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India still hedging its
bets
By Jayanthi Iyengar
NEW
DELHI - Business opportunities do not present themselves
often. But when they do, there's no dearth of interest
groups trying to press home an advantage. A situation of
this kind has arisen in the case of India. The past two
months have seen investment bankers, investment advisory
groups and foreign and Indian brokerage houses with
branches abroad actively lobbying with the Indian
government to further relax foreign portfolio investment
norms.
The carrot that is being held out is that
India could double, if not treble, its net foreign
portfolio investments, which cumulatively stand at
around US$12.16 billion up to end 2002 and account for
$700 million in 2002. "Many new hedge funds have
approached our US office to check out the feasibility of
doing business in India," a dealer with a futures
brokerage house said on the condition of anonymity.
Presently, India permits portfolio investments
only by foreign institutional investors (FIIs). Foreign
hedge funds comprising of a few shareholders and foreign
nationals are not permitted to invest in the Indian
capital market.
Market players differentiate a
hedge fund from a FII based on the composition,
regulatory and prudential requirements and the
investment motives of the fund. The most important
difference is that the former comprises few
high-net-worth individuals, though the latter is an
institution, governed by its articles of association and
subject to the prudential and other norms that apply to
institutional players.
The hedge funds, even in
the US, are largely unregulated, their managers driven
only by the profit motive. Such funds are predatory by
nature, led by fund managers fueled by profit-sharing
motives (the profit-sharing formula could be as high as
30 percent of the profits booked) as against the fixed
compensation packages (1 to 2 percent of the assets
under management) drawn by the institutional fund
managers. This make the institutional investors orderly
players by nature, while the hedge funds are often
unruly, undisciplined and feared.
The power of
hedge funds to destabilize the countries and markets in
which they operate is best summarized by Jeffrey Sachs,
director of Harvard Institute for International
Development. Writing in the Financial Times in 1998,
Sachs summed up the role of the hedge funds in the
Southeast Asian crisis thus, "The international banks
had lent just five Asian countries - Indonesia, South
Korea, Malaysia, the Philippines and Thailand - no less
than $175 billion in short-term loans by mid-1997,
perhaps twice the level of liquid foreign reserves in
those countries. It was the flight of those loans,
accelerated by the short positions of hedge funds and
investment banks, that brought down the Asian
economies."
It is because of this characteristic
that hedge funds are feared the world over, more so by
the developing countries whose financial structures are
fragile. Following the Mexican and the Argentinean
crises, Chile went so far as to slap a tax on capital
inflows. India has not gone that far, but it tends to
discourage short-term capital outflows (less than three
years) by slapping 30 percent capital gains on profits
booked within a year, and 20 percent on profits booked
within a year but repatriated out of the country after
two years. The rate of tax on profits booked at the end
of three years is, however, a reasonable 10 percent, on
par with international standards.
Lobbying for
opening the doors to hedge funds has been periodically
witnessed in India, but several new trends have set off
this debate yet again. At the Indian end, the most
significant development is the recent permission to FIIs
to invest in equity derivatives. This market is nascent.
Local players have not yet developed requisite skills to
make market killings. The immaturity of the Indian
derivatives market thus offers skilled traders
opportunities to book quick, short-term gains. Such
opportunities are the life-blood of hedge funds, which
constantly scout the globe, looking for market
imperfections and arbitrage opportunities to make a
killing.
Simultaneously, India has also made
several structural changes in recent years, taking the
investment and safety standards set by the Indian
capital markets closer to international benchmarks. The
country also permits settlement of derivatives
transactions in the underlying shares. The shares
themselves are undervalued, which makes it possible for
the FIIs with deep pockets to leverage positions in the
market at comparatively low cost. Conversions of
physical shares into a dematerialized form (electronic
shares), shorter settlement cycles (T+3, or settlement
of a deal within three days of entering into it) and a
ban on badla (the highly speculative, Indian
variant of forward trading), have improved the comfort
factor for investors.
Add to this a weakening
dollar, tighter scrutiny of the source of funds and
overall dullness in the US capital markets and you have
the reasons for why emerging markets could yet again be
the flavor of the season in 2003. In keeping with the
overall mood, the US-based Institute of International
Finance (IIF) has already predicted modest growth in
private capital flows to emerging economies in 2003. It
has predicted that private capital flows would be up
from $1,125 billion in 2002 - which was also the lowest
during the decade, with the 1990s averaging $1850
billion annually - to $1262 billion in 2003.
IIF
estimates show that in 2002, China was the single
largest beneficiary in the Asia-Pacific region, though
these capital flows were largely in the form of FDI and
not foreign portfolio flows. Out of the 61.8 billion
private capital flows to the Asia-Pacific region during
the year, the IIF points out that $51.8 billion accrued
to China, largely on account of its accession to the
World Trade Organization.
In the case of foreign
portfolio investments, however, the Chinese situation is
slightly different. The country opened up trading in its
A-group scrips to FIIs only recently. Till then, foreign
investors were permitted to trade only in B-group
shares. This is unlike India, where foreign portfolio
investments have been permitted in equity and debt
segments for close to a decade and the derivatives
segment, too, has recently been thrown opened up to
foreign institutional players. "Basically, hedge funds
are on the lookout for markets with good volatility and
price anomalies and India has both," John Band, chief
executive officer, ASK-Raymond James & Associates,
recently told an Indian business daily, the Business
Standard.
