Fresh lease of life

A 1200-point, or 6.4 per cent, surge in just two days — which allowed the benchmark index of the Indian markets, the Sensex, to hit 20,000 in intraday trading, at the time of writing— was hardly the reaction expected after the market regulator’s ostensible curbs on foreign inflows from portfolio investors. But that’s exactly what happened.

One possible explanation? The Securities & Exchange Board of India (SEBI) didn’t kill the offending instruments called participatory notes (or PNs, which essentially enabled foreign investors not registered with SEBI to buy domestic stocks), as was expected, and advocated, in certain sections of government, the market, and the media. Rather, what M. Damodaran, Chairman, SEBI chose to do was to tone down his final recommendations on P-notes, which are less stringent than the regulator’s original draft.

The three redeeming factors: Sub-accounts of FIIs—either corporate or proprietary—that have sent a letter of intent to register as an FII needn’t wind up their existing positions within 18 months. However, those entities that haven’t sent in their letter of intent would have to liquidate their positions in 18 months.

Second, FIIs issuing offshore derivative instruments (ODIs) with a notional value of PNs outstanding (excluding derivatives) as a percentage of their assets under custody (AUC) of less than 40 per cent shall be allowed to issue further ODIs at an incremental rate of 5 per cent of their AUC in India.

THE ROUGH WITH THE SMOOTH

SEBI's new norms on foreign flows have their pros and cons.

POSITIVES

Will encourage direct participation from pension funds, endowments, university funds and charities.

A one-year track record of the fund seeking SEBI registration as an FII will not be considered; only performance of fund manager will be taken into account. This will make registration easier.

The limit for a single investor in an account has been increased from 10 per cent to 49 per cent.

Proprietary or corporate sub-accounts that have applied for FII registration can continue with business as usual.

NEGATIVES

Only regulated entities in their country of jurisdiction can participate in the Indian market. This will see no new unregulated foreign investors investing in the Indian market as well as will see an outflow of funds from existing entities that aren’t regulated.

Short-term flows can be impacted because as people who are not registered with SEBI as FIIs will have to unwind their position in the next 18 months. Of the total P-notes, 30 per cent (Rs 1.17 lakh crore) of P-notes have derivatives as their underlying.

Finally, if the notional value of PNs outstanding is more than 40 per cent, FIIs can continue with their current exposure but they can issue fresh PNs only against cancellation or redemption. There, say marketmen, are significant concessions vis a vis the earlier proposed recommendations.

Yet, it isn’t as if PNs have been allowed to run amok. Curbs have been put in place, which will have an impact on FII flows, which had hit a record-breaking Rs 71,013 crore in 2007, till October 26th.

Says L. Brooks Entwistle, Managing Director & CEO, Goldman Sachs India: “This (SEBI norms) will slow down foreign flows into India, and we may also see an outflow on account of unwinding from FIIs.” SEBI has ensured that entities—primarily the cash-heavy hedge funds— that aren’t regulated in their country of origin will not have a window to PNs, with immediate effect.

What’s more, they will also have to unwind their positions in the coming 18 months. This is incrementally negative in the short-term from a funds flow perspective, say analysts. SEBI’s stand of course is that it can now put a face to every investor coming into the country.

The stringent norms on PNs were more focussed on derivatives because there aren’t any restrictions on the exposure limits of foreign investors in the derivatives market. Restrictions are present, with respect to FII exposures in individual companies, in the cash market. Also, the nature of the beneficial ownership or the identity of the PN holder is not known.

The instrument is freely transferable and trading makes it all the more difficult to track the identity of the owner. Says Shuchita Mehta, Senior Economist of Standard Chartered Bank: “The recommendations are positive as this is not a blanket ban on PNs, but largely aimed at controlling the leverage flexibility of PNs and reducing the amount of unregulated money entering the system.

The measure to ban PNs with derivatives as underlying instruments is not only for increasing transparency in the flow of money, but also to slow down the quick pace of appreciation of the rupee; in the next few months inflows through this route will slow.”

The notional value of PNs has grown by more than 11 times since March 2004 to roughly $88 billion (as of August 2007), or 51.6 per cent of all AUC of FIIs or their sub-accounts, and approximately 30 per cent of these are with underlying as derivatives. The problem is in the next 18 months. Even if we consider a 10 per cent outflow from the total Rs 1.17 lakh crore (30 per cent of the total PNs with underlying as derivatives), we are talking about an outflow of $3 billion (Rs 12,000 crore).

However, the long-term benefit is clear: The regulator will be able to track the source of foreign money that’s entering Indian stock markets. However, the other benefit, of taming the rupee, may not materialise.