India’s Retail Investing Boom Is Reshaping Capital Flows And Testing Foreign Appetite
In this week’s special edition, Govindraj Ethiraj speaks with Anant Narayan, former whole-time member of the Securities and Exchange Board of India on how surging domestic inflows have outpaced equity supply, stretched valuations and reshaped the balance between local and foreign capital.
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Hello and welcome to The Core Report's weekend edition. We are going to be talking about the very nature and structure of India's capital markets, but also what is driving some of the foreign portfolios in and out as we have seen in the last year and what can be changed if we want to bring about greater harmonisation with global markets, not just for investors sitting outside investing into India, but for Indian investors who could potentially have a much larger pool of global capital markets to play with. So what should be the way forward to discuss all of that? I am joined by Anant Narayan, former whole-time member of the Securities and Exchange Board of India and someone who I have known as a very astute forex trader from another life. Thank you so much for joining me, Anant.
Hey, thanks so much, Govind, for having me. Really a big pleasure to be here. So, look, as you mentioned, there are plenty of factors that go into determining why, you know, capital flows in general come to a country or go out of a country.
Many of those factors might not be in our control, things like geopolitics, things like, you know, trade flows, things like alternative investment destinations globally. There are a few things which could be in our control as well. I'll give you my thesis as to what I think is happening.
Some of it is to do with the fact that the growth of the domestic investor in our markets, we've probably been too successful in it in some ways and there are, I think, other frictional points which also cause problems for foreign investors and this is both direct investments as well as portfolio investments. What has been happening, Govind, and you know this very well, is over the last few years, there's been the rise of the domestic investor. So in March 2020, just before COVID hit us, we had about 4 crore unique investors in the Indian capital markets.
Today that number has crossed 14 crores and clearly we've seen this trend of people coming in and putting in a lot more money into our equity markets through mutual funds and directly as well. This is also translated into a large amount of and a wave of domestic flows coming into the capital markets. So FY25, which is April 24 to March 25, we had about 6.1 lakh crores of net demand for equities coming in purely from domestic mutual funds. Add to that demand from investors like you and me coming in directly and through insurance companies, pension funds and other domestic institutions, that was another 2.7 lakh crores. So the total demand purely from domestic sources was 8.8 lakh crores. Each of the numbers I've given you, Govind, are a record high.
Mutual fund flows are practically twice as high as they were previously. 8.8 lakh crores again is practically twice as high as we've seen in the past. That trend broadly continues into FY26 as well.
Of course, the numbers are a little more plateaued right now. 8.8 lakh crores is a tremendous amount of demand for paper, which is great. Great to have people participating with patient capital, looking for capital formation. On the other side of supply, if I look at supply in the form of IPOs, FPOs, rights issues, QIPs and such like, all of that put together was about 4.6 lakh crores in FY25. That is also a record high. We had over 320 IPOs happening in that fiscal year.
Now record demand for paper and record supply of paper is what capital formation is all about. So that's great news. And by the way, I think there is opportunity to grow this even further.
So that's great news and an opportunity. There's also a flip side. Now this 8.8 lakh crores of domestic demand against that, we also saw outflows of about 1.3 lakh crores from FPIs. So the net demand was 7.5 lakh crores. I mentioned to you that the supply, including through IPOs, FPOs, such like was 4.6 lakh crore. That gap is 2.9 lakh crore. How was that met? It was met by promoters, strategic partners, and so on and so forth, selling in the secondary market to this wave of domestic demand. So this mismatch of fresh supply in terms of actual new issuance going towards capital formation versus demand for paper at 2.9 lakh crores was also a record high. The previous high was 2.1 lakh crore the previous year. So what's been happening over the years, and by the way, in FY20 or so, the demand and supply was practically matched. So what we have seen is over the years, this yawning gap between supply and demand, both are growing, but clearly the gap is also growing.
Now to me, that has all the ingredients of creating pockets of valuation excesses. You might see now, you know, valuation is not an exact science. And we can all debate valuations till the cows come home.
But this mismatch of demand and supply, I think creates the ingredients for possible overvaluations, at least in pockets. Now, if you compare this phenomenon with what we have seen both on FDI as well as an FBI, think of it this way. If you're seeing valuations, at least in pockets going up, as a foreign investor, even if you like a company, you might reckon that at certain valuations, it makes more sense to exit than stay on.
Similarly, if you're looking to do a fresh investment in India, you might find that there are no real cheap opportunities left because there's so much of domestic demand coming through. This is not just in the listed space, it's also in the unlisted space. So AIFs, the alternate investment funds, which invest typically into unlisted paper, both equity as well as debt, that has been seeing record inflows as well.
