Exploiting a ''Heady Mix''
It
is boom time for the Indian economy, Finance Minister P. Chidambaram
periodically reminds us. He has figures to back his case. Most recently,
the CSO has released ''advance estimates'' of national income for 2005-06,
which place GDP growth at 8.1 per cent as compared with 7.5 per cent
in 2004-05. This optimistic projection, pointing to the sustenance of
the recovery since 2003-04, combined with the rapid climb of the Bombay
Stock Exchange's sensitive index (Sensex) to a record-breaking 10,000-plus
level was in his view a ''heady mix''.
Given, the GDP growth figures, one cannot grudge the current government
and its Finance Minister a little intoxication. But what they need to
be careful about is the way they interpret these numbers and the lessons
they take home from the party. According to media reports, there are
at least two conclusions that the Finance Minister has derived from
the figures. In his view: "The Sensex reflects business confidence
and the strong fundamentals of the economy,'' to sustain which "we
should continue to remain on the path of tight fiscal control'' since
it is the adoption of such a fiscal stance that has given India this
growth.
Clearly then, in the Minister's perception, it is growth that drives
the Sensex and it is the government's prudent fiscal policy that drives
that growth. That is, we should all be thankful for the prudence exercised
by the Finance Minister and his colleagues that gives at least some
of us a high. However, even at the cost of sounding churlish when the
balloons are about to pop, a call for sobriety is in order, for a number
of reasons.
First, as the observant many who have braved the potholes and taken
the drive out of Greater Bombay, Bangalore, Chennai, Hyderabad, Delhi,
and Kolkata have noted, an overwhelming majority of Indians who populate
the rural areas, have been largely left out of the party. So have large
numbers of the urban poor whose presence cannot be hidden by the sprawling
malls of the new mega-cities. Agriculture, rural industry and the urban
informal sector have performed poorly for too long, partly because fiscal
''prudence'' of a kind that provides tax concessions to the well-to-do,
erodes government revenues and cuts expenditures to rein in the fiscal
deficit. Curtailed revenue growth and reduced deficits have meant too
little money for much needed investments in irrigation, drainage, health
facilities and educational infrastructure. Mr. Chidambaram himself would
recall the many dream budgets he was personally responsible for, that
affect revenue growth adversely and create anomalies of the kind where
a lower-middle class salary earner pays taxes on income, whereas speculators
in India's booming stock markets are exempt from taxes on the huge capital
gains they garner.
The same growth figures that Mr. Chidambaram quotes when broken down
by sector, point to the sharp variations in growth rates between agriculture,
on the one hand, and manufacturing and services, on the other. Agricultural
GDP grew at 0.7 per cent in 2004-05 and is expected to rise by just
2.3 per cent in 2005-06. Distorted growth has significant social implications.
The boom sectors are not able to offer employment opportunities that
can draw out the large numbers languishing in rural India, so that the
latter can share in the joys of India's urban buoyancy. If incomes grow
in manufacturing and services but employment stagnates or barely rises,
it must be true that there are just a few who benefit from the increment
in national income. Add to this the fact that even in manufacturing
and services there are a few firms, units or individuals that are doing
well, whereas many others perform indifferently or poorly, then inequalities
must be even wider. Not surprisingly the list of Indian millionaires
and billionaires lengthens while income poverty, malnutrition and illiteracy
persists. Maybe it is time to be gracious and inclusive, and widen the
invitees to the hitherto restricted celebration.
Second, there is reason to believe that the two ingredients of the Finance
Minister's boom cocktail have little to do with each other. Even if
not as spectacular as the CSO projects it to be, aggregate GDP growth
in India has been creditable since the 1980s. But the sustained and
rapid rise of the Sensex is much more recent. The Bombay Sensex rose
from 3727 on March 3, 2003 to 5054 on July 22, 2004, and then on to
6017 on November 17, 2004, 7077 on June 21, 2005, 8073 on November 2,
2005, 9067 on December 9, 2005, 10082 on February 7, 2006 and 10113
on February 15, 2006. The implied price increases of more than 100 per
cent over a 19-month period and 33 per cent over the last three and
a half months are indeed remarkable.
