P-note regulations and after

The Securities and Exchanges Board of India (SEBI) caused a furore in the stock market by imposing restrictions on money flowing in through participatory notes or P-notes, as they are more commonly called.

It is not news to anybody that the SEBI, the Reserve Bank of India and the Finance Ministry have been concerned about the opaqueness of these instruments and the quality of money that was flowing into the country through this route. Here is an assessm ent of the likely impact of these measures on liquidity flows into the country.

Ceiling on P-note issue

SEBI has ruled that FIIs holding P-notes that account for less than 40 per cent of their assets under custody (AUC) can issue further P-notes to increase the outstanding proportion to 40 per cent, but at an incremental rate of 5 per cent of AUC per year. However, FIIs with outstanding P-notes exceeding 40 per cent of AUC on September 30, can issue fresh P-notes only on a cancellation or redemption of existing instruments.

This clause effectively seeks to cap the money coming in through the P-note route. As per a recent report by securities firm CLSA, FII holdings in Indian equities were at $220 billion in August 2007. That suggests that the value of P-notes issued (not counting derivatives) by FIIs and their sub-accounts is currently at roughly 26 per cent of the assets managed by them in India. There could, thus, be room for a further 50 per cent increase in the value of these instruments over the next few years, but this increase would be gradual, as P-notes issuance can only be pegged up by 5 per cent every year.

This move appears welcome, given the heightened volatility that accompanied the deluge of funds hitting Indian stocks in August and September 2007.

Given the overall cap on P-notes, there are a couple of ways in which the gross number of P-notes issued can increase from current levels. If a large number of FIIs possessing the intent to issue P-notes enter the Indian equity market, then the P-notes issued each year may see a dramatic increase. However, given that, of the 1,125 FIIs and 3,450 sub-accounts registered with SEBI, only 34 FIIs/sub-accounts issue participatory notes, it is unlikely that there will be a large increase in FIIs that issue P-notes registering with SEBI in the near future.

Unwinding P-notes on derivatives

A sharp increase in the AUC of existing FIIs can also create room for increases in P-note issues, on a calibrated basis each year. However, SEBI has not clarified whether the date for determining the AUC will be frozen at September 30 this year or if it will be reviewed periodically and the limits modified accordingly.

The logic behind this enforcement is understandable since derivative positions held through P-notes could be partially responsible for the uncontrolled spiral in key pivotals in the stock market in recent weeks. P-notes on derivatives are also likely to be held with a more short-term perspective than the P-notes held on cash transactions. Another reason for banning the P-notes on derivatives could be to bar short-only funds that revel in downward-moving markets.

But one limitation of this move is that P-note holders in cash markets can no longer hedge their positions through futures and options. Speculative short positions will also become difficult to initiate since the mechanism for short-selling by FIIs is not yet in place.

Even if this is implemented, it is not clear if P-note holders will be allowed to use this facility. Forcing P-note holders to take only a long (optimistic) view of the market and preventing them from thinking or acting otherwise could be seen as setting limits on the natural functioning of the stock market. One consequence of this could be that some of these external investors may be forced to hedge Indian securities through overseas exchanges. This may cause loss to the exchequer and result in reduced liquidity in the market.

The unwinding of P-notes with derivatives as the underlying is not expected to cause any market upheavals in near term, given the 18-month window allowed for unwinding of such positions.

But extinguishing the $29 billion worth of ODIs on derivatives over the next 18 months, could more than offset any increase that can take place in P-notes by way of cash market purchases. The unwinding of derivatives-backed P-notes may thus balance out increases in further P-note issuances with cash markets as the underlying.

Hedge Fund Angle

The regulator's stress on 'regulated' versus 'registered' entities has caused qualms in many quarters regarding the ebbing of hedge fund money from the market. The fears are justified since hedge funds have been using the participatory notes route for the convenience it provided in gaining exposure to the Indian market.

However, contrary to general perception, many hedge funds are regulated in the countries of incorporation and they have large institutional investors such as pension funds, university funds, charitable institutions, and so on, investing through them. There are more than a dozen hedge funds registered with SEBI and operating in India.

However, since these funds seek high returns through innovative strategies, not all the hedge funds investing through P-notes would want to disclose their strategies that regulation in a country such as India would entail. Their investment horizon would also be relatively short-term.

So, it is highly unlikely that they would go through the long-winded process of first getting themselves regulated in a country with which India has a double taxation agreement (such as Mauritius) and then registering as an FII in India, just to participate in the India growth story. It appears likely that a large chunk of the hedge fund money could turn away from Indian shores.

A wholly unsympathetic stance towards hedge funds may not be warranted. If a market was entirely devoid of short-term investors, there would be no one to sell the stock to long-term investors looking to buy, and vice-versa when they intend to sell.

In other words, short-term investors are essential for imparting liquidity to markets. Though pockets of disequilibrium occur from time to time, markets have a way of getting back to normalcy.

To sum up, it does appear as if liquidity flows into Indian stocks will be affected, with the flows through P-notes on cash transactions capped and P-notes with derivatives as underlying banned altogether.

One section of the investing community, hedge funds, might reduce its presence in the Indian market. However, the strong growth in the Indian economy could attract investors with a longer-term commitment that can make up for the temporary thinning-down of flows.