India is weighing a tax cut, specifically the removal of long-term capital gains (LTCG) tax for foreign investors, to reverse a trend of record capital outflows and declining foreign equity holdings, now at an all-time low of 14%. While the proposal could align India with other emerging markets, experts caution that a tax cut alone may not be enough to attract investors back, citing high valuations, slower earnings growth compared to peers, and various geopolitical and economic risks.
Once a favored emerging market for global capital, Indian equities have seen their allure fade, with foreign holdings plummeting to an all-time low of 14%. Now, India is contemplating a significant tax cut – specifically, the removal of the long-term capital gains (LTCG) tax for foreign portfolio investors – to revitalize its appeal and stem the tide of record capital outflows.
The Proposed Tax Overhaul
The push to abolish LTCG tax is gaining momentum within India's financial circles. Both the capital market regulator and the prominent PHD Chamber of Commerce and Industry have recently urged the government to scrap the tax, arguing that its 2024 increase occurred during a market peak and current conditions necessitate a review. India's Finance Minister, Nirmala Sitharaman, acknowledged the foreign capital exodus on Monday and indicated that calls for an LTCG tax review would be considered.
This comes as foreign investors have sharply reduced their exposure to Indian equities, with foreign holdings hitting an all-time low of 14%. While experts agree that an LTCG tax removal would improve sentiment and align India's tax regime with other emerging markets, many caution that it might not be a sufficient sole catalyst to attract investors back in large numbers.
Amit Bhartia, a portfolio manager at Delorean Partners, highlighted that investors prioritize expected returns over tax breaks. He cited an instance where foreign investors injected 570 billion rupees (approximately $6 billion) into Indian equities in September 2024, only to withdraw 940 billion rupees the following month to pursue cheaper Chinese stocks. "The tax rate didn't change between those two months. The perceived relative return did," Bhartia explained, illustrating that a favorable tax environment alone cannot compensate for perceived lower returns or higher risks.
Mounting Risks and Valuation Concerns
Several factors are currently dampening the Indian market's appeal. These include strained geopolitical ties with the U.S., elevated energy prices, a depreciating currency, and uncertainties surrounding the impact of artificial intelligence. Nomura's report suggests that while an LTCG cut, a drop in global bond yields, and central bank intervention to support the rupee could offer some short-term stability, long-term concerns persist due to geopolitical and technological uncertainties.
Between January and October 2024, India emerged as the third worst-performing market globally, trailing only Indonesia and Turkey. The benchmark Nifty 50 has declined by nearly 9% this year. Foreign investors, who lauded India as the best-performing emerging market just three years ago, have since withdrawn a net $18.9 billion in 2023 and more than $30 billion so far in 2024.
Global brokerage Bernstein noted that India "has to fight for capital in a competition it could once afford to take for granted," emphasizing the need for multiple "catalysts," including a tax cut and easing Middle East tensions, to reverse capital outflows. The report also pointed out India's expensive valuations and disappointing earnings growth. India trades at a rolling 12-month forward price-to-earnings ratio of 18.6 times, significantly higher than Taiwan (16.8 times) and Korea (3.9 times) – both outperformers fueled by strong AI-related stocks. Furthermore, India's earnings growth forecast stands at a much slower 11% compared to the 45% average expected for other emerging markets.
Hanna Luchnikava-Schorsch, Head of Asia-Pacific economics at S&P Global Market Intelligence, reiterated that a tax cut alone wouldn't trigger a major reallocation, as the fundamental trade-off for foreign investors remains unchanged. Despite India's robust structural growth narrative, investors require stronger earnings growth to justify its valuation premium.
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Coming Up
- Nov. 6: FX reserve data as of Oct. 30.
- Nov. 10: Equity market closed for Diwali.
