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May 24, 2013

The scramble for foreign debt

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economy (general) Economy Watch (column)

macro economics budgets and budgeting

investments

To implement a decision first signalled in Budget 2013, the Finance Ministry has announced a major tax concession to investors in Indias debt market. The withholding tax on interest earned on investments by Foreign Institutional Investors (FIIs) and Qualified Foreign Investors (QFIs) in government securities and bonds issued by Indian companies has been slashed from the prevailing 20 per cent to just 5 per cent. This concession is to apply not just to investments made in the future but on all interest income on such investments accruing between June 1, 2013 and May 31, 2015, irrespective of when the investment has been made. That is, even those who made these investments assuming that the withholding tax applicable on interest income was 20 per cent will now benefit from the concession, or be rewarded with a hike in net return. This is indeed a major concession to foreign financial investors in the debt market. Two years back a similar concession was awarded to those investing in Infrastructure Debt Funds, with the concession being extended a year later to foreign currency borrowing from abroad through the issue of long-term infrastructure bonds. Those concessions were presented as ways of incentivising foreign lending for Indias fund-starved infrastructural sector. Given the infrastructural bottleneck the tax concession was seen as crucial for growth. Now all such pretence is being dropped and any foreign investor willing to lend against any kind of foreign currency security issued in India is to be rewarded with this generous tax concession. There are four possible and related explanations for this remarkable generosity on the part of a government that constantly complains of being faced with a fiscal crunch, especially when it comes to financing welfare measures or funding much-needed subsidies. The first is that the liberalisation-induced widening of the current account deficit on Indias balance of payments has made the thirst for foreign capital in post-liberalisation India insatiable. No more is it adequate to incentivise foreign investment in crucial high technology or infrastructural sectors. Liberalisation is forcing the government to reward any kind of foreign investment, so long as it brings foreign currency into the country. The second is the evidence that no more is it adequate to incentivise only foreign investments in equity capital, the long-term capital gains on which had been abolished in 2003. Even though there has been a surge in foreign institutional investment to emerging markets including India, the government is fearful that inflows into the equity market would be inadequate to quench its thirst for foreign capital. So debt flows need to be incentivised too. The third is evidence that foreign investors are showing an appetite for debt. As the government has liberalised rules relating to foreign investment in the debt market, debt flows through the FII

route into India have indeed increased. As Chart 1 shows, net cumulative FII investments in debt instruments that were negligible at the turn of the century, and touched just $5 billion at the end of May 2009 have risen to close to $40 billion by the end of May 2013 (figure for 2013 refers to May 22). As a result the share of debt in cumulative net FII inflows estimated by the Securities and Exchange Board of India rose from just 0.1 per cent at the end of May 2001, to 8 per cent in 2009 and 21 per cent in 2012, only to decline marginally to 18 per cent by late May 2013 (Chart 2). Finally, as growth slows, the current account widens, the rupee slumps and the rating agencies turn aggressive, the government is clearly being pressured into appeasing foreign investors for fear that they would flee. Above all, it is willing to encourage financial inflows in the form of debt as opposed to equity, for investments in instruments issued by both private and public entities and in any sector whatsoever. All of this together explain the governments desire to offer this major tax concession to foreign investors in foreign currency debt instruments. The concession does of course impose huge costs on the nation. Unlike the case with investments in equity, where returns are linked to performance, interest and amortisation commitments on debt have to be met irrespective of the returns obtained in or foreign exchange earned by the investments they finance. The debt being in foreign currency, these binding commitments have to be met in foreign currency as well. So if the tax concession being offered results in a surge in FII investments in the debt market, payments on the current account on account of interest would rise as well. It would rise even faster if the interest rate that has to be offered to foreign financial investors in Indias increasingly uncertain environment also increases. The result would be larger outflows on the current account. Financing a widening current account deficit with debt may be self-defeating. The point is that the withholding tax concession is not being limited to investments in long-term bonds, such as those used to fund infrastructure, for example. Investors in all kinds of bonds would benefit. With economic uncertainty encouraging investments that can exit quickly, there is likely to be an increase in interest in and the issue of short-term bonds. Incentivising short term debt inflows is a sure way of increasing vulnerability to sudden capital outflow that can precipitate a balance of payments crisis, as Indias experience in 1991 and Southeast Asias in 1997 illustrated. The measure could, therefore, increase balance of payments vulnerability. Finally, relying on foreign currency debt to finance domestic expenditures when the rupee is depreciating has implications for the viability of borrowers. Rupee depreciation increases the local currency or rupee cost of servicing foreign debt, imposing an additional and undefined burden on the borrower. Firms exploiting increased foreign investor interest in the wake of the tax concession are likely to over-borrow. They can in difficult times, such as now, find themselves unable to service foreign debt without courting losses and even bankruptcy. For these and other reasons relying on foreign debt to finance a widening deficit, rather than finding ways of reducing that deficit, is not a good idea. Rewarding foreign investors with tax concessions so that they are willing to lend more than they consider prudent is downright foolish. Keywords: Finance Ministry, Tax concession, FII, QFI, Foreign investment, Budget

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c. r. l. narasimhan c. p. chandrasekhar harsh mander makarand waingankar p. sainath