Indian Markets Losing Currency among Investors

GAAR, POLICY PARALYSIS HIT LOCAL TRADING

India's economic growth plunging to a nine-year low in the quarter to March may have come as a big shock to many last week. Now, data relating to equities and currencies show the country's financial markets too are being exported as investors increasingly trade in Indian assets in overseas markets against the backdrop of retrospective taxation measures, policy paralysis and uncertainty. 

Since April this year, a little after Pranab Mukherjee unveiled his budget that proposed a raft of tax measures, including retrospectively taxing indirect transfers, trading volumes in American Depositary Receipts (ADRs), which represent stocks of some of India's top companies such as Infosys, HDFC Bank and Dr Reddy's Laboratories (DRL), have spurted and in some cases are higher than volumes of such stocks on Indian exchanges. Traded value of Infosys ADRs was as high as 154.93% of the total traded value of the stock in Indian markets at the end of May while it was 92% in the case of DRL, 88.43% for ICICI Bank and 85% for Tata Motors. 

Since mid-March through Mayend, open interest of Nifty futures traded in Singapore has increased 26% at 3,49,666 contracts while that of Nifty futures in the local market has fallen by a similar extent to 5,08,193. Open interest is the outstanding position of traders and indicates the amount of money flowing into a market. Nifty is India's premier stock market index while futures on the index facilitate its sale or purchase at a preset price on a future date. 

The higher interest in Nifty traded on Singapore's SGX has been at the cost of Indian markets, which have seen a flight of foreign investors ever since the General Anti-Avoidance Rules (GAAR) to tax indirect transfers of Indian assets overseas were introduced in this year's budget. 

A similar story is playing out on the currency trading front. 

Volumes in offshore, unregulated deals, known as non-deliverable forwards, or NDF, have also been on the rise.The Bank for International Settlements estimating the trade at 50% of the total offshore and onshore volumes. Policy Mistakes Blamed 

Rupee volumes too have surged on the Dubai Gold & Commodities Exchange (DGCX), whose share of overall exchange-traded futures, including NSE, MCX Stock Exchange, United Stock Exchange and Bahrain Financial Exchange, in dollar-rupee contracts has jumped three-folds to 16% from the year-ago level against a 5-8 percentage point jump in NSE and MCXSX volumes over the same period. Indian rules bar foreign investors and NRIs from trading in the local currency futures market, which, in turn, are betting on the rupee in overseas exchanges such as DGCX. The rise in NDF has also been fuelled by arbitrage opportunities between Indian offshore markets like Singapore, Hong Kong and London. 

Much of these are being traced to policy mistakes on the part of the government and financial sector regulators and an operating environment that is being perceived as hostile. Sanjay Nayar, who heads the Indian operations of global buyout firm KKR, says a proxy market is developing overseas. "We should stop externalising our assets and think hard about how much dependence we create on shortterm capital. What we need to do is encourage and develop our local markets, be it bonds, equities or currency, to tap into our latent savings potential instead of a policy bias in favour of avenues that encourage short-term flows from different pools of foreign capital," says Nayar. 

What has also not helped is higher total costs in the Indian market, which otherwise is recognised globally for its financial markets infrastructure. In good times as during the high growth phase of '04-'05 to '07-'08, overseas investors had chosen to ignore costs such as a high securities transaction tax, or STT, and stamp duty, but now these costs are being held against India. Singapore, which has mainly benefitted because of India's governance issues and an uncertain policy and regulatory environment, does not impose such taxes and attracts financial sector firms and investors by offering a lower cost of capital. In short, investors say it is cheaper to trade on the SGX rather than on a similar contract in the Indian markets. 

According to Uday Kotak, executive vice-chairman and managing director, Kotak Mahindra Bank, over the last three-four years, market volumes have not grown, with a lot of it shifting from the cash segment. Local mutual funds have also not grown much with a drop in investor interest. The current challenge is to ensure significant liquidity in the local markets and the participation of domestic savers in equities, he says. "Policy should focus on two key elements — liquidity and transaction costs," Kotak says, citing the case of South America, where in all the major markets there were more volumes in local stocks on the New York Stock Exchange than the local markets. That is something which any large market needs to protect, he says. "What we have ended up doing is boosting the Singapore economy at the cost of India," says the head of a top global financial services company who did not want to be named. "It is a case of the tail wagging the dog and there is little point in locking the doors after the damage has been done," said another professional in the financial sector. 

According to Ajay Shah, professor, National Institute of Public Finance and Policy, the root of these problems lies in the policy mistakes made by the government and regulators. He lists these as a lack of residence-based taxation, targeting tax revenues from non-residents through STT and the prospective attack on the Mauritius treaty through anti-tax avoidance rules such as GAAR, capital controls in the form of barring foreigners from trading currency futures on NSE, and margin requirements imposed by SEBI.