The government is on the horns of a major dilemma when it comes to the real estate sector. Over the past few weeks it has sought to systematically choke external fund flow to this sector. The budget restricted benefits of venture capital investments to nine sectors, a move believed by many to be aimed at the real estate sector.

Earlier this month the finance ministry said that preference shares issued to foreign investors ought to be treated as debt. A few days ago the government removed integrated townships from the list of sectors eligible to garner funds through external commercial borrowings (ECB).

One reaction to the clampdown is for lawyers and bankers to search for ever more exotic instruments to get around the ban. One such ruse is for an Indian real estate company to set up an overseas subsidiary, which can issue preference shares to foreign investors.

The overseas subsidiary can then invest in an Indian real estate project. This shows up as equity, not subject to any restrictions. The underlying reason for all these manoeuvrings is that the Indian real estate is tremendously attractive, because of basic demographics and a supply shortage.

Foreign property funds were borrowing at libor and then investing in preference shares, which could provide interest payments, thinly disguised as dividend, of 13-15 percent. Indian companies, which are finding it difficult to access domestic debt, are willing to pay this sort of dividend/interest. The policymaker’s problem is that the inflows of dollars could be virtually unending, driving up the rupee and rendering exports uncompetitive.

But while the problem is real enough, the government’s response has sometimes been heavy-handed. The restriction on preference shares hit all sectors, not just real estate. Secondly, real estate is a legitimate business, which should be allowed to access capital.
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