Tax Havens Can de-stabilise Our Financial Markets

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Tax Havens...

Tax Havens Can Destabilize OurFinancial Markets

R. Vaidyanathan*

There is a significant rise in Indian investments in tax havens. Outflowof investment from India was $16.07 billion in 2008-09 as compared to$18.1 billion in the previous fiscal. Not only in-bound flows but alsooutward flows are linked with tax havens and the flows are notnecessarily linked with the performance of our economy but with thehappenings in other markets and the level of pressure on tax havens byOECD and more particularly USA. A significant portion of our illegalwealth of India is kept in banks in Switzerland, which is a major taxhaven. Nearly 1 trillion dollars out of 2.8 trillion dollars of Swiss moneyis black money. Out of this 1 trillion USD (nearly Rs 50 lakh crore ournational income) in Swiss banks, how much belongs to the elite of Indiais an issue to unravel. It is the developing countries which are impactedmore due to this flight of capital and hence India should take the lead.

The recent disclosure on thegrowth rate during the second

quarter of the 2009-2010financial year has brought lots of cheersamong policy planners and investors.Quarterly GDP at factor cost at constant(1999-2000) prices for Q2 of 2009-10 isestimated at Rs. 8,34,780 crore asagainst Rs. 7,73,850 crore in Q2 of 2008-09, showing a growth rate of 7.9per cent over the corresponding quarterof the previous year. It is also to be

noted that the GDP at factor cost at

*R. Vaidyanathan is Professor of Finance, Indian Institute of Management, Bangalore. Theviews are personal and do not reflect those of his organization.

current prices in Q2 of 2009-10 isestimated at Rs. 12,79,500 crore, as

against Rs. 11,75,633 crore in Q2 of 2008-09, showing an increase of 8.8 percent. In terms of GDP at market prices,the rates of Gross Fixed CapitalFormation (Investments) at current andconstant (1999-2000) prices during Q2of 2009-10 are estimated at 36.3 percent and 34.7 per cent, respectively, asagainst the corresponding rates of 37.1per cent and 34.5 per cent, respectively,

in Q2 of 2008-09.

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We find that the growth rate in theeconomy continues to be spectacular inthe given global situation and ourinvestment rate is also substantial ataround 36 per cent. Continued growthrates above 7 per cent on quarterly basisgive raise to the possibilities of Indianeconomy reaching above 9 per cent ratein the coming years. This growth rate inthe last decade has been primarilyachieved due to our domestic savingswhereas the role of foreign flows isrelatively minimal.

Table 1 shows the share of savingsand foreign flows in our economy in thelast few years. We find that a

predominant portion of our investmentshave come from our domestic savingsand that too from household savings

(around 70 per cent) whereas foreignfinancial flows are relatively small,attaining a maximum of 14 per centduring 2007-2008 but have fallensignificantly in 08-09. ForeignInstitutional investments or portfolioflows have become negative.

We have different types of foreignfinancial flows into our economy. Themajor ones are

Trade flows arising out of ourmerchandise exports.

Flows due to our invisibles consisting mainly of service exports andremittances from Indian laborersabroad.

Foreign Direct Investment for settingup of factories and other infrastructureprojects.

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Eternal India, January 2010

Table-1 Savings and Foreign Flows (in crores)

Year 94-95 00-01 05-06 07-08 [QE] 08-09

Gross Domestic Savings(GDS)

251463 497218 1156809 1779614 n.a.

Household Sector(% GDS)

199358(9%)

442136(89%)

797117(0%)

1150135(65%)

n.a

Foreign Investmentinflow (% of GDS) of which

16133(6.4%)

31015(6.3%)

94981(8.2%)

248017(14%)

n.a

Direct Investment 4126 18406 39674 138276 161481

Portfolio Investment 12007 12609 55307 109741 [63618]

(QE is quick estimates; n.a. not available)Source: Table-10; page xxxix; National Accounts Statistics 2008; CSO and Table161/159 Hand Book of Statistics on Indian Economy 2009; RBI-Mumbai.

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Foreign Institutional Investments, or

what are called portfolio investments, inthe stock market for bonds and equities.

International aid throughdonors/institutions.

Flows due to funding of NGOsregistered under the ForeignContribution Act regulations with theMinistry of Home Affairs.

