Post on revising the regulatory framework for FDI and capital controls

21 Apr

I have a co-authored post on the reforming the FDI regulatory framework in India on Ajay Shah’s blog here. The post was published on April 21, 2014, and has been co-authored by me, Ajay Shah, and Arjun Rajagopal. The post is being reproduced below. 

 

Capital controls against FDI in aviation: An example of bad governance in India

by Anirudh Burman, Ajay Shah and Arjun Rajagopal.

FDI in aviation was liberalised by the Reserve Bank of India on September 21, 2012 through a change in the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (link). Following that change, private players began putting together a number of complex transactions between Indian and foreign companies such as Jet-Etihad, AirAsia-Tata, and Tata-Singapore Airlines.

On November 20, 2013, the Directorate General of Civil Aviation (DGCA) revised its `Civil Aviation Requirements’ or “CAR” (CAR 4.1.5 to 4.1.16) to state that a domestic airline company cannot enter into an agreement with a foreign investing entity (including foreign airlines) that may give such foreign entity a right to control the management of the domestic operator ( link). This change in regulations has major consequences for some of the transactions which are in progress.
There are two important deficiencies in this action by DGCA:

  1. The CAR makes repeated mention of the requirement of control, without clarifying what the term `control’ means. This creates legal risk for transacting parties.
  2. No rationale has been offered to justify the use of the coercive power of the State via the CAR; no estimates of the costs or benefits of this regulatory action have been provided.

What does `control’ mean?

Rule 4.1.8 of the CAR (link) states:

A Scheduled Air Transport Service/Domestic Scheduled Passenger Airline shall not enter into an agreement with a foreign investing institution or a foreign airline, which may give such foreign investing institution or foreign airlines or others on behalf of them, the right to control the management of the domestic operator.

However, the `right to control the management’ has not been defined. This lack of clarity is compounded by two other regulatory requirements: (a) the directors appointed by the foreign entity cannot exceed more than one-third of the total (CAR 4.1.7), and (b) the substantial ownership and effective control of a domestic operator has to be vested in Indian nationals (CAR 3.1).

The new requirements must mean that `the right to control the management’ involves a form of control over and above these two earlier requirements, but no definition of that form of control is offered. Such lack of precision in drafting of laws results in increased legal risk and should be avoided.

Lack of transparency

When the coercive power of the State is wielded by the executive, this should be accompanied by appropriate checks and balances. Good practice in regulatory governance requires that when regulators wish to make changes to regulations, and thus affect the rights of private parties, the regulators must furnish reasons for making those changes. This increases transparency, predictability, and accountability.

In the case of investments, an investor who commits resources would want an element of control in order to ensure his money is not stolen or wasted. A substantial investment in a company is thus often accompanied by rights regarding management and control of the company. If a regulatory requirement interferes with these rights of investors, the onus is on the regulator to explain why. The changes to the CAR affect the rights of investors and potential investors in the aviation industry, but DGCA has not furnished any reasons for its revisions.

Regulatory actions must not be arbitrary acts of God. They must be steeped in the rule of law. The Draft Indian Financial Code, when enacted, will ensure financial sector regulators make qualitatively better regulations by blocking these kinds of mistakes. All draft regulations will have to be accompanied by reasons for the proposed regulations, as well as a cost-benefit analysis of the proposed regulations. These will be made available for public comment, before the final regulations are adopted. This regulation-making process will result in clearer and better regulations, and will enhance the legitimacy of the regulations and of regulators. The adoption of a similar process by DGCA would have led to a better outcome.

Barriers to international economic engagement: A strategic view

Consider trade barriers. The Indian State has the power to introduce customs duties. A number of government bodies undoubtedly have a major stake in the design of customs duties, and may even have critical expertise in the matter. Nonetheless, the power to introduce and modify customs duties is vested in a single authority — the Ministry of Finance. The Ministry of Textiles, for example, has no power to change the customs duty on imported cloth. This is a healthy arrangement: The Ministry of Finance is responsible for maintaining a unified strategic outlook on the question of trade barriers. The Ministry of Textiles can engage with the Ministry of Finance and suggest changes in tariffs, but responsibility for formulating and promulgating a coherent policy ultimately rests exclusively with Ministry of Finance.

This same strategy is required in the field of capital controls. If multiple regulators or government departments set about writing capital controls, we will have a balkanised mess.

Indeed, the current capital controls based framework is just such a balkanised mess. In the absence of a single governing law for foreign investment, a number of agencies have prescribed foreign investor regulations. The types of capital control restrictions and their rationale can be outlined as:

  1. Entry restrictions by financial regulators such as RBI and Ministry of Finance, usually to promote monetary policy and financial stability (under the Foreign Exchange Management Act, but not restricted to it);
  2. Entry restrictions imposed by DIPP and Ministry of Finance on grounds of national security (may include consideration of factors listed under FEMA as well); and
  3. Regulatory restrictions (including on control and ownership) imposed by sectoral regulators.

