The Hindu Business Line : Right move on PNs

As we become a destination for global investors, we need to check not only the quantum of capital inflows but their quality as well. Any outside infusion of capital into an economy could create a bubble if not used constructively.

Anil Singhvi

Globally, October has never been an easy month for equity markets. In 1987 and 1997 the markets tanked in October and again threaten to this year. In the last 100 years beginning 1907, only in 1947 did the markets move up in October.

As for the Indian markets, though October has never really been a ‘deadly’ month, this yearit may turn out to be one.

Till some years back, it took around a year for the Sensex to climb 1000 points. The time-span for such a climb has shrunk rather quickly to one season and even to a month. And in the first half of October we saw the Sensex climb from 18K to 19K in just four days. But then came the October effect, as circuit breakers were applied on October 16.

The power of money was at play. The Money Momentum Mania (3Ms) was the cause for the indices scaling to such heights. While the various players in the stock market were celebrating, the monetary authorities and the Government were turning apprehensive. The deluge of money, described by some as “funny money”, prompted the regulators to act, by issuing a notification to regulate the issue of Participatory Notes (PN).

What’s PN?

A Participatory Note is an Offshore Derivative Instrument (ODI) . The invention of this product was necessitated as many fund managers did not want to register with SEBI (Securities and Exchange Board of India) as foreign institutional investors (FII), but still wanted to play the stock market.

The mechanism is simple. Contact a foreign broking house registered also as an institutional investor in India and ask it to buy shares in the local market, and issue a synthetic share by way of a PN.

There are about 1,000 FIIs registered with SEBI. Of these, only about 34 are both stock brokers and institutional investors. These are the ones that buy Indian stocks for their own clients as well as on behalf of those who do not wish to be registered in India, mainly hedge funds, that is.

These 34 brokers have issued offshore derivatives to the tune of about $100 billion, or almost 10 per cent of the country’s GDP. Now we get a very clear picture of how we have developed a completely new market that is outside the purview of Indian regulators.

The whole purpose of SEBI’s draft notification is to bring these unknown, unregistered investors into its fold. And this has created much hue and cry and nervousness in the market.

When it started, PN made up only a small portion of the total ownership by foreigners, but this has now reached alarmingly high levels. Until March 2004, it was just 20 per cent of the total FII participation.

By August 2007 it was over 50 per cent and by October it is likely to touch 60 per cent, amounting to around $100 billion.

In the six weeks from September, the RBI has had to grapple with the problem of buying the huge influx of dollars on account of PN purchases..

The case against PN is not only quantitative but also qualitative — that is, quality of investors participating in the Indian market.

Look at how local investors are regulated. In addition to the KYC (know your clients) requirement, they have to be registered with brokers giving details of proof of address, PAN, and so on. Why this step-motherly treatment to Indian investors and red carpet welcome for institutional investors who don’t even want to be registered and yet participate in the Indian market?

Welcome step

The step taken by SEBI is in the right direction. As we become a destination for global investors, we need to not only check the quantum of capital inflows but their quality as well.

Any outside infusion of capital into an economy could create a bubble if not used constructively. We have to avoid the kind of situation that led to the 1997 East Asian financial crisis which affected almost the entire Asian region.

If not for the breaks applied by the policymakers, the Indian stock market could well have headed into a crisis.

While there is no denying the fact that India needs huge amounts of investments for growth, the same should be orderly and, more importantly, on a sustained basis.

The huge amounts of capital currently flowing into the stock market are basically hot money pumped in by hedge funds. These funds do not want to be regulated, and this has become a global problem. India is one of the few countries that is addressing this problem openly and boldly.

To safeguard our capital market against financial crises, it is essential that these funds are not only registered but also monitored. One should not forget the stock market crisis of 2001, when there was a deluge of money coming from OBCs (Overseas Bodies Corporates). PN money is no different.

The cautionary approach of the regulators may be resented by some, but for long term sustainable growth of our capital market, such an approach is imperative.

(The author is Chief Executive Officer of Ican Investment Advisors Ltd, Mumbai.)