is important to revisit key sources of vulnerability.

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Chart 1 India: Wholesale price inflation

%yoy 12 10 8 6 4 2 0 Apr-95 J un-96 Aug-97 Oct-98 Dec-99 Feb-01 Apr-02 J un-03 Aug-04 Oct-05

Source: CEIC Sources of Macroeconomic Vulnerability There are three likely areas of macroeconomic stress in an emerging economy external accounts, public finances and the financial system. Of course, these are inter-related areas and problems in one can spill over into other areas (for instance, fiscal profligacy can lead to external indebtedness). Note that, unlike the first Tarapore Committee, we have not included inflation as a separate factor because we consider it as a symptom rather than a disease. Chart 2 India: Net external position
USD mn 40,000 20,000 0 -20,000 -40,000 -60,000 -80,000 -100,000 1989-90 1992-93 1995-96 1998-99 2001-02 2004-05

Source: CEIC Note: Net external position is defined as forex reserves minus external debt.

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In the case of India, external vulnerability has been dramatically reduced since the 1991 crisis. Partly due to capital controls, external debt is now at a comfortable 17 per cent of GDP, the debt service ratio is a mere 6.5 per cent, and short-term debt is around 6 per cent of overall debt. At the same time, foreign exchange reserves have gone up steadily. A simple way to summarize this improvement is to take the countrys net foreign position (foreign exchange reserves minus external debt). As can be seen from the chart below, India is now a net lender to the rest of the world. At present, this gives the economy an important degree of comfort as it means that a large decline in the exchange rate (say, to correct the current account) or withdrawal of foreign investment is less likely to trigger an external debt crisis. The financial system too went through a clean-up in the nineties. Spurred on by a series of financial scandals, the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India tightened regulation/supervision in the capital markets and the banking system respectively. Importantly, this was achieved even as the financial system was being liberalized so it was not done by imposing even more red-tape and distortions. The efforts appear to have paid off with gross non-performing assets amounting to 5.2 per cent of gross advances and 2.6 per cent of total assets in March 2005 an acceptable level for an emerging market and close to the Tarapore Committee requirements5. In our judgment, the financial system looks reasonably clean for now, even if there have some concern over the credit boom in real estate. Chart 3 India: Combined fiscal deficit of central and state as per cent of GDP
% of GDP 12 10 8 6 4 2 0 1980-81

1984-85

1988-89

1992-93

1996-97

2000-01

2004-05 RE

Source: RBI Annual Reports This leaves the third main area of risk public finances. In our view, this is the most potent source macroeconomic instability for India. The combined deficit of the state and central government historically ran at around 9 per cent of GDP one of the highest in the world. We prefer to use the combined deficit although the first Tarapore Committee had expressed its target in central government terms. As shown in the chart above, this is one area where reform has not yet effected a major long-term improvement. As a result, public debt (excluding contingent claims) has been steadily creeping up for decades and now amounts to well over 83 per cent of
5

Critics will, of course, point out that the recent credit boom has sharply increased assets but have not yet been reflected in NPAs so the ratios are probably too optimistic. Nonetheless, it is an improvement on Indias past.

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GDP. Although the current economic boom is expected to have lowered the deficit to around 7.7 per cent of GDP in 2005/06 (the central deficit to 4.1 per cent), it is still very high. A decline in the deficit to around 5.5 per cent would probably stabilize the debt/GDP ratio but for our purposes it is not good enough to have stabilized the ratio at such a high level6. As Fitch Ratings pointed out in a recent report, it is hard to find a country with similar fiscal dynamics that has not had a crisis.7 We do not wish to discuss here the relative merits of different ways by which the government can stabilize fiscal accounts. It is sufficient for our purposes to point out the risk. One point, however, needs to be mentioned in Indias favour almost all the public debt is internal and is Rupee denominated. This is partly the result of conscious effort to hold down external debt, and was made possible by capital controls that bottle up domestic liquidity and statutory requirements that force banks to buy government securities. Thus, any unwinding of the capital control system must take this into account. Chart 4 India: Combined debt of central and state as per cent of GDP
% of GDP 90 80 70 60 50 40 30 20 10 0 1980-81 1984-85 1988-89 1992-93 1996-97 2000-01 2004-05 RE

Source: RBI If the second Tarapore Committee recommends full capital account convertibility, it will have to find an extra degree of freedom to deal with fiscal rigidities. The ideal solution would be to resolve the fiscal problem but this would require difficult political decisions and tax reforms that are beyond the ambit of the committee. Thus, the authorities will need to look for a second best solution. We think that one alternative is to accumulate a very large war-chest of foreign exchange reserves before removing capital controls. This is because a very large stock of reserves allows policy-makers to provide liquidity to the financial system and simultaneously hold the exchange rate. Reserves do not resolve the underlying policy contradictions but they can buy time and more importantly give credibility to policy-markers during times of stress. Indeed, the sheer size of reserves can sometimes avert the trigger for the crisis (say from currency speculation or a bank run).

