You are on page 1of 11


Tax Havens Can de-Stabilize our Financial Markets

Prof R. Vaidyanathan; Indian Institute Management Bangalore The recent disclosure on the second quarter growth rate for the financial year 2009-2010 has brought lots of cheer among policy planners and investors. Quarterly GDP at factor cost at constant (1999-2000) prices for Q2 of 2009-10 is estimated at Rs. 8,34,780, as against Rs. 7,73,850 crore in Q2 of 2008-09, showing a growth rate of 7.9 per cent over the corresponding quarter of previous year. It is also to be noted that the GDP at factor cost at current prices in Q2 of 2009-10, is estimated at Rs. 12,79,500 crore, as against Rs. 11,75,633 crore in Q2, 2008-09, showing an increase of 8.8 per cent. In terms of GDP at market prices, the rates of Gross Fixed Capital formation [Investments] GFCF at current and constant (1999-2000) prices during Q2 of 2009-10 are estimated at 36.3 per cent and 34.7 per cent, respectively, as against the corresponding rates of 37.1 per cent and 34.5 per cent, respectively in Q2 of 2008-09.We find that the growth rate in the economy continues to be spectacular considering the global situation and our investment rate is also substantial at around 36 percent. The continued growth rates above 7 percent on quarterly basis give raise to possibilities of reaching above 9 Percent growth rates in the coming years. This growth rate in the last decade has been primarily achieved by our domestic savings and the role of foreign flows is relatively minimal. We have given in table 1 the share of savings and foreign flows in our economy in the last few years. We find that the predominant portion of our investments have come from our domestic savings and that too from Household savings [around 70 %] and the role of foreign financial flows are relatively small reaching the maximum of 14 % during 2007-2008 and has fallen significantly in 08-09 where the Foreign Institutional investments or Portfolio flows has become negative.

Table-1 Savings and Foreign flows [Rs Crore] Years 94-95 00-01 497218 05-06 1156809 07-08 [QE] 1779614 08-09 n. a

Gross domestic 251463 Savings [ GDS] Household sector [% GDS] Foreign Investment inflow [ % of GDS] Of Which Direct Investment Portfolio Investment 12007 4126 16133 [ 6.4%] 199358 [79%]

442136 [ 89%]

797117 [70%]

1150135 [65%]

n. a

31015 [ 6.3%]

94981 [8.2%]

248017 [14%]

n. a









Notes: Q E is quick estimates; n. a not available, Source: Table-10; page xxxix; National Accounts Statistics 2008; CSO and Table 161/159 -- Hand Book of Statistics on Indian Economy 2009; RBI-Mumbai.

We have different types of Foreign Financial flows into our economy. The major ones are 1. Trade flows arising out of our merchandise exports 2. Flows due to our invisibles consisting mainly of service exports and remittances from Indian laborers abroad. 3. Foreign Direct Investment coming for setting up factories and other infrastructure projects 4. Foreign Institutional investments or what are called Portfolio investments in the Stock market for bonds and equities. 5. International Aid through donors / institutions

6. Flows due to funding of NGOs which are registered under the Foreign Contribution Act regulations with the Ministry of Home affairs.

