Why the Law Manages Foreign Exchange

In one line

Foreign exchange law regulates dealings in the currencies of other countries, and India's present statute does so in order to facilitate trade rather than to conserve a scarce resource. Precisely: the Foreign Exchange Management Act 1999 (Act 42 of 1999) received assent on 29 December 1999, came into force on 1 June 2000, extends to the whole of India, and applies also to all branches, offices and agencies outside India owned or controlled by a person resident in India, and to any contravention committed outside India by a person to whom the Act applies.

Why a country regulates foreign exchange at all

Because a national currency is not accepted abroad, and a country must earn or borrow the currencies it needs. An Indian importer paying a Japanese supplier needs yen or dollars; an Indian family sending a child to study abroad needs the currency of the host country; a foreign investor buying Indian shares brings foreign currency in. The stock of foreign currency a country holds is finite, and the balance between what comes in and what goes out is its balance of payments.

When that balance is under strain, controls follow. A country whose reserves are falling must either let its currency depreciate, borrow, or ration the outflow. Rationing is administratively the quickest, and it is what India did for four decades: every outward payment required permission, holding foreign currency was an offence, and the burden of proving innocence lay on the citizen.

When the constraint eases, the case for control weakens. Reserves rise, the currency floats, and the machinery of permission becomes a tax on legitimate business without any corresponding benefit. That is the transition FEMA embodies, and stating it is the first thing a good answer on this topic does.

Three purposes survive even in a liberalised regime, and they explain why the Act was not simply repealed.

Monetary stability. Very large and sudden movements of capital can destabilise a currency and a banking system, which is why the capital account remains managed under section 6 while the current account is free under section 5.

Data and monitoring. A state must know its external position, which requires that transactions pass through identifiable channels, and that is the function of the authorised person under section 10.

Enforcement against evasion. Foreign exchange is the medium through which trade misinvoicing, capital flight and the proceeds of crime move, so a management statute retains investigation and penalty powers, in sections 13, 36 and 37.

The long title, which decides how the Act is read

FEMA's long title is: "An Act to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India."