Research and analysis

India: budget and implications for the financial sector

Published 24 July 2014

0.1 Detail

FINANCIAL SECTOR REGULATORY REFORM:

The Budget indicated a commitment to implementation of some of the important recommendations of the Financial Sector Legislative Reforms Commission (FSLRC) like the enactment of the Indian Financial Code considered necessary for better governance and accountability. The government will also put in place a modern monetary policy framework in consultation with the RBI.

Implications:

The commitment to carrying forward the work on financial sector regulatory reform continues the policy initiated by the Congress led United Progressive Alliance government. Various administrative recommendations of the FSLRC are being implemented by the regulators; details of which are not yet available. Some aspects of the Indian Financial Code (IFC) will require combining regulatory powers. The IFC will ensure greater harmonisation of legislation between India and the UK. A new monetary policy framework could involve an inflation targeting framework as per the recommendations of the Urjit Patel Committee.

INSURANCE:

The budget has proposed an increase in the composite FDI cap in insurance to 49% from the current 26%, with full Indian management and control. Currently FDI up to 26% in an insurance company is permitted through the automatic route (without government approval). An increase in FDI beyond 26% in an insurance company will require Foreign Investment Promotion Board (FIPB) approval. It has also proposed that the pending Insurance Laws Amendment Bill be taken up for consideration by the Parliament.

Implications:

Increase in the FDI cap in the insurance sector requires parliamentary approval of the Insurance bill, which has been pending since 2008. The budget does not specify the modalities for increasing the FDI limit without passage of the insurance bill. Apart from allowing an increase in the FDI limit, the passage of the bill in its current form would also permit the entry of Lloyds and other international re-insurers. An increase in the FDI limit in the insurance sector automatically implies an increase in FDI in the pensions sector as well.

BANKING:

An estimated capital infusion of Rs2400bn (£24bn) is required in Indian public sector banks by 2018 to comply with Basel-III norms. It is proposed that this capital requirement would be met in a phased manner by issuing shares to retail investors while preserving public ownership. The proposal to give greater autonomy to banks will be examined. RBI will create a framework for licensing differentiated banks and continuous authorization of universal banks in the private sector. Six new Debt Recovery Tribunals to deal with rising Non Performing Assets of Public Sector Banks have been announced.

Implications:

In line with the emphasis on good governance, the government is considering the recommendations of the Nayak Committee which involves establishing a bank investment company to manage the government’s stake in banks. The differentiated licensing regime will benefit UK financial services firms offering niche services.

INFRASTRUCTURE FINANCING & PRIORITY SECTOR LENDING:

To encourage long term financing for infrastructure, banks will be encouraged to extend long term loans. On the liability side, banks will be permitted to raise long term funds for lending to the infrastructure sector with minimum regulatory pre-emptions such as Cash Reserve Ratio, Statutory liquidity Ratio and Priority Sector Lending (PSL) targets.

Implications:

Banks will now be able to issue long term bonds and lend long term to infrastructure projects, subject to only minimum requirements for mandatory cash reserves, investment in government securities and PSL targets. This is likely to encourage banks to increase lending to infrastructure.

CORPORATE BOND MARKET AND INTERNATIONAL SETTLEMENT OF INDIAN DEBT:

The Budget indicated commitment to developing a vibrant, deep and liquid corporate bond market and currency derivatives market. To this effect, a lower 5% withholding tax regime initially introduced in 2013, was extended from March 2015 to June 2017. The Budget also permitted international settlement of Indian debt securities.

Implications:

Permitting international settlement of Indian debt securities could be seen as a precursor to listing Indian government bonds on an international bond index and making them Euro-clearable. But the budget itself does not give details of how International Settlement will be achieved.

LIBERALISING THE DEPOSITORY RECEIPT REGIME:

The budget announced liberalisation of the American Depository Receipts (ADR) and Global Depository Receipt regime (GDR) to allow issuance of depository receipts on all permissible securities. Completely revamping the Indian Depository Receipt (IDR) scheme to introduce a much more liberal and ambitious Bharat Depository Receipt (BhDR) is also proposed.

