Accelerating India’s Innovation Boom

Over the last three years, entrepreneurship has captured India’s imagination, and for good reasons. Never in our history has it been possible for first-generation entrepreneurs to start companies, raise seed capital and build a business in the way we have seen in recent times. The path available only to wealthy families and elite dynasties has been opened to every Indian today, thanks to the entrepreneurship boom.

Since taking office in May 2014, the Narendra Modi government has implemented a series of policy changes that have supported this unprecedented wave of entrepreneurship. The time taken for incorporation of companies has been brought down to a few days from several weeks. The Modi government has liberalised foreign direct investment across industries, and India is opening its doors to global capital even as the rest of the world becomes more protectionist.

In line with a commitment made in the 2015 Budget to gradually reduced the corporate tax rate, the government has cut the corporate tax rate to 25% for companies with revenues below Rs 50 crore, with the reduced rate now being considered for mid-size companies with revenues below Rs 500 crore. In a move to encourage startups to develop intellectual property-based businesses, the government implemented a concessional tax rate of 10% on income earned from licensing of patents, and India is now more aligned in this respect with global peers.

Small Industries Development Bank of India (SIDBI) has emerged as a significant domestic fund investor in India’s venture capital industry – with SIDBI’s support, several new early-stage funds have emerged to back Indian entrepreneurs, addressing a supply-side issue in the private capital market.

The public equity capital market, whose key function is to provide growth capital to businesses, has also seen substantive reforms. On the public markets side, the entry of Employees’ Provident Fund (EPF) is bringing depth and stability to the equity market while enabling organised sector workers to become beneficiaries of India’s long-term economic growth. The successful rollout of the Aadhaar program has reduced friction and identification costs associated with bank account and demat account opening by over 95% – it takes minutes rather than weeks now to open accounts with Aadhaar’s e-KYC facility. 

The stock market has played a critical role over the decades in supporting the growth of Indian business. When banks were not willing to provide capital to young companies in the 1970s and 1980s, intrepid entrepreneurs turned to the equity market. In the process, wealth creation was democratised and ordinary individuals were able to participate in the growth of companies like Reliance Industries and Infosys, which are today counted among India’s blue-chip corporates.

There are two ideas the government should consider to further streamline capital allocation in the economy and ensure that the wealth created by India’s entrepreneurs is shared widely across society. 

There is a big gap between the long-term capital gains (LTCG) tax rate on unlisted private equity investment and the LTCG rate for listed public equity investment. For unlisted equities, the holding period for LTCG is more than 2 years and the applicable rate is over 20%. For listed equities, the holding period is 1 year and the gains are tax free. This wide discrepancy in treatment makes early-stage startup investment far less compelling when compared to investment in the stock market, even though the positive spillover effects for job creation and innovation are substantial in startup investment. 

This issue already seems to be on the Prime Minister’s radar – in a speech to the capital markets community in Mumbai earlier this year, Prime Minister Modi had said that stock market participants should make a “fair contribution to nation-building through taxes”. It is also worth looking at the taxation of dividends. The current regime of dividend distribution tax (DDT) is an indirect tax on all shareholders, even though it comes out of the company’s pocket. Shareholders, who are collectively the owners of a company, already pay corporate income tax on profits at the company level. DDT is effectively a double tax inimical to the interest of minority, non-controlling shareholders, who is typically a small retail investor. Introducing LTCG for listed equities, eliminating all taxation of dividends and bringing balance between taxation of unlisted private equity and listed public equity investment would go a long way towards improving capital allocation.

Finally, capital markets regulations on new listings and initial public offerings need to be relaxed and adapted to accommodate new-age technology and knowledge-based startups that aren’t able to comply with criteria that would apply more to industrial businesses. For example, companies wanting to list on Indian exchanges are required to have a minimum average pre-tax operating profit of Rs 15 crore in at least 3 years out of the last 5 years. In older times, when investor awareness and knowledge was low, a rule of this type served to protect inexperienced small investors. 

The landscape today stands transformed, where over a crore Indians are participating in the stock market through systematic investment plans, parking in excess of Rs 4000 crore every month into listed stocks. This is number that has doubled in the last few years. Crores of Indians are becoming indirect equity owners by virtue of being EPF beneficiaries. New media platforms and digital connectivity are helping educate the masses on the challenges and opportunities of stock market investing.

