Incentivizing foreign investment in govt debt

The government of Pakistan seems to be striving to attract foreign exchange through a variety of means. In this regard, the State Bank of Pakistan (SBP) has simplified the tax regime for non-residents to encourage investment in long-term debt securities and introduced necessary amendments to facilitate investment in gilt-edged securities. Specifically, the new instructions have sought to implement the changes in the Income Tax Ordinance, 2001 to simplify the tax regime for non-resident companies, having no permanent establishment in Pakistan, and investing through Special Convertible Rupee Account (SCRA) maintained with banks in debt instruments and government securities including Treasury Bills and Pakistan Investment Bonds (PIBs). As per amendments, the capital gains tax will be subject to withholding tax at the rate of ten percent and shall constitute final discharge of the tax liability. Besides, there will be no deduction of 0.6 percent banking transaction tax under section 236P on transactions in the SCRA and no advance tax payment will be required on capital gains under section 147. In addition, no distinction will be made in terms of filer or non-filer in respect of the requirement of registration under section 181, filing of returns under section 114 and filing of statement of final taxation under section 115 regarding income derived solely from capital gains or profit on debt from investment in debt securities.

It is clear from these amendments in tax regime with respect to foreign investment in debt securities have been made to reduce paper work, simplify the tax regime and reduce taxes on foreign investment in government securities in order to incentivise foreign investment through higher returns and lesser interaction with tax bureaucracy. The SBP seems to believe and rightly so, that fresh instructions will help deepen the capital market, generate greater interest in the longer-tenor government securities, diversify the investor base and reduce the cost of debt for the government. It may be stated here that the existing foreign exchange regime was not very much conducive to foreign investment. It allowed non-residents to invest in debt instruments and government securities through the SCRA but the overall tax structure for non-residents was complex. Different rates were applicable for the withholding tax on profit on debt and capital gains tax, penal transaction charges for non-filers, a complex filing process and uncertainty about tax applicability were the key impediments to foreign investment in the local debt market. Anyhow, it is difficult to quantify the precise impact of the latest amendments in foreign inflows in debt instruments as the amount of these inflows has increased from a negligible level to about dollar 1.4 billion in a short period of time even under the existing tax regime, implying that a higher net rate of return on Pakistani gilt-edged securities has actually attracted the foreign investors to debt instruments. As for the existing situation, given an interest rate of about 12 percent on government's long-term debt instruments and a likely depreciation of 5.00 percent of rupee against the US dollar in a year's time, investment in Pakistan is likely to earn a handsome net return of about 7 percent compared to about 2.00 percent in other countries and this is a highly attractive proposition for foreign investors. As Pakistan has negotiated a 6 billion dollar EFF programme with the IMF, there is hardly any chance of default on payment. In fact, the confidence of foreign investors is growing as foreign exchange reserves held by the SBP are now well over 11 billion dollars.

There is no doubt, in our view, that the new amendments will certainly help deepen the capital market, generate greater interest in the longer-term government securities, diversify the investor base and reduce the cost of debt for the government. A higher availability of funds will also increase the supply of available funds to the private sector for the development of the country. However, the immediate positive impact would be reflected in the rise of foreign exchange reserves. It must be remembered, nonetheless, that the fresh amendments could also have certain negative effects. Such funds generally do not contribute directly to the productive capacity of the economy and leave the country at the first hint of uncertainty or if the net rate of return on the Pakistani debt instruments becomes comparatively unattractive. Monetary policy of the country also sometimes becomes hostage to the imperative of maintaining the deployment of such funds within the country to avoid a sudden outflow of these funds. Overall, however, fiscal and monetary authorities of the country need to monitor the situation very carefully and try to avoid the pitfalls associated with the deployment of foreign funds also referred to as 'hot money' or 'carry trades' into our securities market.