6 7

The ratio would stabilize at such a high deficit level because of Indias high nominal GDP growth rate. India Public Finances: Do they Matter?, Fitch Ratings Special Report, January 2005.

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Forex Reserves: How much is enough? India currently has over USD140bn worth of foreign exchange reserves. By most conventional indicators, this is a very large stock of reserves 13 months of merchandise imports and 114 per cent of external debt. We agree that this is enough to meet any an external liquidity mismatch. However, in our view, far more foreign exchange reserves are needed if they are required to perform a task beyond providing external liquidity especially in the context of a serious fiscal dislocation. Chart 5 India: Official reserve assets
USD bn 160 140 120 100 80 60 40 J an-02

J ul-02

J an-03

J ul-03

J an-04

J ul-04

J an-05

J ul-05

J an-06

Source: CEIC It is difficult to put a number on exactly how much is enough but the number is certainly very large conventional standards. In our view, as a pre-condition to convertibility, reserves should at least be able to cover all external debt, six months of imports (merchandise plus services), and at least half of the stock of portfolio investments8. Foreign exchange reserves also need to be able to allow for the fact that after full liberalization residents can pull money out of the country (so at least 33 per cent of demand deposits need to be covered as well). After accounting for these potential outflows, we have arrived at a ballpark estimate of USD300bn more than double the current level. Much of this would have to be sterilized by the central bank because the aggressive accumulation of reserves would otherwise cause money supply to explode. Furthermore, note that the target level of reserves would rise over time as the various variables grow. We do not think we been excessively conservative since we have ignored a number of other potential outflows (such as repatriation of FDI earnings and the possible conversion of time deposits). We do not recommend reserve accumulation as an alternative to fiscal consolidation but merely as a bulwark that ring-fences the problem. What are the Costs of Forex Accumulation? Given the experience of running out of reserves in 1991, it is not surprising that the Reserve Bank has steadily built up reserves over the last fifteen years. The strategy has not been without
8

We estimate that FII investments in the equity market is currently worth around USD100bn.

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its critics. In a widely quoted paper, Suman Bery et al9 argued that this policy diverted funds that would have otherwise fed growth. They calculated that Indias growth would have been 2.7 per cent higher per year in the nineties if the capital had been allowed to flow through into the economy instead of being accumulated. Subsequent studies have, however, questioned the methodology and the findings10. In our view, there are two ways of thinking about the cost of holding reserves in terms of the quasi fiscal cost of sterilization or in terms of the foregone economic activity (these costs should not be added together). The quasi-fiscal cost is equal to the difference between interest receipts from holding the additional reserves and the payments on domestic bonds used for sterilization. Currently the spread between US and Indian long-term rates is about 250bps. So the cost of holding an additional USD160bn of reserves is USD4bn a year (or 0.5 per cent of GDP). The alternative approach tries to work out what is the opportunity cost in terms of the investment/growth foregone by accumulating reserves. This is more difficult to estimate because it must make an assumption about the rate of return on the capital inflow if it had not been taken away by the central bank but had been invested in the economy. If the marginal rate of return on investment in India were 10 per cent, the cost would be about USD8bn per annum (or 1 per cent of GDP). This probably is an upper bound as it is not obvious that all the inflows would have been automatically absorbed by the economy. We are not in a position to gauge whether or not the benefits from capital account convertibility outweigh the cost of accumulating the necessary level of reserves. This is for the new Tarapore Committee to decide. However, we can say that there could be a mitigating factor in favour of reserve accumulation. The accumulation of reserves has a side-effect it weakens the exchange rate and many economists argue that this helps growth by making exports more competitive. According to Surjit Bhalla, a prominent member of the Tarapore Committee, a 10 per cent depreciation buys 0.5 per cent in GDP growth in India11. We have also argued elsewhere that a high stock of reserves serves to reassure investors in emerging markets (both domestic and foreign) and may be very important as a source of confidence that sustains the cycle of high savings and investment12. This means that the cost of reserve accumulation may be partly (perhaps fully) off-set by the growth enhancing effects of a weaker exchange rate and greater investor confidence. Conclusions The Prime Ministers recent announcement has refocused attention on the issue of full capital account convertibility. The country has steadily eased controls since 1991 and for many areas the restrictions are no longer binding. Nonetheless, some restrictions do remain, especially of resident outflows. The new Tarapore Committee needs to weigh the gains from removing the remaining restrictions against the macroeconomic vulnerabilities that remain. In the above discussion, we have argued that external accounts and the financial system by themselves should
9