The effect of having the profit requirement for listing in India is high-tech businesses which have achieved significant progress and built an asset base but are still loss-making are forced to look abroad for raising capital through an initial public offering. Relaxing this requirement will help keep Indian companies in India, and will give an opportunity to India’s burgeoning retail investor base to build wealth by investing in tomorrow’s corporate champions.

The government’s war against black money has severely undermined the attraction of gold and land as investment alternatives. The taxation and regulatory policy ideas highlighted above would further help shift savings into productive, cash flow generating assets that spur the economy forward. India is well on its way to becoming an innovation-driven economy, and these policy reforms would accelerate our country on that path.

(Originally Published: Reflections, Prime Minister Narendra Modi’s website)

Rebalancing of Indian Equity Markets Will Smooth Volatility

Momentous changes in India’s equity market microstructure will improve market efficiency and smooth volatility over time.

Emerging markets are frequently stereotyped as being prone to wild swings and outsized volatility. In particular, India has historically been a market where foreign institutional investment has driven the direction of the market – bearishness by foreign investors has almost always pushed markets downwards, while optimism abroad about India’s prospects equally rockets equities to the stratosphere.

While sharp movements in either direction should not affect practiced value investors, the disproportionate impact of bipolar behaviour by international funds has both wreaked havoc in the Indian stock market, as well as created tremendous buying opportunities for the long-term value investor. For example, in 2014, when foreign investors pumped in over $40 billion into the Indian market after voters handed a single party with a majority in the general election for the first time in 30 years, the benchmark Nifty index rose over 30%.

Now, changes are afoot that will make India’s equity market more even-keeled over time. Employee Provident Fund Organisation (EPFO), an Indian government body, administers a pension fund drawing contributions from India’s formal sector labour force and controls about Rs 8 trillion (US$110 billion) in capital, In 2015, Prime Minister Narendra Modi’s Indian government decided that for the first time in India’s history, the corpus would be deployed in the equity market.

For its entire existence, EPFO had been investing heavily in debt securities. This was a system of indirect financial repression – the government would take workers’ pension and invest it primarily into government bonds. In line with how pension funds are managed globally, the Modi government decided that 5-15% of EPFO’s incremental corpus would annually be invested in exchange-traded funds tied to the major Indian market indices and a basket of government-owned enterprises. This is well below other large economies like Switzerland, where nearly 30% of pension money finds its way into the equity market, the United States (44%), and Australia (51%). EPFO’s equity allocation would translate to Rs 80-120 billion (US$ 1.2-1.5 billion) per year, and it invests in select ETFs that track India’s two benchmark indices, the Nifty and the Sensex.

EPFO draws over $12 billion a year in incremental funds from India’s salaried workers. Given that foreign investors pumped in $40 billion in 2014 and $9.5 billion in 2015, the share of the EPFO corpus invested in equities is relatively small today. Nevertheless, the entry of a significant domestic institutional investor into India’s equity market is a watershed moment. In its first year as an equity investor, the six decade-old EPFO parked 5% of the incremental corpus into ETFs. Late in 2016, it decided to increase the allocation from 5% to 10%, widening its mandate beyond large capitalization stocks to include mid-sized companies.

The Indian government is making a strong push to formalize the economy, and a burgeoning youth population means that EPFO’s incremental corpus from which a chunk is invested in equities should rise over time. The government also wants to increase the percentage allocated to equities over time, and the presence of a long-term domestic permanent capital will bring much needed balance and stability to the Indian market.

This is possibly the biggest structural change the Indian market has seen in the last 25 years, comparable to when the Indian market was opened up to foreign investors. Bringing this corpus into equities wasn’t an easy reform – powerful labour unions have resisted EPFO’s entry into equity investing for decades, but this time the Indian government prevailed.

Given this momentous change, investors would do well to move away from old notions and biases about the foreign investor-induced hyper-schizophrenia of India’s Mr Market. In practical terms, entry timing should matter less and volatility will be mitigated. The Indian market now has a new ballast. The permanent capital provided to equities by India’s largest pension fund means that foreign developments can’t whiplash Indian markets like they have in the past.

(Originally Published: Latticework)

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