India's balance of payments: The tail that wags the elephant ON a local bus trundling round the south of the island, Mauritius does not feel like the centre of a balance-of-payments scare in India. Beaches slip by and a conductor sits puffing below a no-smoking sign. But remote Mauritius, over 1,000 miles (1,600km) from Africa, is no tinpot dot on the map. It is odder and more impressive than that. Mark Twain said it was so beautiful that God modelled heaven on it. Half its people are Hindus, descended from Indian labourers brought over when Britain ruled the island. France once ran Mauritius, too: hence its Gallic creole and baguette-munching office workers dressed to kill. Strangest of all, Mauritius is the world's financial gateway to India (see chart 1). It is the tail that wags the elephant. But its status and the position of outside investors in India have been upended by a bewildering display from India's government. On March 16th India's draft budget unexpectedly proposed two kinds of tax clampdown. First, some takeovers of Indian firms would be retroactively taxed; this was aimed at Vodafone and a handful of other firms. Second, new "anti-avoidance" rules were proposed; the main targets, although not explicitly named, were foreign investors using Mauritius. Thanks to a tax treaty between the two countries, by routing investments into India through holding entities on the island they can pay capital-gains tax at the Mauritian rate, which is, in effect, zero. Between 30% and 40% of the stock of foreign capital in India is probably routed through the island. It was a rotten time for India to pick a fight. Since a crisis in 1991 it has aimed to run a modest current-account deficit funded by sticky capital inflows, in particular purchases of listed shares and foreign direct investment (FDI). But lately things have got hairy. The deficit has hit 4% of GDP because of dear oil and Indians" purchases of gold, which reflect a fear of inflation and mistrust of banks. And the boom in FDI has faded as foreign firms are mugged by reality on the ground in India. Even the central bank says red tape and official dithering put foreigners off. The budget added to foreigners" fears, especially after baffling official "clarifications" of the new rules. Foreigners became net sellers of equities in April. India's foreign reserves are not puny, but are poor by Asian norms. Chatter spread of a balance-of-payments problem. The rupee fell by 7%, forcing the central bank on May 4th to pass measures to attract debt flows to prop it up (see chart 2). By May 7th the government had backtracked. The first part of the changes - clobbering Vodafone et al - would stay, said Pranab Mukherjee, the finance minister. But the anti-avoidance rules, whatever they really meant, would be delayed until March 2013, and safeguards added to protect investors from the tax man's tender charms. The delay has relieved Mauritius, which had feared bits of its finance industry might suddenly go the way of its most famous ex-resident, the dodo. It's a good thing. It'll allow talks between India and us about the guidelines [for any changes to domestic Indian laws] but also our double-tax treaty," says Xavier-Luc Duval, the vice-prime minister. Investors are still nervous, though. "It's regulation by proclamation," says a Mumbai broker. "When people ask the government what it means, it replies, "How the hell do I know? You work it out."" Mr Mukherjee with a billiard ball So a game of sleuth has begun, to fathom where the rules are heading. At stake is over $260 billion of foreign money in India, much of it routed through Mauritius. The mystery is motive: what does the Indian government want? There are three theories: that it is clueless, that it wants symbolic control, and that it wants cash. The unkind view is that the government has no idea what it wants, beyond reversing a supreme-court ruling in January that no capital-gains tax was due on Vodafone's 2007 purchase of its Indian arm. The anti-avoidance bit of the budget, the theory goes, was a last-minute addition. However, India has been annoyed with Mauritius for years, not weeks, and with some justification. The budget's anti-avoidance rules were a souped-up version of those buried in another reform, called the direct tax code, which has been in the works for a while. The Mauritius relationship is an accident, but an old one. The tax treaty, signed in 1982, was meant to boost India's investments on the island; ethnic ties gave India a soft spot for the place. Ever since the cash started to come the other way, India has liked the loot but has been peeved that it has little say over the rules. So the second theory peers into the bureaucratic ego, and judges that India's government has lost face and wants symbolic control. It would be satisfied by a demonstration that it is boss. That