Flow of Funds in TheIndian Economy

We find from the flow of funds in theIndian economy, as published by RBI,suggests that the share of all financialinstitutions (AFIs) in total claims issued(i.e., secondary issues) has moved upfrom 31.7 per cent in 2001-02 to 44.1per cent in 2007-08. The share of non-financial institutions, on the other hand,declined from 68.3 per cent in 2001-02to 55.9 per cent in 2007-08. The risingtrend in the share of AFIs correspondsto the boom period. Acceleration ingrowth rate in GDP from 2002-03 to2005-06 has led to larger resourcemobilization by the financial sector,indicating growing financialintermediation.

The RBI report on Flow of FundsAccounts of the Indian Economy 2001-02 to 2007-08 says:

The Rest of the world [ROW] sectorcaptures the transactions betweendomestic and external sectors. With arange of liberalization measures

undertaken both on the current andcapital account, ROW sector steadilygained prominence in the economy.While India adopted the convertibility of rupee for current account transactions byaccepting the Article VIII of the IMF in1994, various measures have beenundertaken to further liberalize thecapital account as well. The norms forexternal commercial borrowings (ECBs)and foreign direct investment (FDI) werefurther relaxed and limits of investmentwere increased. The foreign institutional

investors (FIIs) were allowed to invest inGovernment securities subject to certainlimits. Reflecting this, net capital inflowas percentage to GDP increased from 1.8per cent in 2001-02 to 9.2 per cent in2007-08. Increased liberalization of current as well as capital accounttransactions has resulted in largerinflows and outflows between thedomestic sectors and ROW. Gross flowsto ROW increased from 6.5 per cent of total financial flows in 2001-02 to 13.0

per cent in 2007-08 Increase in uses vis--vis sources of ROW since 2004-05indicate larger capital inflows into theeconomy.(http://www.rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=10680)

InvisiblesThe Economic Advisory Council to

the Prime Minister, in its report titled Economic Outlook for 2009/2010 says:

Net invisibles, including non-factorservice exports, worker remittances,income from tourism and travel and

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investment income flows aggregated$89.6 billion in 2008/09, an increase of 21 per cent over the previous year.

The two main components of netinvisibles are service sector exports(software & business processoutsourcing or BPO) and remittancesfrom Indians working overseas. A partof the latter derives directly fromactivities of Indian software and BPOcompanies in overseas locations. Theindustry association, NASSCOM hadestimated in July 2009 that exportearnings in 2009/10 would be at USD47 compared to USD 45 last year.

The economic downturn had anegative impact on the level of remittances which were USD 44 billionin 2008/09 and were expected to beUSD 50 billion in 2009/10[http://pmindia.nic.in/Economic_Outlook_Final.pdf ]

This was before the Dubai meltdown.

But we see that software exports andworker remittances are nearly the samein the past few years.

NGO FundingThe other major inflow is due to

funding of NGOs by internationalgovernment and non-governmentalagencies. According to Ministry of Home Affairs website, there are nearly34,000 NGOs registered under theForeign Contribution Regulation Act(FCRA), 1976. In all, Rs. 65,000 crorewas received from abroad between 1994and 2007. Annual receipts have gone upfrom Rs. 1,865 crore in 1994 to Rs.12,290 crore in 2007. Moreinterestingly, around 50 per cent of theassociations do not file reports. Thewebsite of most large NGOs do notprovide details of their balance sheetetc. even though many call themselvesas Civil Society (as if others arecriminal society!!) and insist ontransparency by everyone .Perhaps, itdoes not apply to them.

This writer has tried for many years tocollect the annual financial reports of major NGOs, but without success.Many of these NGOs spend, accordingto the Home Ministry website, themaximum amount on overheads,including foreign junkets.

These flows are also sometimes used

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According to Ministry of Home

Affairs website, there are nearly34,000 NGOs registered underthe Foreign ContributionRegulation Act (FCRA), 1976.Annual receipts have gone upfrom Rs. 1,865 crore in 1994 toRs. 12,290 crore in 2007. Around50 per cent of the associations donot file reports. The website of most large NGOs do not provide

details of their balance sheet etc.

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for activities not conducive to social

cohesion. The International NarcoticsControl Strategy Report MoneyLaundering and Financial Crimes(March 2009) by the US StateDepartment suggests that 30-40 per centof the inflows may be through hawalachannels which are not accounted for.During 2007-2008, according to thisreport, formal inflows into India wereUSD 42.6 billion. So 40 per cent of thisamount, USD 16- 18 billion, could beconsidered illegal flows not under thegaze of law. Recently, the governmentincluded NGOs and other trusts alsowithin the ambit of Prevention of Money Laundering Act (PMLA), 2002,by a notification in the Official Gazetteon November 12.

