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Devangshu Datta: Withdrawal symptoms

FII buying could slow further with arbitrary changes in the tax regime and greater discretionary powers in the Budget's small print

Devangshu Datta  |  New Delhi 

Long-term Budget watchers avoid instantaneous reactions to any new financial measures. The devil is always in the details and those are published weeks later in notifications by the Reserve Bank of India (RBI), Customs and Central Excise, and the Income Tax Department.

Given that the Budget is prepared months in advance, the lag seems unconscionable. However, the delay is not due to administrative inefficiency; it is a political device that offers wriggle-room. Notifications can be softened if there are adverse reactions.

This is the case with the General Anti-Avoidance Regulation (GAAR) proposals. It took a fortnight before the finance minister clarified that participatory notes (P-notes) wouldn’t be taxed. We still don’t know the tax impact on other foreign institutional investor (FII) operations.

In essence, GAAR is being waggled like a big club. The government won’t actually hit P-notes in the 2012-13 fiscal. Maybe it will in 2013-14. The pace of FII buying slowed in the last fortnight and the slowdown could continue if FII see their other operations taxed.

One can make a logical case for taxing P-notes. But several stranger proposals have received less publicity. Start-ups, for instance, are likely to be hard hit by some clauses in the Finance Bill. “Share premium in excess of the fair market value (FMV) is to be treated as income” via a new clause in inserted Section 56(2). This applies to unlisted companies that receive equity contributions from resident Indians. The company would have to substantiate FMV to “the satisfaction of the assessing officer”.

In another clause, Section 68 of the IT Act is to be amended to put the onus on an unlisted company receiving equity contributions to do due diligence on the nature and source of funds received. That is, the company would have to find out if the money it received was clean (how?), and prove this, again “to the satisfaction of the assessing officer”.

One would prefer not to comment on the greater discretionary powers embedded in these proposals. The scope for abuse is obvious. An assessment of FMV for an unlisted concern involves hard work and a certain subjectivity on the part of investment banking specialists. Determining FMV is not part of the domain expertise for start-ups, or the income tax (I-T) department for that matter. On the other hand, investigating the source of funds is core competence for I-T. Why is this being “outsourced”?

Apart from such examples of creative thinking, sentiment could take a knock due to several separate developments. Telenor is reportedly about to seek compensation for the 2G licence cancellations, while also being embroiled in a dispute with its joint venture partner, Unitech.

The TCI fund (The Children’s Investment) has threatened minority shareholder action against Coal India (CIL) for selling fuel at a discount. CIL is also likely to miss its commitments for fuel supply to power plants. Meanwhile, environmental clearances for Posco are held up, all over again. The hapless oil-marketing companies are suggesting that petrol prices be officially re-controlled, rather than unofficially controlled. And, of course, there’s “Truckgate” and “Coalgate”.

There is one common strand: these events throw a poor light on governance. They also indicate there is nothing resembling a coherent plan to revive flagging growth. In the circumstances, an investor who seeks exposure to Indian stocks does so strictly on the basis of company-specific factors, after discounting the deteriorating macro-story. There are plenty of good Indian companies. But valuations always suffer when investors are forced to discount a risky macro-environment.

In the circumstances, market valuations have held up well so far. The Nifty dipped below its own 200-day moving average on an intra-day basis. But it also made a sharp recovery in the last trading session of 2011-12. That recovery was, at least partially, driven by strong FII buying that aimed to avoid taking extra exposure to new taxes in the 2012-13 fiscal.

In fact, the market is pretty much at Budget level. But the technical signals suggest a downtrend is marked, and likely to continue. The 2012 high was recorded at Nifty 5630 on February 22. Since then, a pattern of lower highs and lower lows has been established. The latest low was 5135 on March 29. The key levels to watch in the short-term are, therefore, 5135 and 5630. A fall below 5135 would signify a steeper downtrend while a rise above 5630 would be a positive signal.

Optimists could look for some positive triggers. Clarity on the tax front would be one trigger of course. Another could be a more liberal monetary attitude and policy rate cuts from RBI. This is no longer expected by most smart players — bond yields are rising. A third positive trigger may be improvement of the external environment. The US economy is continuing its recovery. An easing of tensions on the Iran front would be a huge boost.

In the absence of positive triggers, the market will drift down. If things get worse, there could be a sharp correction. Broadly speaking, on the way down, or the way up, rate sensitives would lead the movement. The Bank Nifty, assorted non-banking financial companies and housing loan companies would be in the forefront. Other highly sensitive sectors include metals and energy plays. As always, the fast-moving consumer goods segment is likely to be a defensive haven.

The standout trades are all on the short side. At a Nifty PE of 18-19, the market could lose 15-25 per cent over the next quarter unless there’s a big turnaround. The rupee is under pressure anyhow, and if the FIIs turn sellers, the pressure will mount. A long USD/INR position could be a major winner.

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First Published: Mon, April 02 2012. 00:49 IST