means a crackdown on "black money" (officials on the island say they are co-operating and that most claims about funny business are unjust). And it means squeezing legal activity that offends India's sense of fairness and dignity - that is, "postbox" funds that have little substance in Mauritius and are mainly there to use the tax treaty. There are plenty of skin-and-bone operations in Port Louis, the island's capital. Most India-linked vehicles are required to have local directors and a bank account, and to file accounts. But a tour of the city suggests many lack substance. Over 40 funds listed by India's financial authorities have their address as Les Cascades building. Seven of its eight floors carry the logo of a local business-services firm. A manager says foreign clients make key decisions in the premises. By the racecourse is an accountant's office at which multiple foreign funds in India have their addresses. Its top two floors, desperately lonely for a mid-week afternoon, house subsidiaries of Essar, an Indian conglomerate. An employee says it has 30 staff in Mauritius. That level of staffing is not a postbox affair, but one of the subsidiaries with its head office there is Essar Energy, a London-listed firm with Indian assets and $15 billion in sales. The nice thing about the second theory - that India's government wants symbolic control - is that it promises a happy ending. On this view the rules that are passed in a year's time will mainly feature a tighter definition of the "substance" an entity must have in Mauritius to qualify for the treaty benefits. There is a precedent. India's more recent tax treaty with Singapore says a qualifying entity must either be listed in Singapore or have S$200,000 ($160,000) of annual operating costs. Were Mauritius to match this definition of "substance," perhaps the entire saga could be put to bed. All you would need to do is hire a few more warm bodies and get a bigger office in Port Louis. At worst, says a Mumbai-based fund manager, you could shift to Singapore, with its sturdier treaty. If I needed to move to Singapore in two weeks, it wouldn't be that bad. Mauritian bigwigs say this is naive. Why would India's government have a pedantic obsession with the number of water-coolers in Port Louis? Why would it push money to Singapore for no gain? The debate about substance is a "figleaf," says one. India's goal, however fumbled and wrapped in opacity, is more money. Taxing portfolio investors at the Indian rate of 16% for short-term gains and zero for long-term gains, and other foreigners" gains at the proposed long-term rate of 11%, could raise several billions of dollars a year. The tidiest way for India to get there would be to rewrite the tax treaty with Mauritius, and then renegotiate its treaties with other jurisdictions. If it did this India would break from the system preferred by many rich countries, in which tax is charged on the gains of the ultimate investors in a company or scheme by the country where they reside. Instead, India would shift to an approach where the intermediaries - ie, fund-management firms or companies - pay tax on gains in India, regardless of their holding structures or the ultimate residence of their investors. India would be hypocritical, too: most of its own outward investments, including the takeovers its patriots cheer, usually use low-tax jurisdictions. But it would be within its rights. In 2006 China rejigged its treaty with Mauritius so that it could tax the capital gains of some foreigners. It's the money, stupid Offered a stable and efficiently applied set of new rules, investors would probably pay more tax, not flee. The sums would be modest relative to what they have invested in India. Yet while the Indian government's probable instinct is reasonable, its ability to execute this delicate manoeuvre is limited. Over the next year it will probably tweak away until it finds another unstable equilibrium between the urge to tax foreign capital more and fear of scaring it away. Foreigners will suspect that sooner or later the rules will change again. The cost to India of uncertainty will exceed the benefit of taxes raised under any scenario. The working assumption in Mauritius, too, is of instability. It is quietly trying to diversify its financial industry away from the India tax-arbitrage game and become a hub for Asian trade with Africa. It is deepening other friendships, too. China is helping to build the new airport and a dam, and has loaned it $600m. If the India tax trade does go the way of the dodo, the island will probably bounce back, just as it did after the decline of its sugar and textile industries, with a mix of organisation and forward thinking. Indeed, of the two countries, it is not Mauritius which is running its tax-and-investment policy like a funny little island in the middle of nowhere.