Flow of Funds in the Indian Economy We find from the flow of Funds of Indian Economy published by RBI suggests that the The share of all financial institutions (AFIs) in total claims issued (i.e., secondary issues) has moved up from 31.7 per cent in 2001-02 to 44.1 per cent in 2007-08. The share of nonfinancial institutions, on the other hand declined from 68.3 per cent in 2001-02 to 55.9 per cent in 2007-08. The rising trend in the share of AFIs corresponds to the boom period. Acceleration in growth rate in GDP during 2002-03 to 2005-06 has led to larger resource mobilization by the financial sector, indicating growing financial intermediation The RBI report on Flow of Funds Accounts of the Indian Economy 2001-02 to 2007-08-says The Rest of the world [ROW] sector captures the transactions between domestic and external sectors. With a range of liberalisation measures undertaken both on the current and capital account, ROW sector steadily gained prominence in the economy. While India adopted the convertibility of rupee for current account transactions by accepting the Article VIII of the IMF in 1994, various measures have been undertaken to further liberalise the capital account as well. The norms for external commercial borrowings (ECBs) and foreign direct investment (FDI) were further relaxed and limits of investment were increased. The foreign institutional investors (FIIs) were allowed to invest in Government securities subject to certain limits. Reflecting this, net capital inflow as percentage to GDP increased from 1.8 per cent in 2001-02 to 9.2 per cent in 2007-08. Increased liberalization of current as well as capital account transactions has resulted in larger inflows and outflows between the domestic sectors and ROW. Gross flows to ROW increased from 6.5 per cent of total financial flows in 2001-02 to 13.0 per cent in 2007-08 Increase in uses vis--vis sources of ROW since 2004-05 indicate larger capital inflows into the economy.

Invisibles The Economic Advisory Council to the Prime Minister in its report titled Economic Outlook for 2009/2010 says that

Net invisibles, including nonfactor service exports, worker remittances, income from tourism & travel and investment income flows aggregated $89.6 billion in 2008/09, an increase of 21 per cent over the previous year. The two main components of net invisibles are service sector exports (software & business process out-sourcing or BPO) and remittances from Indians working overseas. A part of the latter derives directly from activities of Indian software and BPO companies in overseas locations. The industry association, NASSCOM has estimated in July 2009 that export earnings in 2009/10 would be at USD 47 compared to USD 45 last year. The economic downturn had a negative impact on the level of remittances and they were USD 44 billion in 2008/09 and expected to be USD 50 billion 2009/10 [] This was before the Dubai meltdown. But we see that software exports and worker remittances are nearly the same in the past few years. NGO Funding The other major inflow is due to funding of NGOs by international Government and non Governmental agencies. According to Ministry of Home affairs website there are nearly 34,000 NGOs registered under Foreign Contribution Regulation act [FCRA] 1976. In all an amount of Rs 65000 crore was received from abroad during 1994 to 2007. Annual receipts have gone up from Rs 1865 in 1994 to Rs 12290 crore in 2007. More interestingly around 50 % of the associations do not file reports. The web site of most of the large NGOs do not provide details of Balance Sheet etc even though many of them call themselves as Civil Society [ as if others are criminal society!!] and insist on transparency by everyone .Perhaps it does not apply to them. This author has tried for many years to collect the Annual financial reports of major NGOs without success. Many of these NGOS spend according to the Home Ministry website maximum amount on overheads including foreign junkets. These flows are also sometimes used for activities not conducive to social cohesion. The International Narcotics Control
Strategy Report Money Laundering and Financial Crimes (March 2009) by the US State Department suggests that 30-40 per cent of the inflows may be through hawala channels which are not accounted. During 2007-2008, according to this report, formal inflows into India were USD 42.6 billion. So 40 per cent of this amount, USD 16- 18 billion, could be considered illegal flows not captured by law. Recently Government has included NGOs and other trusts also within the ambit of Prevention of Money

Laundering Act (PMLA) 2002, by a notification in the Official Gazette on November 12.

Foreign Institutional Flows [FII]:

Among all the inflows these are really important from the point of tax havens. As we pointed out in our essay in Eternal India [April2009]

