The cost of integration

Print edition : April 15, 2000

As the Indian economy becomes more integrated with the U.S. economy, it also becomes more vulnerable to the profit-driven movement of international capital flows, as the recent experience of stock market volatility has shown.


NO two unconnected factors have in recent times had so profound an impact on the Indian stock market as the Microsoft antitrust case in the United States and the tax treatment of Foreign Institutional Investors (FIIs) operating in India. When Justice Tho mas Penfield Jackson of the U.S. District of Columbia ruled on April 3 that Microsoft, the global software giant, was guilty of resorting to anti-competitive practices in its dealings with customers (story on page 82), an adverse reaction was felt not on ly in the U.S. securities market but in far-off Indian stock exchanges as well. The following day, reports surfaced in the Indian media that the Indian tax authorities had served notices of tax demand on a handful of FIIs for back taxes on profits from t heir equity market operations relating to 1997-98.

The combined effect of these two developments on the stock market was catastrophic. On April 4, the Bombay Stock Exchange sensitive index dropped 361 points, the second biggest decline in its history. It closed the day at 4691 points, down from 5052 poin ts the previous day. The market reaction to these two events underscores the degree of integration of the Indian economy in general, and Indian markets in particular, to the global economy.

But first, the story of the FIIs. With nearly Rs.50,000 crores in investible funds as on date, the FIIs collectively have a hold on the Indian stock market that is hard to shake off. The adverse market reaction to the controversy over the FIIs' tax statu s was therefore entirely understandable. At the heart of the controversy was the question of whether FIIs operating out of Mauritius were bona fide residents of that country and were therefore eligible to claim tax exemption under Indian laws (und er the terms of a double taxation avoidance treaty signed by India and Mauritius). Evidently some of these FIIs did not quite satisfy the requirement under the laws of Mauritius that they should have been set up by a minimum of two Mauritian citizens.

The Income Tax Department may have acted beyond its brief in disregarding the Mauritian charter of incorporation and in wanting to establish the identities of the persons behind the companies. But that is a different story altogether. What is of interest is the nature of the Indian government's response, which offers an insight into how foreign capital leaves its imprint on Indian policy formulation.

First, the government tried to put on a brave front by claiming that the income tax notice issued to the FIIs was of no great consequence. Finance Minister Yashwant Sinha went to great lengths to claim that the move was restricted to a handful of institu tional investors and did not signal a reversal of policy on tax treatment of these institutions.

But the market clearly saw in it an implication that went beyond the profits of a few FIIs. It evidently thought that the I.T. notices were perhaps merely the thin end of the wedge as far as FII operations in India were concerned, and that more was in st ore. Although the market recovered somewhat in the next two days, clearly it was extremely nervous about the future direction of equity values.

After the initial show of bravado, the Finance Minister went on to claim that the market's decline was the result of manipulative action by a few speculators and said that there was no reason for investors to panic. But far more than the market, it was t he government that was nervous. When one FII after another threatened to pull out of India, apparently in response to the new tax demand, the government lost its nerve.

It announced on April 6 - less than 72 hours after the first reports of the tax demand surfaced - that the residential status of Mauritius-based FIIs would not be questioned and that the charter of incorporation would be accepted at its face value for th is purpose.

Thus ended the drama which had the market in a tizzy for the few days that the crisis lasted. If the episode has any lessons, it is that international capital is extremely mobile and is constantly in search of safe havens. International portfolio capital , which had a number of emerging market economies to choose from, could be attracted into India only on the promise of exemption from tax on incomes earned. But rather than grant such exemption directly, governments in emerging markets the world over hav e resorted to the fig-leaf of signing tax treaties with countries that promise such a treatment for off-shore investments. Such inflows are a source of comfort in managing the country's balance of payments. But the flip side is that they also cast a shad ow on policy formulations at the macro level. The latest episode has clearly demonstrated that the tax regime for these FIIs can be tinkered with only at a considerable cost to domestic market valuations.

At the Bombay Stock Exchange, online traders look for clues to the free-fall in the market on April 4.-PAUL NORONHA

BUT even without influencing macro policies to suit its purpose, foreign capital can, by the very nature of its investment operations, send signals on price movements in the domestic markets. The verdict against Microsoft is as good an example as any. Mi crosoft's Indian connection goes far beyond the application development centre that the company has commissioned in Hyderabad or the copies of the Windows operating system that powers hundreds of thousands of personal computers in India. It casts a shado w over stock price movements in the country as well. When Justice Penfield Jackson held that Microsoft was guilty of anti-competitive practices in the marketing of its Web browser software, the company's share price tumbled on the Nasdaq, losing close to 15 per cent of its value in a day. The Indian market followed suit by pegging the values of a number of information technology stocks when markets opened for trading the next day.

