As of writing this blog post, India’s forex reserve is around 583700 USD Million. This is a huge figure, and our country’s forex reserves have swelled up in the last 25 years. We are now close to 600000 USD Million figure.
Now, there is a misconception regarding the forex reserves. To most people, it means foreign currency notes available with the central banks, private banks, PSU banks, and govt treasuries. Well, let me clear this doubt. Forex reserves do not mean only dollar currency.
Forex reserves could mean overseas holdings, which the Government of India holds or has legal rights. This means that Currency notes, Gold, stocks, properties, commodities, bonds, and anything that is not contained within the country except currency notes are considered Forex reserves. Currency notes are the only asset that can be regarded as a forex reserve held within the country. Gold is something that is contained within the country and in the overseas vaults. Any gold held in the overseas vault in India’s name is also considered forex reserves. The Gold that is within the country is used to satisfy the domestic demands most of the time.
So far, I have tried to explain the concept of forex reserves. Forex reserves serve the country during the emergency or fulfill the trade imbalances, paying off the debt, etc. It also helps import crude oil and other commodities required to satisfy the growing population’s demand.
Why FEMA Act Was Introduced?
Before the Act and somewhere around 1996, India faced a critical situation where Forex reserves were depleting faster. There were several reasons attributed to the problem. One main reason was the situation where the forex and margin traders were over-leveraging their positions in the overseas markets.
The result was that the traders were overdrawing their bank accounts in India and funding the margin trading account held with the overseas broker in the overseas markets. Now for those who are new to trading, leveraging is the concept where a trader trades with the broker’s money, provided he brings the minimum required capital as per the broker’s demand.
Now leveraging is a double-edged sword. It can cushion up your profit and loss as per the trend. In case of loss, an extra margin has to be funded again. This would continue till the trader closes his or her position. To fulfill the margin requirement, the trader has to withdraw from his Indian bank account and then transfer it to the overseas broker’s bank account.
This transfer means that the withdrawal has to be done in Foreign currency. Now, the banks have the overhead to convert the required amount into that currency and then process the transaction. This means that banks have to use the existing forex reserves. This cycle continued year after year, and in fact, it increased to such an extent that it started weighing heavily on the country’s forex reserves.
This prompted RBI to take action, and the result was the introduction of the FEMA Act 1999. The Act prohibits any margin trading, including forex trading in the overseas markets using Indian bank accounts. This Act was created to safeguard India’s depleting forex reserves in the 90s.
Is FEMA Act still relevant?
We are now in the 2020s, and the country’s population and Forex reserves have swelled drastically. Does FEMA Act have any relevance in today’s market?
My personal opinion is that FEMA Act is not relevant in today’s scenario. In the backdrop of the circumstances which forced RBI to introduce this Act is no more present. Forex reserves have swelled up. On the contrary, people are regularly violating the Act even today. It’s easy to launder money from the country to overseas accounts.
Now more options have opened up than in the 1990s by which people can easily participate in money laundering. The biggest such route nowadays is cryptocurrency. It’s quite easy to buy crypto in the country through P2P markets or available exchanges and then send these cryptos to overseas brokers who have now facilitated the fund deposit through cryptocurrencies. This way, it has become quite easy to transfer money. This means that this Act does not guarantee or safeguard the country’s forex reserves.
Repeatedly studies have shown that any act or rule imposed on the people is bound to be violated. Thus people are compelled to break the Act, which they believe is against their freedom of anything. But, if the same Act is repealed or removed, then the substance or circumstance for which the Act was enacted loses its relevance. People stop giving much importance to anything which is freely and readily available in the country.
In my personal opinion, if FEMA Act is repealed or at least amended in such a way that people start to give less importance to margin trading or forex in the overseas markets, then it will automatically safeguard the interests of the nation.
For this purpose, RBI should allow the fellow countrymen to trade within the permissible LRS or Liberalized Remittance Scheme.
What is LRS or Liberalized Remittance Scheme?
According to the RBI’s LRS, any individual can invest or send USD 2,50,000 annually. This means a person can only invest in shares but not trade through margin trading. This also means that you can buy and sell stocks in the cash market but cannot participate in Future or options trading of the same stock.
Should Forex Trading be Allowed Under LRS?
