Date:03/05/2007 URL: http://www.thehindubusinessline.com/2007/05/03/stories/2007050302950600.htm

Back The myth of emerging market risk

S. Balakrishnan

Borrow at 30 per cent and invest at 5 per cent?

Something like this is happening in India's forex balance sheet. Foreigners are getting 30 per cent on their investments while we are content with 5 per cent on US Treasury bills and bonds.

India's stock market is in an extraordinary boom as the global investment community sees another China in the making. The Sensex has increased almost sevenfold from the 2000s to 14000 in less than five years, delivering super profits to FIIs. And this is just an average. Stories abound of their and private equity (PE) investors making far more in many individual investments.

The (about) $50 billion of net FII investment in Indian stocks does not convey the full picture as there is considerable churning through average sales and purchases of the order of Rs 1,000-1,500 crore a day. It is (good) news that the liquidity in the Indian stock market is good enough to absorb such high volumes of FII activity. It also indicates foreign investors are booking profits at every opportunity (although, on balance, inflows are well into positive territory).

How, one may ask, does the investment of FIIs constitute borrowing? Flows into the stock market add to forex reserves.

When the investment and profit are repatriated, it is equivalent to repaying borrowing with interest. The higher the rate of profit, the higher is the effective rate of `interest' paid on the `borrowing'. Conferring equity repatriation rights at market price on foreign investment (of the direct or portfolio type) makes it no different from debt.

To one's knowledge, there is no data on the exact rates of return earned by FIIs. But there is little doubt that they are several multiples of the dollar rate of interest.

But is not an equity investor exposed to risk? It is true that he could lose some of or all his capital.

However, given the double digit growth rates in several emerging economies, investments in their markets have been a one way ticket to huge profits. In reality, contrary to popular perception, emerging market risk is extremely low. Ask a Mark Mobius or Marc Faber and they would agree that these countries abound in very low or no risk opportunities.

Contrast this with `efficient' (in a theoretical sense) first world markets, where fund managers have to sweat it out to eke out that wee bit of extra return over market and it is clear the risk-reward ratio is overwhelmingly in favour of emerging markets.

Should we offer such `excess' returns to foreign investors, that too tax-free?

The case for a nominal tax on FII profits seems compelling. With such juicy returns, it is certain FIIs will not turn away from India, even if their profits are taxed.

A 10 per cent tax would reduce a 30 per cent return just by 3 per cent to a still very high 27 per cent.

The Finance Minister could easily earn, from this source, Rs 5,000-10,000 crore annually, considerably easing his budgetary woes and making available more resources for welfare spending.