Implications:

Currently issuance of depository receipts (DRs) is permitted only against equity. The proposal to allow issuance of DRs against all permissible securities is in line with the recommendations of the Sahoo Committee. This is likely to see more companies accessing overseas markets. Standard Chartered is the only company that has listed Indian depository receipts. Details of the BhDR scheme are not yet known, but the government hopes that a revised scheme would attract more MNCs to list in India.

FOREIGN PORTFOLIO INVESTORS AND FUND MANAGERS:

The budget announced uniform and inter-usable Know Your Customer (KYC) norms and a single demat account for all asset classes. The budget also announced that Foreign Portfolio Investors (FPIs) and their fund managers will be subject only to capital gains taxes from transaction of securities in India.

Implications:

Elimination of tax uncertainty for FPIs and fund managers by introducing a tax on capital gains is expected to support foreign inflows. Fund managers of FPIs, especially those of Indian origin located in the rest of Asia, are likely to shift base to India. However clarification is needed on whether this change creates a meaningful tax risk for some FPIs who are investing directly from jurisdictions like the USA, UK and Japan (countries with whom India’s Direct Tax Avoidance Agreement does not allow for exemption of capital gains tax).

TRANSFER PRICING:

In order to reduce litigations on transfer pricing regulations, it has been proposed to strengthen the framework for Advance Pricing Agreement (APA) scheme introduced in 2012. A “Roll Back” provision in the APA scheme has been introduced, with effect from 1st October 2014, so that an APA entered into for future transactions may also be applied to international transactions undertaken in previous four years in specified circumstances. Greater flexibility in determining arms length price including allowing a range concept and using multiple year data has also been proposed.

Implications:

The proposals on transfer pricing are expected to bring Indian transfer pricing regulations in line with global standards. It will also reduce litigation costs, number of pending cases and encourage taxpayers to apply for the APA scheme. The provisions with regard to comparability of transactions in determining the arms length price have, however, not been included in the Finance Bill which accompanies the budget and may require amendment to the Income Tax Act.

REITS and INFRASTRUCTURE INVESTMENT TRUSTS (InvITs):

The Budget announced tax pass-through status for REITS and InvITs. InVITs, similar to REITS, would pool resources for investment in PPP and other infrastructure projects. The amendments on REITS and InvITs are expected to come into effect from October 1, 2014.

Implications:

SEBI has issued draft guidelines for REITS but tax considerations had been a hindrance to the development of the REITS market. With the clarification on tax treatment, the REITS market in India is expected to attract the interest of foreign and domestic investors.

ACCOUNTING STANDARDS:

In order to converge with International Financial Reporting Standards (IFRS), adoption of the new Indian Accounting Standards (Ind AS) has been proposed voluntarily from 2015-16 and mandatorily from 2016-17. Regulators will separately notify the date of implementation of IndAS for Banks and Insurance companies, depending on international consensus.

Implications:

The introduction of the new accounting standards will help India meet its commitment to the G-20 on convergence with IFRS. Convergence with international accounting standards is expected to strengthen Indian capital markets by supporting greater foreign financial flows.

0.2 Comment

The Budget has taken forward measures on financial sector development initiated at various points by the Congress led United Progressive Alliance Government. Further details on the specifics of implementation by the government and regulators is now awaited.

Areas of UK interest, including FDI in insurance should further develop the UK –India commercial and economic relationship. Reduced regulatory requirements such as minimum priority sector lending targets for infrastructure lending should be helpful to UK banks.

0.3 Disclaimer

The purpose of the FCO Country Update(s) for Business (”the Report”) prepared by UK Trade & Investment (UKTI) is to provide information and related comment to help recipients form their own judgments about making business decisions as to whether to invest or operate in a particular country. The Report’s contents were believed (at the time that the Report was prepared) to be reliable, but no representations or warranties, express or implied, are made or given by UKTI or its parent Departments (the Foreign and Commonwealth Office (FCO) and the Department for Business, Innovation and Skills (BIS)) as to the accuracy of the Report, its completeness or its suitability for any purpose. In particular, none of the Report’s contents should be construed as advice or solicitation to purchase or sell securities, commodities or any other form of financial instrument. No liability is accepted by UKTI, the FCO or BIS for any loss or damage (whether consequential or otherwise) which may arise out of or in connection with the Report.