So it's not just to, you know, publicly traded markets, it's also the private markets. So both in the private space and in the public space, FDI and FBI have increasingly found it difficult to find entry opportunities, and have increasingly found it easier to exit at very good valuations. So somebody who's invested in an unlisted paper, you know, 10 years ago, 15 years ago, gets an excellent exit now, either to a fresh private equity investor or to the public markets, and likewise with FBI.
So I think what's happened is that if you look at FDI specifically, actually, the gross numbers look reasonably good at $85 billion or so. The problem is twofold. One is we are seeing repatriation, and we're also seeing outward FDI, Indians investing overseas.
I would argue that this valuation is one of the reasons why you're seeing this outward flow of capital. We're giving, you know, we are seeing as a high growth place, we are seen as having a bit of diversification away from the rest of the globe, and so on and so forth. But while we're giving capital good reasons to come in, we are probably not giving it enough reasons to stay because of the nature of the valuation that we're seeing in pockets, and true across both FBI and FDI.
This, I think, is something which can be addressed. I would argue that currently, it's a good trend that we are seeing domestic participants coming in and putting money into capital markets. We have probably weighted too much towards equity markets, maybe a chunk of that can go towards fixed income, towards corporate bonds, towards invits, and REITs, and other hybrid instruments, and away from just equity markets, thereby creating a little more diversity across our, you know, roots of capital formation, and also ensuring that this pockets of overvaluation do not arise.
So that's one area that I think we can address. There are things we can do on the tax side. There are things that we can do on outward investments, out of India side, which can help better balance this portfolio of investments that domestic investors are putting in.
Okay, so you've used valuation as one peg around which you're saying that a lot of these factors are playing around. So and I'll come to that. You talked about the fact that there has been a record demand and supply gap. Can you walk us through a little more, not just the data, the data points you've shared, as to why this supply demand gap, I mean, what does it reflect in terms of what's happening in the economy as a whole?
So first thing is, I'd not call this a valuation issue. I would simply call it a mismatch in demand and supply. Because as I said, valuation is a very contentious topic.
We can argue about this for ages. I think what's happening is the following, look at it from our perspective as investors. What are the opportunities that we have to deploy our savings?
And by the way, the savings pool, as I said, has increased to up to 14 crore investors plus. When an advisor comes to you, they will show you equity options, they will show you commodities, they will show you real estate, they could show you fixed income, and so on and so forth. The reality is on a tax adjusted basis, the most appealing of these investments appears to be equity.
After all, the taxation that happens on equity if you hold it for beyond one year is 12.5% long-term capital gains tax. If you and I buy a corporate bond, now it might give you a good 7% return. But remember, there is no indexation anymore on debt funds.
So whatever you earn by way of coupon, and through capital gains in case interest rates come down, will be taxed at your marginal tax rate. So if you're paying a 30% tax rate, and you're earning 7% coupon, you would actually pay over 2% as tax, including surcharges that goes well over 2%. And that net rate that you get below 5% would struggle to beat inflation.
So even if you're a pensioner who's just retired from government service, and you get this big chunk of savings that you have to now deploy, you would be pushed towards putting money into equity markets, rather than into what your risk appetite would otherwise allow for through fixed income markets, simply because on a tax adjusted basis, you will struggle to beat inflation through fixed income and other instruments.
Now, I think one thing that we could address is remove tax as a determinant of where one puts money in when creating our asset allocation portfolio. Ideally, the way you and I would approach an investment portfolio is figure out what our risk appetite is. If it's, let's say, 15% analysed volatility, then to borrow Harry Markowitz's maxim, you do a diversification across multiple asset classes to achieve that 15% volatility, and maximise your returns against that.
That would then mean you put X amount into equity, Y amount into debt, Z amount into real estate, commodities, and so on and so forth. Now, today, that allocation is being determined largely by tax considerations. If you were to make in some way, the treatment of long term capital gains, neutral across asset classes, then that is no longer a constraint.
And we would then be guided entirely by a risk appetite in doing this risk asset allocation.
And if I can follow up on that, if you look at the composition of investors, and this is a question, in particularly in the last five years, including those who've been attracted by the slick apps, stock broking apps, and, you know, the ability to swipe their way into success or glory as they see fit. How would you say the composition has changed? And how is that in turn driving the nature of the market itself?
So I think, in fact, there was a survey done by SEBI, when I was still there. It was a survey across 93,000 households, very good comprehensive survey covering all sorts of parts of the demography of India. What we saw was, clearly, there's been a lot of entrance of young participants coming in over the last few years.
I think, particularly after COVID, there's been this remarkably high, you know, uptick in the number of people interested in capital markets. Many have come through the mutual fund route. I think the number of unique investors in mutual funds, including those with zero holdings has crossed six crores right now.
It used to be about two crores or so six years ago. So that number has dramatically improved as well. There's also been a few number of people who have taken up trading as a profession.
