India’s ‘Qualified Foreign Investors’: A Carrot with Limited Charm?

On January 1, the Indian government’s New Year’s gift to the country’s stock markets was the announcement of a new class of investors: qualified foreign investors (QFIs). Under this category, foreign nationals can invest directly in the market. Earlier, only pension funds and similar entities were allowed direct access to India’s bourses.

If the government expected the markets to jump the day after the announcement, it was in for a disappointment. On January 2, the Bombay Stock Exchange Sensitive Index (Sensex) rose just 0.4%, or 63 points to 15,518. And this was despite other good news on the economic front, such as manufacturing output rising to a six-month high and inflation falling.

“Good news fails to light up [Dalal] Street,” said The Economic Times. Added Business Standard: “Poor risk appetite among global investors is likely to keep most foreign individuals from entering the Indian stock market in the next few months, despite being allowed direct entry.”

According to analysis from Mumbai-based financial services firm Motilal Oswal Securities, the creation of the new investor class is essentially putting the cart before the horse. Unless the market is buoyant, foreign investors won’t come in. The move to allow them in is good from a structural point of view, because it widens the market base. But if the purpose is to get more money into the market, it will fail, the firm predicts.

India has several regulations regarding foreign investment in companies. One key restriction is a ceiling on foreign holding. For the time being, it is unclear how the QFI investment will be factored in. There are already several companies in India where the foreign holding has reached the permissible limit. HDFC Bank and ICICI Bank, for instance, are largely foreign-owned. If the new investors are to be included under this quota, there will be no shares for them to buy without breaching the limit. And if they are allowed to pick up shares outside this quota, it may make the takeover of companies much easier. One option is non-voting shares, but that has its own problems.

Another stumbling block is that, as with direct investors in Indian mutual funds, investors may need to have a PAN (permanent account number) card. In India, this is principally used for filing tax returns. Dividends from companies and mutual funds are not taxable in India, so foreign investors don’t see why they should acquire PAN cards. Indian authorities say it is to fulfill the KYC (know your customer) norms — a critical requirement in the age of laundering and transferring terrorist money. But investors are worried that the government may decide to make dividends taxable in the hands of the investor (which was the norm earlier). If they give all their personal details to apply for the PAN card, they may find themselves in the tax net.

A few months ago, India allowed individual foreign investors to directly buy units of local mutual funds. There were no takers, mainly because of procedural problems and a falling market. The Reserve Bank of India (RBI) and the Securities & Exchange Board of India (SEBI) are hammering out the procedural issues for QFIs now.

Rajinder Sabherwal, CEO and chief investment officer at Magister Ludi Capital Management, a New York-based global macro fund, notes that foreign investors will buy into the India market or the China market if those countries have a good story to tell. At this point, they don’t. The GDP growth rates are high, but they are low compared to a few years ago, and they haven’t matched analysts’ expectations. “Investors are afraid that they have missed the bus,” he says.

According to analysts, foreign institutional investors (FIIs) may return to India in the second half of this calendar year. (SEBI data shows that FIIs sold equities worth a net US$411.78 million in 2011. In 2010, they had bought US$29.32 billion.) Individual investors may come in when the FIIs return, some predict.

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