Quote In the domestic capital market, substantial inflow of money comes from these tax havens by shell companies or by entities that do not want to be registered. India knows that these tax havens distort global resource allocation as well as domestic initiatives in enhancing government coffers. They encourage venality and are also possible sources of substantial drug and terror money. For instance, Securities and Exchange Board of India took stringent action in 2007 to phase out Participatory Notes (PNs), not registered by FIIs, from the Indian share markets since most of these exotic instruments were issued to / by anonymous entities not regulated by SEBI. The Board pointed out that nearly 50 per cent of the funds flowing in were through entities not registered under it. The PNs had become the most preferred instrument of investment, with the largest investments from abroad in the Indian stock market routed through them. The amount invested through PNs in Indian stock market increased by several times after the UPA government assumed office. The notional value of investment in PNs, which aggregated Rs 31,875 crore in over 10 years up to March 2004, burgeoned to Rs 3, 53,484 crore by August 2007, i.e. increased by over 11 times in just 40 months! Investments through PNs constituted 20 per cent of all FII investments in 2004. This increased to over 51.6 per cent in August 2007. Thus, in 2007, more than half the FII investments were through anonymous PNs. The subaccounts created by the FIIs for these nameless entities are fraught with dangerous consequences and security risk. The sources of these funds are unknown; the investors are nameless; and billions of dollars invested through PNs are address-less. Know Your Customer norms, which the law makes it mandatory for opening simple banks accounts by Indians in this country, are not followed while allowing investment of billions of dollars in the Indian stocks market. The PN mechanism Through which unnamed investors-- participate in our markets, invest and disinvest stocks worth billions of dollars and make and repatriate profits is thus a mystery wrapped in a puzzle, packed in an enigma, crammed inside a conundrum and delivered through a riddle. The clamor for this form of investments is intriguing, if not outright suspicious. Many experts felt that PNs were Weapons of Mass Destruction WMD of our stock markets. Actually, SEBI had

proposed that FII and their sub-accounts not be allowed to issue or renew offshore derivative instruments. It also wanted them to wind up their current revoked under pressure from the Central government. Unquote The ban proposed by SEBI was later withdrawn under Government instructions after the global meltdown.It is important to note that during the meltdown in 2008 nearly USD 16 billion has been withdrawn from our markets and the SENSEX index which was above 20000 during the beginning of 2008 became less than 8000 by the end of 2008. The pull out of these USD 16 billion was not related the performance of our Economy which was still above the 6 percent growth number but due to requirements of funds in other markets since liquidity was drying up in other markets. It was generally believed that PNs are not to be issued to Indians, namely Indian residents/NRIs/PIOs/OCBs etc, essentially to deny Indian entities investing in our share market by using anonymous PN route under Foreign Institutional Investors scheme. But something else was perhaps happening. Indian entities were perhaps funneling funds from tax havens back to India through the FII route. This is, to some extent, borne out by the revelations made in a Security Appellate Tribunal order in the Goldman Sachs case on anonymous entities. The order clearly says that since there were no bar on FIIs and their subaccounts to issue/subscribe/purchase any PNs to/from Indian residents or NRIs/ PIOs/OCBs, it would be reasonable to presume that many of them must have dealt with such persons in the course of their business activities. The SAT concurred with the observation of Goldman Sachs that there was no provision till that date either in the Act or in the Regulations to debar FIIs or their subaccounts from dealing in PNs with Indian residents/NRIs/PIOs/OCBs. The crucial SAT observation was that when the FIIs and their sub- accounts were not debarred from dealing in PNs with Indian residents/NRIs/PIOs/OCBs and many of them would have dealt with the latter, they could not be asked to furnish the undertaking. Now we are finding that again foreign inflows have significantly increased in the last few months in the stock markets. Up to Mid November the amount invested buy FIIs for the fiscal year is Rs 70,182 crore of which Luxemburg, Mauritius UAE and Hong Kongall of which are considered as tax havens or secretive tax jurisdictions has contributed a total of Rs 30,000 crores or more than 40 percent. UK has provided another Rs 5000 crores and a part of it could have

