Relevance- GS 3 | Indian Economy |planning, resource mobilization, growth, development and employment 

Why in the News? 

• Net FDI in India has gone down from $40 billion in FY2021 to effectively zero in FY2025.
• The draft Foreign Investment Rules (FI Rules) released by the RBI has brought some positive changes but fall short in achieving the objective of creating  a “contemporary, user-friendly investment framework”.   
• The binding constraint is India’s suspicious approach towards foreign capital, and it requires a deeper, first-principles overhaul of the Foreign Exchange Management Act (FEMA). 

Issues with the FEMA : 

•  Section 6 of FEMA, capital account transactions remain prohibited unless specifically permitted by the RBI or the government, including the draft FI Rules, essentially serves as a schedule of exceptions to a default state of restriction. 

• Foreign capital is prohibited in sectors such as real estate business, and capped in others such as digital media, broadcasting, multi-brand retail and pensions. 

• Even in fully open sectors, the Indian state regulates individual transactions between private parties.

• For instance, transfers of unlisted shares between residents and non-residents require certified valuations before transaction, with the draft FI Rules further narrowing the latitude, forcing parties to transact at mandated prices rather than negotiate commercially, causing serious friction.

India an outlier among significant economies

• No OECD country maintains general capital and exchange controls
• Chile and Mexico: These emerging economies have avoided transaction-by-transaction regulation, meaning the state does not vet each cross-border deal separately.

If the concern is tax evasion, it should be addressed after the transaction, not through ex-ante controls. India requires a better design of the FEMA. Much of this work has been done in existing expert committee reports by Tarapore, Percy Mistry, U K Sinha, and the FSLRC.

Principles a FEMA Overhaul Should Follow

• Cautious & Temporary Restrictions: Capital flow controls should be used as temporary, emergency measures for macroeconomic risk, based on publicly stated objectives.

• Balanced Security Screening: National security restrictions must feature robust checks and balances. Instead of a single department (like DPIIT) issuing rules like Press Note 3, a multi-department body should weigh security risks against economic costs, similar to the US CFIUS or UK Investment Security Unit.

• Transparent Rulemaking: New rules must undergo public consultation, rigorous cost-benefit analysis, and periodic review.

• Point-of-Entry Focus: Restrictions should primarily operate at the point of entry. Once cleared, foreign investors should receive “national treatment” comparable to domestic investors.

• The Three-Criteria Test: All capital controls must be tested for:
  
  1. Neutrality of vehicle: It shouldn’t matter how the money enters.

2. Neutrality of investor: It shouldn’t matter who is investing.

3. Market failure link: Every restriction must be tied to a clearly identified market failure.

Challenges and Costs

• Invisible Long-Term Costs: The true cost of restricting capital emerges slowly and invisibly, taking the form of unmade investments and firms that are never built.

• Siloed Decision Making: Current restrictive measures (like Press Note 3) are sometimes issued by departments whose primary mandate is promoting investment, without consulting other departments to properly weigh competing economic and security interests.

• Superficial Fixes: Without completely overhauling the foundational statute, tactical policy tweaks will fail to address underlying structural issues.

Conclusion :

India requires a first-principles overhaul of its primary foreign exchange statute to properly balance national security and macroeconomic risks against the economic costs of restricting capital. Minor tactical adjustments, such as the draft Foreign Investment (FI) Rules, are insufficient to change the status quo.

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