To attract foreign capital, welcome it loudly and clearly

Why in the News

Net foreign direct investment (FDI) into India has fallen from $40 billion in FY2021 to effectively zero in FY2025. The draft Foreign Investment Rules (FI Rules) of the Reserve Bank of India (RBI) tidy the framework. They leave the real obstacle untouched: the Foreign Exchange Management Act, 1999 (FEMA) starts from suspicion of foreign capital.

What is FEMA’s default, and why does it hold back foreign capital?

1. What it is: FEMA governs money flows into and out of India. Under Section 6, capital account transactions (cross-border investments and asset purchases) are barred unless the RBI or the government permits them.
2. A schedule of exceptions: Every rule under Section 6, including the draft FI Rules, only lists what is allowed. It works like a locked building where each door needs its own key.
3. Prohibited and capped sectors: Foreign capital is barred from the real estate business and capped in digital media, broadcasting, multi-brand retail and pensions.
4. What investors need: Foreign funds want a clear signal that capital is welcome and near-zero friction between a decision and its execution. The present law makes both hard.
5. The takeaway: A law that starts from “no” makes every investment an exception, which raises the cost of choosing India.

What do the draft FI Rules change, and what do they leave untouched?

1. Operational changes: The draft brings shorter sections, harmonised definitions and an investee-centred framework (rules arranged around the recipient company). These alone cannot deliver the RBI’s aim of a “contemporary, user-friendly investment framework“.
2. Regulation of each transaction: Even in fully open sectors, the state dictates the instrument used, the legal form of the company receiving money and the price the parties may agree.
3. Mandated valuations: Transfers of unlisted shares between residents and non-residents need a certified valuation before the deal. The draft leaves the parties even less room to set their own price.
4. Friction over tax: The mandated price exists to stop tax evasion. Tax evasion can be checked after the deal, so forcing parties to trade at a set price adds needless friction.

How does India’s approach compare with other economies?

1. An outlier with China: India’s web of capital controls makes it an outlier among significant economies, alongside China. No Organisation for Economic Co-operation and Development (OECD) country keeps general capital and exchange controls.
2. Chile and Mexico: These emerging economies have avoided transaction-by-transaction regulation, meaning the state does not vet each cross-border deal separately.
3. Security screening abroad: The Committee on Foreign Investment in the United States (CFIUS) and the UK’s Investment Security Unit are models of dedicated national security screening.

What principles should a FEMA overhaul follow?

1. Restrictions as emergency tools: Curbs on capital flows should be temporary, rest on publicly stated objectives, and serve only to manage macroeconomic risk in an emergency.
2. Balanced security screening: Screening should combine departments with competing mandates. Press Note 3, restricting investment by nationality, came from the Department for Promotion of Industry and Internal Trade (DPIIT) alone, a body meant to promote investment.
3. Consultative rulemaking: Rules need public consultation, cost-benefit analysis and review. The Financial Sector Legislative Reforms Commission (FSLRC) would restrict only at entry, then give national treatment (the same rules as domestic investors).
4. Three tests for any control: A control should treat every investment route and every investor alike. It should also answer an identified market failure, a problem markets cannot fix alone.

Challenges

1. Slow, invisible costs: Curbs on capital show up as investments not made and firms not built, so their cost rarely triggers correction.
2. Gaps no longer hidden: Global interest in India and low world interest rates once hid the cost of these controls. That cost now shows up as real economic harm.
3. Thin base of inflows: With net FDI near zero, any new restriction falls on an already shrunken flow.

Way Forward

1. Reverse the default: Amend Section 6 so capital account transactions are allowed unless a stated rule restricts them.
2. Existing reports as base: Draw a rewritten FEMA from the Tarapore, Percy Mistry, U K Sinha and FSLRC reports.
3. Review sectoral curbs: Retain each prohibition and cap only if it answers an identified market failure.

Conclusion

India’s foreign investment law starts from restriction, so tidying its rules has not reversed the fall in net inflows. Whether the government stops at the draft FI Rules or rewrites FEMA from first principles will decide if foreign capital gets a clear signal that it is welcome.

Matching Previous Year Question

“[2020] If another global financial crisis happens in the near future, which of the following actions/policies are most likely to give some immunity to India? (1) Not depending on short-term foreign borrowings (2) Opening up to more foreign banks (3) Maintaining full capital account convertibility Select the correct answer using the code given below: (a) 1 only (b) 1 and 2 only (c) 3 only (d) 1, 2 and 3 ANSWER: (a)”