In a manner reminiscent of Zeus testing out his thunderbolt, foreign institutional investors (FIIs) like to indulge in a show of strength every time policymakers mention the words ‘FII’ and ‘taxation’ in the same breath. It happened again this Budget day.
The Sensex, which was drifting aimlessly until the Budget speech wound to a close, suddenly went into a tailspin after someone dredged up the clause in the Finance Bill which said that a tax residency certificate was a ‘necessary but not sufficient’ condition for Mauritius-domiciled investors to claim tax breaks.
It then took a series of conciliatory television interviews from the Finance Minister for the markets to go back to business as usual.
Sabre-rattling
This is not the first time that markets have reacted in a knee-jerk fashion to such announcements.
Remember the fracas way back in 2007 when SEBI chief M. Damodaran asked FIIs to wind up investments made through Participatory Notes? That announcement saw the Sensex plunge by 1,700 points in a single day, with all the mayhem finally forcing SEBI to back-track on the requirement. There was also an attempt in the 2012 Budget to introduce the General Anti-Avoidance Rule. This had to be watered down and put off after foreign investors withdrew substantial sums in the succeeding months.
Given this history, one wonders why the Government even makes these half-hearted attempts to check tax evasion by FIIs, without evaluating the consequences.
Before raking this up again, it would be useful for the Government to do some serious homework. What is needed is an objective assessment of the gains and risks to the economy, if a stricter tax regime is imposed on FIIs. The exercise should start with some hard numbers on the nature of FIIs invested in the Indian markets.
Catastrophe?
Numbers from the latest shareholding patterns of companies, for instance, offer a good starting point. As of December 31, 2012, FII holdings in Indian shares were worth a collective Rs 11.59 lakh crore. This was 17.5 per cent of the total market value of all listed shares and 37 per cent of the value of shares available for trading (excluding promoter holdings).
Purely from a theoretical perspective, therefore, these numbers suggest that if all the FIIs decide to move out of the Indian market in one big exodus, they can cause plenty of damage. For, neither domestic institutions (which hold shares worth Rs 6 lakh crore) nor retail investors, can absorb all the shares offloaded in an orgy of FII selling.
But to expect all or even a significant proportion of FIIs to quit India, en masse , just because they are required to pay a capital gains tax, is quite unrealistic. The FIIs themselves have the most to lose from this action.
After all, as the biggest stakeholders in Indian companies after promoters, it is the foreign investors who take a disproportionate hit on their collective ‘wealth’ every time the Sensex plummets.
Not herd-like
One must also recognise that FIIs are not a homogenous bunch of investors who stampede into or out of a country in a herd. The 1700 FIIs registered in India comprise a diverse mix of investors. If some of them are hedge funds and high frequency traders who churn their portfolio hourly to make a quick buck, others such as pension funds, emerging market funds and sovereign wealth funds are here to generate long-term returns.
This diversity ensures that FIIs as a class seldom take a uniform view on stocks, sectors or policy changes. Even on Budget day, for instance, not all FIIs were lined up at their terminals punching in ‘Sell’ orders. SEBI data show that some FIIs made gross purchases of Rs 7,200 crore in stocks, while others sold Rs 8,400 crore in value; resulting in a ‘net’ sales of Rs 1,200 crore.
It also means that not all foreign investors will be equally hit by any proposal to bring their short-term capital gains into the tax net.
In this context, one number that can really help the Government gauge how much FII money is at risk, would be the break-up of FIIs into long term and short term ones. As the identity of all registered FIIs is available with SEBI, this should not be very difficult.
Which FIIs?
The extent of FII pullouts will also depend on the actual tax tweaks being proposed. If the Government invalidates the Mauritius tax treaty, for instance, there is no reason why FIIs domiciled in Singapore or the US or Luxembourg should exit.
Here too, it is possible to quantify the actual impact of such a change. For instance, informal estimates put the proportion of FII investments in India originating from Mauritius, at about 30-40 per cent.
What this means is that even if all Mauritius domiciled investors pull out of India, this would amount to just 7 per cent of the market by value (40 per cent of 17.5 per cent of the market cap).
Participatory Notes
Then there is the fact that, even if the Government does decide to review the tax treaty with Mauritius, not all of them will choose to pack up and leave. There can be no better illustration of this than the FIIs’ dalliance with Participatory Notes (P-Notes).
When they were banned in 2007, they accounted for well over half the FII money invested in India. But five years hence, P-Notes have clearly lost their hold and account for just 11 per cent of total FII investments. Nor has the phase-out dented FII flows, with cumulative FII holdings in India growing from Rs 8 lakh crore to Rs 11 lakh crore in this period.
But even armed with all these facts, it is doubtful if the Government can rake up the issue of tax evasion by FIIs and make the charges stick, in today’s situation.
Ultimately, what really matters in this game of wooing FIIs to India, while getting them to pay their fair share of taxes, is the timing. If the Indian economy was racing ahead at a double-digit pace and its foreign exchange reserves were brimming over, policymakers need have no second thoughts about taxing the gains made by FIIs to the hilt.
But the situation today is the diametrical opposite. The Indian economy has just reported its weakest growth in many years and seems to be tottering on the brink of a balance of payments crisis. Corporate India is hardly managing to expand its profits either.
Is it any surprise, then, that the FIIs feel that we cannot afford to be choosy about their pedigree or intentions, when they are essentially taking a wild card bet on Indian stocks?