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March 7, 2011

Open up the Rupee

PayPal, the company that pioneered payments and money transfers on the internet, recently announced a change in the payment system for Indian residents, by setting a limit of $500 per transaction. Furthermore, users cannot use money credited to them to directly buy goods or services—they will have to get the money paid into their bank account first. PayPal said this change was made in order to comply with Reserve Bank of India (RBI) regulations and, regrettably, did not give any further details.

Many Indians use PayPal—shoppers who buy books or software online, electronic retail entrepreneurs, and freelancers who are paid online for ad hoc or small projects. Typically, they would receive and store money at Paypal, and use it to pay for goods or services, or to make small donations. With these new changes, they must withdraw any received money immediately so the intermediation costs go up—users can still pay others through PayPal with a credit card, but that means paying fees at both ends of the transaction.

The limit of $500 per transaction hurts the bigger players who heavily relied on PayPal as it is trusted by their US customers. Now they have to tell customers to split transactions into chunks of $500—a process that is tedious and appears unprofessional.

The new regulation was announced in a circular by RBI, which stated that the Foreign Exchange Maintenance Act (FEMA) laws do not allow for storing of export proceeds abroad. PayPal is therefore required to put all such money into a pooled account at a “Category 1 I-Bank”, and then transfer it to the exporter’s bank within seven days. The seven-day limit is the RBI restriction, wherein interest needs to be paid above that time (in addition, you have to be a bank); PayPal is required to report in detail all transactions over the $500 limit.

Storing virtual money owned by Indians—in a holding system where you’re allowed to put money in and take it out—is regulated by RBI under the Payment and Settlement Systems Act, 2007. It specifically requires that only banks can offer “open” systems where you can deposit and withdraw funds—such as credit and debit cards. Semi-closed instruments—where you only buy a certain set of services—require RBI approval, and can’t be converted to cash. These are the restrictions that prevent the cashing in of gift vouchers or converting credit card points to money. Barter is okay, cash conversion is not.

It might seem like the best option is for PayPal to become a bank. The question is, can PayPal become a bank? Even if it wanted to, the RBI is unlikely to give the company a license. Or, PayPal could register as a “semi-closed” service, but that doesn’t allow them to pay out money to end-users. The rules may appear to be harsh, but they apply broadly to everyone in the business—this is what stopped the Times Group from offering a similar service earlier.

Having said all this, there is something we must change.

Change the mindset, change the rules
FEMA—the act that dictates the $500 limits, restricts storing money abroad—is unnecessary. It is an artefact of the closed regulatory system that makes the Rupee not fully convertible. After all, why should we care if people hold their foreign currency abroad? If they pay taxes on such income in India, it shouldn’t be a problem.

The RBI or the government believes that India needs the dollars—so you shouldn’t be allowed to store it abroad, and must bring it home and convert it to rupees. But we don’t need the dollars anymore—with $300 billion in foreign exchange reserves, India can finance more than three years’ worth of oil imports (a far cry from just 15 days’ worth in 1992). Moreover, India doesn’t need reserves against every single dollar that India Inc. owns—very little of our government borrowing is in dollars, and corporates can buy dollars from the open market to pay back debt.

The rupee isn’t yet fully convertible. One thing though—there is “current account” convertibility since 1994, so you can buy and sell goods abroad for “trade” purposes. But you can’t buy assets abroad or transfer dollars just as easily—that would be a “capital account” transaction, which would cause you to jump through several hoops. Indian nationals can buy certain assets abroad, up to $200,000 per year. Foreign individuals can’t own rupees at all, while foreign corporates and institutions get near-unfettered access. Non-resident Indians get a quasi-convertible regime with several hurdles.

Why not just allow for full convertibility and get rid of these restrictions?

Pros and cons of full convertibility
Full convertibility will restrict RBI control on the rupee—but then, it won’t need to maintain reserves. In panic situations, we won’t be able to protect our currency quite as much—but we now know that is a symptom, not the disease. Another concern is that convertibility would cause too much volatility in exchange rates. But the impact will be limited since we already have large volumes being traded in both inter-bank and exchange-traded futures markets.

The alternative—of locking down our dollars—has an invisible and more damaging impact in terms of lost opportunities. Simply put, we will grow a lot more if the RBI and FEMA stopped being obsessed with foreign exchange control.

More importantly, full convertibility would allow our exporters to invoice trade partners in rupees. It would allow us to trade with countries like Iran who despise the dollar (Iran sells us a lot of oil for our money). It will allow us to sell our country’s debt and equity to foreign entities more easily—even individuals will be able to buy our stocks and bonds. We will be able to buy assets abroad, even if we needed to report it, without needing permission.

Ajay Shah, professor at the National Institute of Public Finance and Policy, goes one step further and says that we must dilute reporting requirements as well—you could create barriers from onerous reporting requirements while seeming to have full convertibility.

Alongside all these measures, India must ease restrictions on foreigners buying our rupee debt. Apart from reducing interest rates, it will reduce the amount banks, insurers and pension funds need to put into government debt, and thereby help the fledgling corporate bond market. We are a more fiscally responsible country than most of the West, but we pay three times their interest rates.

The PayPal issue cannot be sorted out for PayPal alone—it has to comply with the rules of the land, and if they want to pay out to Indian banks, they must follow the RBI diktat. But the policy response should be to open up our currency. We’ve been protected for too long—and it seems—from ourselves. To quote Tina Turner, we don’t need another hero; we don’t need to know the way home.


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