Our markets drive investors away

The RBI’s intent to wean investors away from the offshore rupee NDF (non-deliverable forwards) market and instead encourage them to hedge their exposures in India is a step in the right direction.

Besides the positive effect the move will have on deepening currency markets in India, it signals a clear intent to be more open to foreign investment. Just how effective the RBI is in reining in this offshore market, is however a moot point.

Against the backdrop of increased currency volatility across markets, it has become necessary for investors to be allowed to hedge their currency exposures across asset classes — equities, fixed income, properties, or even commodities.

The RBI gradually allowed FIIs to hedge their currency exposures. They were however not allowed to access the market directly, but through a Category I merchant banker. The restrictive and costly market access led to the creation of a parallel market for rupee-dollar forwards outside of India. Given the lack of sufficient depth in the currency futures, especially for longer dated contracts, the government and the regulator ought to create enough liquidity across maturities, so that price discovery is efficient, more transparent, and transaction costs are minimal.

Market Development

Development of markets, as defined by ease of access, cost effectiveness, and market depth, must be a goal in itself.

Revenues that accrue to the government by way of transaction taxes and capital gains taxes, must only be regarded as a by-product of this goal. When the government builds a toll road, the primary objective of building one is not just to collect the toll, but to create businesses that are bound to come up alongside, leading to wealth creation.

Unfortunately, governments, both at the Centre and states, milk the markets for their revenue potential, thereby hindering the development of efficient markets.

We see the same story being played out across asset markets, be they equities, properties or commodities.

Security transaction taxes (STT) on equities, exchange traded commodity futures, and stamp duties on land transactions, have helped raise the much-needed revenues for the government, but have impeded the development of efficient markets. In the case of land and property, extraordinarily high stamp duties have dampened the secondary market for an already illiquid asset, thereby hindering efficient price discovery, besides leading to the creation of a thriving unreported economy.

In the case of equities, while creation of an unreported market has not been feasible, STT has instead significantly influenced the creation of a parallel market for equities in other less costly and less restrictive jurisdictions, most notably Singapore.

The Singapore Stock Exchange (SGX) does not levy transaction taxes on Indian equity futures, and has been particularly successful is capturing a sizeable chunk of business from FIIs, away from the Indian markets.

The shift has gathered momentum over the years, with the open interest on Nifty Futures on the SGX at over Rs 20,000 crore, now accounting for about 63 per cent of the overall open interest on the NSE and SGX combined.

Despite the cut in STT rates in this year’s budget, the shift has continued unabated, owing also to the ease of transacting in these exchanges overseas.

The RBI must recognise that its well-intended moves to minimise the extent of the non-deliverable forwards market overseas are unlikely to meet with much success, so long as there is a thriving market for Indian equities overseas.

With the rupee being the underlying currency of their investments, these investors will therefore seek to hedge their rupee exposures in offshore markets.

The RBI must, therefore, work in conjunction with SEBI and the Government, to address the issue of the regulatory and tax arbitrage between Indian and offshore markets, if it is to curb trade in offshore derivative markets for both stocks and currency. While the impending implementation of GAAR is keeping certain classes of investors away from investing directly in the Indian markets, it is something that investors will come to terms with over time.

Regulatory Arbitrage

The bigger problem is STT. The government cannot justify the STT on the basis of similarly regressive taxes in other markets.

The EU financial transactions tax that 11 member states of the EU, other than the UK, are to implement shortly, is just as regressive. Asset markets in India are far less developed that those in developed economies, and regressive transaction costs will do them no good.

Markets for financial assets, unlike physical assets, are more difficult to place curbs on, and will find ways to migrate to less restrictive markets.

Our immediate task is to make both our stock and currency markets deep enough for all classes of investors — domestic and foreign — to invest efficiently and with fewer hassles.

While the RBI’s moves to wean investors away from offshore currency markets are a step in the right direction, a more holistic approach is the need of the hour.

(The author is President, Southern India Chamber of Commerce and Industry.)

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