SINGAPORE/MUMBAI : It’s difficult to say who is playing hard to get. India loves foreign investors, yet it doesn’t trust them fully. Foreign investors adore Indian markets, but head for the escape chute at the first sign of trouble.

At the heart of these contradictions are rules governing foreign portfolio investments (FPI) in India. Over time, rules have been liberalized substantially to allow for free foreign investor entry and exit. Most recently, an easing of rules by the Securities and Exchange Board of India (Sebi) has quelled some of entry pains for foreign investors. There’s more in the works. To complicate matters, however, there are occasional attempts to tighten rules, especially the know-your-client (KYC) rules, to better understand the provenance of funds.

Foreign investors, especially portfolio investors, have a special status in the market hierarchy. Every time there is an attempt to tighten rules, they protest and soon the rules are revoked. It is true that portfolio flows help India bridge its current account deficit (CAD), but that doesn’t help dispel suspicions about their source of funding.

And, despite the clichés—favourable demographics, massive consumption story—foreign investors are still deterred by India’s complex compliance framework, policy flip-flops, and suspicion of foreign capital. Ironically, Singapore—with just 5.7 million people—is the biggest investment hub in South Asia and South-East Asia. The tiny dot on the map is a conduit for large funds flow—second highest foreign direct investment (FDI) flow and fourth largest FPI flow.

Despite the numerous changes, foreign portfolio investors were net sellers of Indian equities during the July-September quarter. They withdrew 22,463 crore from Indian capital markets in the period.

They have also been lukewarm to the corporate tax cuts. “We have invested $1 billion per year on average over the last five years. As we steadily increase our exposure to India, we welcome clarity in policies that lead to greater ease of doing business," said Promeet Ghosh, deputy head for India at Temasek Holdings, an investment company owned by the Singapore government.

India also needs long-term investors who can handle the policy flip-flops and economic changes. Perhaps, India can pluck a leaf from Singapore’s playbook
India also needs long-term investors who can handle the policy flip-flops and economic changes. Perhaps, India can pluck a leaf from Singapore’s playbook


The big question then is why are foreign investors not investing in India despite a known growth story and steps to attract foreign capital since this year’s budget?

Opening the door

While India opened its doors to foreign investment in 1992, it has struggled to figure out end beneficiaries of foreign investments due to lack of strong KYC rules and weaker information exchange with other jurisdictions. India became a signatory to the International Organization of Securities Commissions (IOSCO) for mutual assistance on enforcement and regulatory co-operation with several countries only in 2003.

There was an overall improvement in transparency, but one segment remained opaque: participatory notes, or P-notes, instruments issued by registered foreign investors to other overseas investors who wish to invest in the Indian markets without registering with the market regulator. Anonymous P-notes are ripe for round-tripping—unaccounted money sent overseas illegally and then routed back home through tax havens as foreign capital. While many P-note investors may have been legitimate, the veil of secrecy raised doubts.

In 2007, P-notes made up 50% of FPI assets under custody, which prompted the government to contemplate curbs on these instruments. Result: a historic 9% crash in the benchmark Sensex, forcing the government to immediately step back. To make P-notes irrelevant, the government and regulators started simplifying foreign investor registration process. In January 2014, a transition was undertaken to ease foreign investor entry into the country by changing the KYC norms from uniform across categories to risk-based.

FPIs were now categorized into three subsets: Category 1 for low-risk funds (such as sovereign wealth funds); Category 2 for medium-risk funds (such as mutual funds, insurance companies); and Category 3 for high-risk funds such as hedge funds. Interestingly, from an earlier position which required every fund to be broad-based, Sebi decided to persist with the broad-based criteria only for funds falling in category 2, which meant every fund investing in India needed at least 20 investors.

Making P-notes irrelevant

Between 2014 and 2019, Sebi continued to ease rules for foreign investors and simultaneously make P-notes irrelevant. The direct registration processes were made simpler; P-notes were saddled with more disclosure requirements and their transfers were restricted. Gradually, the share of P-notes declined to about 6% of the total FPI flows at present.

On 21 August this year, Sebi further reduced the FPI subsets to just two. This was based on the H.R. Khan committee’s recommendations. The regulator’s website also showed that it had dispensed with the broad-based criteria. “This will simplify and expedite the registration process and would bring about considerable ease in continuous compliance requirement," said Sebi. It is still unclear which kind of FPIs would fall in the two categories.

In addition, foreign investors will need to fill only one application form for registering and investing in India. Currently, they need to fill an application with Sebi and one with the Central Board of Direct Tax (CBDT) for obtaining a permanent account number, or PAN. Henceforth, it will be a single window clearance with a single form. “While the form will be much simpler, it will still be 15-20 pages compared to, for example, a handful of pages to invest in China under stock connect," said Laurence, director, technology and operations, Asia Securities Industry & Financial Markets Association, or ASIFMA.