come from tax jurisdictions under the administrative protectrate of UK like British Virgin Island or Channel islands. Interestingly Christian Aid along with Tax Justice Network has classified UK and USA as most important tax havens. Their research says that the main global suppliers of financial secrecy are rich nations operating in specialized enclaves like Delaware [USA] that often have links to smaller satellite jurisdictions that are conduits for illicit financial flows into the mainstream capital markets. It pointed to the UK in particular, as half the worlds secrecy jurisdictions are located in Commonwealth countries, Crown dependencies or British Overseas Territories. London, he said, was at the centre of a network of satellite jurisdictions and although it ranked the most transparent of the jurisdictions in the index, had the potential to do more harm than small island havens because of its more important role in global offshore finance. [ 07-2.htm] It is also mentioned in another report by Times of India Nearly half of the Rs 70,000 crore in offshore investment that's come into Indian bourses this fiscal, till October, is from alleged tax havens such as Mauritius, Hong Kong and Luxembourg -the three together contributing almost Rs 25,000 crore of the net inflow from foreign institutional investors. The government is little worried about the fact that a huge chunk of this investment is coming from alleged tax havens such as Mauritius, Hong Kong and Luxembourg. What can be of concern to the government is the rising share of participatory notes (PNs) in the total FII inflow into stock markets. Since the identity of PN investors is not revealed, the government had put a tight leash last year on such investments after it feared that some dirty money might have entered the market, riding on PNs. Poor market conditions towards the end of 2008 had, however, forced the government to remove restrictions on PNs, but it had asked FIIs to register in India rather than invest through PNs. It is estimated that of the net FII inflows of Rs 44,000 crore during September-October, nearly a third or Rs 14,000 crore was through PNs. [] Not only that there are reports that there is significant rise in Indian investments in tax havens Outflow of investment from India in 2008-09 $16.07 billion in 2008-09 from $18.1 billion in the previous fiscal.[ See Table-2]. The outward direct investment (ODI) included both equity and

loan. Singapore retained the No 1 spot in the list of India Incs favorite investment destinations with Indian companies investing $3.6 billion in that country in 2008-09. But the investment of $3.6 billion in Singapore was a 56 per cent drop from the $8.3-billion the city-state received from Indian companies in 2007-08

Table-2 Top Ten Destinations for Outbound Investments [USD Millions] Country Singapore Netherlands Cyprus Mauritius USA UAE Russia Isle of Man China British Virgin Islands
Source: Business Line 09-08-09

2008-09 3681 2776 2256 1805 874 792 676 335 246 231

2007-08 8352 1936 514 1467 1096 784 366 125 35 806

The Netherlands came next with Indian companies investing $2.77 billion in 2008-09, up from $1.93 billion in the previous financial year. Tax havens such as Cyprus and Mauritius received $2.25 billion and $1.8 billion respectively in 2008-09. They were followed by the US with $873.58 million worth investments from Indian companies in 2008-09, the UAE ($791.78 million), Russia ($676 million), tax haven Isle of Man ($334.7 million), China ($246.03 million) and another tax haven British Virgin Island (230.48 million) in 2008-09. Significantly, outward investment to tax havens rose significantly from 2007-08 to 2008-09. In the case of Mauritius it went up from $1.4 billion (in 2007-08) to $1.8 billion (in 2008-09), Isle of Man ($124.97 million to $334.7 million during the same period), Cyprus (from $544 million to $2.25 billion). However, investments to countries such as the US, the UK and Singapore fell during the corresponding period.

