A cohesive tax and economic policy approach is required to encourage capital flows
I have never figured out why the registration and regulation of FIIs was handed to Sebi in the 1990s. It is not Sebi’s job to register and restrict the investments by investors, domestic or foreign. Why then did Sebi, instead of RBI, bear this albatross across its neck for two decades? While it is clear that India had exchange control regulations and a foreign resident could not freely buy or sell Indian securities at one point of time, it simply wasn’t Sebi’s job to do exchange control. Imagine if traffic police were given the additional mandate to regulate traffic on twitter and social media! Yes, it is regulation of traffic, but it’s really not their job and they wouldn’t have the competence to do this effectively. Despite my efforts to find the reason, I never really found out the father of this foster child.
Anyway, Sebi bore this burden for long and didn’t really know how to handle this beast. On one hand, the regulations were meant to control exchange flows into securities, mainly of the portfolio kinds i.e. passive investments, while on the other, once registered, one could invest as much as one wanted and disinvest as much as one wanted. In other words, the controls were not even remotely a check on hot money. The confused regulations allowed individuals to invest in India through this route (through another convoluted scheme called the sub-account of the FII) but disallowed a manager to register unless he represented at least one ‘broad-based fund’. The FIIs also picked ‘good jurisdictions’ from which to welcome money, which included lots of iffy nations and tax havens while excluding mainstream and friendly nations like Kuwait.
In short, if the purpose was to impose controls, it didn’t really succeed in controlling short-term inflows and outflows. If the purpose was to restrict money from bad jurisdictions, the purpose wasn’t served. If the purpose was to attract only institutional money, the purpose was lost in translation. The route never really imposed any special qualitative controls on money laundering and tainted money, which was rather imposed by the central bank through its control of the banking channels. In short, the ‘route’ for investment had become quite popular simply because one had to come through one of the four or five approved routes if one wanted a piece of the India action.
That story, of course, held till there was a piece of India action. As the India story soured, the government realised that the pointless hoops created for foreign investors to invest had outlived their pointlessness. The first dawning of this realisation came with the introduction of the QFI route, a simple way for a foreign investor with just a hundred dollars to invest in Indian equities and mutual funds units. The QFI route was yet another alphabet soup of routes and never picked up because it caused trepidation amongst foreign investors about how they would be taxed. In any case, we never needed any routes for investment, and caps on control of Indian companies could be easily achieved without elaborate registration requirements.
The Chandrasekhar committee whose recommendations were accepted by Sebi last week and whose recommendations also seem to find favour with the finance ministry are a step in the right direction. Of course, it makes a piecemeal recommendation of merging two routes, the convoluted but well-treaded FII/sub-account route with the dud QFI route. Various other methods will continue after this merger—there will be an NRI route, a foreign venture capital route and the FDI route, to name the significant ones.
Two important improvements can be expected with the new foreign portfolio route, though this is based on Sebi press release rather than on reading the contents of the report, which for some reason is still not in public domain. First is the dismantling of the contradictory and silly regulations around registration of the foreign entity. A person must be free to come from any jurisdiction that has reasonable standards against money laundering. Period. Besides looking for tainted money, all foreign money should be welcome, whether institutional or retail. Second and more important is the dismantling of Sebi registration for making these portfolio investments. The simple process of registering with a credible private sector entity, coupled with straightforward rules on money laundering, would go a long way in at least removing the thorns in the way of foreign capital.
Caution must be exercised too on two fronts. One is that thorns are being removed. This is a necessary but not sufficient reason to invest in India. The economy still needs all the centripetal forces of competitive boosts, tax certainty and policy movement for investors to be interested in India compared to the many other options available to them. Second, if even a minute amount of tax uncertainty pollutes the new FPI route from the dysfunctional QFI route, that would be a clear self-goal. In other words, while investors had enormous tax comfort and certainty in arriving on Indian shores through an unnecessary FII registration, even a 5% uncertainty imported from the QFI regime is likely to exacerbate foreign capital flight rather than encourage new capital to come in. The historically different languages spoken by the revenue/tax people in the finance ministry from the ones in the same ministry who shape economic policy must give way to a cohesive policy which will encourage capital flows. Every dollar of risk capital which flows into the country creates ripple effects of up to four dollars of ricocheting growth in the economy. The finance minister must forge a cohesive policy out of this promising development. Nothing less will be acceptable to the economy.
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