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Has Sebi done the right thing on PNs?
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October 31, 2007
With the markets continuing to rise, the focus has shifted from the short-run impact to the long-run one, and most agree it will bring transparency.

Tushar Sachade
Executive Director (Tax and Regulatory Services)

Restrictions on flows that look suspicious, enhance the markets' reputation and lead to healthy flows.

India's growth, the second-fastest among the world's 20 major economies, has been luring foreign investors in droves, with the Sensex touching record levels.  The sharp rise has been attributed to FII investments, with 75 per cent of floating stock in FII hands and 52 per cent of FIIs' AUC in the form of P-Notes.  Further, while most Asian currencies have appreciated against the dollar since April, the rupee has risen the most - it rose 10.08 per cent against the dollar while the yuan rose only 2.93 per cent.

It is in this backdrop that Sebi introduced restrictions on P-Notes citing concerns over the copious inflows and anonymity that P-Notes offer. From the P-Notes issuers' perspective, while we have FIIs/sub-accounts directly investing in India, they have also been acting as a conduit for third-party investments by way of issue of P-Notes.  The P-Notes-issuing business is presumably a significant revenue churner for FIIs/sub-accounts.  With the restriction on P-Notes, this business is likely to be curtailed.

Both conceptually and in practice, restrictions on suspicious flows enhance the reputation of markets and lead to healthy flows. In spite of KYC norms and disclosure requirements, there are inherent limits to the extent to which the identity of a beneficial P-Note investor can be determined. On account of the limitations of disclosure norms coupled with the need to regulate the quality of inflows and control enhanced volatility, the restrictions on P-Notes were warranted.    

Further, from a P-Note investor's perspective, while anonymous investors need to be clearly prohibited from indirectly accessing the Indian market, Sebi has indicated its willingness to broad-base the criteria for direct registration. This would lead to a tectonic shift in the investment model followed by erstwhile genuine P-Note investors, who would now seek to directly participate in the Indian market. The relaxation of track record and regulated entity criteria for pension funds is a welcome initiative, in this direction. The regulator should look at further liberalising the regulated entity front to allow front-door entry for more investors, such as, hedge funds who are willing to accept greater transparency and disclosure norms.

While the P-Notes restriction has not raised an entry barrier to capital inflows, it has channellised the same through the main door where the regulator can keep a watch.  Further, the introduction of new products such as security lending and borrowing, ability to short sell and long-term derivative contracts, along with improvements in the investment platform for institutional investors, would in our view, act as a catalyst in making India a truly mature capital market. The P-Notes restriction is a landmark event in the history of Indian capital markets and will help in creating a cleaner market where the identity of all investors is known, thereby ensuring good quality funds and preventing sudden outflows.

Lokesh Nathany
National Head (PMS & Wealth Management)
Almondz Global Securities

Volatility will rise in the near term as not more than 40% of an FII's assets can be invested via P-Notes.

Any regulations, when introduced, have a reaction time and an application time. The new restrictions introduced by Sebi on the use of P-Notes by FIIs and on hedge funds are going through the reaction phase.

The capital markets reacted with a rally and touched an all-time high surprising everybody who expected the markets to correct. The restrictions will surely have a negative impact on the markets over the short term. The futures market will bear the brunt as FIIs will wind up their positions over the next 18 months. The current volumes will also go down as no fresh exposure via P-Notes is allowed till they register as FIIs. Volatility may increase in the spot markets in the near term as not more than 40 per cent of an FII's assets under custody can be invested via P-Notes. The other negative implication will be on the taxation front. Currently many foreign investors route their investments through FIIs, who are registered in Mauritius and thereby enjoy the tax treaty. Many FIIs who will register now may not be registered in Mauritius and hence may not get advantage of the tax treaty.

A huge pipeline of IPOs by corporate India to raise capital supported by relatively small domestic funds coupled with the lesser incremental flows from large foreign funds will weigh on the Indian market performance in the coming six months. We may also see a slow-down in the pace of currency appreciation and reduction in excess domestic liquidity accumulation. Overall, the restrictions will have a negative impact on liquidity, currency and markets, thereby increasing the volatility in the near future.

The long-term implication on the markets, however, is very positive as the new regulations will ensure that more stable and reliable funds enter the Indian market. The biggest danger for an emerging market like India is being flush with funds from unknown sources in good times and seeing the flight of capital during difficult times. The current restrictions will restrict inflows in the short term but over the long term, the flows will be steadier, clean and will stay for longer periods.

Another positive feature of the new guidelines is the permission to allow a new set of investors like pension funds, foundations, endowments, university funds and charitable firms or societies. These categories of funds are by nature long-term investors. Another important relaxation by the regulator is the withdrawal of compulsory renewal of registration by FIIs every three years.

India is one of the most attractive markets currently, not just on the basis of its current bull run but also due to the huge demographic and intellectual advantages making it an attractive consumption and outsourcing story. This is the time to put restrictions to ensure that the house is in order. Investors will flock to India sooner or later as they cannot afford to miss the India growth story.

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