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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.
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