It would be tempting to dismiss the developments in the two markets in the wake of the Microsoft verdict as a mere coincidence. But the reality is that markets of liberalising economies are increasingly moving in sync with the markets of more mature econ omies as they respond to earnings-impacting developments. Such are the ties that bind the emerging markets to the developed ones that a significant price movement in the U.S. market, for instance, has invariably led to a sympathetic variation in the Indi an market. For instance, when Tata Telecom and a few other telecom stocks posted sharp gains in value, in the period between mid-February and mid-March this year, analysts attributed the gain to the fancy that U.S. investors had taken to telecom stocks l isted on the Nasdaq, during the same period.

Anecdotal evidence clearly suggests that at least in the case of information technology and communication stocks, the favourable sentiment with which such stocks have been viewed in the U.S. has had a spillover effect that pushes up the valuations of lis ted Indian IT enterprises.

The connection gets doubly reinforced when an emerging market stock gets listed in the U.S. as well. Its performance in the U.S. market gets reflected in the domestic market and with it a whole range of similarly placed stocks (even if they themselves ar e not listed in the U.S.). The case of Infosys Technologies is illustrative. Its performance on the Nasdaq lifted valuation for the stock in the Indian market and with it a whole range of IT stocks with equally impressive performance credentials.

Infosys' American Depository Shares-linked stock options were listed on the Nasdaq in March 1999. The scrip, which was priced at $34 at the time of an initial public offer to American investors, is currently quoting at $276 (the price at the Nasdaq on Ap ril 7). Since each underlying scrip was subsequently split into two, the effective offer price for U.S. investors worked out to $17 per unit of capital in the company. In other words, there has been almost a 16-fold appreciation in value in a little over a year.

Infosys' performance in the U.S. market is of course only a reflection of the buoyancy in the valuation of IT stocks in general. The Nasdaq Composite Index of stock prices has more than doubled in the last year and a quarter. Indian IT stocks have better ed even that growth record. The Business Line index of prices of technology stocks went up five times during the same period. There is thus a situation where IT stocks in the U.S. and similar stocks in India have posted attractive returns on inves tments. There is also the phenomenon of Infosys - to name just one of a number of star performers in this sector that are offering attractive returns on investment. A conclusion that there exists strong linkages in the market performance of IT stocks in India and the U.S. thus seems inescapable.

The listing of Indian scrips is an important first step in the process of integration of the Indian stock market with the developed world. Global investor perceptions about future performance have an impact on the valuation of such scrips in the overseas market. In turn, this sets off a powerful signal on the valuation of these stocks in the domestic market. If, for instance, investors in the U.S. value the future prospects of Infosys in more positive terms than their counterparts in the Indian market d o, it is only a matter of time before prices in the Indian markets too start reflecting the trend even if it does not quite match the levels that the scrip might attain in the U.S.


The presence of FIIs who have the freedom to invest in both these markets reinforces the signalling effect. Their investment decisions cannot but be influenced by perceptions of valuation by their counterparts in the more mature markets with regard to th e same set of stocks that they are interested in. It is a moot point whether the Infosys scrip would have appreciated as much as it did since March 1999 in the Indian market had it not been for the relentless uptrend in price that the scrip had recorded at the Nasdaq. From here on, a bandwagon effect begins to manifest. The favourable perception of value in the case of a few IT stocks begins to seep into the next rung of IT stocks and in no time a whole range of stocks in this industry begin to reflect in varying degrees a higher valuation. The process of integration could now be said to have well and truly set in.

BUT there is also a downside to this. As adverse signals on valuation begin to sweep through the mature markets, they cast a shadow over domestic valuation as well. It is difficult for Infosys or other software companies to command a premium in market va luation if investors in the U.S. are pessimistic about their country's near-term economic prospects. After all, Infosys - and other IT companies - generate a substantial chunk of their incomes from customers in the U.S. Not just IT stocks but a whole ran ge of other stocks in the manufacturing sector are dependent on the performance of the U.S economy. Therein lies the problem.

Imagine a scenario where the U.S. economy contracts owing to an inability to sustain the ballooning trade deficits that it has been posting for some years now. The only way out would be a contraction of future consumption and, by extension, growth. Shoul d the engine of economic growth in the U.S. start to sputter, the repercussions are bound to be felt in the distant shores of India. Portfolio flows from the U.S. would dry up. Worse, existing investments may head home as investors in the U.S. seek to li quidate their holdings of Indian stocks. Domestic stock markets would inevitably start registering losses. At another level, profits of Indian companies too would begin to decline as the U.S. may no longer be able to lift all that India is able to produc e and export. In fact, a contraction of the U.S. economy has implications for global trade and by extension India's trade with other countries. An all-round decline in exports and the profitability levels of Indian companies are bound to tell on domestic market valuation as well. Indian stock markets could be hit by what the Americans would call "a double whammy".

That is the price one pays for global integration - or, more precisely, integration with the U.S. economy. If such an integration provided the Indian market an initial thrust to valuations in the past, it can hardly hope to escape the rigours of a revers e effect - if and when it takes hold.

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