The Modi government came to power on the promise of a new beginning for the economy, a beginning that will change the mindset of the Licence Raj socialism that has invaded and pervaded the Indian economy, and Indian financial markets. Tragically, the two most controlled sectors of the Indian economy are the two important growth poles of the Indian economy—agriculture and financial markets.
Not so long ago, circa 2006, there was much official GoI talk of Mumbai becoming a financial centre. This talk died down along with GDP growth in UPA-2. The Modi government has signalled that its top priority is the generation of economic growth and the provision of jobs to a job-starved population, especially the young population. There is talk of reviving the manufacturing sector which has been stagnant at 15% of GDP for as long as most people alive can remember. India has survived, to date, because of exceptional growth in the services sector. Job growth in the future will have to come from both manufacturing and services.
It is likely that history will remember PM Narendra Modi as not only the most astute and formidable politician that India has ever produced, but also perhaps the luckiest one. To achieve his goals, and fulfil his promises, Mr Modi needs to get growth to happen. Sustainable growth of India's potential of 8% growth will involve some right decisions, but it is not clear that the decisions will necessarily have to be tough ones. The luck part comes in from the fact that inappropriate and bad policies in the past have generated a lot of low-hanging growth fruit which can be easily plucked. Actually, forget the low-hanging fruit, there is so much fruit on the ground rotting away and waiting to be salvaged.
One such rotting fruit is India's legislation and policies regarding investment in the Indian stock market. In today's globalised world, legitimate international capital should, and will, flow to those countries that provide the highest and safest returns to the individual investor. Part of the returns is the “cost of doing business”, an item that PM Modi has said that he wants to reduce.
At present, the ease of doing business in the US (or practically any other country) is as follows. Anybody can enter their financial market subject to know your client (KYC) norms. Indeed, even an Indian can do so (and does so) subject to constraints imposed by RBI (no more than $125,000 per person per year). But what if Mr John Doe from America wants to invest in India? He can only do so via costly structures provided by major investment banks. Since Mr Doe may not know much about India, he may want to hire a local expert to manage his money. But he is not allowed to do so. Instead, he is required by Sebi to go to an expensive foreign institutional investor (FII) to manage his money at whatever exaggerated costs the FII can charge and get away with.
If you ask the Indian authorities (RBI, Sebi) as to why this absurd role, they will say that foreign portfolio money is short-sighted, fickle, and will run away at a moment's notice and surely I, or you, or Mr Modi would not want that. True. So what does RBI/Sebi do to contain foreign inflows so they don't run away at a moment's notice? At present, to date, the FIIs have cumulatively invested in the Indian stock market a total of $350 billion. This number is estimated on the basis of net foreign flows each year and the average gains on these flows as given by the percentage gain in the Sensex. Now, according to the deans at RBI/Sebi, it is much better to trust $350 billion with 50 FIIs than to trust $350 billion with 1 million individuals. Surely, the herd instinct is more applicable with a 100 bankers (remember the worldwide Great Recession of 2008-09 brought upon us by these masters of the universe) than with 1 million individuals. But don't tell RBI/Sebi that.
But the problem is not over even if RBI/Sebi become sensible and act in the nation's interest. There is a third institution to worry about—the taxman, yes the same gentleman who brought you retrospective taxes. What did retro taxes bring us? No tax revenue, and declining investment from both Indians and foreigners. The tax policy regarding portfolio investment has the same negative effects.
An Indian firm, operating out of India, is treated differently with regard to portfolio investment than a foreign firm. Both are investing in the stock market. But the Indian firm is treated extra special, so special that zero tax revenue is gained! As documented above, the Indian firm is not allowed to invest foreign money in the Indian stock market. Assume this were to change; assume acche din aa gaye hain. Phir bhi, koi farak nahin padega. Because the Indian tax authorities will treat the Indian firm as an “Indian establishment” subject to the top 30% tax rate for both the Indian firm (good) and the capital gains made by the foreign investor (absurd). This arises from the simple operation of calling up an Indian broker from Indian soil to buy Indian stocks; if the call is made from outside India to the broker, the client is not subject to the income tax rate of the broker or the fund manager. Instead, the client pays whatever tax rate is applicable in his or her jurisdiction.
The uniquely Indian (nowhere else in the world is such an own goal tax policy followed) policy has predictable consequences. At present, of the $350 billion foreign money invested in
India, none is invested with an India-based firm. No asset management jobs are created in India, and worse, no tax money collected. There are two sources of tax money from investment in Indian stocks. There is tax money to be gained from the incomes of the employees of the firm managing the money (tax revenue A) and capital gains taxes from the investment (tax revenue B).
Under the present system, the government of India obtains zilch from either category A or B. If an Indian firm was allowed to accept foreign money for management, then tax revenue B will remain zero, because there would be no incentive to operate via an Indian firm if complete “pass through” of taxes was not allowed, i.e. the foreigner must not, should not, pay on capital gains a tax rate equal to the tax rate of the fund manager.
However, when an Indian firm is allowed to manage foreign money, tax revenue A from the incomes of India-based fund managers goes up manifold as the managers’, and employees’, incomes are taxed at 30%. On management of $350 billion, and an income stream from fund management of only 3%, the fund managers’ income would be close to R60,000 crore. At a 30% tax rate, this will yield the government R18,000 crore.
What is the low-hanging, on the floor, fruit in the Indian securities industry? An expansion of the financial services sector in India, the approach towards Mumbai being a financial centre, plenty of jobs, and close to R20,000 crore in income tax revenue per year! Why hasn't such a win-win policy been pursued till date? When such policy absurdities arise, my rule is to look for who benefits, who gains rent, and whose scam it is to benefit from the present bad policies. The list is long and includes anybody who prefers that bad, anti-competitive, anti-growth, pro-rent-seeking system continues. And based on “revealed preference” this includes domestic and foreign vested interests—and major institutions in India.
The author is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla