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What the P-Note relaxation could mean

These are unprecedented times and market regulators across the globe have been up in arms fighting the tumbling stock prices. The Reserve Bank of India and Securities and Exchanges Board of India (SEBI) have been pro-actively managing the situation at home with a series of policy changes.

One such measure, taken last Monday, was SEBI’s decision to reverse its stance on offshore derivative instruments (ODIs). While this move could stem the outflow of money from the stock market to some extent, there are a few pitfalls as well.

It was exactly a year ago that SEBI, amidst a furore, had imposed restrictions on the issue of these instruments in order to stem the copious inflow from overseas into the capital market. But as the SEBI chairman, Mr C. B. Bhave, put it this week: “The context has changed completely since then,” and hence the move to revert to the pre-October 2007 state.

ODIs are investment vehicles through which overseas investors not registered with the Indian regulators can take an exposure to Indian equities. Participatory notes, or p-notes, are one form of ODI. Participatory notes were held to be the principal route through which $9 billion of foreign institutional investor (FII) money flowed into the stock market in September and October 2007.

Both RBI and SEBI were then worried about the entities that were gaining a back-door entry into the stock market through this route and causing a frenzied rise in stock prices and spurring the rupee to appreciate sharply to almost 39 against the dollar.

The most significant change brought about last October was banning further issue of p-notes with derivatives as underlying and stopping sub-accounts from issuing p-notes. The existing p-notes on derivatives and those issued by sub-accounts were given 18 months from October 25 to unwind. The share of p-notes in the assets under custody (AUC) of FIIs was then restricted to 40 per cent.

These moves met with great success. The froth in the derivatives segment on the National Stock Exchange dissipated, with turnover in this sector dropping almost 40 per cent by November 2007.

However, SEBI’s press release after its board meeting on October 6 states: “It was decided to do away with restrictions on issue of PNs by FIIs against securities, including derivatives, as underlying.” The implications of this statement are — first, p-notes with derivatives as underlying or the p-notes issued by sub-accounts need not be unwound by March 2009.

Second, FIIs can issue fresh p-notes with derivatives as underlying and thirdly the ceiling of 40 per cent of AUC for p-notes has been done away with.

It is the first implication that is the most significant, given the current scenario in the equity and currency markets. The unrelenting decline in equity prices since January and the consequent depreciation of the rupee to a new all-time low has been caused mainly by the FIIs pulling out close to $10 billion from Indian stocks thus far in 2008. With inflation hovering around the 12 per cent mark, the central bank is keen to rein in the currency depreciation that is boosting the cost of imported commodities.

Data released by SEBI last October revealed that 30 per cent of the total p-notes outstanding at the end of August 2007 had derivatives as underlying. The figure amounted to roughly $30 billion then. Even if one-third of these positions are yet to be unwound, the impact of another $10 billion (could be higher due to rupee depreciation) moving out of the country, on the Indian rupee and stock prices can be substantial. The move to lift the ban, while being unfair on those who have taken the earlier ruling seriously and already closed their positions, is an attempt to stem further outflow caused by this legislation.

The question is whether it was necessary to lift the ban on issuing p-notes on derivative instruments altogether. SEBI could have extended the deadline for unwinding these instruments by another year instead of doing a volte face. It is known that aggressive players in the global arena take directional calls on the equity market and worsen market declines.

Given the present scene, when regulators of even developed markets are imposing bans on short-selling, opening the derivative markets to global hot money can lead to short positions being initiated on Indian indices and stocks, exaggerating the market fall.

Removing the 40 per cent ceiling on fresh participatory notes is not expected to have any impact given the tight liquidity conditions and the fact that many FIIs have yet to utilise their present limits.

The increase in the number of FII and sub-account registration since last October, viewed in the back-drop of the exodus of funds from India, seems to indicate that though global investors are interested in investing in Indian equities, they are awaiting the end of the current credit and financial market crisis before bringing funds in.

The current SEBI directive, however, maintains the guidelines laid down with respect to entities to whom p-notes can be issued and is silent on issue of p-notes by sub-accounts. It was mandated last year that p-notes (by FIIs) should be issued only by entities that are both regulated as well as registered.

This, coupled with stricter KYC compliance, was aimed at halting the round-tripping of money in to India and to preventing unregulated hedge funds from taking exposure to Indian equities. If SEBI maintains the status quo with respect to these guidelines, the fear of unwanted entities playing havoc with Indian stock prices will be far less.

SEBI has also said that a comprehensive review of the FII guidelines would be undertaken in the near future and a consultative paper is going to be put out soon. Keeping the doors of the derivative segment closed for entities not registered with the Indian regulator and maintaining a strict vigilance on the subscribers of p-notes will be good for the long-term health of the stock market.

Source: Business Line

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