Now that catches the attention of people because, you know, derivatives and futures and options is something that has also been talked about quite a bit. That number is about one crore people in a given fiscal year. So FY25, we actually did the analysis.
It was about 1.1 crore unique people who participated in derivatives market.
And when you say that they took up trading as a profession, which means they were doing something else, they stopped doing that and became full time or?
We've seen bits of everything happening. We've seen people focus a lot more on trading as the primary profession. We've also seen people who are otherwise engaged in other professions, including Uber drivers, suddenly pick up index options trading also on the site. So it's been a kind of a common phenomena. As you said, the proliferation of apps and the fact that we have our digital public infrastructure has really made entering capital markets very, very easy and trading is really just a click of a button. So all of that has clearly facilitated entry of people.
This is not bad. I mean, getting people involved in capital markets. Exactly, you know, while sometimes the regulator is seen as somebody who's against speculation, we're not against speculation.
I speak for SEBI now, but SEBI is not against speculation. We need speculation, we need trading, we need derivatives, because after all, a healthy capital markets ecosystem requires instruments that build depth, that build liquidity and build opportunities for people to risk manage their portfolio. So all of that.
Can I ask you a 1 question here? How do derivatives or the kind of derivatives we see in Indian markets, add or enhance the liquidity of secondary market trading?
So let's start from first principles, like you said, in an ideal world, when you have derivative trading, let's say in futures and particularly in longer contracts, etc. Derivatives offers you leverage. So what you could, if you could buy, you know, 100 rupees worth of one share, through derivatives, through futures, you could probably buy 500 with that same 100 rupees.
So that leverage is a huge element, which draws in people who'd like to trade. Now, the other thing that derivatives allows is for hedging. So for instance, you and I, if you are investing in arbitrage funds, that essentially works in the premise that you buy in the cash market, and you sell through the futures market and therefore get a interest rate differential across the two markets.
So arbitrage, trading, speculation, all of that is facilitated through derivatives, because it's cheaper. And therefore, the volumes tend to be a lot more. Now, that then rubs off into the cash market as well, when you have a sufficient quantity of people playing in the derivatives market, the people, especially those who are arbitraging also provide a pipe between the derivative market and the cash market, that in turn enhances the cash market liquidity.
So what that means is, if you have a large investor, let's say a large sovereign wealth fund, who needs to do a shift between one stock to the other as part of a portfolio rebalancing, and therefore has to move a big chunk of flows, you know, buying one stock and selling the other stock. The fact that you have these arbitrageurs and traders provides the liquidity for them to move these funds through without really moving the market too much. Otherwise, if it was bereft of, arbitrageurs and traders and derivative markets, the markets could end up being very thin, particularly when large flows come in.
So in theory, this is extremely good, there's nothing wrong with it. What we have seen, though, which has caused us some concerns over the last few years, is our three real issues. First is that we've seen that retail participants in derivative markets, particularly in index options, have been at the receiving end and losing money.
And our research showed that for FY25, that number was 91% of all retail participants. I mentioned to you that 1.1 crore unique individuals traded. On average, including those that made money, they lost about 1 lakh rupees each. So the total loss made by the retail and the individual ecosystem was about 1.1 lakh crores. That's a sizable amount of money. This is money which could have gone into capital formation into creating new businesses and so on and so forth.
And on the other side, the people who made the money were not other Uber drivers.
They were basically institutional players. And sitting somewhere else. And by the way, a chunk of what was lost by the individuals also went as commissions to brokers and to exchanges and to SEBI, as SEBI fees, etc.
So, and of course, STT and taxes to the government. So it was transaction costs for the intermediaries and people in the ecosystem and losses. The losses likely went to large institutional players, including high frequency traders who obviously had better ecosystems of, you know, algorithms, etc.
And MIT degrees, maybe.
Yeah, so clearly, they were, you know, better adept at managing flows and therefore being on the other side. Now, by the way, typically in derivative markets, you do find that retail and globally, you do find that retailers at the receiving end and it's a simple mathematical fact that you have transaction costs when you come in. As a price taker, you're taking a bit of a spread, there are transaction costs of brokerage, exchange fees, etc.
So it is normal that the outcome will not be 50-50 in favour of the retail participant, it is likely to be 70-30 or so. But when it's 90-10 against the retail person, then that suddenly gets your antenna going up saying, you know, clearly, there's a question mark here about the awareness and suitability of some of these products to some of the retail participants, including, I'm sorry to pick on Uber drivers, but on Uber drivers who are participating here. So that was one issue that we had.
The second concern that we had, Govind, was that the volumes that we saw in the derivative markets were multiple times the volumes that we saw in the underlying cash market. In fact, before I left SEBI, I remember checking for some of the weekly contracts, both Nifty as well as Sensex. What we saw was the volumes in the index options market on expiry day was 700 or 800 times the underlying cash market volumes on that expiry day in the constituent stocks.