How India compares

Yet, there is still too much regulatory fog and too many barriers to investing in India, unlike Hong Kong or Singapore, which allow free capital flow. “Indian regulation often appears to have a certain degree of schizophrenic control within its DNA, which continues to weigh heavily on the level of comfort foreign investors have investing in Indian markets," said Patrick L. Young, a capital markets expert and chief executive of crowdfunding platform Hanza Trade.

Different countries restrict free capital flow in different forms. For instance, Indonesia has a negative list to protect its manufacturing sector. If a sector does not fall in negative list it is entitled to 100% foreign capital. Indonesia, unlike India, does not have exchange controls.

Like India, both Thailand and Malaysia have exchange controls. Malaysia requires foreign portfolio funds to register. Thailand has done away with the need for offshore funds dealing in securities belonging to IOSCO-recognized countries and providing private fund management services to register with authorities. The Philippines is fairly liberal in attracting foreign investments, but it is more surveillance oriented. Foreign investments are monitored carefully.

A matter of KYC

India’s checks or caps on foreign investment in certain sectors are an act of prudence and well understood. The investment caps for foreign investors will continue as long as there are exchange control regulations and limits on FDI in certain sectors; the investment caps are important to mitigate any round tripping," said Rohan Solapurkar, tax partner, Deloitte Singapore. He goes on to argue that on FDI investment, it is unfair to compare India with Singapore or Hong Kong because they are primarily used for trading and not manufacturing. “India is competing for foreign investment primarily with other countries such as Indonesia and Vietnam," he said.

But the devil dwells in the details, especially in India. “Sebi is clubbing 57 circulars and 183 frequently asked questions into one master regulation. This is a massive undertaking. Some important things could be lost in translation or anomalies introduced," said the head of a consultancy firm which advises funds on investing in emerging markets.

For instance, minority stakes in Indian companies taken through the FDI route is now facing uncertainty as Sebi has mandated that equity investment below 10% will be classified as portfolio investment. This can force many foreign funds, which had invested through the FDI route, to register as a foreign portfolio investor.

Another good example is Sebi’s beneficial ownership circular of April last year. The circular—that proposed that resident Indians, non-resident Indians, persons of Indian origin, and Overseas Citizens of India cannot be beneficial owner of a fund investing in India—was initially ignored. The intention was perhaps justified because funds have typically been opaque about beneficial owners.

Oddly these restrictions were introduced even when the H.R. Khan panel was working to simplify regulations for foreign investors. Foreign investors were up in arms, especially Indian fund managers. Sebi then referred the circular to the panel which recommended rescinding the restrictions. Sebi rolled back the proposed restrictions in September 2018.

India continues to have some unique restrictions due to its eternal fight with black money and round-tripping. “Other jurisdictions would ideally go after the wrongdoers and not impose higher compliance requirements on every participant. An example is the clubbing requirement to calculate investment limits based on common ownership and control which is very unique to India," said Laurence.

The tax conundrum

Apart from KYC norms, India’s fickle tax laws have also visited FPIs. An example is the recent fiasco over levying a surcharge on foreign portfolio investors registered as trusts and other non-corporate structures. Under pressure from the investors, the finance ministry rolled back the surcharge on 23 August. Then, in the last quarter of 2015, 300 foreign investors were slapped with a minimum alternate tax (MAT) demand, an additional tax rate of around 20% on long-term capital gains which was zero earlier. It was business as usual: protests followed by a rollback.

There is also heartburn over India’s levy of capital gains tax. “None of the major jurisdictions charge capitals gains tax to foreign investors even if they charge capital gains to domestic investors. Even the US does not charge capital gains, just levies 30% tax on dividends that you receive. This capital gains tax is a permanent loss to investors," said Samir Arora of Helios Capital, a Singapore-based hedge fund.

Given that India needs to boost its slowing economy—which has been pegged by all major global institutions at just about 6%—it needs sustained foreign capital flows. “Everybody is competing for foreign funds, and despite India’s growth story, it is not the only market. For steadier fund flows you need a longish period of steady GDP (gross domestic product) numbers and policy certainty. Ideally, policies governing foreign flows should not be changed for four-five years," said Mohit Satyanand, a Delhi-based investor.

Finally, India also needs long-term investors who can handle the policy flip-flops and economic changes. Perhaps, India can pluck a leaf from Singapore’s playbook and strive for continued relevance by listening and taking steadier policy decisions. The key is not looking at all foreign money with suspicion. As one hedge fund manager puts it: “It’s always exciting, inconsistent, and risky to invest in India. It reaps rewards but also leaves you battered and bruised." This perception needs to change.

Jayshree P. Upadhyay was in Singapore for the Asia Journalism Fellowship.

Close