These structural changes at the Indian
end apart, several developments have also taken place in
the US, which is making the new US hedge funds look
outwards at alternate investment destinations such as
India, which continue to offer a 15-20 percent
annualized return on capital even under depressed market
conditions.
As far as the US hedge funds go, the
immediate provocation for scouting for alternate markets
is a new registration requirement. This requirement has
been slapped by the US Treasury and requires US offshore
funds to register themselves with the US Treasury
Department's Financial Crimes Enforcement Network. The
new norms apply to hedge funds which have a US
clientele, are organized and/or sponsored by US citizens
and have investments exceeding $1 million. This
essentially means that the new norms apply to all large
hedge funds promoted by US nationals. It also means that
US offshore funds, which have been routing investments
through known tax havens like Mauritius to invest in
India and other emerging markets, would now be subject
to the US Treasury's scrutiny.
The US
government, of course, is tightening the disclosure
norms for US hedge funds in order to monitor drug, crime
and terrorist monies after September 11, but the speed
with which US hedge funds have been looking eastwards
seems to suggest that scrutiny of any kind is abhorrent
to them, and to their style of functioning.
Market experts anticipate that the new norms
will ensure the splitting of US hedge funds into smaller
ones to beat financial scrutiny, but at the same time,
market expectations are that the coming years will only
see the tightening of norms for US hedge funds.
It is against this background that several
foreign and Indian brokerages with branches abroad
report that they have been receiving inquiries from new
US hedge funds about doing business in India. Dealers
with these firms argue that India should officially open
its doors to US hedge funds, since they already invest
in the country, using a circuitous route. They point out
that these hedge funds, and not the FIIs, were
responsible for bringing in the $700 million in net
portfolio investments in 2002. These sums, they point
out, were brought in by the hedge funds through the FII
sub-accounts and participatory note routes.
To
understand this argument, one needs to understand the
definition of an FII in India. FII regulations date back
to the early 1990s. They were formulated under G V
Ramakrishna, the first chairman of the Securities and
Exchange Board of India (SEBI), the Indian equivalent of
US capital markets regulator, the Securities Exchange
Commission (SEC).
The former SEBI chairman took
the view that India should open up its capital markets
only to known and recognized FIIs. He argued that this
precaution was necessary to ensure that drug, crime and
terrorist money did not find its way into India.
After the Southeast Asian crises, this line of
thinking has come to be enshrined in economic text books
as the right approach to insulating nations from the
volatility of global capital flows. But Ramakrishna took
this view as early as 1991, way ahead of the Mexican,
Southeast Asian and Argentinean debacles, which have
sealed the debate on the desirability of hot money
flows.
Under Ramakrishna's tutelage, India's
foreign portfolio investment norms defined an FII as
follows:
An FII investing in India must be registered with
SEBI.
An FII seeking registration with SEBI must be
registered with a recognized foreign securities
regulatory authority (recognized by SEBI) or by a
foreign tax authority.
An FII seeking registration with SEBI must have a
five-year track record.
If the FII in question is a newly organized entity,
SEBI may consider the track record of its parent/group
company based on which the registration to the new
entity could be granted.
If the FII proposes to directly invest in Indian
portfolio companies, it would have to be broad-based,
which means it must have at least 50 shareholders, each
holding not more than 5 percent of the corpus of the
FII.
The thought process at that time was that
the markets would be opened up to investments from
foreign individuals in the course of time, but that
thought has been debunked after the repeated market
meltdowns which exposed the fragile underbelly of the
financial markets.
Thus, these norms are
tailored to ensure that only known institutional
entities, subject to regulation in the country of their
origin, are permitted to trade in the Indian markets.
The broad-based holding norm again ensures that only
institutions and not individuals gain direct access to
the Indian capital markets.
However, the
existing norms do not debar an FII from taking on either
individuals or hedge funds as clients. Thus, a
well-known FII operating in India may have
high-net-worth individuals like George Soros on its
client list. Such high-net-worth individuals would be
within their rights to invest in India through the
sub-accounts of the 480-odd SEBI-registered FIIs
operating in the India.
This list includes known
institutional investors like Goldman Sachs Asset
Management Company, Van Hedge Fund Advisors
International Inc, Sloane Robinson Investment
Management, Farralone Capital, Oak Tree, Wessex,
Standard Capital and Bayer Alden. Interestingly, Soros,
too, has a broad-based fund registered in India.
Indian and foreign brokerage houses, which
currently smell opportunities for new business, have
been arguing in recent weeks that since the norms are
already being circumvented, it may be in India's
interest to officially open the doors to the US hedge
funds.
India's finance ministry officials,
however, do not agree with this argument. They point out
that India's cautious approach helped her insulate
herself from the Southeast Asian crisis. Besides,
forcing the US hedge funds to route investments through
SEBI-registered and globally recognized foreign
investment entities ensures that the FIIs are answerable
for the source of funds being managed by them. "In case
the regulator here or in their parent country finds them
guilty of dealing in dirty money, the entities would
face action either here or at home, based on where the
crime has been committed," as a senior finance ministry
official said.
Ministry officials further point
out that the world has already seen the kind of damage
that can be wrecked by the aggression of the foreign
hedge funds. They point out that having insulated itself
from the Southeast Asian meltdown, it would be foolish
of India to leave itself open to the predation of the
foreign hedge funds at so late a stage. "Even if the
process is slow, it is preferable to encourage
longer-term capital flows in the form of FDI, rather
than to open the doors to hot money flows," the official
said.
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