Indian Financial Services – Onshore vs. Offshore Venues

When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both, serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change and to maintain high ethical standards.

It now seems that those hopes were premature. The revolution in the stock market used to be one of the best success stories of economic reforms in India. It might have fallen apart in recent month and years. The more likely scenario could be one where India-linked finance will happen offshore, while our regulators and government squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance is suffering from one setback after another.

Business as usual, in India, is taking us to a destination where RBI, SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance is taking place overseas, and the overseas market will dominate price formation for India-related financial products.

Why might this happen?

Money always follows the path of least resistance; therefore orders that used to come to India are easily being switched to other venues. An array of other venues has now come up:

  • Nifty futures trade in Singapore on the SGX and in USA on the CME.
  • An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market’).
  • Derivatives on the rupee trade overseas on the exchange traded market and OTC market (linear contracts are termed `the NDF market’).
  • Trading in individual stocks is taking place on the ADR and the GDR market.

Mistakes of domestic policy are giving a substantial shift in India-related finance to overseas locations. The two most important pillars of the Indian financial system are trading in the rupee and in the Nifty, and with both these, India is rapidly losing ground. If present policy mistakes continue, the role of the onshore market will continue to decline, for both the rupee and Nifty.

The plight of the Nifty

Let’s focus on Nifty – the most important financial product in India. The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy whereas the overseas markets offering India-linked financial products are already developed financial centres and face no such problems. In the baseline scenario, Indian policy-making will meander on clueless and unconcerned and NSE will continue to lose ground.

Things are neither that much simple nor only stop here. First, NRIs pioneered sending order flow to overseas venues, and made them liquid. Next are Indian MNCs, who run global treasuries, who easily patronize the overseas venues. And then there are HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul.

With these kinds of possibilities, Singapore’s appeal goes beyond just the type of markets it offers. For one, India demands new investors deal with a thicket of documentation. While opening a foreign institutional investment account in most countries takes a few days, in India it is up to six weeks. So the start itself is a hurdle.

And then, there is taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and is apprehensive about tomorrow (if GAAR is used to abrogate the Mauritius treaty).

The bigger hurdle is India’s more severe taxation. Singapore does not tax capital gains and its tax on interest income allows for certain exemptions, such as foreign-sourced dividends. Whereas, India has a 15% short-term capital gains tax on listed securities. Most domestic debt instruments carry a 20% tax on income earned, which according to many market experts is the “biggest showstopper”.

The obvious choice

Put these factors together, and suddenly Nifty futures on SGX are a credible option. And this is exactly how things have worked out. In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE’s. It is astonishing to see that for the biggest Indian product – Nifty – an overseas exchange has got superior open interest.

Things changed when SEBI banned Participatory Notes (P-notes) in October 2007. SGX’s share in the total open interest (outstanding positions) in the Nifty futures product rose to around 50% from as low as 6% before the ban. A year later, the market regulator lifted the P-note ban, which led to a fall in SGX’s share to around 25%. But since then, SGX’s share has been rising steadily again. SGX now enjoys a 68% share in the total open interest on Nifty futures contracts.

And the recent blunder that added to the misery is the GAAR fiasco that resulted in exodus of foreign investors’ from the Indian regulatory boundaries. And while the government has softened its stand on GAAR considerably, foreign investors now seem increasingly concerned about the uncertainties of Indian policymaking.

The predicament of Rupee

The Indian rupee has grown rapidly to becoming the 16th most traded currency in the world. From less than 0.2% of the world forex turnover in 1998, it has grown rapidly to constitute about 0.9% of the world forex turnover in April 2010. It is one of the biggest emerging market currencies with the Korean Won, Russian Ruble, Chinese Renminbi and the Mexican Peso being its close competitors.

Trading in the rupee is composed of the following elements of the market:

The rupee-dollar is the most important price of the Indian economy. The overall market for the rupee is roughly $70 billion a day out of which roughly one-third is spot, and the rest is derivatives. The offshore market today is as big as the onshore market, as roughly half of rupee trading takes place in India.

In its 2010 triennial central bank survey on foreign exchange and derivatives market activity, Bank for International Settlements (BIS) also pointed out that about half of the dollar-rupee market was overseas.

Though the RBI has done away with many capital controls, access to the currency market onshore still has some restrictions giving rise to offshore currency trading. Having said that, it must also be noted that most emerging market currencies are traded heavily in prominent currency trading centres such as Singapore, Hong Kong, the UK and the US. This is an inherent feature of currency trading. Of course, countries which have capital controls tend to push a larger proportion of trading offshore.

The development in the Rupee market

InterContinental Exchange Inc. and CME Group Inc., among the world’s largest futures exchanges, have launched rupee-dollar futures contracts in the month of Jan 2013. This clearly shows the growing importance of the rupee in the global currency market.

Needless to say, large electronic exchanges will do their best to both capture market share and increase the size of the market. And given their advantage over domestic competitors of access to foreign market participants, as well as freedom with product design, the share of offshore trading could continue to rise.

Rupee trading on other markets does not necessarily mean that trading in local markets is shrinking. Though it may be the case that the cake is enlarging, but our slice isn’t.

As India internationalizes, domestic customers of financial services, and the foreign order flow, will increasingly shift their business to providers abroad considering the problems in the local financial system. NRIs do not like to send orders to India given that India as yet lacks a residence-based taxation framework; they would rather send their orders to US (on ICE & CME), Dubai (on DGCX) or London.

The obvious implication

When foreign investors send an order to India, there is an entire chain of activity where revenues are generated. This includes brokerage companies, accountants, lawyers, hotels, aviation services, etc. When the same foreign investor sends this order to Singapore instead, this entire chain fuels the Singapore economy instead. And as global interest in Indian derivatives surges, it is Singapore, not Mumbai that is reaping the benefits.

The swing shows how deeply a tax gaffe last year damaged foreign investor sentiment and the cost to an economy that has seen growth tumble to around 5.5% following the sharpest slowdown in a decade. India is now paying the price for poorly written rules last year aimed at ensnaring tax evaders, ironically including those routing investments through Singapore, which instead sparked outcry among foreign investors and an outflow of funds.

What worries India is that Singapore markets are now attracting flows in other derivatives, creating not only a missed opportunity for India, but also the risk of a parallel overseas market offering arbitrage opportunities that distort domestic prices.

Last but not the least, prospects of Bombay, emerging as an international financial centre will subside. If we can’t even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren’t India-linked?

Some steps in the right direction

Since all taxes are distortionary and a basic principle of public finance is that we should have a low rate that is spread across a large tax base; our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013-14 makes progress on two fronts (reducing STT from 1.7 to 1 basis point, and reducing distortions between equities and non-agricultural commodities).

One more announcement from the budget was in best of the spirits: FIIs are allowed to trade in currency futures. This will also give more liquidity and depth to currency futures and there are two reasons for expecting this, taxation of commodity futures and the entry of FII orders flow.

Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.

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