Foreign Institutional FlowsAmong all the inflows, these are

really important from the point of taxhavens. As we pointed out in our essayin Eternal India (April 2009):

In the domestic capital market,substantial inflow of money comes fromthese tax havens by shell companies orby entities that do not want to beregistered. India knows that these taxhavens distort global resource allocationas well as domestic initiatives inenhancing government coffers. Theyencourage venality and are also possiblesources of substantial drug and terror

money. For instance, Securities and

Exchange Board of India took stringentaction in 2007 to phase out ParticipatoryNotes (PNs), not registered by FIIs,from the Indian share markets sincemost of these exotic instruments wereissued to/by anonymous entities notregulated by SEBI. The Board pointedout that nearly 50 per cent of the fundsflowing in were through entities notregistered under it. The PNs hadbecome the most preferred instrumentof investment, with the largestinvestments from abroad in the Indianstock market routed through them. Theamount invested through PNs in Indianstock market increased by several timesafter the UPA government assumedoffice. The notional value of investmentin PNs, which aggregated Rs 31,875crore in over 10 years up to March2004, burgeoned to Rs 3,53,484 crore

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The author of this article hastried for many years to collectthe annual financial reports of major NGOs, but withoutsuccess. Many of these NGOsspend, according to the HomeMinistry website, the maximumamount on overheads, includingforeign junkets. These flows

are also sometimes used foractivities not conducive tosocial cohesion.

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by August 2007, i.e., increased by over11 times in just 40 months! Investmentsthrough PNs constituted 20 per cent of all FII investments in 2004. Thisincreased to over 51.6 per cent inAugust 2007. Thus, in 2007, more thanhalf the FII investments were throughanonymous PNs. The sub-accountscreated by the FIIs for these namelessentities are fraught with dangerousconsequences and security risk. Thesources of these funds are unknown; theinvestors are nameless; and billions of dollars invested through PNs areaddress-less. Know Your Customernorms, which the law makes itmandatory for opening simple banksaccounts by Indians in this country, arenot followed while allowing investmentof billions of dollars in the Indian stocksmarket. The PN mechanism throughwhich unnamed investors participate inour markets, invest and disinvest stocksworth billions of dollars and make andrepatriate profits is thus a mystery

wrapped in a puzzle, packed in an

enigma, crammed inside a conundrumand delivered through a riddle. Theclamour for this form of investments isintriguing, if not outright suspicious.Many experts felt that PNs wereWeapons of Mass Destruction (WMD)of our stock markets. Actually, SEBIhad proposed that FII and their sub-accounts not be allowed to issue orrenew offshore derivative instruments.It also wanted them to wind up theircurrent revoked under pressure from theCentral government.

The ban proposed by SEBI was laterwithdrawn under governmentinstructions after the global meltdown.It is important to note that during themeltdown in 2008, nearly USD 16billion were withdrawn from ourmarkets, and the Sensex index whichwas above 20,000 during the beginningof 2008 plunged to less than 8,000 bythe end of 2008.

The pullout of these USD 16 billionwas not related to the performance of Indian economy, which was still abovethe 6 per cent growth rate but due torequirements of funds in othermarkets since liquidity was drying up inother markets.

It was generally believed that PNs arenot to be issued to Indians, namelyIndian residents/NRIs/PIOs/OCBs etc.,essentially to deny Indian entities

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The sub-accounts created byFIIs for nameless entities arefraught with dangerousconsequences and security risk.The sources of these funds areunknown; the investors arenameless; and billions of dollarsinvested through PNs areaddress-less.

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particular, as half the worlds secrecy

jurisdictions are located inCommonwealth countries, Crowndependencies or British OverseasTerritories. London, it said, was at thecentre of a network of satellite

jurisdictions and although it ranked themost transparent of the jurisdictionsin the index, had the potential to domore harm than small islandhavens because of its more importantrole in global offshore finance.(http://www.christiantoday.com/article/ christian.aid.unveils.list.of.most.secretive.tax.havens/24507-2.htm )

