India to curb foreign funds
deluge 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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