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Opening up bond markets to QFIs: will inflows improve?
Thu, May 31, 2012
Source : Sanjay Kumar Singh

On May 29, Tuesday, the government elaborated further on its initial announcement made in the budget that Qualified Foreign Investors (QFIs) would be allowed to invest in corporate bonds. With this step, QFIs have now been allowed into every segment of the Indian capital market: equities, mutual funds, and bonds. 

QFIs will now be able to invest up to $1 billion in corporate bonds in India each year.

On several operational aspects, too, norms have been eased for this class of foreign investors. Earlier, QFIs had to belong to countries that are members of the Financial Action Task Force (FATF, a global body that is trying to check money laundering and terror funding) and signatories to International Organisation of Securities Commission’s (IOSCO) memorandum of understanding. This left out several countries that have pools of investors interested in investing in India. Now the Finance Ministry has expanded the list to which QFIs can belong to include several countries belonging to the Gulf Cooperation Council (GCC) and the European Commission.

Another restriction existed regarding cash holdings by QFIs. Any cash which QFIs brought in had to be invested within five days. Any cash obtained from selling their investments in India too had to be reinvested within five days. If this was not done, the money had to be repatriated. But since international money transfers are expensive, this provision added to QFIs’ operational costs. Now the five-day limit has been removed.

Earlier, QFIs were not allowed to open non-interest-bearing rupee accounts with qualified banks in India, as foreign institutional investors (FIIs) can. Their money was kept in a pooled account maintained by their Qualified Depository Participant (QDP). This has now been permitted. 

Key drivers of change

As is well known, the European sovereign debt problem is leading to a risk-averse environment, so portfolio flows into Indian equity markets have weakened. India’s own domestic woes – slowing growth, twin deficits, and a policy environment that is inimical to private investment – have also made our equity markets unattractive to foreign investors. At the same time, a high current account deficit means that Indiadesperately needsforeign inflows to fund its deficit. By opening up the bond markets to QFIs, the Indian government hopes that foreign investments will come to India in search of the higher yields available here.

While there is an element of urgency involved (given our macro-economic difficulties), the current norms should also be seen as part of a long-term process of opening up the various components of the Indian capital markets to QFIs, since these norms have been evolving for quite some time now.

Why attract QFIs?

The FII route is meant for large institutional investors with vast client bases (pension funds, hedge funds, and so on).

By opening up the QFI route, the government is making the Indian capital market (including the bond market, which is shallow and undeveloped) directly accessible to a wider class of investors, both institutional and retail: private banks and their high net worth clients; broker-dealers with proprietary trading desks who don’t qualify as FIIs but would qualify as QFIs; partnerships; corporates and individuals.

Entry norms for QFIs are also less stringent than for FIIs, so access is much easier for them. They don’t have to register with Sebi. FIIs need to have at least a one-year track record to register in India; QFIs don’t have to fulfil such a pre-condition. QFIs also don’t have to pay a fee of $5,000 every three years (and $1,000 for each sub-account) that is levied from FIIs. All they have to do is open a securities account with a Qualified Depository Participant (QDP) through whom they can route their orders to their broker (they can’t do so directly, as FIIs can). Thus, opening up the QFI route lowers the entry barrier for foreign investors.

More needs to be done

Though thelatest announcements will go a long way towards making the Indian capital markets more attractive to QFIs, a few stumbling blocks remain.

On the tax front, the QDP is responsible for deducting the tax applicable on a QFI’s trades before the money is repatriated to it. QDPs claim that the onus placed upon them is far greater (than on the custodian banks in case of FIIs). They fear that they could be held responsible and tax demands raised on them,if, say, in futurethe government changes the short-term capital gains tax to be levied on QFIs.This is the GAAR effect which has created a lot of fear in the minds of all market participants.QDPs also want clarity on withholding taxes, rates of taxation, and double taxation avoidance agreement (DTAA).

At present, QFIs have to pay tax on profit from each trade. This is perceived as unfair: they are taxed on their profits immediately but have to wait for tax refunds when they make losses.For fair treatment the QDP should be asked to deduct losses from profits before paying tax.Profits and losses could be added up for the whole financial year before tax is deducted.

Alternatively, the taxation norms of QFIs could be aligned to those existing for FIIs. In their case, all trades are computed for tax purposes on a daily basis and they pay advance tax.

Clarification is also required on the tax rates applicable to QFIs: will they be similar to the rates applicable to NRIs and FIIs?
Will fund inflows improve?

Yield on Indian debt is higher than in many of the countries to which QFI investors belong. So the easing of QFI norms could encourage inflows into debt markets, provided the government comes out with clarifications on tax-related issues at the earliest.

The depreciating rupee is another deterrent for foreign investors as it erodes their returns. But this is really a chicken and egg situation: if foreign inflows improve, this problem will get taken care of automatically.

India’s central bank too has taken a number of measures to increase foreign currency inflows (such as freeing up NRE deposit rates). If Tuesday’s measures by the Finance Ministry are a harbinger of more such steps to attract foreignfunds, then at least the government would have done its part in dealing with the balance of payment problem and the depreciating rupee.

sanjay.singh@citrusadvisors.com
 
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