What seems to be a cause célèbre for the market (mis)behaviour and of all-round debate, despondency and gloom is a sudden discussion paper brought out by Sebi on Offshore Derivative Instruments (ODIs) in which Sebi has proposed that FIIs and their sub-accounts would not be allowed to issue/renew ODIs with immediate effect and they should wind up the current position over 18 months. Sebi has also proposed to discontinue the further issuance of ODIs by the sub-accounts of FIIs and to allow only certain category FIIs to issue ODIs in a restrictive manner. Sebi does not seem to propose a complete ban on ODIs, because that may be futile.
The reaction of the market as soon as it opened yesterday, suggested that the market presumed that the policy in its present form will be implemented. The market reacted in desperation and panic only because of the reduction of leveraging potential available through the PN route. This sends an interesting signal.
One is reminded of May 17, 2004, when the fall and recovery were almost similar. The sudden collapse in the indices, leading to a market halt appears to be equally irrational as their sharp parabolic rise in recent months. But such is market. It is, at the end of the day, despite the availability of mathematical apparatus for prediction, analysis and risk measurement, an assemblage of human emotions which are ruled by greed and fear, hope and hubris.
The P-Note which seems to be the Hamlet of the piece has been in existence since around 1996, when the international investment community began taking the Indian stock market seriously. There are several reasons one could possibly think of for the P-Note to have become a preferred investment choice for foreign portfolio investment.
One could be the cumbersome procedure for the registration of FIIs and their sub-accounts; the second could be the flexibility available to the ultimate investor because the investor could pre-determine or select the securities in which the investment could be made in the Indian market; the third could be the ease and cost at which the investment could be made in the Indian stock market; fourth, the concerned investor could determine how long it wanted to remain invested in the market; fifth, the FII or the sub-account could guarantee a fixed return to the investor at a hefty fee; sixth, since an FII that invests its proprietary funds has P-Note investors, such an FII could easily offer the facility to exchange portfolios among two of its foreign clients without any change of its portfolio in India.
This allows the FII to run a mini-derivative exchange in its books. On top of it, the exposure of the P-Note holders to the derivatives market offers high leveraging opportunities in the same securities in which the investors have taken positions in the cash market. And finally, the ultimate investor could remain anonymous.
Of these reasons, the registration procedures for the registration of an FII or a sub-account have been enormously simplified. Secondly, the stock exchanges' own systems and procedures have significantly improved and the cost of transaction reduced. This would only imply that it is other set of benefits, including the availability of leveraging opportunity through derivatives, that seems to be a compelling reason for the attractiveness of P-Notes.
This is evident from Sebi's data in the Discussion Paper which points to a notable increase in the number of FIIs offering P-Notes, as well as in the share of P-Notes in FII investments and in the derivatives market. It is clear from the data that not only have P-Notes become more popular, but also they are contributing in a significant measure to FII turnover and open interest, and to the overall turnover of the derivatives market.
There are reasons to believe that the derivatives market movement has an important role to play in fuelling the rise of the indices. The derivative market allows the underlying investor a huge leveraging opportunity at a low cost.
Sebi is not really concerned with the direction of the market as much as it is with safety - to ensure safety of the market falls within its purview, as does investor protection. Market development and market regulation are its triple mandate. The proposed Discussion Paper is in tune with this mandate.
Many experts have commented that the Sebi proposal, if implemented, will be retrograde and interventionary. It is not clear if this is a rational reaction or an emotional one. It is being claimed by market gurus (many of whom happen to be fund managers or hedge funds who have vested interests) that huge amount of funds are waiting in the wings, because of the confidence in the "India story".
If that is so, such funds should not have any reason to complain about the Indian market because the golden age for India has only just begun. Experience over the last 18 years in the market confirms the belief that the international investment community prefers markets where the underlying economy is stable, with strong growth opportunities, where the corporate sector is doing well and the performance is sustainable, where the stock markets are deep, liquid and safe, and the regulatory framework evokes confidence.
India wins on all these counts more than any other emerging market. So long as these reasons continue to remain valid, it is difficult to imagine that the need for a mere registration as an FII or a sub-account would act as an overriding deterrent, unless of course, that money abroad is seeking out a non-transparent highly leveraged investment opportunity in the Indian market for reasons best known to them. In that case, they will find Sebi's present proposals objectionable.
Two questions remain. First, why should India not allow money to come in freely - after all, we are in a laissez-faire economy, and second, would such a measure be able to drive away the PN market? The advocates of the first often confuse a free market from a free-for-all market; there can hardly be any argument about the preference of a transparent regulated investment route over a non transparent one.
Like it or not, till the rupee becomes a fully convertible currency, the regulated FII route will remain. In this context, unbridled capital flows through a non-transparent route could hardly be desirable, because of its attendant consequences on the economy and the market.
With reference to the second question, it will be difficult to imagine a situation where the PN route will completely dry up; it may still exist overtly or covertly, but the curbs might help to insulate the market from exhibiting unnatural exuberance, without stopping the flow of investments through the FII route. But one needs to see in what form the final policy will be implemented by Sebi in consultation with the RBI and the government. The impact on the market can only be judged thereafter.
The author is Dean, Tata Management Training Centre, Pune. These are his personal views and represent neither the views of the Tata Group nor of SEBI.