Now, why is that a problem? Now, as a regulator, it's our job to worry. If you have one market, which is, you know, let's say volume of x, and which determines the settlement price for another market, where the volume is 700x, that smacks of the LIBOR situation that we had many years ago, where a very tiny market determines the fate of, you know, several times larger, you know, overlaid market.
So that kind of causes question marks about financial stability, about manipulation, possible manipulation, and so on and so forth. So it's not a system that a regulator would be comfortable with. And they would want to address this possible mismatch and the implications for market stability and, you know, integrity.
The third issue that we saw was, remember, when I gave you the example of how derivatives helps the ecosystem, that is typically when 60 to 70% of the contracts are beyond one month. That's when you see the real bang for the buck in terms of, you know, volume and price discovery and depth and, you know, ability for a large fund to actually hedge for six months or one year. All that happens when the contracts are beyond one month.
So 60-70% should be beyond one month. In our case, a vast majority of the contracts expire the next week. Now, that's clearly not a healthy context.
And by the way, in one of my speeches in, I think, a long time back in July 24 or so, I quoted three papers, which are actually from the US, which showed that zero day to expiry options, which is practically index options on expiry day kind of trading, actually increase market volatility and not decrease it. Now, I would extend that to say, if something is actually causing increased volatility, there is a risk, it's detracting from capital formation, not adding to it. So these are the three real issues that we had retail losses, which seemed inordinate, and raised questions of suitability appropriateness, the mismatch in the volumes, which gave serious risks of the tail wagging the dog kind of situations, which is not healthy.
And finally, the fact that there was not enough of longer term volumes, which is where the value add and which is where the, you know, positive contribution to capital formation can happen. Now, we have tried to address this. On the flip side, Govind, there have been the reason why we've been also reticent to take dramatic action.
One is we have to remember that as a regulator, our job has to be minimalistic. Our job is not to come between willing buyers and willing sellers, unless there are very good compelling reasons to do so. And with the best of intent, we could end up doing things which have unintended consequences, and therefore impinge upon the entire ecosystem.
So we might think we know the answers, and we come and say, let's stop this or start that. But we don't know what the impact would be, because this is a very, very complicated world. The second, you know, realistic issue is many, many people in the ecosystem depend on derivatives, particularly index options for their top line and bottom line.
We know of large brokers and exchanges and clearing corporations, where between 60 to 90% of their top line comes from index options. Now, if you had to come down like a tonne of bricks and try and curb some of this, these would impact these intermediaries directly, and these institutions directly. And that in turn could impact the entire market ecosystem in ways that we don't anticipate.
So it goes back to my point about But that's not a widely known fact, is it? That the intermediaries stand to be more affected than the retail investors who we were really thinking about all this while.
So the intermediaries know it. The regulator knows it. And those that are listed entities, they have to disclose their financials.
It's very obvious in their financials that the big chunk comes from derivative markets. Not everybody is listed, but you can make out from those numbers. So this is the real, you know, lay of the land.
I think what SEBI has been trying to do over the last two years on derivatives is go as thoughtfully as possible, try and address some of these issues in a manner which is consultative, in a manner which is very open. In fact, the consultation papers we came out with in July 2024, followed by one in February 2025. These were, we poured our hearts out there.
We actually said everything that we're thinking about. And we said, please come and tell us where we are right, where we are wrong, and what would you like us to tweak here and there. On the first paper, I remember we received more than 60,000 responses as part of a public consultation.
We also had intense consultations with an expert working group that we had constituted with all stakeholders, including brokers, including investors, including exchanges, and so on and so forth. We also had our standards forum and advisory committees actually pour over this. We have plenty of discussions.
And finally, we came out with two sets of circulars, one on 1st of October 2024, the other one on end of May 2025. Both of which were steps to try and address these three issues that I mentioned, without impinging upon the other side issues that I mentioned as well. We are trying to find this golden balance.
It's an ongoing kind of journey. I have no idea what SEBI is seeing right now. Ever since I've left SEBI in October, I haven't seen the data that SEBI would otherwise see.
But I'm sure whatever SEBI does will be thoughtful based on data, based on what they see as the outcome of those steps that we've already taken. If fresh steps need to be taken, I'm sure they'll take it again in a very consultative manner. If nothing needs to be done and a lot of the issues are already addressed, then we'll probably stop here.
And I mean, we did see the budget, you know, increase the securities transaction tax, but that's a slightly different topic. Let me go back to where we started and really focus on the flows.
