Union Budget 2006-07 and the Capital Market

If you feel Indian bourses are overheated, and you need to diversify? Well, the Finance Minister now gives you an opportunity to buy stocks in Chinese, Japanese or Hong Kong markets through the mutual fund route! This has been done using a two-step approach. First, the ceiling on investments in overseas instruments has been raised from $1 billion to $2 billion (about Rs 9,000 crore!). Secondly, the requirement of 10 per cent reciprocal share holding has been done away with. This means that Indian mutual funds now have the entire stock universe of foreign markets to select from unlike the 47 stocks that met the 10 per cent share holding criteria, earlier.

With the Budget proposing removal of the 10 per cent reciprocal shareholding requirement for investment in foreign equity, various fund houses of the country are planning to launch foreign equity funds.

The finance minister's proposal to strike a degree of parity within the mutual fund segment with regards to taxation is one of the high points. For instance, at present, close-ended equity funds are treated differently from to open-ended funds with regards to dividends.

The budget has now proposed that close-ended equity funds will be at par with open-ended equity funds with respect to taxation. Now dividends on close-ended equity funds (like open-ended equity funds) will be tax-free, i.e. fund will not have to pay a dividend distribution tax on close-ended funds.

While theoretically speaking, the move to double the limit for overseas investments is likely to see Indian investments abroad, it may not serve much practical purpose, unless such products are properly marketed, since domestic equity funds are not even investing in global companies to the extent of the existing limit of US$ 1 bn. However, it is hoped that relaxation in investment norms will motivate the fund houses to launch a range of products that invest outside India. These could be targeted at specific overseas markets (say, a fund dedicated to Japan or China), a class of markets (an emerging markets fund for Indian investors), or any combination of these. If this happens it would mean an opportunity to Indian investors to diversify over countries as they come across better opportunities abroad.

While 20 stocks enable the fund manager to diversify the portfolio but the existing guidelines prevent the fund manager from investing in companies like Microsoft or Google, as these companies don't have a stake in any listed company in India. Also, no banking or technology stocks meet the requirements and therefore the fund couldn't diversify into these sectors even if it wanted to. These restrictions will go as soon as the guidelines relaxing the 10 per cent restriction are revoked.

The budget has also given qualified domestic equity funds the flexibility to invest in overseas exchange-traded funds (ETFs) cumulatively up to $1 billion. Much like the move to hike overseas investments, this measure should also enable Indian mutual funds to diversify to a large extent. It shall also mean a greater integration of the Indian markets with the international markets.