The Real Exchange Rate, Fiscal Deficits and Capital Flows: India 1981-2000, Suman Bery, Deepak Lal and Devendra Pant, EPW 2003. 10 Foreign Inflows and Macroeconomic Policy in India by Vijay Joshi and Sanjeev Sanyal, IPF 2004, Brookings/NCAER. 11 From Second Among Equals: The Middle Class Kingdoms of India and China, Surjit Bhalla, Presentation at the Institute of International Economics (Washington), February 2006. 12 See Demographics, Savings and Hyper-Growth by Sanjeev Sanyal, DB Global Markets Research, July 2005.

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be able to take the stresses of free capital flows. However, we feel that fiscal consolidation has not progressed far enough. We would argue that the authorities should ideally embark on a major fiscal correction that lowers the combined deficit well below 5.5 per cent of GDP. If not, as a second best solution, they should at least deliberately create a war-chest of foreign exchange reserves as a bulwark against sudden shocks. According to our estimate, the Reserve Bank would currently need around USD300bn worth of reserves to provide a credible war-chest. This target level would rise as the economy expanded and, therefore, would be probably higher by the time the capital account becomes fully open. We estimate the direct cost of holding the incremental stock of foreign exchange at 0.5 per cent-1.0 per cent of GDP. The new committee needs to weigh this cost against the likely benefits of free international capital movement. A factor that may mitigate the cost of accumulating reserves is that the strategy could make exports more competitive and boost investor confidence, and therefore be growth enhancing. In the end, both investors and policy-makers must recognize that capital account convertibility is part of a broader economic strategy rather than an end in itself.

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Appendix 1. Guidelines for External Commercial Borrowing (RBI circular dated 1st August 2005) 1. ECB refer to commercial loans [in the form of bank loans, buyers credit, suppliers credit, securitised instruments (e.g. floating rate notes and fixed rate bonds)] availed from nonresident lenders with minimum average maturity of 3 years. ECB can be accessed under two routes, viz., (i) Automatic Route outlined in paragraph 1(A) and (ii) Approval Route indicated in paragraph 1(B). (A) AUTOMATIC ROUTE Under the extant policy, ECB for investment in real sector -industrial sector, especially infrastructure sector-in India, are under Automatic Route, i.e. do not require RBI/Government approval. In case of doubt as regards eligibility to access Automatic Route, applicants may take recourse to the Approval Route. i. Eligible borrowers (a) Corporates registered under the Companies Act except financial intermediaries (such as banks, financial institutions (FIs), housing finance companies and NBFCs) are eligible. Individuals, Trusts and Non-Profit making Organisations are not eligible to raise ECB. (b) Non-Government Organisations (NGOs) engaged in micro finance activities are eligible to avail ECB. Such NGO (i) should have a satisfactory borrowing relationship for at least 3 years with a scheduled commercial bank authorised to deal in foreign exchange and (ii) would require a certificate of due diligence on `fit and proper status of the board/committee of management of the borrowing entity from the designated Authorised Dealer (AD). ii. Recognised Lenders (a) Borrowers can raise ECB from internationally recognised sources such as (i) international banks, (ii) international capital markets, (iii) multilateral financial institutions (such as IFC, ADB, CDC etc.,), (iv) export credit agencies, (v) suppliers of equipment, (vi) foreign collaborators and (vii) foreign equity holders. Furthermore, overseas organisations and individuals complying with following safeguards may provide ECB to NGOs engaged in micro finance activities. (b) Overseas organisations planning to extend ECB would have to furnish a certificate of due diligence from an overseas bank which in turn is subject to regulation of host-country regulator and adheres to Financial Action Task Force (FATF) guidelines to the designated AD. The certificate of due diligence should comprise the following (i) that the lender maintains an account with the bank for at least a period of two years, (ii) that the lending entity is organised as per the local law and held in good esteem by the business/local community and (iii) that there is no criminal action pending against it. (c) Individual Lender has to obtain a certificate of due diligence from an overseas bank indicating that the lender maintains an account with the bank for at least a period of two years. Other evidence /documents such as audited statement of account and income tax return which the overseas lender may furnish need to be certified and forwarded by the overseas bank. Individual lenders from countries wherein banks are not required to adhere to Know Your Customer (KYC) guidelines are not permitted to extend ECB. (d) The key operative part in the credential of the overseas lender is that ECB should be availed from an internationally recognised source and one of the recognized categories is 'foreign equity holder' as indicated above. It is clarified that for a 'foreign equity holder' to be eligible as 'recognized lender' under the automatic route would require minimum holding of equity in the borrowers company as under: (d. i) ECB up to USD 5 million minimum equity of 25 per cent held directly by the lender,
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(d. ii) ECB more than USD 5 million minimum equity of 25 per cent held directly by the lender and debt-equity ratio not exceeding 4:1(i.e. the proposed ECB not exceeding four times the direct foreign equity holding). iii.Amount and Maturity (a) ECB up to USD 20 million or equivalent with minimum average maturity of three years (b) ECB above USD 20 million and up to USD 500 million or equivalent with minimum average maturity of five years (c) The maximum amount of ECB which can be raised by a corporate is USD 500 million during a financial year. (d) NGOs engaged in micro finance activities can raise ECB up to USD 5 million during a financial year. (e) ECB up to USD 20 million can have call/put option provided the minimum average maturity of 3 years is complied before exercising call/put option. iv. All-in-cost ceilings All-in-cost includes rate of interest, other fees and expenses in foreign currency except commitment fee, pre-payment fee, and fees payable in Indian Rupees. Moreover, the payment of withholding tax in Indian Rupees is excluded for calculating the all-in-cost. The all-in-cost ceilings for ECB are indicated from time to time. The following ceilings are valid till reviewed. Average Maturity Period Three years and up to five years More than five years All-in-cost Ceilings over 6 month LIBOR* 200 basis points 350 basis points