So you've described the Indian equity landscape quite comprehensively. And you also talked about how or why this leads to, let's say, valuations going up, the share demand and supply for paper, the presence of domestic institutional investors, which has gone up, the presence of retail investors, which has gone up, and then that's split into direct secondary markets, and of course, this burgeoning world of derivatives. Now, into this, foreign portfolio investors have come in the past, but in the last year or so, they've been mostly exiting, except that in the last month or so, they've turned around a little bit after the India-US tariff deal.
Now, how that will last or not is a slightly different issue. But let's look at what can make it simpler, if so, for foreign portfolio investors, and what are the points of friction that they're experiencing today, compared to other markets? And what could we do here on if we need to do anything? And you've already expressed some thoughts on this in the past.
That's right. So there are some things on tax, which I think can make an impact for foreign investors. But just a step back on the points that you made, just to summarise.
As you said, this is a complicated topic. I'm approaching this elephant as one blind person looking at one particular leg and describing something. There are many, many other facets, which have to be understood completely.
But the broad point I'm trying to make is, one of the reasons why I think we're seeing this ebb in capital flows, both FDI as well as FBI, is that we have this welcome trend of more domestic participants taking part in our capital markets, both unlisted space as well as listed space, that's good. But I think a lot of the incremental savings is being channelled towards equity markets, our domestic equity markets, and not enough into other alternative capital market asset classes, which is in turn causing pockets of possible overvaluation or mismatch between demand and supply in some pockets of equity market, which in turn is making it difficult for net foreign inflows to come in. To address this portion, what I would suggest is, A, we should try and move gradually if required towards asset agnostic capital gains tax regime, where you and I do our asset allocation based not on tax considerations that equity is tax friendlier than fixed income, but we do it based entirely on our risk appetite. So that's the first part.
So is there a like a model or a formula here, when you say that not enough is going into other asset classes, though we've seen a big plunge into gold of late, but let's say you talked about REITs or fixed income and other newer maybe instruments, what could be an ideal?
So let me give you a broad number, I could be off broad number. 10 years ago, the amount of fixed income that was held in mutual funds across all mutual funds put together was about twice what they held in equity. Today, the same set of mutual funds may be grown a little bit, they hold twice as much in equity than they hold in debt.
So what's happened is we've seen the shift now, it's a microcosm of what I think is a broader thing. Of course, our debt markets have gone up. But in terms of direct retail participation into debt markets, the amount that has gone into debt markets is far lower than what has gone into equity markets.
And again, something which is topical, Govind and you know this well. Remember, we used to have FMPs in the past, you know, fixed maturity plans and so on and so forth, which were tax friendly, you know, fixed income instruments for three years, five years that you would actually invest in. That product class has gone completely and entirely, I would argue because of tax considerations, right?
The fact that indexation is no longer there, and therefore, it's not attractive for people to invest there. So this is a representation of the fact that a lot of money has gone into equity markets in relation to money going into the debt markets. Again, this is a complicated topic, but it's a simple way of looking at it.
And I think if we move towards a regime where we had a tax regime on capital gains, which was asset agnostic, by the way, I'm not for a minute suggesting that equity taxation should come up to fixed income. For capital formation, for investment, taxation should be friendly. So keep the taxes low for capital formation, and keep it uniformly low across all asset classes.
I think that will make for a healthier composition of the investments and people will automatically move from equity to to debt, etc, when they see pockets of opportunities in one or the other. The second thing I would argue is, and this is kind of controversial, I would argue allow Indians to invest abroad more, right? Now, we do have LRS, but LRS is not for them.
And there are a few mutual fund schemes in which you put money.
That's right. So I'll come to that in a second.
So LRS, of course, you know, what a million dollars each of us can take out, but that's not, that's more for HNIs. The common people would struggle to go through the, you know, paperwork. Plus, imagine if you're a small person trying to open an account globally, nobody's going to pay you any attention, right?
They're more interested in getting the high net worth individuals to come out, no global relationship manager is going to bother about you if you're a tiny person coming in from India. So for the common people, we had the route of investing through mutual funds in a fund of fund of scheme where you can invest overseas, that has a limit of $7 billion. And that limit was hit a long time back, of course, you have something being released once in a while, but broadly, that limit has been kind of stopped.
I like that route. Because when we invest through that route, remember, we are investing in rupee units in India, and through Indian mutual funds, which means when we finally exit those investments, the money has to come back to India. Now, if you and I take money out through LRS, it goes and it never comes back, likely it'll never come back, it'll just stay overseas.
Here, the money has to come back into India. And I think what it helps to do is one, from an investor perspective, we get a better balanced portfolio, because global assets, it's not about patriotism, it's about having a risk friendly kind of asset allocation. And you put whatever 10-15% in global assets as part of your overall asset allocation, whatever your investment advisor or your analysis tells you is appropriate for you.
