If the finance ministry’s concept note on financial special economic zones (SEZs) is any indication of the government’s thinking, India might be on its way to getting its first international financial services centre (IFSC).

Work on Prime Minister Narendra Modi’s pet project, the Gujarat International Finance Tec-City (GIFT City), which could house India’s first IFSC, had slowed down in 2013. But now, especially with a Modi-led government in power at the Centre, various regulatory hurdles are expected to be eased.

The proposed IFSC, in the SEZ area of the GIFT City, 20 km from Ahmedabad, could house major global exchanges and financial institutions catering to international markets. Geographically, the city is uniquely placed between Europe and Japan. The government hopes this will help the IFSC act as an alternative international exchange on a par with the Singapore Exchange (SGX) and the Dubai International Finance Centre (DIFC). Companies operating outside the SEZ area of the GIFT City are expected to provide in the domestic area banking, financial and insurance services to the Indian shore. The city is also being touted as India’s first greenfield smart city – its first phase is likely to be fully operational by the end of 2016, according to GIFT City Company Ltd officials. (Click here for graphics)

The need for such a project, as the concept note suggests, stems from the fact that there has been a hollowing of financial markets in India in recent years. Various regulatory provisions issued by the Reserve Bank of India, Securities and Exchange Board of India, Insurance Regulatory and Development Authority of India and other regulators have prevented transactions involving Indian companies in reinsurance, derivative transactions in securities, commodity and currency derivatives. With these transactions currently being carried out at financial centres like London, Dubai and Singapore, India’s opportunity loss is seen at about $ 34 billion (Rs 2.1 lakh crore), according to an EY report on IFSC. So, to the extent that financial SEZs in India can compete for this business, the associated service payments and salaries could accrue in India and boost growth.

Of the total proposed area of 868 acres, the Gujarat government has already transferred 673 acres to a special-purpose vehicle set up in a joint venture with IL&FS. The proposed 62 million sq ft of built-up area in the GIFT City is to be built in three phases – 12.6 million sq ft has already been allocated, earning the city a total revenue for Rs 1,010 crore so far. But while physical infrastructure, such as central command centre, waste-disposal management, district-cooling system and a gas-based power station, are already in place, only two towers have come up with only six firms currently operating in the area.

Of the 12.6 million sq ft already allocated, the total allotment in the SEZ area has been only 3.5 million sq ft. This includes an allotment of 3 million sq ft to IL&FS and 0.25 million sq ft each to real estate developers Hiranandani and Brigade Enterprise. This implies over 72 per cent of the total allocated area is outside of the SEZ. As the financial SEZ is the anchor of the GIFT city project, the lack of interest is surprising.

Part of this, it seems, stems from the fact that considerable ambiguity prevails over the existing regulations, which need to be modified to give shape to the IFSC. Clarity is also required on the range of activities to be permitted in the SEZ and the type of participants likely to be given permission to conduct operations there.

On the regulatory front, a member of the GIFT city board illustrates the kind of problems that regulators are grappling with. “If Deutsche bank, for example, wants to raise money in Germany and lend it to someone in US, this activity, which is currently happening in Dubai and does not involve converting into rupees, should be allowed here (in the GIFT City). The problem, however, is that of ring-fencing. How do you ensure operations of foreign banks in the GIFT City are ring-fenced from their India operations? Further, while this activity does not expose Indian companies and banks, what if, say, ICICI Bank wants to be allowed to venture into this activity, since it is already carrying out such activities from its Singapore offices?”

So, regulators like Sebi, RBI and Irdai, and the finance ministry, have to provide clarity on the range of activities and player types to be allowed in the SEZ, and also address issues ranging from capital account restrictions, financial regulations, taxation and arbitration to regulatory infrastructure and restrictions on trading in various instruments. According to experts, unless there is a greater clarity from regulators – by RBI in the case of bond, currency and derivative markets; Sebi for equity markets; and FMC for commodity markets – interest in the project is likely to stay muted.

Considerable ambiguity also exists on the issue of taxation and the legal system needed to be put in place for its smooth functioning. On the former, R K Jha, managing director & group chief executive of GIFT City Company Ltd argues the existing tax regime does not make it cost-effective for international operators. Currently, units in the SEZ are charged a minimum alternate tax (MAT) of roughly 20 per cent. In Dubai, the tax is zero, while in Malaysia and Singapore it is three per cent and 10 per cent, respectively.

The legal system, too, is a constraint. Currently, India ranks 186th among 189 countries in enforcing contracts, according to the World Bank’s ‘ease of doing business’ report. With such a low level of contract enforceability, the GIFT City is unlikely to function smoothly as an international finance centre.

