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FII Issue-The Indian government treats NRIs as criminals- So prevalent and enforcing is this view that today, hardly any NRI invests directly in the stock market in India Read This:

Transparency and responsible regulation

New Dellhi, October 29, 2007
Business Standard
Surjit S Bhalla

It's time for some honourable FII* to argue for a transparent regulation of foreign portfolio inflows. But Godot might arrive sooner.

India is facing large capital inflows. This is a problem. So let us begin at the beginning. What determines capital inflows? The answer is simple — the owner of the inflow wants to make a profit higher than that can be obtained in the country of the foreign investor or in other emerging market countries. A simple point — it is relative returns, not absolute ones, that matter. Who are the foreign investors in India? People of Indian origin (PIOs) or non-resident Indians (NRIs) and genuine foreigners. Let us examine the determinants for each. But before that, a comment on the recent policy on participatory notes (P-notes) banning off-shore derivatives.

This is a very positive development. About $30 billion, or 16 per cent of FII assets, were devoted to trading in off-shore derivatives. This component of P-notes demand existed for two reasons. First, the use of off-shore P-note derivatives allowed FIIs to build positions in individual stocks in excess of that allowed by Indian law. This was not possible with inflows into most other emerging markets — hence, the exaggeration in the buy-India campaign. Second, the off-shore use of the derivatives allowed foreign investors to not pay the 33 per cent tax rate that ordinary Indians pay. Income from trading derivatives is not considered as capital gains in India and, therefore, it is unlikely that the use of Mauritius or Singapore treaty would prevent a 33 per cent tax on on-shore derivatives. Hence the demand for off-shore derivatives.

This leveraging demand on one of the few stock markets in the world to allow P-notes, and an emerging market that gifted a large currency appreciation as well, meant an unexceptionally excessive demand for Indian stocks. This demand for P-notes would be removed in 18 months, possibly earlier. It is important to note that capital inflow is not affected much by this removal. Financial engineering and margining requirements would mean that at a maximum, about 10-20 per cent of the $30 billion would be removed. This is a very small dent in the capital inflow problem.

PIO/NRI foreign inflows: There are two forms such inflows can take: equities and debt (fixed-income instruments, deposits). Unknown to many, and not emphasised by many in the know, the Indian government treats NRIs as criminals. Period. In my interaction with several government officials over the last decade, and participation in several government committees (including RBI and Sebi), I can say with some confidence that this rather wrong and pig-headed view is quite prevalent. So prevalent and enforcing is this view that today, hardly any NRI invests directly in the stock market in India. I am a fund manager (Oxus Fund Management) and I have had to turn away numerous applicants because the procedure to handle their money is quite prohibitive — possible de jure but impossible de facto.

Why this naïve and misguided view of our own citizens? There is the argument that the NRIs act as a conduit for round tripping, that is, a domestic Indian sends money abroad and brings it back into India to take advantage of the taxation treaty in Mauritius or Singapore. However, while it may have been true when capital gains taxes were 30 per cent, it is not so since 2004; the short-term capital gains tax in India is now only 10 per cent, and the fees and hassles of setting up shop in Mauritius is so large that it is not a factor influencing most individuals.

These Indians are some of the prime legitimate demanders of P-notes (the illegitimate use of derivatives is over). This demand remains and the only purpose of the FII licensing system is to transfer the hard-earned money from these thin cat citizens to fat cat FIIs — a more regressive transfer of money is difficult to imagine.

FIIs love the licensing regime for this reason, and given their enormous fatness and catness, they can be expected to lobby, and lobby hard, for the continuation of the licensing regime. And as foot soldiers they have their “lobbyists” in India. Who are these lobbyists? The clerks, accountants and lawyers working at firms which process FII applications, and the brokers who handle FII trading in India. But these brokers do not get any share of the much larger profit made by FIIs in charging shamefully high fees from foreign-based Indian clients and other investors barred entry into India by the regulator. The fees charged by FIIs from Indian clients is a further embarrassment since it is the Indian government that is facilitating this exploitative trade. But this doesn’t matter for Indian lobbyists as they would rather make the extra buck today, than share in the extra growth which would make them even richer.

You can see the lobbyists in the media — print and TV. They rather inaccurately and shamelessly argue
that the FII licensing regime is necessary to contain the markets and not let “market fundamentalism” operate. They think they are striking a chord among those who believe in sensible regulation, with the bogeyman being hedge funds. Just as there is disclosure required of fund managers and stock analysts to state their positions in the market to avoid “conflicts of interest”, so there should be a requirement that those who file FII applications and/or broker for FIIs should state how their business and profits are bloated because of the continuation of the present non-transparent FII regime.

The operational view of the lobbyists is that licensing can prevent hedge funds and bad money from entering the country. Hence, licensing will ban hedge funds and is therefore useful. Who is the most conservative and stable of money managers? Endowments and pension funds. And who do these squeaky cold money managers employ to manage their money? In large part, hedge funds.

To Sebi’s credit, even the regulator does not buy this absurd self-serving view. It has already allowed some hedge funds to enter the country. Why not rapidly move to a transparent policy allowing all to enter the Indian market, especially off-shore Indians? The correct policy is the registration of all investors with Sebi. With this transparent policy, hedge funds would be just like any other investor and subject to the same FII limits as NRIs and other cold money managers. Neither the regulator nor the government (nor self-styled and self-interested experts) should care as to who the holder of the money is; the only thing we should care is that the investors follow domestic laws. So please, let us stop using virtual imaginary evils to implement real bad policies.

Won’t this transparent policy increase capital inflows into India and thereby make the copious inflows problem worse? No, because the Indian, like the foreigner, is subject to on-shore stock purchase limits. If this limit is reached, as it has for several major stocks (such as SBI, Tata Steel and Zee News), the foreign (and NRI) investor would have to buy riskier second and third tier stocks. And that means less inflow.

One clarification. The stated limits for foreign ownership are quite high, in some cases even 100 per cent. If a liberal foreign investor share of 50 per cent is taken as the average allowed share for FIIs, and since the average promoter holding is 52 per cent, the foreigner’s 50 per cent share entitles him to only 24 per cent of the market cap in India. Today, foreigners own about 20 per cent of the market cap. In other words, there isn’t much room for additional transparent capital inflow.

But the real culprit behind copious inflows is the interest rate and exchange rate policy of India. But that will need a separate treatment. Forthcoming soon.
Source: http://www.businessstandard.com/economy/storypage.php?leftnm=3&subLeft=3&chklogin=N&autono=302515&tab=

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  • FII- Foreign Institutional Investor
  • SEBI- Securities And Exchange Board Of India

 

 

Surjit S Bhalla

About the Author

Surjit S. Bhalla is managing director of Oxus Research and Investments, a New Delhi-based economic research, asset management, and emerging-markets advisory firm. He taught at the Delhi School of Economics and has held various positions at the Rand Corporation, the Brookings Institution, the research and treasury departments of the World Bank, Goldman Sachs (1992-94), and Deutsche Bank (1994-96). He is the author of research papers on a wide range of topics including farm productivity and agricultural policy; poverty and inequality; the determinants of growth, with emphasis on the separate roles of economic and political freedom; inflation and capital account convertibility; and determination of interest rates, exchange rates, and stock prices. He is also a regular contributor to newspapers and magazines on economics, politics, and cricket.