Tamal Bandyopadhyay: Confusing signals from North Block

The government's gains from transaction tax may be lost in higher borrowing costs for it

Palaniappan Chidambaram's Budget has confused the financial sector even more than the government's Common Minimum Programme did. There were no surprises in terms of the emphasis on agriculture and the target of doubling farm loans in three years. But most of the other measures for the financial sector are vague, indifferent or contradictory.

First, consider the interest rate signals. The day before the Budget, the government's Economic Survey hinted at a possible interest rate rise. "With the fiscal deficit remaining high and signs of a pick-up in the flow of credit to the commercial sector, the possibility of interest rates moving northwards cannot be ruled out," the Survey said.

In his Budget, Chidambaram spoke of a "benign" interest rate regime. He announced a higher interest rate island for senior citizens but left the administered rates unchanged. Now, there is nothing wrong in offering senior citizens a bit extra but what is the point in talking about "benign" interest rates when the administered rates are left unchanged and out of sync with the banking system?

By doing that, the ministry has also effectively jettisoned the Rakesh Mohan panel report on small savings. The Mohan panel paper has been in favour of making administered rates market related. Had the government accepted this recommendation, it would have made at least token cuts in the administered interest rates, as the last three Budgets had done.

If this is contradictory, the finance minister's statement on the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (Sarefaesi) Act, 2002, is vague.

Recently, a Supreme Court judgement struck down a provision in the Act (under Section 17(2)) that required borrowers to deposit 75 per cent of the amount claimed by lenders before they could file appeals with Debt Recovery Tribunals. Referring to this, Chidambaram said the Act would be amended so that the lenders' right was protected and at the same time the borrowers would not get a raw deal.

Now, how can you please both borrowers and lenders? Will the bankers be happy if the deposit requirement is reduced to 50 per cent of the claim or even 25 per cent? And if that is done, how will the borrowers react? Is there any guarantee that there won't be any more court cases after the amendment?

The Budget also focussed on infrastructure financing. It said an inter-institutional group (IIG) of banks and financial institutions will pool in resources worth Rs 40,000 crore and target infrastructure airports, sea ports and tourism projects.

The IIG will consist of the Industrial Development Bank of India (IDBI), Infrastructure Development Finance Corporation (IDFC), State Bank of India, ICICI Bank, Life Insurance Corporation of India, Punjab National Bank and Bank of Baroda. It is expected to ensure the speedy disbursement of loans and implementation of core sector projects.

First, the IIG concept is quite old, first suggested by the former Power Minister, the late Rangarajan Kumaramangalam. Second, and more important, the IIG per se cannot be a booster for infrastructure sector financing.

Infrastructure project financing has its own rules and unless the financial intermediaries are ready to play by those rules, no IIG can save the sector. With the death of financial institutions that have traditionally been extending loans to long-term projects, the government must find ways to nurture the core sector.

Banks do not have long-term funds and these projects typically start paying after five to six years. The concept of "take out" financing "" where one financial intermediary replaces another after a few years by taking over the liability "" has not yet taken off in India.

Also, these projects are unable to pay the double-digit interest rates that banks typically charge for long-term loans. What is needed, therefore, is interest rate intervention by the government, a structured subsidy. If the government is unwilling to "intervene" in interest rates for these projects, the private sector will never invest in the core sector.

Finally, the Budget proposal that is attracting the maximum attention is the transaction tax. The plan is to levy a 0.15 per cent (that is, 15 paise per Rs 100 worth of transaction) of tax on all buy transactions executed on the stock exchanges.

This would include bonds and equities. To offset this, the Budget also proposes a reduction in short-term capital gains and the abolition of long-term capital gains tax.

Certainly there is merit in taxing equity transactions because it will bring some non-paying tax entities into the net. At the same time the reduction in capital gains would give investors some relief. But for fixed income markets, the ground reality is different.

Most participants, like banks and primary dealers, treat the income from interest and trading profits as business income and hence are taxed at the highest rate; they are not going to benefit from the changes in capital gains tax.

The fixed income market thrives on volume and not volatility, so any tax on the value of the transaction would drastically reduce the volumes and hence liquidity, which will manifest itself in mispriced assets and higher rates.

Unlike the stock market "" where the price of a scrip could move by even hundreds of rupees "" the price movement on government paper is normally five to 10 paise on a normal day.

Brokerage and Clearing Corporation of India charges work out to less two paise (per Rs 100). If one factors in the proposed tax of 15 paise, then the total cost will go up to 17 paise. But traders do not make this much money. On a Rs 5-crore government securities deal (this is the normal size of a deal), the transaction tax works out Rs 75,000 while the trading profit on such a deal is normally Rs 5,000.

Since the tax will be levied uniformly, it will become meaningless to trade in short-term assets. For example, on a 91-day Treasury Bill the tax would work out to 60 basis points (one basis point is one-hundredth of a percentage point) in terms of yields "" about 14 per cent of the total return the investor will get over three months. Market-making would be impossible since a two-way trade would be at least 125 basis points wide compared to the present spread of 3 to 4 per cent between a bid and ask price.

"The securities transaction tax proposal, in its current form, would have a particularly severe impact on returns to fixed income investors, especially on investments in short-duration instruments," a J P Morgan research note said.

Unlike stock markets, debt market transactions are fully funded "" there is no netting during the day. This would mean that tax has to be paid on all transactions,. Since traders normally trade on a 5 to 7 paisa margin, the tax would virtually kill the intra-day volumes and the markets would turn illiquid.

The primary dealers "" the market makers for government securities "" would have to shell out almost 50 per cent of their net profit for this tax if they were to continue in its current form on top of the normal 35 per cent tax on business income.

They collectively made a pre-tax profit of Rs 1,470 crore in 2003-04. Had they been subjected to the transaction tax last year, they would have paid Rs 450 crore on that.

If the finance minister decides to stick to the proposal, the entire financial system will be affected. How? The banks will run a huge systemic risk as the SLR (statutory liquidity ratio) holdings will lose their relevance in an illiquid debt market. The SLR holdings are meant to be liquidated to generate cash during crises. In an illiquid market, banks will not be able to do that.

The biggest loser will be the government because it will find it difficult to push through its annual borrowing programme. Once the tax is factored in, the entire price discovery mechanism will be distorted and the yield will start rising.

The new tax will particularly affect the market when interest rates are on the rise. So the government may end up paying more than what it will get through the transaction tax mop-up from the debt market since the cost of borrowing will rise.