India's struggle to attract foreign portfolio investment (FPI) is not simply a question of high capital gains tax, but also reflects concerns around relative returns, earnings growth and the country's medium-term growth prospects, according to Ridham Desai, Morgan Stanley's veteran market strategist.
In a conversation with Nivesh Shah, Desai said foreign investors would return to Indian equities when they see the potential for better returns compared with other markets. While taxation has created certain operational challenges for overseas funds, he argued that it is not the primary reason behind the slowdown in foreign inflows.
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"Ultimately, it's about relative returns. The minute you start seeing better relative returns, or you suspect that returns are going to improve in a certain asset, it attracts flows," Desai said.
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He pointed out that several technical aspects of Ind44ia's tax framework complicate investments for foreign institutional funds. These include the requirement for benchmark funds to accrue tax liabilities daily, the absence of provisions for setting off certain tax liabilities, compliance requirements and uncertainty surrounding past tax assessments.
Currency depreciation has added another layer of complexity. Since taxes are calculated on rupee-denominated gains, overseas investors may end up paying tax even when their dollar-denominated returns are considerably lower.
However, Desai maintained that these issues become more significant when investors are not generating attractive returns in the first place.
Desai stressed that attracting foreign capital remains important for India, given its persistent savings deficit and investment requirements. While foreign direct investment (FDI) is preferable because it brings long-term capital, technology transfer, manufacturing capabilities and employment, foreign portfolio investment also plays a critical role.
He said the FPI ecosystem extends beyond listed equities to include private equity and venture capital, which have been instrumental in funding India's startup ecosystem and supporting research and development.
"It's not our birthright to get foreign capital," Desai said, adding that India must make its investment environment as attractive as possible to compete with other destinations.
He also called for a broader policy message welcoming foreign investors, arguing that tax changes are only one among several measures that could improve sentiment.
Desai also highlighted the growing disconnect between India's economic performance and its stock market returns. While corporate earnings and economic activity have remained resilient, the Nifty has struggled to reflect that strength.
According to him, investors are questioning whether India's current earnings growth can be sustained over the medium term. He said India's earnings growth has recently lagged behind several competing markets, including Japan, Taiwan, South Korea, China, the US and Germany.
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He also flagged concerns around artificial intelligence potentially disrupting India's competitive advantage in exporting services, alongside longer-term questions about demographics and whether India can become a high-income economy before its population ages.
Despite these concerns, Desai remains constructive on India's prospects. He expects the country's diversified earnings base to eventually attract investor interest, particularly if concerns around the global AI investment cycle intensify.
On sectors, he identified opportunities in banking, IT services, consumer businesses and capital expenditure. Rising capital goods imports and bank credit growth, he said, point towards an emerging investment cycle.
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