Themes > Current Issues
25.09.2012
Foreign Finance and India's Development*
C.P. Chandrasekhar
The
Manmohan Singh government pretends to be obsessed with fears of a
collapse of foreign investor confidence and foreign capital inflows.
A recent act signalling such fears is its retreat on the question
of adoption of GAAR (or General Anti- Avoidance Rules). GAAR seeks
to prevent abusive use of provisions in the law to 'legally' avoid
(as opposed to illegally evade) tax payment, resulting in private
gains that are not in keeping with the intent of the law or the national
interest.
The rules are logical, fair and increasingly considered international best practice. They clarify the provisions of the law and detail the norms that should govern their application. Many countries, including developed ones like Canada, are already implementing their version of GAAR. Recognising the importance of anti-tax avoidance rules, the Direct Tax Code (aimed at rationalising and simplifying the tax system) and the Budget for 2012-13 sought to implement GAAR in India. The move was creditable, even if there could be debate on the adequacy of specific provisions.
Surprisingly, an adverse response from domestic and foreign corporations, exaggerated by the media and self-appointed ''experts'', has given cause to an influential section of the government led by the Prime Minister (during his short term as Finance Minister and after) to demand deferment or even the dropping of its implementation. The current deferment is till 2013, but if the use of the rent-an-expert-committee practice is any indication, the proposal would be deferred, based on the recommendations of the Parthasarathi Shome committee, for another three years. After that, in all probability, it would not be implemented at all. Never has a committee set up to stall implementation of an announced policy arrived at its conclusions in such a short period of time.
In stonewalling GAAR on the grounds of restoring investor confidence, the Prime Minister and a section of his cabinet are violating the transparency they claim to be committed to as ''reformers''. They are doing so even at the cost of reversing the decision of the earlier Finance Minister, Pranab Mukherjee, who stoutly defended not just the adoption of GAAR but also the decision to retrospectively amend the law to make clear the government's intent on and penalise the avoidance of capital gains taxes as it alleges happened in the case of the Vodafone takeover of Essar. Both these are now unlikely to be adopted. The reason given for withdrawing from this completely sensible policy direction is the perceived need to appease foreign investors. In fact the principal objective of the current government seems to be that of winning and sustaining the whimsical 'confidence' of foreign capital at all costs. This is the altogether new and defining feature of economic policy in contemporary India.
What the GAAR example illustrates is the dramatic change in India's relationship with foreign capital since Independence. In the 1950s, there was near unanimity that winning a degree of autonomy vis-à-vis foreign capital was a prerequisite for consolidating India's political freedom. Today, many see recognition by foreign capital as a favoured investment destination as a measure of the country's economic success. It could be argued that India is now a mature political democracy with no threat to its sovereignty. So there need be no fear of foreign capital, and its recognition can serve as an ''independent'' barometer of performance. However, there is much evidence of the ways in which sovereignty has been affected by the accumulated presence of foreign (especially financial) capital in the country since liberalisation.
One reason why autonomy relative to foreign capital was seen as crucial in the post-Independence years was that such independence was a prerequisite for the creation of domestic policy space. Moreover, it was argued, that only if such space existed could the newly independent state pursue a strategy of national development that would better the standard of living of its people. During the first four decades after Independence India did manage to carve out that space with policies of protection and regulation of the volume, destination and terms of engagement of foreign investment in the country. Purely financial investments were discouraged or banned, some sectors were kept out of the purview of foreign investors, caps on foreign equity holding were set in others, partnership with domestic capitalists was encouraged, and the terms for technology transfer were regulated. In these and other ways the state mediated the relationship between foreign and domestic capital keeping the interests of national development in mind. The policy of ring-fencing the domestic economy and keeping a few selected gates open was clear.
Unfortunately, the failure to reduce the power of and discipline domestic landlords and monopolists undermined the ability of the system to use the resulting policy space to its full potential. It was when that failure combined with the push of foreign capital looking for new avenues of expansion, that dependence on foreign finance, especially from private sources, increased. An unusual growth trajectory was followed during the 1980s. The government borrowed domestically to hugely expand its current (not investment) expenditure. With supply side bottlenecks present, especially in agriculture, this triggered inflation. To rein in inflation and keep growth going, the government borrowed abroad to finance imports of goods in short supply. Foreign exchange was also used to import of goods satisfying the demands from the upper income groups. The result was a sharp rise in India's external debt GDP ratio. It was that rise combined with evidence of a growing shortfall in foreign exchange earnings relative to expenditure (or a rising current account deficit) which led to a loss of creditor confidence, forced India to exhaust its limited foreign exchange reserves and precipitated the crisis of 1991. That policy should have cautioned the government against increasing India's dependence of foreign capital. Ironically, the policy of liberalisation adopted in the wake of the crisis only increased that dependence, with a growing role for non-debt forms of capital especially foreign institutional investment.