And it also helps you address this pockets of valuation, which means if I should not be restricted to investing only into Indian equities, because I simply see no other tax friendly opportunity available in relation to other markets. If that was to go away, and if I had opportunities through the mutual fund, then I would, you know, probably put a little more into global markets.
It helps in a different way. Some of the people who have exited from India, the FDI, as well as the FBI and strategic investors, what they found is, and these are MNCs that have a stake in a large stake in India, what they find is their valuations in India for their subsidiary are seven or eight times higher than the earnings price earnings that they can get in their home country. Why would you not exit a certain portion?
And so we've had companies which account where the subsidies in India account for 5% of their global sales, but 40% of the market cap globally, because of the valuations we get here. I think these kind of mismatches arise because there's not enough arbitraging flows going between domestic markets and global markets to an extent that will be helped if we had more room within the mutual fund ecosystem to invest overseas. Now, I know it's a touchy topic at a time when rupee is looking a little volatile.
Are you actually saying let's put more money outside? But I would argue that if you were to do it in stages, you know, seven to eight, eight to nine on a monthly basis, maybe over a year, you increase by $12 billion or so. I would argue that all it does is move some of RBI's reserves into our household balance sheet as rupee assets held overseas in equities, etc.
And because it will help, you know, get a better balance in our domestic markets, it will actually bring in more dollars in terms of FPI and FDI. So in a way, it's allowing the door to open so that a little bit of money flows out, and a lot more can come in, because your balance is achieved in domestic markets. So if you can't see beyond your nose, it looked like, oh, my God, this is silly, you're asking people to take out money at a time when rupees looking volatile, I would argue, unless you open your doors, people won't come in.
And net money will actually accrue when you do when you do this. So I think that's one big theme, which is an asset neutral taxation policy, which is low for investments, and allowing in a graded manner, some amount of money to be invested overseas, so that it helps investors and B, it brings a little more sanity into our local markets, and therefore brings in FDI and FPR over a medium term. The second part is in terms of friction.
Now, one thing which I've written about Govind is the tax regime that overseas investors face in India. Again, I'm not saying this is the be all and end all, there are 1000 variables in this multivariate equation, but tax is one of them. So what I've seen, Govind is that globally, in most major markets, the philosophy that the local administration follows for tax on foreign investors is a residence based taxation.
What this means is, as Indian passport holders, as Indian residents, if you and I invest in the US, in ETF in the US and NASDAQ or whatever it is, if we have capital gains in the US, you and I are not liable to pay capital gains tax in the US. (32:49) Instead, we have to declare our assets to the Indian authorities and pay capital gains tax here. So this is the OECD recommended residence based taxation model, which practically every major jurisdiction follows, except for India.
We are the aberration where we say we will follow a source based taxation model. We say you're an investor working and investing in India, you're making capital gains here, I want to see a part of that pie. And I will withhold a certain part of tax, which I determined to be your capital gains tax that you have to pay out here.
Now, this has multiple problems. First of all, anything which is an aberration and is an exception creates problems for global investors, you have to have one set of tax and operation process for the rest of the world. And for India, you have to create this entire ecosystem to support what India is asking for.
Second, there are plenty of global investors, large ones and good ones who are actually exempt from paying any capital gains tax in their home country. So imagine if you have zero capital gains tax to be paid globally, and you're being charged or you've been deducted for withholding tax in India. What do you set that up against?
So despite the presence of double tax avoidance treaties, you are being withheld, taxes are being withheld here, which you cannot get a set off in your home country, because there's no tax liability out there. Second, even if I'm liable to pay capital gains tax, so if I'm a HNI in the US, and I'm earning a lot of money, and I've got lots of investments, then I'm probably liable to pay 20% capital gains tax in the US as a US citizen. If that citizen was to invest in India, you have to get a set off against the withholding tax.
But when they invest through a fund, and when they withdraw the money eventually, what the fund will do is give them a provision for withholding tax, because the fund itself is not paying taxes yet, it might pay much later. In the NAV, they will give a provision for withholding tax. Getting a set off for a provision for withholding tax against the tax payable in the US is next to impossible.
So you end up paying two times the Finally, the third, again, very, very silly thing, we calculate capital gains on rupee basis. So if I'm a global investor investing in India, given the recent rupee depreciation on a net basis, I might actually have a loss. But in rupee terms, I might see a profit.
And then I'm being charged withholding tax on the rupee basis when actually for my home country, I'm actually having a loss. So all of this creates a lot of issues. One of the things that we are hoping to achieve over the next few years, whenever it is it is deemed necessary, is maybe we should also move towards a residence based tax model for foreign investors.
This is both across FDI as well as FBI. Now, this might again sound politically wrong, saying, Oh, my God, you're taxing domestic participants 12 and a half percent or whatever. And you're letting these foreigners go tax free.