This multiplicity of regulations also leads to uncertainty of regulatory objectives. Investors have no idea of what criteria is used to assess their investments, and grant them business permissions. It is important to recognize that the justifications used to impose regulatory restrictions for relying on the distinctions between private and public, or domestic and foreign entities, is that these distinctions are reasonable proxies for the other characteristics (national security, systemic risk) that are a valid basis for differential treatment. As in so many areas of regulation, the misapplication of easy proxies for characteristics that are difficult to assess becomes a glaring reminder of regulatory uncertainty. It is important that regulatory objectives be identified clearly in relevant statues and regulations.

In addition to the legal and regulatory uncertainty created by such a multiplicity of regulators and regulations, the regulations themselves may violate India’s obligations under various multilateral and bilateral investment treaties: Many, if not, most such agreements provide for national treatment of investment once it has been allowed to enter the domestic market. Regulators should not be allowed to impose regulatory restrictions after foreign investment has already entered the domestic market. Under this principle of competitive neutrality, there should be no difference in the conditions imposed on the State Bank of India and those imposed on Etihad, when they invest in Jet Airways.

This requires more than administrative changes. A reform of the legalframework is essential. For example, the restrictions in the CAR appear to be grounded in the expansive powers granted to DGCA under the Aircraft Act, 1934. Section 5 of the Act (link) states:

Power of Central Government to make rules. – (1) Subject to the provisions of section 14, the Central Government may, by notification in the Official Gazette, make rules regulating the manufacture, possession, use, operation, sale, import or export of any aircraft or class of aircraft and for securing the safety of aircraft operation.

Those same powers could ground preferential treatment in other areas of regulation. To the extent that other regulatory bodies with responsibilities for other sectors have similar powers, those sectors too are vulnerable to violations of the principle of competitive neutrality.

The report of the FSLRC proposes a cleaner, clearer regulatory framework for foreign investment, one which is consistent with these obligations. Section 2.5 of the report states:

The Commission envisages a regulatory framework where governance standards for regulated entities will not depend on the form of organisation of the financial firm or its ownership structure. This will yield ‘competitive neutrality’. In this framework, the regulatory treatment of companies, co-operatives and partnerships; public and private financial firms; anddomestic and foreign firms, will be identical.

The draft Indian Financial Code, which encodes the principles articulated in the report, explicitly requires all regulators to maintain competitive neutrality while framing regulations. Section 84 (Principles of consumer protection) and section 141 (Principles of prudential regulation) contain the following identical language:

[C]ompetition in the markets for financial products and financial services is desirable in the interests of consumers and therefore… there should be competitive neutrality in the treatment of financial service providers;

This will ensure that sectoral regulators in the financial sector will not be able to discriminate against foreign and domestic firms/investment.

Pending the introduction of the Code, it would be helpful to incorporate its underlying principles into the existing regulatory framework. For example, the BJP has suggested that they will block FDI in retail but they will remove all capital controls against FDI in other sectors. Any government wishing to carry out such a change would need all capital controls be defined at only one place, where a single policy decision is taken. After this, it should not be possible for any other department of government or a regulatory agency to introduce capital controls.

The required single-window system should have the following characteristics:

  1. A comprehensive definition of foreign investment;
  2. A rule-of-law based mechanism for the government to allow/prohibit entry of foreign investment in specific sectors;
  3. A single regulatory barrier for foreign investment before it can enter the domestic market. Currently FIPB is an example of such a barrier;
  4. Clear documentation of approval of foreign investment that must be binding on all government authorities;
  5. Clear enumeration of reasons for which foreign investment can be restricted, and who can impose these restrictions (without any catch-all provisions like “for any other reason”);
  6. A positive obligation on the government to ensure competitive neutrality, OR a restriction preventing the government from discriminating against foreign investment once the investment has been allowed to enter India; and
  7. A review mechanism where foreign investors whose investment has either (a) been rejected, or (b) been subjected to discriminatory treatment compared to a domestic investor, can seek redressal.

Conclusion

There is great outrage in India today, against a capricious State that is a major source of risk for firms. These failures on capital controls are one important component of that problem. It is the right of politicians to interfere with international economic integration – e.g. to block FDI in retail or not or to have tariffs on import of apples or not. But there should be a single-barrier where this political decision is made.

One Response to “Post on revising the regulatory framework for FDI and capital controls”

  1. Steve September 6, 2014 at 8:34 pm #

    A common argument for capital controls is that they benefit the economy by making it more stable. That is a false argument because capital controls are not imposed to benefit the economy, they are imposed to benefit government officials and bureaucrats.

    The present situation is a perfect case in point. If their assets and liabilities are marked to market, virtually all Western democracies are bankrupt . This global financial crisis did not develop because capitalism went awry, or because economies were “unstable,” but rather because of decades of mismanagement by irresponsible politicians. The reason that capital controls are suddenly in vogue again is simply because they provide the only mechanism by which the same politicians who created the problems can bail themselves out, i.e. by stealing private capital.

    End of story.

    http://www.surviveandprosper.org/government_is_coming.html

    Like

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