Note: *For the respective currency of borrowing or applicable benchmark. v. End-use (a) ECB can be raised only for investment (such as import of capital goods, new projects, modernization/expansion of existing production units) in real sector - industrial sector including small and medium enterprises (SME) and infrastructure sector - in India. Infrastructure sector is defined as (i) power, (ii) telecommunication, (iii) railways, (iv) road including bridges, (v) ports, (vi) industrial parks and (vii) urban infrastructure (water supply, sanitation and sewage projects); (b) ECB proceeds can be utilised for overseas direct investment in Joint Ventures (JV)/Wholly Owned Subsidiaries (WOS) subject to the existing guidelines on Indian Direct Investment in JV/WOS abroad. (c) Utilisation of ECB proceeds is permitted in the first stage acquisition of shares in the disinvestment process and also in the mandatory second stage offer to the public under the Governments disinvestment programme of PSU shares. (d) NGOs engaged in micro finance activities may utilise ECB proceeds for lending to selfhelp groups or for micro-credit or for bonafide micro finance activity including capacity building. (e) Utilisation of ECB proceeds is not permitted for on-lending or investment in capital market or acquiring a company (or a part thereof) in India by a corporate. (f) Utilisation of ECB proceeds is not permitted in real estate. The term real estate excludes development of integrated township as defined by Ministry of Commerce and Industry, Department of Industrial Policy and Promotion, SIA (FC Division), Press Note 3 (2002 Series, dated 04.01.2002).
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(g) End-uses of ECB for working capital, general corporate purpose and repayment of existing Rupee loans are not permitted. vi. Guarantees Issuance of guarantee, standby letter of credit, letter of undertaking or letter of comfort by banks, financial institutions and NBFCs relating to ECB is not permitted. vii. Security The choice of security to be provided to the lender/supplier is left to the borrower. However, creation of charge over immovable assets and financial securities, such as shares, in favour of overseas lender is subject to Regulation 8 of Notification No. FEMA 21/RB-2000 dated May 3, 2000 and Regulation 3 of Notification No. FEMA 20/RB-2000, dated May 3, 2000, as amended from time to time, respectively. viii. Parking of ECB proceeds overseas ECB proceeds should be parked overseas until actual requirement in India. It is clarified that ECB proceeds parked overseas can be invested in the following liquid assets (a) deposits or Certificate of Deposit or other products offered by banks rated not less than AA(-) by Standard and Poor/Fitch IBCA or Aa3 by Moodys; (b) deposits with overseas branch of an authorised dealer in India; and (c) Treasury bills and other monetary instruments of one year maturity having minimum rating as indicated above. The funds should be invested in such a way that the investments can be liquidated as and when funds are required by the borrower in India. ix. Prepayment Prepayment of ECB up to USD 200 million may be allowed by ADs without prior approval of RBI subject to compliance with the stipulated minimum average maturity period as applicable to the loan. x. Refinance of existing ECB Refinancing of existing ECB by raising fresh ECB at lower cost is permitted subject to the condition that the outstanding maturity of the original loan is maintained. xi. Debt Servicing The designated Authorised Dealer (AD) has the general permission to make remittances of instalments of principal, interest and other charges in conformity with ECB guidelines issued by Government / RBI from time to time.