That was the reason why we're doing it or that thinking was what drove this.
I'm saying that thinking is warped. And this nobody's exempting anybody from capital gains tax. All we are saying is you please pay the tax that you are liable to pay in your home country. Now, if you're coming from Singapore, and capital gains tax in Singapore is zero, the debate to have is why is India having an LTCG which is much higher than Singapore?
It's a generic question across two jurisdictions. So nobody's being exempted. We are simply saying you, we follow the global model of you pay the tax that you're liable to pay in your home country, we will not charge you out here.
So if you had something like this, then the question about, the Tiger Global Fund, etc, wouldn't even arise. Because the moment you're a foreigner, we don't bother you with tax here locally. Now, I know this is a charged topic.
I know there are lots of passionate feelings about this. I just think that if we with a cool head, look at the entire landscape, we are not doing anybody a favour by exempting or not having a withholding tax in Indian jurisdiction. (36:39) We are simply following the global model.
If the global model was to move eventually given geopolitics and all the changes which are happening, then fine, we can also move there. But we can't be an aberration. And currently by being an aberration, we are increasing the friction, we are making one, we are adding to the set of reasons why foreign investors are looking at India and asking and saying, should I really come here?
And plus with all this, if you add the legal and the judicial questions and you know, questions which arise, it just adds to the narrative that India is a complex place to work in. Why do we want to add to that? This is within our control.
So I think given that, look, if you start with the premise that we are a capital starved country, and we need investments to come into the country and we have a compelling story, we have a fantastic set of macros, people like India, they want to come here. We've got to make it easy both for domestic investors and for global investors to come and contribute to capital formation. This is and treating capital flows as a taxable event and concentrating on that as a taxation event is, I think, I'm sorry to be dramatic here, but I think it's a bit like trying to tax the proverbial goose that's laying the golden eggs.
Where you can apply the taxation is after the eggs have come out, not at the time of, you know, the actual laying of the eggs. You feed the goose whatever it wants, excited to produce more, but don't tax it.
And we've obviously had this regime for a long time now. And we've also seen portfolio investments steadily rise in this period. The turnaround has only happened in the last year or so.
I mean, the dramatic turnaround in terms of even FII holding as percentage of Indian capital markets, which has been over 17-18%, which has now come down, of course. So then what's, so why did everyone come in knowing all of this? And why did they turn around?
Just to sort of academically close off that loop. So again, the caveat again, this is a complex multivariate equation. To say tax policy versus capital flows is not easy.
Obviously, there's some growth in the economy.
That's a caveat. Second thing, this is not, they've been there forever. Remember, for a long time, LTCG was zero.
So 2018, when we shifted towards coming back to LTCG, that's when this withholding tax issue came back. So it's a recent phenomenon. If I see from the time that LTCG came back, and therefore withholding tax came back, there has been one year where we've seen a couple of years where we've seen spectacular inflows.
That's also admitted. So for instance, during COVID year, we saw over $30 billion in that fiscal year. I don't know what the exact numbers, but it was very, very large amount of inflows that came in.
So it's not as if people have not come in. But the reality is, if I look at the aggregate flows, Govind, between the time that LTCG was reintroduced to now, and I'm not saying correlation is causation. I'm simply saying, if I aggregate the numbers, the numbers are much lower than they, even in absolute terms, forget about percentage terms, than they were previously.
Now, again, I hasten to add, this is not correlation equal to causation. But I can tell you this, having met several FPIs when I was at SEBI, in fact, the chairman, Mr. Pandey, and I, the last six months of my tenure there, we went to six centres globally, we met 700-800 FPIs, both together as well as in one on ones. Many of them give this feedback, that you know, you're an aberration when it comes to taxation.
And there was a lot of study done I did personally and SEBI did as well to actually corroborate that. So all that I've told you is a result of all the thinking and discussion that happened. So I'm not saying this is the panacea and that you change the taxation policy and a flood of money will come in.
It's not that simple. But there is no doubt in my mind that this is an irritant, which is causing people to think before they come into India. And this is something within our control.
Okay, last question. So one of the points that you've also talked about is expanding the definition of investors. (40:28) And what that means is that, how do you allow more investors to come in without having to go through mountains of paperwork? And you've had some thoughts there.
Right. So, you know, historically, Govind. European, for example.
Yeah. So historically, we've been very careful about global flows, ever since FPIs were allowed in the mid 90s or so. You'll remember all the controversies that periodically come up around p notes.
Is it promoter money roundtripping and coming back to prop up a particular asset and so on and so forth. So for us, one of the and because you're not capital con convertible, that kind of adds to the questions of possible circumvention, etc. So for us, knowing the colour of the money has been extremely important, particularly on occasions, right?
