Foreign Direct Intervention

India is one of the few emerging market economies which runs a trade deficit equivalent to about nine per cent of GDP. That means it is dependent on foreign capital flows. If the latest tax spat goes beyond sulking and investment actually starts to freeze up, India could face a balance of payments crisis.

The coordinated letter from international trade associations — including America’s Business Roundtable and the Confederation of British Industry — was sparked by New Delhi’s decision to retrospectively change the laws on capital gains tax. It is as much a rallying cry to investors as it is a message to the government.

Indian’s annual financing requirement of $119 billion is the highest in Asia, according to Nomura. Its trade deficit for the financial year ending in March 2012 has been estimated at a record $175-180 billion by the commerce ministry, up from $104 billion a year ago.

Last year, around $63 billion was invested from overseas in the Indian economy. Half came from foreign direct investment (FDI) and the other half from portfolio investors. Another $60 bn came into India through remittances from overseas workers. With the trade deficit rising on the back of higher oil imports, India needs to be increasing foreign inflows not shooing them away.

The government may believe investors would continue to see the returns in India as outweighing the additional tax burden. Even Vodafone, which is bearing the brunt of the retrospective tax legislation, may not exit what is still one of the world’s fastest growing markets. But, India doesn’t need an exodus of capital for a crisis to manifest itself. All that would take is if for new money to dry up. That’s why a letter from some of the world’s largest trade associations should worry the Indian government. It follows a similar salvo from the Securities Industry and Financial Markets Association, which represents institutional investors, last week.

New Delhi may be quite justified in pursuing reform of its investment tax regime to close loopholes. But, retrospectively changing tax laws has rightly got foreign investors hot under the collar. The government should remember that there won’t be any revenue to tax if investments dry up.