In two articles in the Business Standard (Brown Equities, White Profits, Feb. 4, 2006 and Ban FIIs not P-Notes, Sept. 9th, 2006) I I had talked about the license raj that exists with respect to the financial sector in India – specifically, the licensing route for foreign portfolio investments (via the licensing of Foreign Institutional Investors (FII)).

License raj has been widely acknowledged to be not only highly inefficient but also a system which encourages large scale corruption. However, unlike the previous license raj which provided a monopoly status to inefficient domestic firms (and corresponding payments to domestic authorities for this privilege) the FII license raj bestows benefits to almost exclusively foreign firms. (I don't know whether any payments exist but the numbers do show that the monopoly benefits to foreign firms is rather obscenely large!)

I say almost because some domestic brokerage firms have been "bought out" by the system. Like any license system with obscene gains, the attention of all turns towards how to get the license for oneself and damn the others. This is how the license system in India lasted for over 40 years: entrepreneurs, capitalists and industrialists were considerably hurt by this corrupt system but it lasted because those who were allowed entry into the hallowed halls of corruption were loathsome to lose their privilege. So today with Indian banks operating overseas as brokers for FIIs.

How does the FII license raj operate and who does it benefit? In order to monitor the entry of foreign portfolio investments, the government of India set up a check point: before entry, owners of money had to register their entry with SEBI. This is a sensible monitoring procedure and parallels monitoring practices in most countries. However, in India, quite predictably, the monitoring purpose morphed into regulation and before one could say "rent-seeking" it transformed into a license. Not everybody could send their money into India; they had to first obtain a license from SEBI, a license that was not easy to obtain. Indeed, so difficult that an entire industry (the participatory notes or P- Notes) has developed outside the Indian shores to cater to investors who are prohibited direct entry into India.

When asked about the need for the stringent licensing procedures, some masters at the Finance Ministry, RBI and SEBI have one answer: you know, there is a lot of terrorist money and money laundering going on, so we cannot be too careful. Can you imagine what will happen if such bad money comes into India?

Money laundering is an important concern. Nevertheless, more than $ 70 billion has entered India via the FII route, and about half that in the last five years. How has terrorist laundering been checked for the money that has been allowed entry into India? The masters answer that this has been made possible through implementation of strict Know Your Client (KYC) procedures. KYC norms are implemented by banks - both the foreign bank sending money and the domestic Indian bank receiving money. In other words, the very implementation of international KYC norms means that licensing portfolio investments into India is now obsolete. So why continue?

Who benefits from an obsolete rent-seeking policy? Because entry into the Indian portfolio market is licensed, a parallel off-shore market (PNotes) in Indian securities has developed. How big is this market? About 50 percent of FII investments, or about 25 percent of all delivery trades in India. Yes, you got it right - FII delivery trades are 50 percent of all (delivery) trading volume, and PNotes constitute at least 50 percent of the FII trades. The magnitudes are not small.

And they translate into obscene gains for foreign investment banks who have been licensed by the government of India to make supernormal profits - from the holding of an FII license. How supernormal? Domestic brokerage rates for institutions are 0.1 percent for delivery trades and .06 percent for index futures. For those investing in India via PNotes (the laundered/terrorist money in GoI parlance), the foreign brokerage firms charge nearly five times the market rate - approximately 0.5 percent (delivery) and 0.25 percent (futures).

This difference in non-PNote and PNote trades leads to excess profits - the cumulative excess profits from the FII/Pnotes operation is now over $ 4 billion dollars. If the normal 80/20 rule applies (80 percent of volume by 20 percent of the firms) then the top few foreign brokerage firms (e.g. Morgan Stanley, Goldman Sachs, Merrill Lynch) probably have made an outsized packet from the operation of the Indian FII licensing system. Don't ask them to lobby for change!

Who has lost? If the PNotes volume was conducted on Indian shores (what would happen if foreign investments were monitored, not licensed), there would be extra employment at brokerage firms, extra assets for the domestic fund management industry, and extra corporate profits to be taxed at a 33 percent rate. Simple calculations suggest that Indian banks and brokerage firms have cumulatively lost over $ 750 million dollars in revenue; the asset management firms have lost over $ 32 billion in management profits (at a 20 percent rate on capital gains); and the government has lost over 10 billion dollars in tax revenue. Today, the government is losing, from the operation of the FII policy, close to $ 1.5 billion in tax revenues, or about Rs. 6000 crores.

There are about 25 million taxpayers in the less than Rs. 2 lac category; income up to Rs. 1.1 lac is non taxable. The 10 million or so poor workers of India earning between Rs. 1.1 and Rs. 1.5 lacs contribute a little more than Rs. 6000 crores to the tax kitty. So the UPA government has a choice: it can continue to provide a few foreign investment firms multibillion dollar profits (and go to sleep at night thinking it had closed the door to money laundering) or it could reduce the tax rate to zero for the poor workers of India earning less than Rs. 1.5 lacs. What do you think the aam aadmi government will choose? What do you think it should choose?