The Hindu Business Line : Effective only for the short term?

Regulatory perceptions and compulsions vary from regime to regime. Unless there is serious financial crime or malfeasance, we may not get the cooperation of other governments. As for the Know Your Client rules the regulator relies on, the global record is that they are observed more in breach. SEBI’s proposal on PNs is good in parts and may moderate the inflows only for the present, says K. SUBRAMANIAN.

The late Deng Xiaoping of China was happy with any colour of a cat, black or white, as long as it caught mice. Not so the Reserve Bank of India (RBI), which has been steadfast in demanding that the colour of participatory notes (PNs) be white.

The policy divide between the Government and the RBI came to the fore in the Lahiri Committee Report. The RBI gave a well-reasoned dissenting note. Sadly, the differences dragged on despite serious macro-economic implications created by large inflows.

Need to moderate flows

The government has been dismissive of the RBI’s concerns even as it was increasingly evident that the inflows collaterally damaging the economy were from nameless entities.

What started as a stream in the early years has turned into a torrent. On October 16, SEBI reported that the value of PNs had gone up from $8.1 billion in March 2004 to $89.8 billion by August 2007. While SEBI estimates the share of PNs as 30 per cent, others put it over 70 per cent. The notional value of PNs outstanding bloated 11 times, from Rs 31,875 crore in March 2004 to Rs 3,53,484 crore by August 2007.

In 2007 alone, FIIs brought in $16.7 billion. The Sensex shot up from 16,000 and has pierced the roof, touching 20,000 on October 29.

North Block woke up to realise that the flows were ‘copious’ and that stock market quotes were not certificates for the fundamentals of the economy.

Not surprisingly, the need for moderating the flows assumed urgency. Even earlier, there were reports of consultations between the government and the regulators on the subject.

On October 16, the SEBI released its draft proposals to regulate PNs. On October 17, the market (FIIs) hit back and drove down the Sensex by 1,700 points. Perhaps, the market got it wrong and the SEBI lost no time in clarifying its intention.

The Government did appear to panic and the Finance Minister went overboard in assuring the FIIs of its honourable intentions. Though the market rallied, its behaviour has been erratic. Most surprisingly, on October 26, a day after SEBI formalised its proposals, the market crossed 19,000 again! It was ‘business as usual’ for FIIs. Are they reconciled to SEBI’s proposals?

SEBI’s view

While SEBI has sent out the cloying message that it has no intention of restricting inflows it has in the same breath also warned that they should come through the “front door”, operate transparently and adopt KYC (Know Your Customer) rules.

The SEBI’s proposal has two parts: The first, and more important, restricts the issue of offshore derivative instruments (ODIs); the other regulates the opening of FIIs and sub-accounts.

The first is less troublesome. FIIs and their sub-accounts should not issue or renew ODIs with underlying assets as derivatives. They have to wind up the current position over 18 months.

FIIs having more than 40 per cent of PNs may issue only against cancellation or redemption of existing PNs. Those with less than 40 per cent can issue further ODIs at an incremental rate of 5 per cent of assets under custody (AUC).

If the first part is enforced, it may moderate the inflows. Some foreign critics have faulted it as a covert imposition of capital controls. There will be pressure from developed countries, especially the US, to maintain an open door for portfolio flows.

‘Super-fund’ to bail out banks

The US Treasury Secretary, Mr Hank Paulson, has already made this plea in a speech delivered in Washington D.C. before his visit to India.

When the US is passing through a severe financial crisis and its banks and funds are in disarray, he would be averse to losing Indian opportunities. China seems to count less in his current assessment. Though he has floated a proposal to establish a ‘super-fund’ to bail out banks, there is scepticism and lack of cooperation from European partners.

It is not clear whether there has been an examination of the contingent foreign exchange liability the SEBI scheme entails. The value of outstanding derivatives is humongous.

Though they may not all be taken out at one go, they have the potential to create a crisis, such as the one faced by Thailand in December 2006. That erupted as the Thai move was rather sudden and provoked foreign investors. This may also explain the pains taken by the government and the SEBI to engage in an advance dialogue with FIIs and involve them in the final decision.

More serious doubts are about the second part of the proposal — direct or front-door entry of FIIs, especially hedge funds. There is an abiding faith that hedge funds are ‘regulated’ by their home governments.

Unfortunately, hedge funds continue to be unregulated entities. There is no global regulation or agreement on their activities.

The Securities Exchange Commission (SEC) of the US went into the matter in a long and well-researched report. Though the SEC was divided in its decision over registering hedge funds, its then chief Mr Donaldson went ahead and issued orders. What the SEC wanted was simple registration, not regulation.

The order was set aside by a lower court on a petition from aggrieved hedge funds. There was hope that the US government would appeal to the Supreme Court. The Bush administration decided against any appeal.

Rather, in February this year, it took the decision that there was no need for greater government oversight of the growing hedge fund industry and other private investment groups.

This was based on the Report of the Presidential Working Group which had examined the issue. As explained in a report (New York Times, February 23, 2007), “the administration … announced that investors, hedge fund companies and their leaders could adequately take care of themselves by adhering to a set of non-binding principles.”

The group’s conclusions reflected the anti-regulatory ideology of the administration and the formidable influence of Wall Street and the wealthy hedge funds. In short, there is no regulation of hedge funds in the US, the fountainhead of most such funds.

The OECD made an effort for some years to ‘name and shame’ countries which have lax provisions encouraging tax evasion, money laundering, and so on. The valiant efforts of the Financial Action Task Force (FATF) floundered on the lack of US cooperation.

Regulating hedge funds

Within the G-7 also, opinion is divided. Germany could not succeed in pushing its idea of regulating ‘locust funds.’

Though the SEBI chief, Mr M. Damodaran, has made frequent pronouncements on SEBI’s capability to deal with hedge funds and in getting the cooperation of home governments, these claims fly against the facts. Even a small and friendly country such as Mauritius did not cooperate when SEBI had to investigate transactions relating to the Ketan Parekh scam.

Unfortunately, regulatory perceptions and compulsions vary from regime to regime. Unless there is serious fraud, financial crime or malfeasance, we may not get the cooperation of other governments. Violations of SEBI or RBI orders may not be serious offences in the eyes of foreign regulatory agencies. Nor can we rely on their readiness or willingness to co-operate.

SEBI places a lot of reliance on Know Your Client (KYC) rules. Indeed, these are holy cows for bankers. However, the global record is that they are observed more in breach. Often, junior officials become victims when big banks are prosecuted.

SEBI may do well to recall its own long-standing battle with UBS Securities’ which questioned the rules. The SAT set aside SEBI’s order and the matter is pending with the Supreme Court. In this scenario, what are the KYC rules that SEBI will enforce on litigious FIIs?

If there is any assessment of SEBI’s proposal, it is like the curate’s egg — good in parts. It may moderate the inflows for now but may not wholly succeed in establishing the colour of notes.

(The author, is a former Finance Ministry official, with experience in international, financial and trade issues.)

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