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Business
FINANCIAL SCENE
A SEBI shock or overdue correction? financial scene
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Move to moderate foreign institutional investors’ inflows unnerves the markets
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The stock markets’ reactions to SEBI’s proposals on participatory notes have been extreme.
It will be argued for a long time to come whether the early morning precipitous fall in Indian stock indices on Wednesday (October 19) warranting a temporary closure of the markets was due to a genuine reaction to certain Securities and Exchange Board of India proposals relating to foreign institutional investors or the beginning of a massive correction phase after the recent heady surge in prices.
Late on Tuesday, the SEBI had placed on its website a discussion paper on offshore derivative instruments (ODIs), more popularly known as participatory notes (PN).
The preferred conduit
Far from being an arcane issue of interest only to analysts, regulators and the like, discussions on promissory notes have in fact become main stream. This is because the PN has become the most preferred conduit for the FII money coming into India, accounting for, according to SEBI statistics, more than 50 per cent of the funds managed by FIIs in India in August this year.
PN outstanding value
The value of PNs outstanding was Rs. 3,53,484 crore. In March 2004, PNs outstanding were just Rs. 31,775 crore. Obviously, even as FIIs started investing more and more in India, they were finding plenty of investors for their PNs.
The relative familiarity with PNs as a nomenclature does not mean that they are understood by the common man. In simple terms, PNs are offshore derivative instruments issued by registered FIIs to their overseas clients keen to invest in Indian stocks.
The identity of the PN holder is not required to be disclosed to Indian regulators. Subject to minimal reporting requirements, PNs thrived under the cloak of anonymity enjoyed by their holders.
Lack of transparency
In 2003, following a high-level meeting of financial regulators, it was decided to impose certain prudential norms on the PNs.
Chiefly, only entities registered with their respective regulators abroad could buy these. In other words, it was enough if overseas regulators knew the identity of the PN holders never mind that in the country where the investments were made they remained anonymous.
Issues relating to transparency and possibly national security were apparently far from everyone’s mind as the Sensex rapidly set successive records, crossing 19000 and seemingly within striking distance of 20000. Large inflows from FIIs have driven up the prices and PNs have become a significant conduit for channelling foreign funds into Indian stocks.
This explains why a mindlessly euphoric market reacted so sharply on Wednesday. Any other adverse news would have been ignored but SEBI’s proposals to rein in the issuance of PNs have been in an entirely different league, more so because they are expected to enter the rule book soon.
Even the Finance Minister’s clarification that the intention was not to ban but only to regulate the PNs did not "soothe" the markets although towards the close on Wednesday there was a turnaround of sorts. Extreme volatility has characterised trading on Thursday and Friday.
At this point it looks as though that only when the SEBI’s moves are understood in their perspective that the markets will go back to their ‘normal’ levels of volatility. That seems to be some distance away. Some initial reactions were inane.
Instead some inane comments were heard. That the SEBI’s action is a throwback to the era of controls; that no one can check inflows into Indian markets and so on. One extreme view that has been doing the rounds is that neither the RBI nor the SEBI should do anything to upset the rhythm of FII inflows. It is immaterial whether it has caused a runaway appreciation of the rupee besides driving the Sensex and the Nifty to unrealistic levels.
Which points to one of the key issues here. On Wednesday, what was in evidence was the vulnerability of Indian stock markets, seemingly under the control of a handful of overseas investors. Know Your Customer norms (KYC) are in place across the financial sector. For opening a Rs.100 SB account a bank asks for all sorts of identifications, proof of residence and so on.
It is naïve to argue that genuine overseas investors will stay away if they are forced to register with regulators in India. Anonymity may be desirable for some of them but cannot be an overriding factor for most investing in India.
Obviously macro economic fundamentals, economic and political stability, the prospect of another round of robust corporate earnings matter to a much greater degree.
The question of ensuring transparency in all financial transactions is unexceptionable. The SEBI’s moves have in fact come in late. To think they are a proxy for controls on capital flows is wrong.
C. R. L. NARASIMHAN
The stock markets’ reactions to SEBI’s proposals on participatory notes have been extreme.
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