It is also mentioned in another reportby Times of India that nearly half of theRs 70,000 crore in offshore investmentthats come into Indian bourses thisfiscal, till October, is from alleged taxhavens such as Mauritius, Hong Kongand Luxembourg the three togethercontributing almost Rs 25,000 crore of the net inflow from FIIs. Thegovernment is little worried about thefact that a huge chunk of this investmentis coming from alleged tax havens suchas Mauritius, Hong Kong andLuxembourg. What can be of concern tothe government is the rising share of PNs in the total FII inflow into stock markets. Since the identity of PNinvestors is not revealed, thegovernment had put a tight leash lastyear on such investments after it feared

that some dirty money might have

entered the market, riding on PNs. Poormarket conditions towards the end of 2008 had, however, forced thegovernment to remove restrictions onPNs, but it had asked FIIs to register inIndia rather than invest through PNs. Itis estimated that of the net FII inflowsof Rs 44,000 crore during September-October, nearly a third or Rs14,000 crore was through PNs.(http://timesofindia.indiatimes.com/biz/ india-business/50-of-FII-investment-comes-from-tax-havens/articleshow

/5259167.cms )Not only that, there are reports that

there is significant rise in Indianinvestments in tax havens. Outflow of investment from India was $16.07billion in 2008-09 as compared to $18.1billion in the previous fiscal (see Table-2 on the next page). The Outward DirectInvestment (ODI) included both equityand loan. Singapore retained thenumber one spot in the list of India Incsfavorite investment destinations, withIndian companies investing $3.6 billionin that country in 2008-09. But theinvestment of $3.6 billion in Singaporewas a 56 per cent drop from the $8.3billion the city-State received fromIndian companies in 2007-08.

The Netherlands came next withIndian companies investing $2.77billion in 2008-09, up from $1.93

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billion in the previous financial year.Tax havens such as Cyprus and

Mauritius received $2.25 billion and$1.8 billion, respectively, in 2008-09.They were followed by the US with$873.58 million worth of investmentsfrom Indian companies in 2008-09, theUAE ($791.78 million), Russia ($676million), tax haven Isle of Man ($334.7million), China ($246.03 million) andanother tax haven British Virgin Island(230.48 million) in 2008-09.Significantly, outward investment to taxhavens rose significantly from 2007-08to 2008-09.

In the case of Mauritius, it went upfrom $1.4 billion (in 2007-08) to $1.8billion (in 2008-09), Isle of Man($124.97 million to $334.7 millionduring the same period), Cyprus (from$544 million to $2.25 billion).

However, investments to countries suchas the US, the UK and Singapore fellduring the corresponding period.

It reveals that not only in-bound flowsbut also outward flows are linked withtax havens and the flows are notnecessarily linked with the performanceof our economy but with the happeningsin other markets and the level of pressure on tax havens by OECD andmore particularly USA.

A significant portion of our illegalwealth of India is kept in banks inSwitzerland, which is a major taxhaven. Nearly 1 trillion dollars out of 2.8 trillion dollars of Swiss money isblack money, says Konrad Hummler,Chairman of the Swiss Private BankersAssociation. ( Swiss Review , August2009). In August 2009, one Swiss franc(CHR) was nearly the same as one US

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Table-2:Top Ten Destinations for Outbound Investments

Country 2008-09 2007-08Singapore 3681 8352Netherlands 2776 1936Cyprus 2256 514Mauritius 1805 1467USA 874 1096UAE 792 784Russia 676 366Isle of Man 335 125China 246 35British Virgin Islands 231 806

(USD in millions)Source: Business Line (August 09, 2009)

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dollar. He says that Switzerland has

become a paradise for foreign capital onwhich tax is not paid. The uproar fromforeign governments isunderstandable. Out of this 1 trillionUSD (nearly Rs 50 lakh crore ournational income) in Swiss banks, howmuch belongs to the elite of India is anissue to unravel.

Recently, there was a report that UBS,the Swiss bank, was fined 8 millionBritish Pounds for misusing RNRLmoney by the British Financialregulator. The penalty was imposedafter UBS employees were foundspeculating in foreign currency andcommodities withmoney illegallytaken fromcustomer accounts in this caseRNRL andReliance Energy.

(http://www.bloombergutv.com/indust ry -news/bank ing- indust ry -news/ 37293/ubs-fined-8mn-pounds.html )

This also indicates the wrongdoingsof individuals connected to institutionslocated in tax havens.

What Should India Do?Actually, it is the developing

countries which are impacted more dueto this flight of capital and hence Indiashould take the lead. Christian Aid

estimates that every year, 160 billion

USD are lost by developing countriesdue to these tax havens. The Jews gotback the money (in 2002) appropriatedby these banks from Jews in the 1936-1945 period of Hitlers dictatorship andmass deaths. Nigeria got back somemoney, as did Philippines and alsoIreland. We need political will. Also, wecan levy some percentage of fine on theholders of black money and encouragethem to bring it back since returns inIndia are more attractive than anywestern country.

