Quality of FPI inflows is improving (The Hindu)

Mains Paper 3 : Economy
Prelims level : Double tax avoidance agreement
Mains level : Quality of FPI inflows is improving India’s foreign investment

Context

• While foreign investment flows do tend to be less stable as these are influenced by global liquidity drivers, the quality of these flows is undergoing a positive change.
• Studying the FPI flows into the Indian equity market since February, when the pre-Budget rally began, it can be seen that more money has been received from foreign investors with a longer investment horizon, belonging to the less risky categories.
• Also, fund flows from low-tax jurisdictions have been receding.
• The inference is that the regulatory tightening over the last few years has helped sanitise this channel considerably.

FPIs to the fore

• As a wave of optimism gripped equity market since February this year, in anticipation of the return of the Modi government, FPIs have been in the forefront, driving the rally. Assets of FPIs increased by ₹3,19,766 crore between February and May 2019.
• Mutual fund assets increased by a far lower ₹1,24,856 crore in this period.
• With FPIs fuelling the rally, the liquidity cycle seems to have come a full circle. We seem to have gone back to a period when foreign investors wield a greater influence on stock prices when compared to domestic investors.
• But unlike earlier, we have less to fear about the market getting destabilised by these foreign fund flows now.
• If we dissect the increase in FPI assets between February and May, the largest increase in assets has been recorded by foreign mutual funds, whose assets have increased by ₹1,56,657 crore in the four-month period. Similarly, pension funds, who invest for the long haul, also registered an increase of ₹25,859 crore.
• These are long-term investors. It also needs to be noted that investors from the US account for the largest share 35.7 per cent of the total FPI AUC, currently.
• Share of investors from Mauritius is now down to 14 per cent from 26 per cent in 2012.
• Falling share of investors from Mauritius is good news for the exchequer as it means that tax evasion using offshore low tax jurisdictions and double tax avoidance treaties is on the wane.

Regulatory tightening

• This cleansing is mainly due to the efforts of the market regulator, SEBI. Share of the opaque participatory notes has declined from more than 50 per cent of FPI assets to 2.4 per cent due to higher disclosure requirements and clamp-down on opaque structures.
• Tax evasion and money laundering through brass plate companies set up in offshore financial centres has also been addressed with the tweaking of the DTAA (double tax avoidance agreement) with Mauritius and Singapore in 2017.
• Capital gains recorded on shares purchased after April 1, 2017, by investors from these countries have become subject to tax from FY18.

Implementing General Anti Avoidance Rules

• However, a 50 per cent concession on the tax rate was given on gains made from April 1, 2017 to March 31, 2019, if the investors show that they have a substantial presence in the country of origin.
• From April 1, 2019, these investors will be taxed at the full domestic capital gains tax rate. Investors who were using the Mauritius route to treaty-shop might have begun routing their investments through other channels with the benefit getting phased out.
• The General Anti Avoidance Rules (GAAR), that became effective from April 2017, is another reason why dubious inflows posing as FPI flows might have reduced.
• Tax benefit that arises from innovative tax arrangements can be closely scrutinised and questioned by the taxman now.

What does it mean

• The large inflows into mutual funds since 2015 had led to the expectation that domestic mutual funds will be able to support the equity market even when foreign flows turn adverse.
• But with flows into MFs turning more muted and sensitive to fund performance over the last year, the market will once more turn to FPIs for liquidity support.
• While the foreign flows in 2019 were driven by domestic factors, it needs to be noted that these flows are largely a function of global liquidity availability, which in turn depends on global central bank policies.
• The Federal Reserve halting its rate hikes has once again given a fillip to dollar carry trade that initially fuelled the global equity market rally since 2009.
• But if central banks move towards a tightening stance again, these flows will be affected.
• Intensification of trade war, geo-political tensions, and so on, can also throw a spanner in the works.
• On the positive side, India’s demographic advantage and faster growth numbers will continue to be a draw for investors from developed countries, ensuring inflows over the long-term.

Conclusion

• In short, the dependence on FPI flows has rendered our market more vulnerable to short-term fluctuations.
• The silver lining is that the flows are from more legitimate sources now.

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Prelims Questions:

Q.1) With respect to “- ‘Scheme for Trans- disciplinary Research for India’s Developing Economy’ (STRIDE)”, consider the following statements:
1. Its objective is to strengthen research culture and innovation in colleges and Universities.
2. Bhushan Patwardhan committee has been set up by the UGC to oversee the entire scheme.

Which of the statements given above is/are correct?
A. 1 only
B. 2 only
C. Both
D. None

Answer: C
Mains Questions:
Q.1) Describe the major implications of the SEBI’s moves seem to have curbed the short-term and risky variety of foreign portfolio flows.