The Flight to IFSC

On February 29, when Finance Minister Arun Jaitley announced the tax bonanza for International Finance Service Centre (IFSC), it became certain that India's first IFSC in the Gujarat International Finance Tec (GIFT) City is a reality. The FM waived off securities transaction tax (STT), commodity transaction tax (CTT) and long-term capital gains (LTCG) on financial trades and transactions in IFSC. He also abolished the dividend distribution tax (DDT), while reducing the minimum alternate tax (MAT) to 9 per cent from 18.5 per cent, thus making IFSC an attractive proposition compared to its peers in the region.

However, the waiving off all taxes can pave the way for the downfall of the Indian domestic market. Foreign institutional investors (FIIs), the lifeline of the Indian equity market, are likely to migrate to IFSC because, besides the tax benefits, financial transactions there will happen in foreign currencies, eliminating their average loss of 5-6 per cent every year due to rupee depreciation.

India's equity market has four main participants - retail investors, proprietary traders, domestic institutions and FIIs. Opening up of IFSC would see FIIs and proprietary traders move to trade in IFSC. Today, almost 60 to 65 per cent of volumes are contributed by FIIs and proprietary traders, and if these two players move out of the market, it would drain out liquidity from the domestic equity market.

But there is a larger concern - stability of the Indian capital market. Domestic institutions - mutual funds and insurance companies - have been a big support for the market in the past couple of years. During the recent commodity crisis, domestic institutions supported the Indian markets when there was sustained selling across the globe by FIIs. Thanks to their buying, India largely remained unaffected.

The global financial crisis of 2008 has been the best example of the impact of rapidly opening up of financial markets and what it can do. While IFSC will have trades predominately between FIIs, its ramifications are huge. Today, Indian securities and indices are traded overseas including in the Singapore Exchange, but those are in derivatives only. In the absence of a spot market, the volatility is less, but IFSC will have a spot market as well as a derivative market. Therefore, with an underlying available to reflect price movement, it can cause huge volatility.

A few years ago, in a freewheeling chat, a top official of market regulator Sebi had mentioned that the government didn't want retail investors to participate in the equity market, as it feared investor rage in the event of a scam. Instead, the preferred route for retail investors is through mutual funds. Now, when things seem to be improving, with investors preferring the mutual fund route for equity investment, IFSC could act as a dampener even for the growth of retail participation in the equity market.