Business

PNs: changing tune of regulators

— FILE PHOTO

SEBI headquarters in Mumbai.

Public memory is short and policymakers turn this to their advantage. An excellent example is the re-entry of Participatory Notes (PNs) through the back door.

A Participatory Note (PN) is a derivative instrument or contract note issued by foreign institutional investors (FIIs) to market participants who do not want to reveal their identities or are not registered with the Indian regulator.

FIIs invest funds on behalf of such investors, who prefer to avoid making disclosures as required by various regulators. Before banning them permanently, the Securities and Exchange Board of India (SEBI) in October last had urged all such entities to come forward and register themselves with SEBI as market participants. The number of foreign entities registered with SEBI has risen to 1,539 from fewer than 1,000 a few months ago.

In a desperate attempt to salvage the capital market, the regulator has now reversed all the decisions it took on October 25, 2007 to ban the entry of PNs. SEBI had announced such a final set of regulations on Overseas Derivative Instruments (ODIs), particularly on PNs, after finding that the entry of these entities was creating high volatility in the markets. This had brought a sigh of relief to the financial markets and its regulators.

Market regulators had a twin objective in regulating PNs. While the Reserve Bank of India’s (RBI) mandate was financial stability, it was market stability that SEBI intended to uphold by reining in PNs. Former RBI Governor Y. V. Reddy had consistently raised this issue in several forums.

The PN issue first cropped up in 2004, when the regulatory authorities found that around Rs. 24,000 crore (around 25 per cent of total FII investment) had entered the market through the PN route. A similar situation was observed during the stock market boom in 2000. The investigations into the Ketan Parekh-led stock market scam of 2001 uncovered the fact that around $2 billion had been brought in and taken out of the country through OCBs registered in Mauritius. However, in the aftermath of the scam, and following the recommendation of a Joint Parliamentary Committee (JPC), the RBI had banned OCBs from investing in the stock market, secondary as well as primary market. The PNs are alleged to have come back through Mauritius, a route well known for money laundering, and the ultimate beneficiaries of these capital flows were resident Indians.

A little history behind this PN episode: after the Reserve Bank made a hue and cry regarding PNs in 2003 and 2004, SEBI had said, in a statement issued on January 23, 2004: “It has been decided that outstanding PNs against unregulated entities will be permitted to expire or to be wound down on maturity, or within a period of five years, whichever is earlier.” SEBI also had decided to regulate the fresh issue of PNs by making it mandatory that from February 3, PNs against underlying Indian securities could be issued only to the registered entities. The statement further said that the FIIs or sub-accounts are required to ensure that no further downstream issuance of such derivative instruments is made. The FIIs issuing such derivative instruments have been told to exercise due diligence and maintain complete details of the investors, based strictly on ‘know your client’ principles.

The market reacted to this decision, made at the beginning of 2003, by beginning to fall. SEBI, in a volte-face, legitimised the PN investments it had just deplored. The then BJP-led NDA Government had good reason to approve: keeping the market buoyant was crucial to its `India shining’ agenda.

Surging inflows have been a big challenge for the RBI. These have been further accelerated with huge inflows into the stock market. The relentless capital inflows through the FIIs pushed the BSE Sensex to 20000 in October 2007. FIIs brought in $9.46 billion in Indian stocks in 2005, $8 billion in 2006 and a record $17 billion until October 2007. The Sensex lost about 50 per cent from its all time high of 21,206.77 (intra-day) recorded on January 10 this year by closing at 10,527.85 on October 10, 2008. With a final regulation on PNs, announced on October 25, 2007, a long-standing concern of the RBI was resolved by curtailing the entry of hot money into the system.

Now the mistake committed by the BJP-led NDA Government as well as the present Congress-led UPA Government are the same. The reversal of the decision on PNs on February 3, 2004, prior to that year’s general election, was inspired by the fear that a falling market would damage the ’India Shining’ campaign. Now the UPA Government has brought back the same PNs to salvage the falling stock markets, with an eye on the forthcoming general elections.

A kind of desperation is reflected in the decisions of RBI and SEBI, as though the whole economy is represented by market indices. Another decision that deserves to be discouraged is the hike in interest rates of non-resident Indian (NRI) accounts.

The story of the collapse of India’s foreign exchange reserves in 1990-91 following a combination of withdrawal of foreign currency bank deposits by NRIs, the collapse of the Soviet Union and the oil-price rise in the wake of the (first) Iraq War and how this forced the process of economic reform is well known.

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