Balance of Payments & FEMA

Balance of Payments (BoP) and the Foreign Exchange Management Act (FEMA) are critical topics for JAIIB, covering India's external sector management, foreign exchange regulation, and the institutional framework governing cross-border transactions. Understanding these concepts is essential for banking professionals who deal with foreign exchange operations, trade finance, and regulatory compliance.

Balance of Payments is a systematic record of all economic transactions between residents of a country and the rest of the world during a specific period. It reflects the demand for and supply of foreign exchange and indicates a country's economic health in the global context.

The BoP account has two main components:

India faced a severe BoP crisis in the early 1990s driven by several factors:

• Rising Current Account Deficit: Increased from 1.35% of GDP in 1980-81 to 3.69% of GDP in 1990-91
• Poor economic policies such as import substitution and trade restrictions
• Drop in foreign remittances from Arabian nations due to the Gulf crisis
• Political instability at the centre harmed the confidence of foreign creditors, particularly NRIs, resulting in an outflow of NRI deposits
• Rising external debt: Increased from 12% of GDP in 1980-81 to much higher levels by 1990-91
• Fiscal deficit rose from 5.1% of GDP in the early 1980s to 8.4% of GDP in 1990-91
• Domestic debt surged from 33% of GDP in early 1980s to over 50% of GDP in 1990-91

The government resorted to external borrowing to lower the foreign exchange deficit, which further worsened India's external debt position. The debt payment burden increased from 2% to 3.8% of GDP.

The BoP crisis triggered comprehensive economic reforms, known as the LPG reforms (Liberalisation, Privatisation, Globalisation):

• Liberalisation: Relaxation of trade regulations, enhanced production capacity, abolition of government industrial licensing, and liberty to import goods
• Privatisation: Expanded role for the private sector in the economy
• Globalisation: Opening of economic frontiers for international investors and multinationals

The reforms intended to accomplish high economic growth, lower inflation, minimise the current account deficit, and address the balance of payments issue. Attracting significant Foreign Direct Investment (FDI) was one of the key goals.

The IMF plays a crucial role in managing the international monetary and financial system and is closely linked to BoP management.

• Board of Governors: Each governor is appointed by their respective member country; advised by the International Monetary and Financial Committee (IMFC) and the Development Committee
• Executive Board: A 24-member board that discusses all aspects of the Fund's work; decisions are normally made by consensus

• Promote international monetary cooperation
• Facilitate the expansion and balanced growth of international trade
• Promote exchange rate stability
• Assist in the establishment of a multilateral system of payments
• Make resources available to members experiencing BoP difficulties

Under FEMA, the emphasis shifted from regulation (as under FERA) to management of foreign exchange. This was a fundamental philosophical change — from a restrictive to a facilitative approach.

FEMA, 1999 was enacted to:

• Consolidate and amend the law relating to foreign exchange
• Facilitate external trade and payments
• Promote orderly development and maintenance of the foreign exchange market in India

An authorised person under FEMA means an authorised dealer, money changer, offshore banking unit, or any other person authorised to deal in foreign exchange or foreign securities.

• The Central Government has made Foreign Exchange Management (Current Account Transactions) Rules, 2000 under the Act
• Capital account transactions are governed by RBI regulations issued under Section 6(2) and 6(3)

FEDAI plays an important role in the forex market infrastructure:

• Issuing guidelines and rules for handling foreign exchange business
• Training bank personnel in areas of foreign exchange
• Accreditation of forex brokers
• Advising/assisting member banks in settling issues in their dealings
• Representing member banks on Government/RBI/other bodies
• Announcing daily and periodical rates to member banks

The RBI introduced the FX-Retail platform to improve pricing outcomes for retail users:

• Announced in RBI's Statement on Developmental and Regulatory Policies (October 04, 2017)
• Provides a mechanism where client pricing is directly determined in the market
• Gives customers access to an inter-bank electronic trading platform where bid/offers from retail clients and authorised dealer banks are matched anonymously and automatically
• Brings transparency, enhanced competition, and better pricing for customers
• Reduces the risk banks face in warehousing transactions until aggregated to a market lot
• Banks may charge a pre-agreed flat fee towards administrative expenses (must be disclosed to the customer)

Investment in Government Securities by non-residents is subject to FEMA provisions:

• Eligible investors: Resident individuals, firms, companies, State Governments, provident funds, trusts, NRIs, OCIs, and Foreign Portfolio Investors (FPIs) registered with SEBI and approved by RBI
• Foreign Central Banks (FCBs) are also eligible, subject to RBI terms in the Scheme for Rupee Investments
• Government securities are issued for a minimum of Rs. 10,000 (face value) and in multiples of Rs. 10,000
• Primary Dealers (PDs): Registered with RBI; buy government securities directly from RBI and resell them. The PD system was introduced by RBI in 1995

• Theorem 1: Bond prices move inversely to interest rates
• Theorem 2: Price increase when interest rates fall is greater than price decrease when rates rise by the same percentage
• Theorem 3: Longer maturity = higher price sensitivity
• Theorem 4: Lower coupon bonds experience more price sensitivity than higher coupon bonds of the same maturity

1. FEMA replaced FERA — effective June 01, 2000; emphasis shifted from regulation to management
2. Tarapore Committee (1997) recommended legislative changes leading to FEMA
3. India's BoP crisis (1990-91): Current account deficit rose to 3.69% of GDP; fiscal deficit hit 8.4% of GDP
4. LPG reforms (1991) were the response to the BoP crisis
5. Section 6 of FEMA deals with capital account transactions; Section 7 with exports
6. Authorised person under FEMA includes authorised dealers, money changers, and offshore banking units
7. FEDAI issues guidelines, trains personnel, accredits brokers, and announces daily rates
8. IMF functions: Regulatory, Financial, and Consultative
9. FX-Retail platform enables anonymous, automatic matching of retail and bank forex orders
10. Primary Dealers system introduced in 1995 to create a market for government securities
11. Investment by non-residents in G-Secs is subject to FEMA regulations
12. Government securities minimum denomination: Rs. 10,000