By Indrajit Basu
Many developing countries would die for just a fraction of the foreign funds that are currently flowing into India. In India though, the surge of foreign money that is driving up the country's stock markets, along with its currency, has rattled policy makers who believe it may be doing more harm than good.
In a move that caught many off-guard, the Securities and Exchange Board of India (SEBI) has proposed policy measures that for the first time seek to restrict offshore derivative
instruments (ODI), also called participatory notes (PNs) - the financial instruments used by foreign investors to play and invest in the Indian stock markets.
In a note issued late on Tuesday, SEBI said that "following consultation with the government", it had decided to implement measures that will not allow "FIIs [foreign institutional investors] to issue/renew ODIs with immediate effect", and the FIIs "are required to wind up their current position (issued PNs) over 18 months, during which period SEBI will review the position from time to time".
These proposals, SEBI added, are open to discussion, but they will be considered as a directive by the SEBI board on October 25.
SEBI also proposed that there should be no further issue of PNs by sub-accounts of FIIs. Sub-accounts are corporate or special-purpose vehicles floated by FIIs in which they manage money on behalf of overseas clients. Significantly, even PNs issued to buy stocks (not derivatives) will be restricted.
The measures, according to SEBI and the Finance Ministry, are prompted by the recent surge of foreign funds into India and their quality. Regulatory agencies like SEBI, the Reserve Bank of India, and the government, are also concerned about the anonymity that these instruments provide the buyers.
The impact of such measures was immediately reflected by the stock market the following day (Wednesday), when the Sensex index fell a massive 1,700 points, or over 9%. However, after Finance Minister P Chidambaram issued a clarification on Wednesday, the market recovered handsomely.
"What was announced by SEBI yesterday is a part of the series of steps that it have been taken to moderate the capital inflows into India," Chidambaran said. Easing fears that the government is keen to ban PNs altogether, he added: "Investors through participatory notes are certainly welcome to invest in India; but for the present, it is important to moderate these capital flows. And therefore, SEBI has proposed a number of measures that will moderate these capital flows."
Since India emerged as one of the fastest growing economies in the world (just behind China), the country has been the focus of attention of all FIIs. According to Ruchir Sharma, managing director at Morgan Stanley Investment Management, "India currently features as the top destination for FII investments even ahead of China, which is now considered overvalued."
Over the past 10 months, for instance, India saw an inflow of $17 billion in foreign investment, which is more than twice what the country saw in the whole of 2006 ($8 billion). The inflow became even more spectacular last month following the interest rate cut by the United States' Federal Reserve Board, leading to a sharp fall in the dollar and investors consequently seeking better returns in emerging markets. India was one of the biggest beneficiaries.
FIIs pumped close to $8 billion into India in the first two weeks of October alone, more than $5.5 billion of which went into the stock markets. The benchmark stock index, the BSE Sensex, has soared by more than 5,000 points in two months.
But what is a PN and why is it so hot? Since India limits international access to the Indian capital market only to SEBI-registered FIIs, foreign funds not registered in India have found a way to trade in the domestic market by creating participatory notes. These are derivative instruments issued against an underlying security (say a share or a debt instrument). Foreign investors who are not registered or otherwise eligible to trade on Indian stock markets buy PNs from FIIs registered in India, and those FIIs in turn use the funds to trade in India on behalf of the PN holders.
Although initially the PN was devised to enable unregistered foreign investors to test the Indian markets, eventually it evolved into a useful financial instrument for two reasons. One, the PN helps some foreign investors to save on transaction costs and record-keeping overheads. Two, since they are indirect investment instruments and are not subject to regulatory compliance (applicable to registered FIIs), PNs often help investors remain anonymous.
It is this second benefit that has made PNs an extremely popular instrument. Indian authorities believe that not only do most foreign hedge funds use PNs to play the Indian markets, but a host of Indian money launderers first transfer funds out of the country through the informal "hawala" system, and then bring it back using PNs.
The PN's popularity can be gauged from the fact that in the past three years close to $89 billion has been pumped into Indian stock markets through PNs.
Small wonder then that most FIIs consider SEBI's moves retrogressive. "PNs are a practical way of getting international capital into India and allowing international investors to manage volatility and to hedge their positions," said Adrian Mowat, chief Asian and emerging equity strategist at J P Morgan. "Restricting that is going to be negative for the Indian markets because it will make switching positions tough while new money will have to register afresh, a process that will take time."
FIIs add that while India wants the capital flows to be transparent, it also wants the money to remain there for the longer haul, "which is a good measure in the long term" since it impacts both investment stock and the future flow of investments in India. However, "It doesn't send a very positive message to the FII in the short run," said N Jayakumar, CEO of Prime Securities.
Not everyone agrees that the impact would only be short term. In a statement, CLSA, a leading FII in the Asia Pacific, said that if such "harsh measures" are implemented in their entirety, "there could also be an adverse impact in the longer term sentiments towards investing in India." CLSA cites the instance of Malaysia, which experienced indifferent stock market performance and a prolonged bout of depressed trading volumes following the country's imposition of capital controls after the Asian financial crisis of 1997.
Nevertheless, these concerns do not seem to bother Indian policy makers much. "Market sentiment is not a function of capital flow, inflows alone," said Finance Minister Chidambaram. "The fundamentals of the Indian economy are still sound and what SEBI has announced to moderate capital inflows is a necessity step; a step in the interest of investors and in the interest of the capital market. I am sure investors will see the its positive sides soon."
Adds a SEBI official, "All SEBI wants is non-expansion for some PN with large positions. There is no proposal to ban PNs and SEBI is looking at simplifying FII registration norms so that if foreign investors wish to register in India as FIIs, they are most welcome."
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