Market observers, the financial media and a range of analysts concur
that FII investments have been an important force, even if not always
the only one, driving markets to their unprecedented highs. Having amounted
to $2.84 billion during 2001, net FII investment dipped to $740 million
during 2002. The surge began immediately thereafter and has yet to come
to an end. Inflows rose to $6.59 billion during 2003, $8.52 billion
2004, 10.70 billion in 2005 and are estimated to have exceeded $1.5
billion (or an annualised $12 billion) during the first one and a half
months of 2006. Going by data from the Securities and Exchange Board
of India (SEBI), while cumulative net FII flows into India since the
liberalisation of rules governing such flows in the early 1990s till
end-March 2003 amounted to $15,804 million, the increment in cumulative
value between that date and the middle of February 2005 was $26,924
million.
If the Finance Minister is to argue that this surge in FII flows is
the result of strong economic fundamentals, then he is suggesting that
for more than a decade, the accelerated economic liberalisation launched
initially by a Congress government had not been able to deliver the
fundamentals needed to attract adequate capital flows. Moreover, since
the period prior to and when the surge began was one of NDA rule, he
is possibly also unconsciously suggesting that it needed a non-Congress
government to shape the necessary fundamentals. Fortunately for him,
we can save him the embarrassment of facing up to his implicit confessions,
since it is clear that what underlies the surge is not changed economic
fundamentals but an engineered stimulus in the form of the rules governing
FII investment: its sources, its ambit, the caps it was subject to and
the tax laws pertaining to it.
Even before the budget of 2002-03, the cap which was to apply on FII
investments in individual companies had been relaxed. Foreign institutional
investors could invest in excess of 24 per cent of the paid up capital
of a company with the approval of the general body of the shareholders
granted through a special resolution. The 2002 budget went further and
declared that FII (portfolio) investments will not be subject to the
sectoral limits for foreign direct investment except in specified sectors.
These changes obviously substantially expanded the role that FIIs could
play even in a market that was still relatively shallow in terms of
the number of shares that were available for active trading. Further,
inasmuch as the process of liberalisation keeps alive expectations that
the caps on foreign direct investment in different sectors would be
relaxed over time, acquisition of shares through the FII route today
paves the way for the sale of those shares to foreign players interested
in acquiring companies as and when FDI norms are relaxed. This creates
the ground for speculative forays into the Indian market. Figures relating
to end December 2005 indicate that the shareholding of FIIs in Sensex
companies has been increasing at the cost of promoters and stood at
29.2 per cent. The latter's holding has decreased from 51.5 per cent
to 49.7 per cent between December 2004 and December 2005. Given variations
across companies this would imply ownership of a controlling block by
the FIIs in some firms which can be transferred to an intended acquirer
at a suitable price.
That such speculators are present here is clear from the type of investors
who are making investments through the FII route. Market observers have
noted the growing presence in India of institutions like Hedge Funds,
which are not regulated in their home countries and resort to speculation
in search of quick and large returns. These hedge funds, among other
investors, exploit the route offered by sub-accounts and opaque instruments
like participatory notes to invest in the Indian market. FIIs registered
in India are permitted to undertake investments on behalf of clients
who themselves are not registered in the country. These clients are
the so-called ‘sub-accounts' of registered FIIs. Other investors use
instruments like participatory notes sold by FIIs registered in the
country to clients abroad. These are derivatives linked to an underlying
security traded in the domestic market. They not only allow the foreign
clients of the FIIs to earn incomes from trading in the domestic market,
but to trade these notes themselves in international markets. By the
end of August 2005, the value of equity and debt instruments underlying
participatory notes that had been issued by FIIs amounted to 47 per
cent of cumulative net FII investment. Through these routes, entities
not expected to play a role in the Indian market can have a significant
influence on market movements. In October 2003, The Economist reported
that: ''Although a few hedge funds had invested in India soon after
the country began liberalising its financial markets in the early 1990s,
their interest has surged recently. Industry sources estimate that perhaps
25-30 per cent of all foreign equity investments are now held by hedge
funds.''
