FII inflow cant be long-term FDI

Posted on September 23, 2010 | Author: Jaideep Mishra

It would be premature to remove the

distinctions and characterize portfolio
investment above 10% of shares as FDI, as
done in the higher-income economies.

There is a heavy downpour of funds on the

domestic bourses. The bull run makes a
notable backdrop to the recent Report of the
Working Group on Foreign Investment, the
expert committee headed by U K Sinha of UTI
Asset Management.

The report calls for reducing transaction

costs on capital inflows from abroad, easing
regulatory complexity and curbing legal
uncertainty, which cannot broadly be faulted.

However, in calling for treating foreign

portfolio investment above a certain
benchmark level of shareholding as foreign
direct investment (FDI) for policy purposes,
the report seems to make several tenuous
arguments.

Given the panoply of rigidities, shortcomings

and lacunas in the real economy, it makes no
sense to gloss over the distortions and
assume that trends in the financial markets
do reflect ground realities.

The report goes on to suggest that for foreign

investment coming in via the so-called
automatic route, there be no distinction
between FDI and portfolio investment. It
would be perverse incentive, for instance, to
play the markets and reap the tax benefits
and incentives available for FDI projects.

The fact remains that there is a huge

investment backlog in the real sector here,
which is why for infrastructural projects, for
example, there is much focus of policy
including tax incentives on offer to coagulate
funds, expertise and resources.
As for taxation of portfolio inflows, the report
prescribes tax-free treatment, which again is
questionable. It is categorical that whether
India applies a securities transaction tax, a
stamp duty or a capital gains tax upon
residents, integration with the world of
international finance requires not applying a
burden of taxation upon non-residents.

It is true that the stock market is a leading

economic indicator, and buoyant portfolio
flows by foreign institutional investors (FIIs)
do point at firm growth and earnings trend in
the offing. But it cannot be gainsaid that
heightened capital inflows tend to harden the
rupee, which can have negative implications
for the real sector generally.

And an artificially-stronger rupee would

require currency intervention by the central
bank, which has its costs. Hence, the need to
continue with the securities tax, stamp duty
and levy short-term capital gains tax on FII
transactions, as per the existing norms. Yet,
the report calls for investment in listed or
unlisted securities at a level above 10% of
shares to be considered as FDI.
The reports rationale for such a policy regime
is that it is standard practice within the
Organisation for Economic Cooperation and
Development (OECD) economies, as well as
in peer countries such as Brazil,South Korea,
South Africa and Turkey, which have
comparable-sized domestic markets, it is
averred.

However, it would clearly be premature in our

regulatory regime to remove the distinctions
and characterize portfolio investment above
10% of shares as FDI, as done in the higher
income economies.

Abroad in the mature markets, there is no

glaring infrastructure deficit and investment
backlog in the real economy, which is why
there may be policy logic in not
differentiating between portfolio flows and
FDI.

In sharp contrast, we do need proactive

policy to boost manufactures and attendant
economic activity, and hence the continuing
need to policy distinguish between portfolio
inflows and FDI.

This is not to suggest that there is no need

any longer to develop the domestic capital
market. There most certainly is. It is precisely
to have a thriving secondary market for
equity shares that there is, for instance, no
long-term capital gains tax for shares held
more than a year levied on portfolio
transactions.

Further, long-term capital gains are very

much applicable on asset sales other than
equity. Yet, if the committees report is
accepted as policy, and foreign shareholding
above 10% considered as FDI, complete with
compliance with existing rules, regulations
and procedures for the latter, it would
actually make the inflows liable for long-term
capital gains tax!

In any case, it would be totally unwarranted

to do away with targeted focus on FDI, given
the sheer investment requirement. It is
welcome that the report wants the regulatory
regime under the know-your-client /customer
norms for investing in the Indian stock
market tightened, so as to meet OECD
standards of best practices.

We do need to have sound systems in place

to prevent money laundering, round-tripping
of funds and other untoward activities in the
financial marketplace.

But the basic flaw in the report is the attempt

to read too much into India’s macroeconomic
indicators, albeit much developed in recent
years. It notes that there has been a huge
stepping up of capital inflows and outflows in
the economy, and deep links between
current account and capital account
integration, with de jure capital account
openness.

This is why the report calls for rationalizing

the classification of inflows, and uniform
policy regime, tax treatment et al. However,
our current account balance is hugely
dependent on remittances of NRIs. And we do
need to shore up capital inflows via separate
venture capital investment and FII funding.

Yet, the report wants FIIs, FVCIs and NRIs

abolished as an investor class. Also,
removing the caps on rupee denominated
corporate debt without a thriving debt
market in place would surely be doubly
distorting and rev up systemic risks. The
reports entire macroeconomic stance clearly
needs a thorough rethink.