The nervousness is back, and so are direct physical controls. In an otherwise staid monetary policy document released on 3 February 2015, Reserve Bank of India governor Raghuram Rajan has inserted one small restriction: henceforth all foreign portfolio investors investing in debt instruments—issued by government or private sector companies—have to hold on to their investments for a minimum of three years.
The policy decision is a discreet admission of the risks confronting the Indian economy, as well as a hint of the Indian central bank’s anxieties.
But imposing administrative controls in this day and age—even if they are meant to mitigate risks—sends wrong signals, especially when alternative fiscal instruments are available to achieve the same results. Even the European Union has agreed to implement such a measure despite stiff opposition from Britain and Sweden: the magic bullet is called a Tobin tax.
India must also consider introducing such a tax With Finance Minister Arun Jaitley searching for newer sources of revenue, Budget 2015-16 (to be announced on February 28) will be the right vehicle for announcing this levy.
Named after American economist and Nobel laureate James Tobin, the tax is levied on financial transactions and is aimed at curbing speculation and volatility. Although the tax was originally proposed by Tobin in the 1970s for a post-Bretton Woods global financial system—to curb short-term currency speculation and its attendant risks to the economy (through high interest rates)—over time it has come to denote taxes on all kinds of financial transactions, with each country re-interpreting the concept in its own unique manner. For example, Italy imposed a variation of the tax on high frequency share trading in September 2013—a 0.02% tax on trades occurring every 0.5 seconds or faster. [1]
After years of discussions and dissent, 11 European countries—Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia and Slovakia—have also decided to introduce a financial transactions tax from 1 January 2016. [2] Under the finalised proposal, the 11 countries will impose a 0.1% levy on exchange of shares and bonds, and a 0.01% impost on derivative transactions.
However, Britain and Sweden have already voiced their dissent to the proposal and are likely to oppose its enactment. It is also not known whether Italy will continue with the tax on high-frequency trading after 2016.
The Tobin tax approach has been tried in other countries as well—such as Thailand, Brazil, Chile, and Malaysia—with mixed results. However, in Brazil and Malaysia (and, to some extent, in Chile) the tax is said to have achieved the desired results of curbing volatile short-term currency flows.
India already has a form of Tobin tax in place—the Securities Transaction Tax (STT). Introduced in 2004, the STT is levied on every transaction of securities listed on the stock exchanges and mutual funds. According to Budget documents, the STT helped net Rs. 5,497 crores revenue for the government during 2013-14. [3] The estimate for 2014-15 is Rs. 5,991 crores.
A Tobin tax could be levied on foreign portfolio investors who decide to cash out their investments in Indian bonds before a certain period. This has dual benefits—the investments stay for a longer and predictable period (thereby insulating the economy from egregious volatility), and earn additional revenue for the government as well.
This might be much more elegant than what the RBI is proposing. The RBI monetary policy document states: “…it is decided in consultation with Government that all future investment by FPIs in the debt market in India will be required to be made with a minimum residual maturity of three years. Accordingly, all future investments within the limit for investment in corporate bonds, including the limits vacated when the current investment by an FPI runs off either through sale or redemption, shall be required to be made in corporate bonds with a minimum residual maturity of three years. Furthermore, FPIs will not be allowed to invest incrementally in short maturity liquid/money market mutual fund schemes.” [4]
This is a direct administrative decree that not only transmits confusing signals to market participants but could also incur their displeasure. Rajan even admitted in a recent newspaper interview: “I generally believe we should not micro-manage. But the one place where I do make a strong exception is on financial stability. There are situations when market participants do not fully internalise the consequences of their action because they know they can leave before the consequences hit them.” [5]
One reason for the directive could be swelling short-term loans and the bunching up of repayments in the near future. However, data seems to indicate otherwise: according to external debt data till 30 September 2014, released by the Ministry of Finance, short-term debt is only 18.9% of the total external outstanding debt of about $456 billion. At the end of June, it was slightly higher at 19.6%. [6]
So, why is the RBI imposing this diktat now? Clearly, it is a bit jumpy about the consequences of an interest rate hike by the U.S. Federal Reserve Bank some time this year. When that happens, many global investors are expected to withdraw funds from emerging markets like India and invest in the U.S. instead.
Such an outflow could create pressure on the current account, the rupee exchange rate, and on domestic interest rates. India experienced this in 2013. Rajan wants to bullet-proof the balance-sheet not only before the event, but also prior to the announcement of the Budget at the end of February.
Rajrishi Singhal is Senior Geoeconomics Fellow, Gateway House. He has been a senior business journalist, and Executive Editor, The Economic Times, and served as Head, Policy and Research, at a private sector bank.
A version of this was published on the Hindu Business Line, here
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References
[1] Clinch, Matt, Italy launches tax on high-frequency transactions; CNBC, 2 September 2013, <http://www.cnbc.com/id/101002422#>
[2] European Commission, Proposal for a Council Directive implementing enhanced cooperation in the area of financial transaction tax, 14 February 2013, <http://ec.europa.eu/taxation_customs/resources/documents/taxation/com_2013_71_en.pdf>
[3] Ministry of Finance, Government of India; Revenue Budget, Budget Documents, <http://indiabudget.nic.in/ub2014-15/rec/tr.pdf>
[4] Rajan, Raghuram G, Sixth Bi-Monthly Monetary Policy Statement; 5 February 2015, <http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=33144>
[5] Sriram R., Bodhisatva Ganguli and Gayatri Nayak, ‘The War on inflation is still not won: RBI Governor Raghuram Rajan’, The Economic Times, 5 February 2015, <http://articles.economictimes.indiatimes.com/2015-02-05/news/58838165_1_rbi-governor-raghuram-rajan-urjit-patel-committee-inflation>
[6] External Debt Management Unit, Economic Affairs Department, Ministry of Finance, Government of India, India’s External Debt as at End-September 2014, December 2014, <http://finmin.nic.in/the_ministry/dept_eco_affairs/economic_div/ExternalDebt_Sep14_E.pdf>