Status: Incomplete – While the Securities and Exchange Board of India (SEBI) has made some changes, meaningful reform to raise the ceiling on foreign institutional investors has not yet occurred.

Difficulty: Low – Raising the ceiling on foreign institutional investors will require a regulatory decision by SEBI, and not legislation in Parliament.

This is the eight installment in a series of articles on the Modi Reforms Scorecard by the staff and experts at the Wadhwani Chair in U.S.-India Policy. The series seeks to provide analysis on why reforms marked as “Incomplete” or “In Progress” have not been completed, and what impact such reforms could have on specific sectors or the economy at large.

The Indian markets enthusiastically cheered an unfettered mandate by the populace to Prime Minister Narendra Modi and his government in 2014. The benchmark Bombay Stock Exchange (BSE) index jumped nearly 25 percent before completion of the first full fiscal year 2014-15 to close at approximately 27,600 points, in anticipation of the change in the administration.

This bull run was primarily fueled by foreign portfolio investors (FPIs) who reposed faith in the new regime’s promise for fiscal rectitude, pumping net investments of $16.1 billion (Rs 1.113 trillion) in equities and $24.1 billion (Rs 1.661 trillion) in debt the first year of the Modi government. However, the trend saw material swings and sharp reversals over the remaining tenure of the government. These swings were impacted, to a certain extent, by changes in Indian regulations, capital markets, and income-tax developments.

Background

With the rupee facing pressure from the rise in crude oil prices, the U.S. trade wars, Brexit, and rising non-performing assets, the government in tandem with SEBI has taken several measures to ease capital inflows and simplify the operating framework for FPIs. The year 2018 saw the highest number of FPIs registrations in the tenure of the Modi government with the simplification of regulations, SEBI’s clamp down on offshore derivative instruments, and Indian equities outperforming most emerging markets in the last few years.

SEBI clarified that it will apply the look through approach for determining when an investment fund qualifies as a “broad-based fund,” or a fund that has at least 20 investors, with no single investor holding more than 49 percent. This move has enabled an investment fund which has a bank, sovereign wealth fund, pension fund, or insurance / reinsurance company as a majority investor, to qualify as a broad-based fund and for a Category II FPI license, despite the fund not meeting the minimum 20 investors’ test, making it much easier for these institutions to invest in India.

Procedural Changes

From a procedural perspective, simplifications were introduced to the process of shifting from one local custodian to another, implementing free of cost transfers of holdings in a multi-managed structure, appointment of multiple custodians by multi‑managed funds, and launching of new share classes by a broad-based fund. These simplifications have cut red tape considerably.

After the activation of India’s first International Financial Services Centres (IFSCs) at Gujarat International Finance Tec-City in Gujarat state, FPIs have been allowed to invest in commodity derivatives on IFSC bourses, which is presently not permitted for FPIs outside of the IFSC. Trades on IFSC bourses are not subject to capital gains tax, securities transaction tax, commodity transaction tax, goods and services tax, or stamp duty. The IFSC bourse needs to have sufficient transaction volume and depth before it becomes an attractive proposition for FPIs.

The introduction of revised know-your-customer norms by SEBI in April 2018 (with material revisions in September 2018), requiring disclosure of material ultimate beneficial ownership and control in FPIs, was the government’s attempt to ensure transparency and accountability. Though well-intentioned, the attempt to incorporate internationally prevalent disclosure norms resulted in implementation challenges, prompting SEBI to revise the guidelines and provide additional compliance time. The revised guidelines have, so far, been acceptable to most FPIs as the deadline of March 20, 2019 for compliance fast approaches.

Revisions in April and June 2018 to the framework for investment in debt securities, particularly the introduction of credit concentration norms, were ill-advised. In February 2019, some revisions were reversed, despite a proposed parallel attempt by the RBI to create a separate Voluntary Retention Route for FPIs. The reduction of the minimum residual maturity period for FPI investments in debt securities, from three years to one, is a welcome move.

Tax-Related Issues

A beneficial tax framework (in the 2015 budget) to encourage global fund managers to set up operations in India to manage investment funds out of India was a step in the right direction; however, the tax law is riddled with several predominantly non-tax related conditions which makes practical implementation a distant reality.

Moreover, the reintroduction of the long-term capital gains tax on cash equities and units of equity oriented mutual fund units while still retaining securities transaction tax, was another big impact measure. However, the government eased this tax levy by providing cost step-up benefits for investments made prior to the re-introduction of the long-term capital gains tax.

Exclusion of investors in Category I and II FPIs from the ambit of the indirect transfer tax provisions has mitigated several practical issues. The extension of the concessional tax rate of 5 percent on eligible Indian corporate debt securities and government securities until June 2020 was welcomed. However, clarity that the concession applies to Indian rupee denominated debentures (as well as bonds) is much needed.

The Path Forward

A committee under the chairmanship of H R Khan is working towards rewriting the FPI regulations to make access for FPIs even more efficient and to expand the list of instruments that FPIs could invest in. Wheels are already in motion for the introduction of a combined form for (a) registering as an FPI with SEBI, (b) procuring a tax identification number, and (c) for opening a bank account and a dematerialized account in India, which will simplify and shorten the activation process for new FPIs.

Overall, much has been done by the Modi government to attract investments from FPIs and India should stay the course of the reforms, which should continue yielding dividends in the near future, and build further on them. The government and regulators could do well to leverage prior consultations with stakeholders to ensure that reforms are not introduced prematurely, only to be revamped subsequently to incorporate stakeholder feedback.

Mr. Mukesh Butani is a Non-Resident Senior Associate with the Wadhwani Chair in U.S.-India Policy Studies at CSIS, and the Managing Partner at BMR Legal.