Perils of excessive speculation
The ministry of finance recently introduced gold bonds for Indian households, a commendable step to channel India’s large household savings to productive uses. The Employees’ Provident Fund Organisation has just taken baby steps to invest a small fraction in the equity markets, for the first time in its 65-year history. Finance minister Arun Jaitley and his deputy Jayant Sinha have repeatedly exhorted Indian savers to invest more in productive assets such as equities. In the 21st century, foreign investors have invested approximately $200 billion in the stock market that is presumably used for economic activities to generate jobs. In the same period, Indians spent the same amount to buy gold that is stored in bank lockers and under mattresses. Gold bonds are an attempt to lure households’ savings away from mattresses to markets. As the government starts to cautiously nudge household savers from the mattress to the market, the bedrock for this shift is households’ trust in markets.
That there is a wide trust deficit among households in our asset markets is well-established and documented in surveys by organizations such as the Securities and Exchange Board of India (Sebi). This distrust is mostly founded on the litany of stock market scams, misselling of financial products, extreme volatility and the nature of participants in equity markets. Bridging this trust deficit will require, among other things, conscious steps to erase the current perception that the asset market is a “speculative den”. In this context, the recommendation of the Standing Council of the Indian Financial Sector to remove the securities transaction tax (STT) on equity derivatives is flawed and blinded by its enthusiasm to attract foreign investors at the risk of putting a spoke in the wheels of the government’s recent laudatory steps.
That India is not an attractive destination for financial services trading and there is a need to make it one is the premise for the council of experts that was constituted in June 2013 and which submitted its report in September 2015. The report lists the unattractive aspects of the currency, equity and commodity derivatives markets in India for the foreign investor. Chief among them are capital controls and tax policies. The overall thematic recommendation of the report is one of unfettered access and ease of doing business for foreign investors in the Indian markets. In isolation, these are well-intended recommendations, worthy of consideration. However, in the larger context of deepening India’s domestic financial services industry while also being attractive to foreign investors, the report sways to one extreme.
STT, introduced by former finance minister P. Chidambaram in 2004, is currently charged at 0.1% for trading in shares on both the buyer and the seller. However, for trading in derivatives, which are a leveraged bet on stock price movements, only the seller pays 0.01%. This unbalanced tax structure served as a perverse incentive and propelled a shift in retail investors from investing in shares to speculating through derivatives. Since STT, derivatives volumes have grown at an annual compounded rate of 67% vis-à-vis share volumes’ 15%. The derivatives market today is 16 times that of shares, the highest in the world, after South Korea. Ninety percent of this volume is speculation by retail investors and proprietary traders. This dominance of small and mostly speculative investors in derivatives is in sharp contrast to the profile of investors in developed markets. This distinctively speculative character of the equity markets breeds distrust among potential first time investors.
Recognizing the potential dangers of a large speculative market, Sebi recently raised the minimum contract sizes of equity derivatives from Rs.2 lakh (set in 2000) to Rs.5 lakh, ostensibly to deter small speculators. But the distorted STT structure that favours derivatives over cash remains. If anything, the STT for equity derivatives needs to be raised to establish parity with STT on shares, not be removed as the council suggests. It is easier to neutralize perverse incentives for speculation by equalizing net STT for buyers of both shares and derivatives. STT has raised between Rs.2,000 crore and Rs.8,000 crore annually. Hence, removing STT on both shares and derivatives is a tax revenue decision that the ministry needs to consider, especially in the current regime of zero long-term capital gains tax.
Foreign investors that are already registered with Sebi do not have any more restrictions on trading in equity derivatives in India than their domestic counterparts, other than currency exposure, which is a risk they bear anyway by choosing to invest in foreign markets. The report argues that a bulk of the derivatives trading has moved to offshore locations due to the STT on derivatives and unfettered access in foreign jurisdictions. While it is desirable to attract these volumes back and create indirect jobs, the costs will far outweigh the benefits of doing so. An analogy could be of roads and driving. If India wants her citizens to buy more cars and learn to drive on roads, building a racetrack for foreign racers will necessarily scare away first-time and new drivers. Similarly, an unfettered market in derivatives for sophisticated foreign investors runs the risk of scaring away potential first time domestic investors.
The Standing Council report takes no cognisance of the costs of its recommendations for the real economy. At a time when India has embarked on a critical mission to reduce its dependence on foreign flows by leveraging households’ savings to better uses through asset markets, the council’s recommendations can exacerbate the existing market mistrust of households.
Ajit Ranade, Anantha Nageswaran and Praveen Chakravarty are, respectively, chief economist of the Aditya Birla Group, co-founder of the Takshashila Institution and visiting fellow, IDFC Institute
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