With the adoption of that programme of liberalisation, regulation and control of foreign investors has been whittled away through policy. The surge in foreign capital inflows that followed, particularly during the first decade of this century, has resulted in a substantial accumulation of foreign capital in the country, especially footloose financial capital. And as was believed in the immediate post-Independence years, this growing dependence has indeed constrained domestic policy space.
Nothing illustrates this more than the fact that every new policy initiative, whether it has anything to do with foreign finance (such as taxes on capital market transactions) or not (such as the food security bill) is in the final analysis assessed in terms of the impact it would have on foreign investor confidence. Moreover, new policies that are controversial because of the adverse impact they would have on the livelihoods and standards of living of a large number of the nation's citizens (such as the grant of right of entry to foreign investors into multi-brand retail) are advocated on the grounds that not doing so would adversely affect investor confidence. Matters have now gone beyond the bounds of rationality.
Take the case of GAAR referred to earlier. Sections of the media, which otherwise favour reform, transparency and all things related, are justifying this retreat by the government as a response to India's equity and currency markets being hammered by panic-stricken investors. The absurdity of this view needs highlighting. To start with, if foreign investors are of the kind who hammer markets when measures that are rational, fair and in the national interest are planned to be implemented, then it would be best to do without such investors. Second, it is difficult to believe that foreign investors would altogether stay out of a profitable market if they are not permitted to avoid taxes. GAAR has been on the anvil ever since it became clear that the tax treaty with Mauritius was being misused, leading to the routing of an overwhelming share of foreign investments into India through that country. Moreover, GAAR has figured in past discussions over the Direct Tax Code. So if foreign investors find GAAR anathema, they should have stopped coming to India quite sometime back, and even pulled out past investments made in the country. There has been no sign of that.
Finally, though in recent times there has been much talk of a flight of foreign investors out of the country, there seems to be no clear evidence of that. What has happened, as has happened many times in the past, is that the composition of foreign capital inflows into the country has changed. If we consider 2011-12 as a whole and examine the composition of capital inflows, we find that though there was a change in the composition of investment flows away from portfolio flows to direct investment flows, the aggregate private investment flow into equity remained more or less the same at $39-40 billion in both 2010-11 and 2011-12. Not much should be made of the shift from portfolio to direct investment, since the difference between the two is largely definitional. If a foreign investor cumulatively acquires equity equal to 10 per cent or more of the shareholding in the target firm, that investment is treated as direct investment. If not, it is put in the portfolio investment box. So, like portfolio investors, many so-called direct investors are also looking for capital gains rather than long term-returns and can be as flighty. Further, with the stock market weak and volatile, investors may have preferred not to adopt the FII route for investment. This too reduces portfolio investment. That the shift away from portfolio to direct investment does not say much about investor confidence also comes through from the increased inflows into NRI deposits that rose from $3.2 billion in 2010-11 to as much as $11.9 billion in 2011-12.
In sum, there is no immediate need for the government to panic on grounds that foreign investors are panicking. If it still does bend over backwards, as in the case of GAAR, to please foreign investors it would be for two longer-term reasons. First, a strategy of growth predicated on large inflows of foreign finance, which requires constantly appeasing investor sentiment. That strategy is particularly vulnerable in a period when the current account deficit is widening substantially, as it is today. And, second, the fear that if foreign investors lose interest in India and withdraw their footloose, financial investments balance of payments and currency crises cannot be prevented just because the country has accumulated reserves based on capital inflow.
