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May 24, 2013

The scramble for foreign debt
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  TOPICS economy (general) Economy Watch (column) .

the Finance Ministry has announced a major tax concession to investors in India’s debt market. This concession is to apply not just to investments made in the future but on all interest income on such investments accruing between June 1. Given the infrastructural bottleneck the tax concession was seen as crucial for growth. Now all such pretence is being dropped and any foreign investor willing to lend against any kind of foreign currency security issued in India is to be rewarded with this generous tax concession.macro economics budgets and budgeting investments To implement a decision first signalled in Budget 2013. There are four possible and related explanations for this remarkable generosity on the part of a government that constantly complains of being faced with a fiscal crunch. even those who made these investments assuming that the withholding tax applicable on interest income was 20 per cent will now benefit from the concession. or be rewarded with a hike in net return. especially when it comes to financing welfare measures or funding much-needed subsidies. 2015. Liberalisation is forcing the government to reward any kind of foreign investment. The first is that the liberalisation-induced widening of the current account deficit on India’s balance of payments has made the thirst for foreign capital in post-liberalisation India insatiable. so long as it brings foreign currency into the country. Those concessions were presented as ways of incentivising foreign lending for India’s fund-starved infrastructural sector. with the concession being extended a year later to foreign currency borrowing from abroad through the issue of long-term infrastructure bonds. Two years back a similar concession was awarded to those investing in Infrastructure Debt Funds. Even though there has been a surge in foreign institutional investment to emerging markets including India. the government is fearful that inflows into the equity market would be inadequate to quench its thirst for foreign capital. This is indeed a major concession to foreign financial investors in the debt market. the long-term capital gains on which had been abolished in 2003. No more is it adequate to incentivise foreign investment in crucial high technology or infrastructural sectors. irrespective of when the investment has been made. The third is evidence that foreign investors are showing an appetite for debt. That is. As the government has liberalised rules relating to foreign investment in the debt market. debt flows through the FII . The withholding tax on interest earned on investments by Foreign Institutional Investors (FIIs) and Qualified Foreign Investors (QFIs) in government securities and bonds issued by Indian companies has been slashed from the prevailing 20 per cent to just 5 per cent. So debt flows need to be incentivised too. 2013 and May 31. The second is the evidence that no more is it adequate to incentivise only foreign investments in equity capital.

there is likely to be an increase in interest in and the issue of short-term bonds. therefore. to 8 per cent in 2009 and 21 per cent in 2012. rather than finding ways of reducing that deficit. such as those used to fund infrastructure. for example. The measure could. increase balance of payments vulnerability. Rupee depreciation increases the local currency or rupee cost of servicing foreign debt. is not a good idea. All of this together explain the government’s desire to offer this major tax concession to foreign investors in foreign currency debt instruments. As a result the share of debt in cumulative net FII inflows estimated by the Securities and Exchange Board of India rose from just 0. the rupee slumps and the rating agencies turn aggressive. Investors in all kinds of bonds would benefit. QFI. such as now. imposing an additional and undefined burden on the borrower. Foreign investment. these binding commitments have to be met in foreign currency as well. it is willing to encourage financial inflows in the form of debt as opposed to equity. Finally. Financing a widening current account deficit with debt may be self-defeating. and touched just $5 billion at the end of May 2009 have risen to close to $40 billion by the end of May 2013 (figure for 2013 refers to May 22). So if the tax concession being offered results in a surge in FII investments in the debt market. Firms exploiting increased foreign investor interest in the wake of the tax concession are likely to over-borrow. The point is that the withholding tax concession is not being limited to investments in long-term bonds. the government is clearly being pressured into appeasing foreign investors for fear that they would flee.1 per cent at the end of May 2001. Keywords: Finance Ministry. For these and other reasons relying on foreign debt to finance a widening deficit. The concession does of course impose huge costs on the nation. relying on foreign currency debt to finance domestic expenditures when the rupee is depreciating has implications for the viability of borrowers. Budget . find themselves unable to service foreign debt without courting losses and even bankruptcy. as growth slows. as India’s experience in 1991 and Southeast Asia’s in 1997 illustrated. Rewarding foreign investors with tax concessions so that they are willing to lend more than they consider prudent is downright foolish. for investments in instruments issued by both private and public entities and in any sector whatsoever. FII.route into India have indeed increased. It would rise even faster if the interest rate that has to be offered to foreign financial investors in India’s increasingly uncertain environment also increases. Finally. As Chart 1 shows. only to decline marginally to 18 per cent by late May 2013 (Chart 2). net cumulative FII investments in debt instruments that were negligible at the turn of the century. They can in difficult times. With economic uncertainty encouraging investments that can exit quickly. Above all. Unlike the case with investments in equity. the current account widens. payments on the current account on account of interest would rise as well. Incentivising short term debt inflows is a sure way of increasing vulnerability to sudden capital outflow that can precipitate a balance of payments crisis. The debt being in foreign currency. where returns are linked to performance. Tax concession. The result would be larger outflows on the current account. interest and amortisation commitments on debt have to be met irrespective of the returns obtained in or foreign exchange earned by the investments they finance.

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