There is also an important associatedissue: terror funding. SEBI has asked

stock exchangesand otherintermediaries andall marketparticipants towatch out for UN-

listed terror funding entities. ( BusinessStandard, October 26, 2009). The originof much of these funding could be fromsecretive tax havens or through hawalaroutes.

The French are planning to tax theproceeds of dividends and interest fromtax havens. France plans to raise taxeson funds transferred to tax havens andon dividends coming from these

jurisdictions, to conform with G-20plans to crack down on countries thatdont comply with global tax standards.

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Actually, it is the developingcountries which are impactedmore due to this flight of capitaland hence India should takethe lead.

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(http://www.royalgazette.com/rg/Article

/article.jsp?articleId=7d9b8a73003001d&sectionId=65 )

While G-20 is already in the processof finalizing counter-measures to rein inthese banks by March 2010, topofficials of the French governmentconfirmed to ToI that France will settlefor nothing more than cripplingsanctions on these banks by the Group if they dont respond to the calls for moretransparency in their functioning by thattime. ( http://timesofindia.indiatimes.com/india/Way-out-for-India-France-

fo r-sanctions-agains t-banks- in -tax -havens/articleshow/5288982.cms )

India can thus join countries likeFrance and apply more pressure onthese tax havens.

Since the financial flows from thesesecretive jurisdictions can destabilizeour financial system particularly if they are not well regulated it isimportant that India takes steps to dealwith them. Also, Indian Parliament(both Houses) in a joint sitting shouldpass a resolution that all unaccountedmoney held by Indians in tax havensbelongs to the Indian people and hencethe Government of India. This willestablish the basis for further action.India should implement fully the KnowYour Customer norms in all globalfinancial flows. This implies PNs are tobe regulated only to such entities fully

under the glare of SEBI. According to

global anti-graft watchdogTransparency International, Indiashould endorse the United NationsConvention Against Corruption(UNCAC) for recovery of Indiaswealth hoarded in foreign banks. SinceSwitzerland, Bahamas and Jamaicahave already ratified the UN Act and if India ratifies it, we can use it as aninstrument to get the details aboutIndian money stashed there. Out of the140 countries that have signed theUNCAC, 120 have ratified it.

Currently, a delegation from FinancialAction Task Force (FATF) is in India toassess our preparedness to join it as afull member. Currently, India has anobserver status. FATF has 34 members,mostly from developed countries, and itwould be useful for India from the pointof view of information sharing andscrutiny. Once we become its member,

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There is also an importantassociated issue: terror funding.SEBI has asked stock exchangesand other intermediaries and allmarket participants to watchout for UN-listed terror fundingentities. The origin of much of these funding could be fromsecretive tax havens or through

hawala routes.

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it will be a key step in ensuring that

investments to and from India will beFATF complaint and the entiresystem would have been tested andcertified. Needless to add, India should

join as full member of FATF andalso ratify the global corruption treatyof the UN.

India should also form a Ministry forGlobal Finances to deal with this issueon a war-footing. India also shouldcreate a Special Purpose Vehicle or evena Financial Institution to sterilize andabsorb the funds flowing from these taxhavens. With an anticipated growth rateof more than 8 per cent in the comingyears, the foreign financial flows in theform of FIIs and FDIs will onlyincrease. There is a need to sterilize itfrom the point of view of domesticinflation as well as from the point of

view of drastic rise in rupee value. This

means a concerted strategy should beadopted in the coming five years tofacilitate the inflows, sterilize them anduse the same for infrastructuredevelopment. Also, India shoulddistinguish between funds and personsholding the funds. The former needsstrategic handling whereas the laterneeds to be dealt with as per laws of theland. More important point is the issueof destabilization of our financialmarkets due to these tax havens. This isall the more reason for India torecognize the amount of funds illegallykept there and talk about it openly andevolve mechanisms to minimize itsnegative impact on our financialsystem. If appropriately planned, thesefunds can become facilitators for a bigpush to our economic growth.

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Youth

Youth is the time to go flashing from one end of the world to the other to try themanners of different nations; to hear the chimes at midnight; to see the sunrise in townand country; to be converted at a revival; to circumnavigate the metaphysics, writehalting verses, run a mile to see a fire, and wait all day long in the theatre to applaudHernani.

Robert Louis Stevenson

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Tax Havens Can de-stabilise Our Financial Markets

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