The GAAR example is telling for another reason. Though not devised primarily as a revenue raising measure, there is no gainsaying the fact that it (and the related adoption of retrospective rules on capital gains taxation) would help the government garner much by way of taxes. There are many measures of relevance to India's poor majority, varying from an expanded employment guarantee programme, provision of subsidised food through the public distribution system, minimal social security, education for children, health facilities and safe water and sanitation, that require financing. Advance on every one of these fronts has been absent or wholly inadequate, with the government attributing failure to the lack of resources to finance these ventures. Moreover, expenditure on these activities in the absence of resources is seen as contributing to a rising fiscal deficit, which too erodes investor confidence. Thus, the need to appease the foreign investor not only constricts policy space but also does so in a way in which there is an almost direct relationship between the concessions made to the foreign investor and the benefits not accorded to those who need them most and have been deprived of the gains of growth for long.
In sum, pursuit of a strategy of development predicated on ensuring large and persistent inflows of foreign capital tends to be one that fattens the rich by depriving the poor. This tendency towards rising inequality is intensified because the strategy requires more than just permitting private investors retain what they rightly or wrongly already appropriate. It requires enlarging the spheres from which they can draw more profit. Through new tax concessions, transfers of various kinds and sale of land and scarce assets to the private sector at extremely low prices, the government has to engineer profit inflation.
This role of the government clearly played a role in driving the surge in capital flows that supported growth during the last decade. While this was a period when globally there was a sharp rise in cross-border flows of capital, India was a favoured beneficiary because of actions adopted by the Indian government. Just before the FII surge began, and influenced perhaps by the sharp fall in net FII investments in 2002-03, the then Finance Minister declared in the Budget for 2003-04: ''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 concessional rate of 10 per cent at that point of time. The surge was no doubt facilitated by this further concession that converted India's equity market into a tax-free enclave.
Once on this trajectory, the policy of continuing ''liberalisation'' in which the state persistently favours private capital is justified by arguing that foreign investor interest is waning because of the ''slowing'' of reform. All India needs to do, the advocates of the neoliberal strategy argue, is announce a few ''big ticket'' reform measures, such as opening multi-brand retail for foreign investment or allowing sale of equity in public sector banks to foreign investors, for investor confidence and the economy to revive. This means the government should also not prevent foreign firms from benefiting from ambiguity in the law, such as happened in the case of tax avoidance by Vodafone when it acquired equity in the Indian cell phone industry. What is ignored here is that neither have foreign investors runaway as yet nor have they come only when they had these ''big ticket'' concessions. Hence, by advancing such arguments the advocates of reform reveal the role of the state and the parasitic nature of capital in this regime of accumulation, which requires persistent concessions to coax the latter into investing for growth. The relationship between foreign capital and India has indeed changed—only for the worse.
* This article was published in the Frontline Volume 29, Issue 19, September 22- October 5, 2012.
The rules are logical, fair and increasingly considered international best practice. They clarify the provisions of the law and detail the norms that should govern their application. Many countries, including developed ones like Canada, are already implementing their version of GAAR. Recognising the importance of anti-tax avoidance rules, the Direct Tax Code (aimed at rationalising and simplifying the tax system) and the Budget for 2012-13 sought to implement GAAR in India. The move was creditable, even if there could be debate on the adequacy of specific provisions.
Surprisingly, an adverse response from domestic and foreign corporations, exaggerated by the media and self-appointed ''experts'', has given cause to an influential section of the government led by the Prime Minister (during his short term as Finance Minister and after) to demand deferment or even the dropping of its implementation. The current deferment is till 2013, but if the use of the rent-an-expert-committee practice is any indication, the proposal would be deferred, based on the recommendations of the Parthasarathi Shome committee, for another three years. After that, in all probability, it would not be implemented at all. Never has a committee set up to stall implementation of an announced policy arrived at its conclusions in such a short period of time.
In stonewalling GAAR on the grounds of restoring investor confidence, the Prime Minister and a section of his cabinet are violating the transparency they claim to be committed to as ''reformers''. They are doing so even at the cost of reversing the decision of the earlier Finance Minister, Pranab Mukherjee, who stoutly defended not just the adoption of GAAR but also the decision to retrospectively amend the law to make clear the government's intent on and penalise the avoidance of capital gains taxes as it alleges happened in the case of the Vodafone takeover of Essar. Both these are now unlikely to be adopted. The reason given for withdrawing from this completely sensible policy direction is the perceived need to appease foreign investors. In fact the principal objective of the current government seems to be that of winning and sustaining the whimsical 'confidence' of foreign capital at all costs. This is the altogether new and defining feature of economic policy in contemporary India.
