Capital Market On The Mat

Mutual funds do not pay capital gains tax if they invest for seven years or more; this is why the field is littered with closed mutual funds with terms of 7-10 years trading at enormous discounts to net asset value. Now, apparently, investment in mutual funds will be exempt from capital gains tax, if it is for three years or more; in effect, therefore, the CBDT proposes to bring down the minimum period from seven to three years. So next year, we will see many three-year tax-saving mutual funds; the flood of these unattractive, poorly funded, expensively run schemes will continue.

 

It was the practice in the primitive age to exempt income from various financial instruments bank deposits, shares, government saving schemes etc with a separate exemption limit for each. There was no rationale for encouraging investment in each separately; separate exemptions protected some instruments mainly those issued by the government and its daughters against others mainly private ones. Dr Manmohan Singh abolished these distinctions and introduced a single exemption for investment income from many instruments; this exemption is for Rs 13,000 now. Mr Chidambaram proposes to reduce it to Rs 12,000, and to introduce another exemption for income from shares and mutual funds to the tune of Rs 3,000. Return of the primitive practices.

Long-term capital gains are taxed in the hands of most taxpayers at 20 per cent; somehow the CBDT had left partnerships' capital gains taxable at 30 per cent. That rate is now to be brought down to 20 per cent. Most partnerships declare as little income as possible; partners take their profits as inflated expenses or in cash to avoid income tax. Hence, the 10 per cent reduction in their capital gains tax will have no effect at all.

In 1992, G V Ramakrishna had decreed that foreign institutional investors would not be allowed to invest at most 30 per cent of their funds in fixed-interest instruments. This figure has now been raised to 100 per cent. This has scandalised Swaminathan Aiyar, who thinks this is the way to get into the next debt trap. He would be absolutely right if both the interest rates and the exchange rate were fixed: in that case, the FIIs would be assured of dollar returns of 16 per cent and more about double the rates they would get on similar dollar-based instruments in industrial countries. If they were, there could be a flood of foreign investment in Indian private debt, and eventually a debt crisis. However, if Reserve Bank stopped manipulating interest rates, any capital inflow would bring down interest rates, and outflow would raise them and cause capital losses to the sellers of debt. Debt flows would regulate themselves, just as equity flows are doing. However, the liberalisation of foreign investment in debt requires even greater skills from the RBI than it has hitherto displayed.

Finally, the limit of the loans that an individual can be given by a bank against shares and debentures has been raised from Rs 500,000 to Rs 1 million. Those who have tried to raise overdrafts against shares will know that nationalised banks just do not give such overdrafts. If one can find a nationalised bank which would, one would not trust it to return the shares. I have tried to raise a loan from a foreign bank, which is more forthcoming. But it takes transfer deeds signed in advance, and can liquidate the investments at any time. It offers a much simpler alternative: I can put money in a long-term deposit with it, and earn 12 per cent, and break it whenever I need the money. A nationalised bank too would do this, but the procedure would be more cumbersome, and interest loss greater. Hence, I think that the raising of the limit against shares and debentures will be infructuous.

The above measures are simply weak in logic. However, the finance minister is reported to have done one more thing which goes beyond poor logic it was unwise. Sebi has hauled a number of brokers over the coals for short selling i.e, for selling shares they did not possess. The idea was that they had beaten down the prices of some shares by short selling, expecting to square up at a profit, or to buy the shares for delivery at an even lower price than their sale price and make a profit. Short selling is not illegal, even under Sebi's Byzantine rules. It goes on an enormous scale, especially in the national stock exchange, within the settlement period. Even if it were illegal, it is undetectable: it is always open to a short seller to buy the shares in the market before he has to deliver them. Even if he cannot, all stock exchanges have established mechanisms for non-delivery by short sellers. They buy the shares in the market, and recover from the short sellers the excess of the purchase price over the price at which the short sellers had sold the shares. Thus short selling is simply not Sebi's business. Yet last week, it forced five directors of the Poona Stock Exchange to resign, and harassed short sellers on the Bombay Stock Exchange. When it did so, I thought it was Sebi's usual frenetic stupidity. But now there are reports of frantic calls from the finance ministry to Sebi. It is a coincidence that the ministry should come out with its package for the capital market just when Sebi has moved against short sellers. If it were more than a coincidence, it would be sinister, especially since what the ministry is presumed to have asked Sebi to do is strictly outside its powers and the ministry's.

This is not to say that the finance minister has no cause for worry about the capital market. Of the companies which got Sebi's permission for issues in 1995-96, 275 companies with permission to issue Rs 39.5 billion have returned their cards. Public demand for equity is at an ebb. But the remedies are not what the finance minister has been given to believe.