When ratings agency Standard & Poor's cut India's outlook to negative from stable, citing slow progress on its fiscal situation, as well as deteriorating economic indicators, it was a bolt out of the blue. Many quickly identified what would happen if GAAR and other tax laws where implemented according to the government’s plan. The implications of these laws were magnified. There is a one-in-three chance of a downgrade to India's credit rating if external conditions continue to deteriorate. Finance Minister has termed it 'a timely warning'. Fund managers are in a bind thanks to the various ambiguities present over tax rules.
This has directly impacted the foreign flows into the country's equity market almost trickling to a halt this month. Aberdeen Asset, which manages $300 billion of assets globally, said it chose not to bid at the latest bond auction this week as 'risks stemming from high inflation and substantial fiscal slippage required us to adopt a cautious stance’. This is one situation that India cannot risk being in, considering the fragile economy. The rising current account deficit (CAD) prevents the government from taking harsh measures against foreign flow. Probably realising their position, global players are pressuring the government to roll back the taxes, which in fact, are already in place in some of the other countries where they invest.
Going by FII data, the first two months of the year 2012 saw foreign institutional investors pumping in a little over Rs 36,000 crore into the country. However, the figures dropped to Rs 8,381 crore in March during which various changes in tax laws were proposed in the Budget. Reeling under the effect of these announcements, the FII investment turned out in the negative in April, pulling away over Rs 301 crore, thus magnifying the effect of the uncertainty faced by the foreign investors over Indian taxation laws.
Also, the proposed rules prompted the $1.5-billion Macquarie Asian Alpha Fund to exit short positions in Indian single stock futures. Macquarie has maintained its short position on India, by shifting it to Singapore, which has no capital gains tax.
In addition, the retrospective charge on foreign investments like the Vodafone's purchase of Hutchinson's Indian assets has affected the investor sentiment.
GAAR, a key provision in the Direct Tax Code is another stumbling block for FIIs. Currently nearly 50% of FII money is estimated to be flowing in through tax haven Mauritius, and be directly impacted if GAAR is implemented. Losing no time, the FIIs were quick to point out that India's fiscal condition will be under pressure and equity markets may be headed to a severe decline if the GAAR is to be implemented.
Mirroring the impact of these changes the benchmark index, Sensex is down around 7% from its pre-budget high on February 21. In the meantime, the rupee too hit a three-month low on April 24 compounding to these troubles.
In the meantime, the government has tried some damage control announcements mainly the finance minister's assurance during his visit to the United States last week.
However, New Delhi can't afford to keep investors guessing. Reasons for these being firstly, India's trade deficit is at a record high of $185 billion for the recent fiscal year, up from $104 billion in the previous 12 months. Even if one were to assume that net capital inflows from foreign investors and remittances by foreign workers remain steady at around $120 billion, the country is bound to face a $60 billion shortfall. And if foreign direct investment and portfolio investment dry up, the gap could double to $120 billion.
Also, FIIs currently hold around 17% of the total market for Indian equities, equivalent to around $200 billion.
The only silver lining on this dark cloud is that the finance bill is yet to be made law which means that if India amends its stand on retrospect tax codes and provide clarity as to what the impact of the anti-avoidance rules will be for institutional investors, it would surely help to clear the cloud of un certainty hovering over the FIIs currently.