It is a grey area. Perhaps no one might have even thought or discussed it. But here is my opinion that margin trading, including Forex trading through overseas brokers, should be allowed under LRS. Though the limit can be fixed, in this case, annual spending of not more than 5000 USD should be allowed. But again, every step or idea has both pros and cons. My opinion can have both pros and cons, but that can be discussed, and accordingly, amendments can be made. By doing so, people will get what they want, and also Forex reserves can be maintained by this.
Pros and Cons of allowing Forex Trading under LRS
There can be a long list of pros and cons if there is a discussion on this particular topic. However, I will try to restrict my discussion to limited numbers.
- Human psychology and nature always revolts the restrictions. People have always tried to circumvent their ways for the things and acts that laws have banned all around the world. The examples are in abundance, and the biggest example is the prohibition of alcohol in the US in the 1920s. Once the US lifted the embargo, people stopped the smuggling and hoarding of liquor. You see, people don’t give much importance to the things, stuff which is easily accessible. Take the case of prostitution in the USA compared to India. Crimes are high in the absence of a legal framework in India compared to the USA, where it is easily and legally available. People will stop money laundering if the act is repealed or at least amended.
- Repealing the act or at least providing an amendment would open ample options, and this will definitely reduce the burden as people will look for more safe and legal options where they will be able to park their money without a hassle. As govt has done its job and now people will look for better and safe choices. They won’t be any further tempted to break any law.
- Govt will be able to tax any income generated from these kinds of trading activities, and also, it will bring back forex only.
- As I say, ample options would open up if the act is repealed. This would mean that many scamsters, fraud, and shell companies would open up to lure unsuspecting citizens for trading and investment purposes. We could see a rise in online frauds and scams if the act is repealed or at least amended.
- Trading in the overseas markets is much riskier as compared to trading in Indian markets. Several factors contribute to larger losses compared to losses that you will make while trading in Indian markets. The first point is the leverage that can compound losses significantly. Overseas brokers offer leverage as high as 400, and few even offer 1000 times. Indian brokers offer at the max 20 times the leverage as per the SEBI rules. People only look at the profit they will make by leveraging their positions but forget market dynamics that can compound losses at the same rate as well. Compared to Indian forex markets, the second point is that overseas markets are highly volatile and always depend on the mercy of the big notorious banks who frequently take their positions opposite the majority of the traders. Take the example of the 2012 flash crash of CHF/EURO where the CHF rate against EURO fell more than 20% because the swiss bank decided to remove the peg against EURO. Third point →Forex market runs 24X7 while trading with brokers and on exchanges is done five days a week. Indian markets operate only from 9 am to 5 pm. But overseas markets work 24X5. Any leveraged position might attract trouble while you are sleeping in Indian time. RBI always stabilizes any volatility in INR pairs by buying or selling in tranches. This act of RBI sometimes helps the traders to minimize their losses. Unlike the West’s notorious banks, RBI has never allowed INR pairs to appreciate or depreciate more than 3% in a single day. The fourth point is the China factor. Chinese banks are notoriously known for their currency manipulation, and this can wreak havoc on trader’s position if trading in overseas markets. The fifth point is that there is no upper or lower circuit limit in the Forex market, and this implies that trading won’t stop if a particular currency depreciates more than 10%. Imagine the situation when you are sleeping with positions open with the overseas broker. Even the stop losses won’t be triggered if the fall is fast.
- There is a possibility of money laundering to fund terrorism, drugs and other illegal activities.
- Taxation and cost of exchange can be a burden.
I have discussed the limited pros and cons of allowing trading forex in overseas markets. There could be more pros and cons. A lengthy discussion can be done, and RBI can offer possible solutions to all these problems in consultation with key stakeholders. For example, RBI and SEBI can provide licenses even to overseas brokers just like they have given foreign banks licenses to operate in Indian markets. This way, the chances of scammers and fraudsters operating and duping Indian traders would minimize. Proper accounting and reporting to the RBI and other financial regulators should be made mandatory to trace the money circulation in the international markets. There should be a provision for tax audits for those who wish to open and trade in overseas markets.
It’s a grey area but needs immediate attention by RBI and other financial regulators. People will keep violating the FEMA act, and over the last couple of years, money laundering has increased. It will continue to rise even though RBI and other banks are aware and fully acknowledge that people are trading in overseas markets, and it has become easier to fund these accounts. But RBI and other banks have been reluctant to discuss or put forward a proposal to amend the FEMA act. It’s high time that they should give it serious consideration.