What the GAAR example illustrates is the dramatic change in India's relationship with foreign capital since Independence. In the 1950s, there was near unanimity that winning a degree of autonomy vis-à-vis foreign capital was a prerequisite for consolidating India's political freedom. Today, many see recognition by foreign capital as a favoured investment destination as a measure of the country's economic success. It could be argued that India is now a mature political democracy with no threat to its sovereignty. So there need be no fear of foreign capital, and its recognition can serve as an ''independent'' barometer of performance. However, there is much evidence of the ways in which sovereignty has been affected by the accumulated presence of foreign (especially financial) capital in the country since liberalisation.
One reason why autonomy relative to foreign capital was seen as crucial in the post-Independence years was that such independence was a prerequisite for the creation of domestic policy space. Moreover, it was argued, that only if such space existed could the newly independent state pursue a strategy of national development that would better the standard of living of its people. During the first four decades after Independence India did manage to carve out that space with policies of protection and regulation of the volume, destination and terms of engagement of foreign investment in the country. Purely financial investments were discouraged or banned, some sectors were kept out of the purview of foreign investors, caps on foreign equity holding were set in others, partnership with domestic capitalists was encouraged, and the terms for technology transfer were regulated. In these and other ways the state mediated the relationship between foreign and domestic capital keeping the interests of national development in mind. The policy of ring-fencing the domestic economy and keeping a few selected gates open was clear.
Unfortunately, the failure to reduce the power of and discipline domestic landlords and monopolists undermined the ability of the system to use the resulting policy space to its full potential. It was when that failure combined with the push of foreign capital looking for new avenues of expansion, that dependence on foreign finance, especially from private sources, increased. An unusual growth trajectory was followed during the 1980s. The government borrowed domestically to hugely expand its current (not investment) expenditure. With supply side bottlenecks present, especially in agriculture, this triggered inflation. To rein in inflation and keep growth going, the government borrowed abroad to finance imports of goods in short supply. Foreign exchange was also used to import of goods satisfying the demands from the upper income groups. The result was a sharp rise in India's external debt GDP ratio. It was that rise combined with evidence of a growing shortfall in foreign exchange earnings relative to expenditure (or a rising current account deficit) which led to a loss of creditor confidence, forced India to exhaust its limited foreign exchange reserves and precipitated the crisis of 1991. That policy should have cautioned the government against increasing India's dependence of foreign capital. Ironically, the policy of liberalisation adopted in the wake of the crisis only increased that dependence, with a growing role for non-debt forms of capital especially foreign institutional investment.
With the adoption of that programme of liberalisation, regulation and control of foreign investors has been whittled away through policy. The surge in foreign capital inflows that followed, particularly during the first decade of this century, has resulted in a substantial accumulation of foreign capital in the country, especially footloose financial capital. And as was believed in the immediate post-Independence years, this growing dependence has indeed constrained domestic policy space.
Nothing illustrates this more than the fact that every new policy initiative, whether it has anything to do with foreign finance (such as taxes on capital market transactions) or not (such as the food security bill) is in the final analysis assessed in terms of the impact it would have on foreign investor confidence. Moreover, new policies that are controversial because of the adverse impact they would have on the livelihoods and standards of living of a large number of the nation's citizens (such as the grant of right of entry to foreign investors into multi-brand retail) are advocated on the grounds that not doing so would adversely affect investor confidence. Matters have now gone beyond the bounds of rationality.
Take the case of GAAR referred to earlier. Sections of the media, which otherwise favour reform, transparency and all things related, are justifying this retreat by the government as a response to India's equity and currency markets being hammered by panic-stricken investors. The absurdity of this view needs highlighting. To start with, if foreign investors are of the kind who hammer markets when measures that are rational, fair and in the national interest are planned to be implemented, then it would be best to do without such investors. Second, it is difficult to believe that foreign investors would altogether stay out of a profitable market if they are not permitted to avoid taxes. GAAR has been on the anvil ever since it became clear that the tax treaty with Mauritius was being misused, leading to the routing of an overwhelming share of foreign investments into India through that country. Moreover, GAAR has figured in past discussions over the Direct Tax Code. So if foreign investors find GAAR anathema, they should have stopped coming to India quite sometime back, and even pulled out past investments made in the country. There has been no sign of that.