xii. Procedure Borrower may enter into loan agreement complying with ECB guidelines with recognised lender for raising ECB under Automatic Route without prior approval of RBI. The borrower may note to comply with the reporting arrangement under paragraph 1(C)(i). The primary responsibility to ensure that ECB raised/utilised are in conformity with the ECB guidelines and the Reserve Bank regulations/directions/circulars is that of the concerned borrower and any contravention of the ECB guidelines will be viewed seriously and may invite penal action. The designated AD is also required to ensure that raising/utilisation of ECB is in compliance with ECB guidelines at the time of certification. (B) APPROVAL ROUTE The following types of proposals for ECB are covered under the Approval Route. i. Eligible borrowers

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(a) Financial institutions dealing exclusively with infrastructure or export finance such as IDFC, IL&FS, Power Finance Corporation, Power Trading Corporation, IRCON and EXIM Bank are considered on a case by case basis. (b) Banks and financial institutions which had participated in the textile or steel sector restructuring package as approved by the Government are also permitted to the extent of their investment in the package and assessment by RBI based on prudential norms. Any ECB availed for this purpose so far are deducted from their entitlement. (c) Cases falling outside the purview of the automatic route limits and maturity period indicated at paragraphs 1A(iii) (a) and 1A(iii) (b). (d) ECB with minimum average maturity of 5 years by non-banking financial companies (NBFCs) from multilateral financial institutions, reputable regional financial institutions, official export credit agencies and international banks to finance import of infrastructure equipment for leasing to infrastructure projects. (e) Foreign Currency Convertible Bonds (FCCB) by housing finance companies satisfying the following minimum criteria: (i) the minimum net worth of the financial intermediary during the previous three years shall not be less than Rs. 500 crore, (ii) a listing on the BSE or NSE, (iii) minimum size of FCCB is USD 100 million, (iv) the applicant should submit the purpose / plan of utilization of funds. ii. Recognised Lenders (a) Borrowers can raise ECB from internationally recognised sources such as (i) international banks, (ii) international capital markets, (iii) multilateral financial institutions (such as IFC, ADB, CDC etc.,), (iv) export credit agencies, (v) suppliers of equipment, (vi) foreign collaborators and (vii) foreign equity holders. (b) From 'foreign equity holder', where the minimum equity held directly by the foreign equity lender is 25 per cent but debt-equity ratio exceeds 4:1(i.e. the proposed ECB exceeds four times the direct foreign equity holding). iii. All-in-cost ceilings All-in-cost includes rate of interest, other fees and expenses in foreign currency except commitment fee, pre-payment fee, and fees payable in Indian Rupees. Moreover, the payment of withholding tax in Indian Rupees is excluded for calculating the all-in-cost. The all-in-cost ceilings for ECB are indicated from time to time. The following ceilings are valid till reviewed. All-in-cost Ceilings over 6 month LIBOR* 200 basis points 350 basis points

Average Maturity Period Three years and up to five years More than five years

Note: *For the respective currency of borrowing or applicable benchmark. iv. End-use (a) ECB can be raised only for investment (such as import of capital goods, new projects, modernization/expansion of existing production units) in real sector-industrial sector including small and medium enterprises (SME) and infrastructure sector-in India. Infrastructure sector is defined as (i) power, (ii) telecommunication, (iii) railways, (iv) road including bridges, (v) ports, (vi) industrial parks and (vii) urban infrastructure (water supply, sanitation and sewage projects); (b) ECB proceeds can be utilised for overseas direct investment in Joint Ventures (JV)/Wholly Owned Subsidiaries (WOS) subject to the existing guidelines on Indian Direct Investment in JV/WOS abroad.

