The Hindu Business Line : Wrong prescription

The dramatic market recovery after the precipitous fall at the start suggests that the players have spotted the fine print in the proposed regulatory fiat.

The Government, RBI, SEBI and all those charged with the responsibility of the macro management of the economy are quite right in their diagnosis of the problem of unabated flow of foreign money into the capital market. The flow in recent times has been exceptional. There is also enough evidence in the global market to suggest that some of these investments may have been put together on money borrowed against the collateral of underlying investments in Indian equity. When such heavily leveraged investments are in turn ploughed into derivative instruments such as futures and options, the super structure of the equity valuation created in this manner rests on a shaky foundation. The apprehension that the slightest disturbance in the global financial architecture can lead to a dramatic reversal of the flow of funds is not without merit.

But being right about the diagnosis of the problem does not necessarily guarantee the efficacy of the prescription. The cap on participatory note-based investment, as SEBI has sought to do, makes no sense. It implies that proprietary investment in the Indian market by registered foreign institutional investors is virtuous but that intermediated by them but belonging to a pool of third-party investors is somehow tainted. Persons of Indian origin and non-resident Indians who may pool in their savings through well-known investment institutions abroad may not quite share that judgment. Indeed, a more conservative view among some policy makers is to regard the problem as having its core in the unbridled flow of portfolio investments rather than the flow accentuated by participatory notes. In any case, it is not too difficult to structure a pooled sum of money, which is what participatory note-based investments are, into proprietary investments through artful financial engineering. As long as overseas investors see the Indian capital market as a profitable destination for their funds, a way may well be found for routing investments into it, a cap on participatory note notwithstanding. At the very least, they may resort to creating a market for FII certificates, as by SEBI’s own admission the problem of participatory note-based investments is restricted to 34 such institutions among the 1,500-odd FIIs registered with it. Indeed, the dramatic recovery in the course of a day after the precipitous fall at the start suggests the market players did spot the fine print in the proposed regulatory fiat.

This is not to say that a sudden surge in the flow of funds does not pose regulatory challenges. The dramatic inflows and the prospect of equally strong outflows can play havoc with the economy. But the solution to the problem lies in scaling up the size of the national economy to a point where the already marginal nature of its linkage to the outside world is brought down further. It calls for eliminating constraints on its growth through administrative and policy reforms so that portfolio investments seem even smaller relative to the size of the economy.

Related Stories:
SEBI plans curbs on FII participatory notes
Participatory notes account for over 40 pc of FII inflows
PN most preferred route for FII investments

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