Finally, though in recent times there has been much talk of a flight of foreign investors out of the country, there seems to be no clear evidence of that. What has happened, as has happened many times in the past, is that the composition of foreign capital inflows into the country has changed. If we consider 2011-12 as a whole and examine the composition of capital inflows, we find that though there was a change in the composition of investment flows away from portfolio flows to direct investment flows, the aggregate private investment flow into equity remained more or less the same at $39-40 billion in both 2010-11 and 2011-12. Not much should be made of the shift from portfolio to direct investment, since the difference between the two is largely definitional. If a foreign investor cumulatively acquires equity equal to 10 per cent or more of the shareholding in the target firm, that investment is treated as direct investment. If not, it is put in the portfolio investment box. So, like portfolio investors, many so-called direct investors are also looking for capital gains rather than long term-returns and can be as flighty. Further, with the stock market weak and volatile, investors may have preferred not to adopt the FII route for investment. This too reduces portfolio investment. That the shift away from portfolio to direct investment does not say much about investor confidence also comes through from the increased inflows into NRI deposits that rose from $3.2 billion in 2010-11 to as much as $11.9 billion in 2011-12.
In sum, there is no immediate need for the government to panic on grounds that foreign investors are panicking. If it still does bend over backwards, as in the case of GAAR, to please foreign investors it would be for two longer-term reasons. First, a strategy of growth predicated on large inflows of foreign finance, which requires constantly appeasing investor sentiment. That strategy is particularly vulnerable in a period when the current account deficit is widening substantially, as it is today. And, second, the fear that if foreign investors lose interest in India and withdraw their footloose, financial investments balance of payments and currency crises cannot be prevented just because the country has accumulated reserves based on capital inflow.
The GAAR example is telling for another reason. Though not devised primarily as a revenue raising measure, there is no gainsaying the fact that it (and the related adoption of retrospective rules on capital gains taxation) would help the government garner much by way of taxes. There are many measures of relevance to India's poor majority, varying from an expanded employment guarantee programme, provision of subsidised food through the public distribution system, minimal social security, education for children, health facilities and safe water and sanitation, that require financing. Advance on every one of these fronts has been absent or wholly inadequate, with the government attributing failure to the lack of resources to finance these ventures. Moreover, expenditure on these activities in the absence of resources is seen as contributing to a rising fiscal deficit, which too erodes investor confidence. Thus, the need to appease the foreign investor not only constricts policy space but also does so in a way in which there is an almost direct relationship between the concessions made to the foreign investor and the benefits not accorded to those who need them most and have been deprived of the gains of growth for long.
In sum, pursuit of a strategy of development predicated on ensuring large and persistent inflows of foreign capital tends to be one that fattens the rich by depriving the poor. This tendency towards rising inequality is intensified because the strategy requires more than just permitting private investors retain what they rightly or wrongly already appropriate. It requires enlarging the spheres from which they can draw more profit. Through new tax concessions, transfers of various kinds and sale of land and scarce assets to the private sector at extremely low prices, the government has to engineer profit inflation.
This role of the government clearly played a role in driving the surge in capital flows that supported growth during the last decade. While this was a period when globally there was a sharp rise in cross-border flows of capital, India was a favoured beneficiary because of actions adopted by the Indian government. Just before the FII surge began, and influenced perhaps by the sharp fall in net FII investments in 2002-03, the then Finance Minister declared in the Budget for 2003-04: ''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 concessional rate of 10 per cent at that point of time. The surge was no doubt facilitated by this further concession that converted India's equity market into a tax-free enclave.
Once on this trajectory, the policy of continuing ''liberalisation'' in which the state persistently favours private capital is justified by arguing that foreign investor interest is waning because of the ''slowing'' of reform. All India needs to do, the advocates of the neoliberal strategy argue, is announce a few ''big ticket'' reform measures, such as opening multi-brand retail for foreign investment or allowing sale of equity in public sector banks to foreign investors, for investor confidence and the economy to revive. This means the government should also not prevent foreign firms from benefiting from ambiguity in the law, such as happened in the case of tax avoidance by Vodafone when it acquired equity in the Indian cell phone industry. What is ignored here is that neither have foreign investors runaway as yet nor have they come only when they had these ''big ticket'' concessions. Hence, by advancing such arguments the advocates of reform reveal the role of the state and the parasitic nature of capital in this regime of accumulation, which requires persistent concessions to coax the latter into investing for growth. The relationship between foreign capital and India has indeed changed—only for the worse.
* This article was published in the Frontline Volume 29, Issue 19, September 22- October 5, 2012.
© MACROSCAN 2012