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Sterilisation of another kind needed
July, 19th 2007

Making equity unattractive for FIIs, besides rendering the rupee weaker, would also see funds shift from equity in favour of fixed income schemes.

S. Murlidharan

A problem of plenty like the embarrassment of riches evokes mixed feelings and begets varied reactions. The countrys abundant foreign exchange reserves piled up mainly on the back of FII investments over the years and the consequent rising Indian rupee should have normally warmed the cockles of every Indian but clearly one constituency is worried sick the exporters who have had a vested interest in ensuring that the rupee remains depressed so that when they convert their foreign exchange earnings, they get more rupees.

Comparisons with China

A section of them feels that the Government has let them down by not emulating China which has been successfully resisting international pressures, especially from the US, to substantially revalue its currency upwards in order to stem the burgeoning trade deficit the US suffers year after year with that country.

It is not as if the Government has not bestirred at all. Till recently, the RBI actively carried out sterilisation operations from time to time to suck out the extra dollars sloshing around but that was about all. The Government admittedly did not fire on all cylinders with a view to deliberately keep its currency low come what may. There were of course extenuating circumstances for these half-hearted, and what critics call, half-measures. Unlike Chinas, Indias hasnt been an export-led growth.

China saw to it that giant capacities were created so that overseas markets could be penetrated. A weak currency, initially a catalyst, later on assumed a major role in helping it achieve this goal. Anyway, in a free economy like India, the Government has to keep off the market and allow the market forces to assert themselves.

Comparisons thus are odious and we have ,therefore, got to focus on factors unique to us while addressing the problem of the exporters many of whom, especially in the BPO segment, might otherwise fold up unable to face up to the challenge of the rising rupee. After all, BPOs are not in the same league in which the IT trinity of Infoys, Tata Consultancy and Wipro find themselves in. For all one knows, the trinity may remain impervious to the new challenge in view of the huge margins they enjoy in any case.

Halting the rupee

To halt the rupee on rampage, as it were, one of the possible solutions could be for the Government to render investments in equity by the FIIs unattractive. Strange as it might sound, the strategy would cry a halt to the huge influx of foreign exchange brought in by the FIIs, the movers and shakers of the market. As it is, investment in shares is cosseted with a couple of significant tax benefits exemption from tax on dividend and exemption from long-term capital gains earned through the bourses.

While these unmerited tax sops are available to everyone, the benign DTAA with Mauritius that barters away the Indias revenue interests and insulates their (FIIs) short-term capital gains as well from tax, in addition makes investment in the Indian share markets irresistible for them. By dismantling these unmerited tax benefits and by entering into a fresh treaty with Mauritius that denies its residents a wholly unmerited tax advantage in India, the Government would succeed in halting the massive inflow of dollars brought in by the FIIs which incidentally lulls us into the cosy belief that everything is hunky-dory on the forex front, whereas the truth is FII money is footloose and can vanish as dramatically (especially when one factors in the widely prevalent practice of round-tripping through the laughably simple expedient of Participatory Notes) as it enters India.

Rendering of equity unattractive for FIIs, besides rendering the rupee weaker, would also end up unwittingly as a sterilisation operation of another kind tectonic shift of funds from equity in favour of fixed income schemes, thereby bringing about a modicum of sobriety in the share market and giving a leg-up to the debt market which it is badly in need of. For good measure, the Government may, in a change of tack, give tax sops to interest from banks and other organised institutions as a clincher.

(The author is a Delhi-based chartered accountant.)
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