The complexity of legal system in India, its unpredictability and the absence of a concrete resolution mechanism, force Indian businesses to opt for foreign law – English or Singaporean – as the law applicable to their contracts, and choose foreign seats of arbitration like London or Singapore. For it to compete with other IFSCs, GIFT needs to offer a legal system that is on a par with others. This will require a new approach.

Simply creating the necessary physical and regulatory infrastructure might not translate into projects’ success. Conversations with experts reveal, on a more practical level, the prohibition on alcohol in Gujarat is likely to emerge as a sticking point. A professional says: “If I decide to shift from Mumbai to the GIFT City, it might not be possible for me to go out and have a beer or wine after work. How will the project attract manpower when prohibition of alcohol tends to be a big minus for Gujarat?” A key challenge will, therefore, be creating the social infrastructure necessary to attract talent.

Possible solutions
While some hesitation among regulators is understandable, experts say, with the finance ministry likely to implement the recommendations of the financial sector legislative reforms commission (FSLRC), under Justice Srikrishna committee, implementing some of those in financial SEZs could be a way to test the ideas on a relatively modest scale. This line of thinking echoes in the ministry’s concept note as well.

For smoother implementation, Samir Barua, former director and faculty member at the Indian Institute of Management (IIM), Ahmedabad, proposes a three-step process. In the first phase, the GIFT City could offer a low-cost alternative to global BFSI clients wanting to have a physical presence in India. The idea is to take advantage of the country’s unique physical position, and offer companies a cost-competitive base for operations. Certain kinds of back-office works already happening in cities like Bengaluru could also start at the city in the first phase.

In the second, international exchanges within the IFSC could be connected to other exchanges – both global and local. Companies could initially engage in limited currency transactions to address regulators’ concerns over rupee convertibility. In the third, the city could look to compete at a global level with the likes of Dubai and London.

Various changes in the existing financial and legal regulatory regime have been proposed for this. First, with experts in favour of full capital account convertibility within financial SEZs, it might require exemptions under the existing Foreign Exchange Management Act (Fema) regulations. This means RBI will need to issue notifications to allow capital infusion without restrictions or conditions. Permission will also be required to allow brokers to open and operate dollar-denominated accounts.

On the issue of dispute resolution and contract enforcement, Jha suggests setting an alternative dispute-resolution mechanism. This will require forming within the city an appellate court. Its ruling, to be given within a specified period, will be final. “In financial services, people want quick resolution,” Jha reasons. This will effectively bypass the problems of civil courts.

Putting in place a regulatory structure, capable of dealing with different areas, is critical to the SEZ’s success. But the activities fall under the ambit of different regulators. For example, capital convertibility and debt management are under RBI’s domain, while an international stock exchange, the kind BSE proposes to set up, will fall under Sebi’s.

To deal with regulatory issues, GIFT City officials suggest a specialised regulator for the financial SEZ. The concept note also talks about a regulator to enforce the financial SEZ Act, subset of the Indian Financial Code (IFC), and further setting up a Bench of the financial sector appellate tribunal. The proposed regulator should be vested with powers to implement specific regulations and notifications for financial transactions within the SEZ.

On the issue of taxation, continuing with the current practice of levying 20 per cent MAT on units will reduce the competitiveness of companies in the IFSC, say officials. The rate of taxation has to be comparable with other financial centres competing with India. A proposal is lowering the MAT rate for IFSCs to three per cent, close to the Malaysian level, with a sunset clause of 10 years.

But Barua contends the levy should be gradual, rather than an abrupt increase in taxes at the end of a tax holiday. This will give companies time to adjust to a higher tax rate. Principally, though, he argues the focus should not be on tax incentives but on making it attractive for companies to operate from the GIFT City.

The concept note also talks about the need to exempt transactions inside the SEZ from the securities transaction tax (STT), commodities transaction tax and the service tax. A key reason why trading in the Nifty futures has shifted to Singapore is the levy of an STT. So, doing away with such taxes in the SEZ is likely to improve the financial system’s competitiveness.

But setting up the regulatory infrastructure alone is not enough. Jha acknowledges: “An ecosystem has developed over the years in other IFSCs that is difficult to compete with. When you are starting from scratch and competing with established centres like Dubai and London, you have to offer something better.” This suggests considerable investment will be required in social infrastructure.

Creating this ecosystem to enable the city to compete with the centres like Dubai and Singapore will take time. With a favourable government, though, officials are hopeful the project with pick up steam. A senior Gujarat government official says: “By 2015-end, we will see a critical mass. We are seeing a bandwagon effect getting created. Everybody knows it is a project of the government, which is fully backing it.” Indicating the renewed interest in the project, Kotak Mahindra Bank and NSE are likely to announce their association with the project soon.

A series of meetings between state and central governments and regulators have also taken place. Jha says the changes in rules, including amending the Banking Act and the Sebi Act, are likely to be notified by April. But many are awaiting the Union Budget for a clear signal on the government’s intent.