It reveals that not only in-bound flows but also outward flows are linked with Tax havens and the flows are not necessarily linked with the performance of our Economy but with the happenings in other markets and the level of pressure on Tax havens by OECD and more particularly USA. A significant portion of our illegal wealth of India is kept in Swiss Banks which is a major Tax haven. Nearly 1 trillion out of 2.8 trillion of Swiss money CHRis black money says Konrad Hummler The Chairman of the Swiss Private Bankers Association.[Swiss review-- August 2009]. In August 2009 one Swiss franc CHR is nearly same as one US dollar. He says that the Switzerland has become a paradise for foreign capital on which tax is not paid. The uproar from foreign governments is understandable.Out of this 1 trillion USD [nearly 50 Lakh Crores our national income] in Swiss banks how much belongs to the elite of India is an issue? Recently there was a report UBS the Swiss Bank was fined 8 million British Pounds for misusing RNRL money by the British Financial regulator. The penalty imposed after UBS employees were found speculating in foreign currency and commodities with money illegally taken from customer accounts --in this case RNRL and Reliance energy. [] This also indicates the wrong doing by individuals located in the institutions located in the Tax havens. What should India Do? Actually it is the developing countries which are impacted more due to this flight of capital and hence India should take the lead. Christian Aid estimates that every year 160 Billion USD is lost by developing countries due to these tax havens. The Jews got back the money [in 2002] appropriated by these banks from Jews in the 1936-1945 period of Hitlers dictatorship and mass deaths. Nigeria got back some money, Philippines and also Ireland. We need political will. Also we can fine the holders of black money some percentage and encourage them to bring it back since returns in India are more attractive than any western countries. There is also an important associated issue. The issue of terror funding. SEBI has asked stock exchanges and other intermediaries and all market participants to watch out for UN listed terror funding entities. [Business Standard 26-10-09]. The origin of much of these funding could be from secretive tax havens or through Hawala routes. French are planning to tax the proceeds of Dividends and interest from the tax havens. France plans to raise taxes on funds transferred to tax havens and on dividends coming from these


jurisdictions, to conform with the Group of 20 plans to crack down on countries that don't comply with global tax standards

While G-20 is already in the process of finalizing countermeasures to rein in these banks by March 2010, top officials of the French government confirmed to TOI that France will settle for nothing more than crippling sanctions on these banks by the Group if they don't respond to the calls for more transparency in their functioning by that time. [] India can join countries like France and apply more pressure on these tax havens. Since the financial flows from these secretive jurisdictions can destabilize our financial system -particularly if they are not well regulated it is important that India takes steps to deal with them. Also Indian Parliament [both houses] in a joint sitting should pass a resolution that all unaccounted money held by Indians in Tax havens belongs to the people and hence Government of India. This will establish the basis for further action. India should implement fully know your customer [KYC] norms in all global financial flows. This implies PNs are to be regulated only to such entities fully under the glare of SEBI. According to global anti-graft watchdog Transparency International, India should endorse the United Nations Convention Against Corruption [UNCAC] for the recovery of Indias wealth which has been hoarded in foreign banks. Since Switzerland, Bahamas and Jamaica have already ratified the UN Act and if India ratifies it, we can use it as an instrument to get the details about Indian money stashed there. Out of the 140 countries that have signed the UNCAC, 120 have ratified it. Currently a delegation from Financial Action Task Force [FATF] is in India assessing the preparedness of India to join it as a full member. Currently India has an observer status. FATF has 34 members mostly from Developed countries and it would be useful for India from the point of view of information sharing and scrutiny. Once we become member then it will be a key step in ensuring that investments to and from India will be FATF complaint and the entire system would have been tested and certified. Needless to add India should join as full member of FATF and also ratify global corruption treaty of UN


India should form a Ministry for Global Finances to deal with this issue on a war footing. India also should create a Special Purpose Vehicle or even a Financial Institution to sterilize and absorb the funds flowing from these Tax havens. With an anticipated growth rate of more than 8 percent in the coming years the foreign financial flows in the form of FII and FDI will only increase. There is a need to sterilize it from the point of view of Domestic inflation as well as from the point of view of drastic rise in rupee value. This means a concerted strategy should be adopted in the coming five years to facilitate the inflows, sterilize and use it for infrastructure development. Also India should distinguish between funds and persons holding the funds. The former needs strategic handling and the later needs to be dealt with the laws of the land. More important point is the issue of destabilization of our financial markets due to these tax havens. There is all the more reason for India to recognize the amount of funds illegally kept there and talk about it openly and evolve mechanisms to minimize its negative impact on our financial system. If appropriately planned then these funds can be facilitator for a big push for our economic growth. ______________ The author is Professor of Finance at Indian Institute of Management Bangalore. Views are personal

You might also like