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(c) Utilisation of ECB proceeds is permitted in the first stage acquisition of shares in the disinvestment process and also in the mandatory second stage offer to the public under the Governments disinvestment programme of PSU shares. (d) Utilisation of ECB proceeds is not permitted for on-lending or investment in capital market or acquiring a company (or a part thereof) in India by a corporate except for banks and financial institutions eligible under paragraph 1B(i)(a) and 1B(i)(b). (e) Utilisation of ECB proceeds in real estate is not permitted. The term real estate excludes development of integrated township as defined by Ministry of Commerce and Industry, Department of Industrial Policy and Promotion, SIA (FC Division), Press Note 3 (2002 Series, dated 04.01.2002). (f) End-uses of ECB for working capital, general corporate purpose and repayment of existing Rupee loans are not permitted. v. Guarantees Issuance of guarantee, standby letter of credit, letter of undertaking or letter of comfort by banks, financial institutions and NBFCs relating to ECB is not normally permitted. Applications for providing guarantee/standby letter of credit or letter of comfort by banks, financial institutions relating to ECB in the case of SME will be considered on merit subject to prudential norms. vi. Security The choice of security to be provided to the lender/supplier is left to the borrower. However, creation of charge over immovable assets and financial securities, such as shares, in favour of overseas lender is subject to Regulation 8 of Notification No. FEMA 21/RB-2000 dated May 3, 2000 and Regulation 3 of Notification No. FEMA 20/RB-2000, dated May 3, 2000, as amended from time to time, respectively.

vii. Parking of ECB proceeds overseas ECB proceeds should be parked overseas until actual requirement in India. It is clarified that ECB proceeds parked overseas can be invested in the following liquid assets (a) deposits or Certificate of Deposit or other products offered by banks rated not less than AA(-) by Standard and Poor/Fitch IBCA or Aa3 by Moodys; (b) deposits with overseas branch of an authorised dealer in India; and (c) Treasury bills and other monetary instruments of one year maturity having minimum rating as indicated above. The funds should be invested in such a way that the investments can be liquidated as and when funds are required by the borrower in India. viii. Prepayment (a) Prepayment of ECB up to USD 200 million may be allowed by ADs without prior approval of RBI subject to compliance with the stipulated minimum average maturity period as applicable to the loan. (b) Pre-payment of ECB for amounts exceeding USD 200 million would be considered by the Reserve Bank under the Approval Route. ix. Refinance of existing ECB Refinancing of outstanding ECB by raising fresh ECB at lower cost is permitted subject to the condition that the outstanding maturity of the original loan is maintained.

x. Debt Servicing The designated AD has the general permission to make remittances of instalments of principal, interest and other charges in conformity with ECB guidelines issued by Government / RBI from time to time. xi. Procedure

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Applicants are required to submit an application in form ECB through designated AD to the Chief General Manager, Foreign Exchange Department, Reserve Bank of India, Central Office, External Commercial Borrowings Division, Mumbai 400 001 along with necessary documents.
xii. Empowered Committee RBI has set up an Empowered Committee to consider proposals coming under the approval route. C. REPORTING ARRANGEMENTS AND DISSEMINATION OF INFORMATION i. Reporting Arrangements (a) With a view to simplify the procedure, submission of copy of loan agreement is dispensed with. (b) Borrowers are required to submit Form 83, in duplicate, certified by the Company Secretary (CS) or Chartered Accountant (CA) to the designated AD. One copy is to be forwarded by the designated AD to the Director, Balance of Payments Statistics Division, Department of Statistical Analysis and Computer Services (DESACS), Reserve Bank of India, Bandra-Kurla Complex, Mumbai 400 051 for allotment of loan registration number. (c) The borrower can draw-down the loan only after obtaining the loan registration number from DESACS, RBI. (d) Borrowers are required to submit ECB-2 Return certified by the designated AD on monthly basis so as to reach DESACS, RBI within seven working days from the close of month to which it relates. ii. Dissemination of Information For providing greater transparency, information with regard to the name of the borrower, amount, purpose and maturity of ECB under both Automatic Route and Approval Route are put on the RBI website on a monthly basis with a lag of one month to which it relates. 2. Foreign Currency Convertible Bonds (FCCB) The policy for ECB is also applicable to FCCB in all respects. 3. Structured Obligations In order to enable corporates to raise resources domestically and hedge exchange rate risks, domestic rupee denominated structured obligations are permitted by the Government to be credit enhanced by international banks / international financial institutions/joint venture partners. Such applications would henceforth be considered by the Reserve Bank under the Approval Route.

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