The interest of speculative forces of this kind was whetted by a major
decision taken in the budget for 2003-04 to render the speculative gains
registered by these investors free of capital gains tax. Budget speech
2003-04 declared: ''In order to give a further fillip to the capital
markets, it is now proposed to exempt all listed equities that are acquired
on or after March 1, 2003, and sold after the lapse of a year, or more,
from the incidence of capital gains tax. Long term capital gains tax
will, therefore, not hereafter apply to such transactions. This proposal
should facilitate investment in equities.'' Long term capital gains
tax was being levied at the rate of 10 per cent up to that point of
time. The surge was no doubt facilitated by this significant concession.
What needs to be noted is that the very next year, P. Chidambaram as
Finance Minister of the current UPA government endorsed this move. In
his 2004 budget speech he announced his decision to ''abolish the tax
on long-term capital gains from securities transactions altogether.''
It is no doubt true that he attempted to introduce a securities transactions
tax of 0.15 per cent to partially neutralise any loss in revenues. But
a post-budget downturn in the market forced him to reduce the extent
of this tax and curtail its coverage, resulting in a substantial loss
in revenue. In the event, fiscal extravagance rather than fiscal prudence
finally triggered the speculative surge in stock markets that still
persists.
The implications of this extravagance can be assessed with a back-of-the-envelope
calculation which, even while unsatisfactory, is illustrative. Market
capitalization in the Bombay Stock Exchange stood at Rs. 16,85,989 crore
at the end of 2004. This rose by more than Rs. 803,000 crore to Rs.
24,89,386 crore at the end of 2005. If we assume for purposes of our
illustration that this is indicative of the gains registered by every
one who traded shares after holding them for a year, the capital gains
tax they would have had to pay would have amounted to Rs.80,000 crore.
This is equivalent to the total receipts from Corporation Tax in financial
year 2004-05 and a quarter of the gross tax revenue of the Centre in
that year. While actual transactions in the market would not have yielded
capital gains of this magnitude and while it may be true that the surge
in the market may not have occurred if India had not been made a capital
gains tax haven, these numbers point to the kind of losses we are possibly
talking about. They make nonsense of the claim that it is fiscal prudence
and strong fundamentals that have ensured buoyancy in the stock market.
Rather, fiscal extravagance in the form a huge tax concession to the
domestic and foreign super rich has delivered the ''bonanza''. The attendant
implication is that resources that could have been mobilized for employment
programmes, for social expenditures and for much needed capital investment
have been squandered.
Mr. Chidambaram is, of course, intelligent enough to have recognised
all this, especially since he played a role in the unfolding game. If
he has yet chosen to use GDP growth figures to whitewash the nature
and sources of the speculative boom, there must be adequate reasons.
One is that he can use these numbers to justify in the name of ''fiscal
prudence'' his ''inability'' to provide adequately for much-needed social
and capital expenditures. Another, is that he, along with the Prime
Minister and the Deputy Chairman of the Planning Commission, can use
the ruse that liberalisation has delivered India's ''heady'' economic
performance to press ahead with liberalisation measures that allies
and supporters of the current government oppose.
The evidence for the latter is overwhelming. Besides privatisation of
airports, FDI in retail and opening up a host of new sectors for 100
per cent foreign investment through the automatic route, it is being
reported that formal moves are afoot to launch over the next four months
a series of initiatives to provide ''a significant push to economic
reforms''. These initiatives include relaxing environmental restrictions
on construction in metro areas, introducing legislation at the State
level that can facilitate contract farming, removing 250 items reserved
for the small scale sector from the currently reserved list, modifying
labour laws to allow for an increase in the work week from 48 to 60
hours, amending the Industrial Disputes Act to give units flexibility
to hire seasonal workers and amending the Contract Labour Act to increase
labour flexibility.
Fortunately, there are forces within and outside government that are
bound to strongly oppose indiscriminate liberalisation of this kind
justified on specious grounds. Unfortunately, however, battles of this
kind are making clear that economic policy is being hijacked by a few
who do not stand for the programme which the electorate voted for in
the last election and on the basis of which this government was installed
in power. The energy lost in these battles may setback the development
agenda to an extent where the current government may find it difficult
to return to power, even if it manages to complete its term.