Now, by the way, the other irritant, which FPIs tell us about is, I know they can start trading in Hong Kong or in Singapore, with 24 hours notice, whereas they struggle to come into India, you know, they have to navigate SEBI, they've got to navigate RBI, the tax authorities, and you know, the lawyers and accountants and so on and so forth. Now, the way I would look at this is a risk based approach. It's true that in some cases, we have to be very, very cautious about who's behind a particular fund.
So if it's a SPV in an island nation, where there are privacy laws, and therefore, it's very difficult to find out where the money is coming from, unless you went through a very, very deep legal process, which is next to impossible. Obviously, you have to be very, very careful about that kind of money coming in, and maybe taking outsized position in a particular corporate group, that would raise all sorts of questions, right? At the same time, we shouldn't try and paint all funds with that single brush.
So examples are, you know, 80% of the funds that come into India, the assets under management that come into India, through FBIs, come through either sovereign wealth funds, or through insurance companies and pension funds, or through mutual funds in jurisdictions like Europe and the US. So think of it this way. If I have a entity which is a tiny entity, which is not publicly listed, and they're doing some large investments, domestically, I would have a lot of questions.
But if it's a large mutual fund scheme, HDFC, or SBI mutual fund, or an ICICI, whoever, investing, I would have zero questions, because I know it's an independent fund manager, who's taking a pool of money from diverse investors, and doing a diverse set of, you know, investments. So a similar situation exists with many mutual funds, both in the US and in Europe, for examples. So we talked about this earlier, there is something called the USITS in Europe, which is the undertaking for collective investments in transferable securities.
It's the equivalent, I would argue, of our mutual fund ecosystem in India. The way it works is, that necessarily has to be a pooled vehicle of collective investment schemes, where there are restrictions on how much an individual investor can bring in. It has to be a pool vehicle with Prorata and Paripasurites, which means that I cannot, as an investor, say I will only invest in a particular asset.
It's a blind pool, which will invest into all assets that the independent fund manager decides to invest in. And on the manager, there are restrictions on how much they can invest in a particular name themselves. There has to be diversification across groups and names, etc.
So this is akin to a large mutual fund in India doing an investment. Why would I have questions about that? So what I've been suggesting is, we should make it extremely easy for such funds, a sovereign wealth fund, an insurance company, a pension fund, or USITS, which are like collective investment schemes, which many jurisdictions count as a gold standard for investment kind of vehicles.
Similarly, trusts and mutual funds in the US under SEC, these are by definition, a lot more safer. And they don't raise questions about parentage and where the money is coming from, etc. For them, we should be able to provide a diplomatic passport saying, please come into India, we will give you the status equal to that of a domestic, you know, financial institution, insurance company or a pension fund here.
And you do whatever it is that our domestic institutions can do. You want to invest in a listed security, be our guest. You want to invest in unlisted, including in debt, including in hybrids, including in loans, go ahead.
Why would we have a question with that? So I think rather than painting everybody with one brush, and forcing everybody, including whom we trust, to fill out 100 forms, to actually give us a list of all their authorised signatories with wet signatures, evidencing what their signatures look like. Why would you subject well regulated people where we can get a confirmation from our corresponding regulator, that these people are clean, we're looking at them, don't worry about them?
Why on earth would we not give them a diplomatic passport? Now, this is again, a touchy subject, because people are afraid of this being misused to bring in money for nefarious purpose, etc. But I'm saying if we have a dialogue, and particularly after the EU, you know, treaty, and which talks about investments, as well as trade flows, there's no reason why we can't have a detailed dialogue, you know, arbitrated by our ministry and the EU ministries across ESMA, across the local regulators in Luxembourg, or in Dublin, and with RBI, SEBI, the Ministry of Finance, and all of them, all of us coming together and saying, okay, let's understand how you ensure that these people are clean. Let's get comfort around that.
Let's define a protocol where you certify to us that this particular person I'm looking after, and I know this person is clean. And we'll give them a diplomatic access to our capital markets to so that both of us are happy. They want to diversify and come into India, we want to draw in our fair share of capital from the global markets, all of us are happy, right?
So, and then if you want to make life tougher for the opaque SPVs, which we think are doing funny things, by all means, let's make it really tough for money, which is looking a little funny to pass through a litmus test and Agni Pariksha before it comes into the country, no problem with that. I think this risk based approach is important.
There are so many more points I'd love to touch upon and we've run out of time. I think you've raised a lot of questions and pointers on the structure of the capital markets, on what we can do to make it safer, deeper, wider, and really make investor or investing a much more fun play thing to do, rather than a stressful thing to do.
So, but we will come back to some of those issues in coming, hopefully in forthcoming conversations. So thank you so much for joining me today.
Thank you so much for having me, Govind, really appreciate it.
Thank you.
