P-NOTES

Participatory notes and the individual investor
VIVEK MANI
In the first four days of the week gone by, foreign institutional investors pumped in Rs 8108 crores (over $2 billion) into Indian stockmarkets, driving the BSE Sensex up from last week's closing level of 17,773, to 18,814 and almost touching the 19K mark. On October 9 alone the Sensex vied with the proverbial cow that jumped over the moon, to vault a phenomenal 788 points! At the end of the week, it paused for breath and, thankfully, lost 395 points, to end the week at 18,419, up 646.
The top 5 contributors were L&T, Reliance Industries, ONGC, Reliance Communication and Bharti, which, combined, added 428 points. Infosys was the major drag, pulling down the Sensex 43. Given the weakness of the dollar, in which about 60 per cent of its billing happens, the increase in Q2 topline by 8.8 per cent and bottomline by 1.9 per cent, in rupee terms, was commendable, but not enough for investors wishing to see 6 sixes in an over from it!
Whilst FIIs were pumping in over $ 2billion, domestic mutual funds were net sellers. The RBI for one, and this columnist, for another, is a bit skeptical about the true identity of money behind the FII figures. Using Participatory Notes (PNs) it is possible for individuals to route funds through registered FIIs as scrutiny and verification are more benign than for domestic investors. Given, also, the fact that gains can be virtually free of tax, it is not surprising that the PN route becomes an attractive conduit for investment into favoured markets. The RBI is, rightly, worried, and wishes for a stop on fresh PNs, but the Finance Ministry is unwilling to do that.
Investors are also blasé about political crises, one that could lead to early elections and the sort of uncertainty that investors dread. The rally, of course, could have been a wonderful source of funding for such. It is only at the end of the week that the knees of
Congress leaders grew weaker than unformed jelly in confronting the Left. It gave higher weightage to political survival than to the long term energy security for the country. In the case of Indian politicians, long term is up to the tip of their nose!
This myopic view hits companies, and thus the economy. Oil marketing companies are first made to suffer losses by being forced to price petro products below what the market would pay. They are later partially compensated (42 per cent in this case) by issuance of oil bonds, which the Government did last week to the extent of Rs 23,500 crore. This is done with a view to artificially containing the fiscal deficit. Oil marketing companies such as IOC, HPCL and BPCL suffer the losses with practical silence; the government is, after all, the majority owner. Their stocks represent intrinsic value at beaten down prices, though when that value will be realised is anybody's guess. Political wimps will not be able to change such foolish policies.
In other news, the government is likely to formally approve the pricing for the KG gas. Yet, legal issues still remain to be sorted.
Reliance Industries has sought a 3-year drilling holiday in view of the severe shortage of oil rigs, which it ought to get. It, alongwith other exploration companies, have committed to conduct oil and gas recoveries at a certain pace which the shortage of rigs prohibits.
The market has been moving up on increased liquidity, part of it also liquidity diverted from lending in the sub-prime mortgage market to earn higher returns. The sectors that have driven the market are also facing different sets of problems. The IT sector is coping with a weakening dollar. The telecom sector is hampered by spectrum shortage. The auto sector faces higher interest costs on EMIs and tougher emission standards (rightly so). In the petroleum sector prices are controlled. The capital goods sector has little spare capacity.
Yes, the weekend correction was necessary and yes, should there be a continuation of it next week, as one hopes, it would make the market a healthier place. And yes, RBI is right and if, indeed, PNs are a source of concern, it is better to tackle the problem sooner rather than wait for the markets to reach such heights the fall from which would be far more damaging. RBI Governor YV Reddy is right to sound a caution. Is Chidambaram ready to look into it? Or will politics again prevent sensible action?
What are (Participatory Notes) P-Notes?
P-Notes are financial instruments or contracts that are issued by FII’s to investors and hedge funds who wish to invest in India stock markets, but who are not registered with SEBI (Securities and Exchange Board of India).
This is similar to American Depository Receipt; Though the US investor buys the Indian stock by paying US dollars, he never gets the stock credited into his demat account. Instead it remains as depository share, which can be traded like a stock.
How are P-Notes regulated?
According to the statistics available at the SEBI web site, there are 109 registered FII’s as on today, of which 34 Issue P-Notes. FII’s who issue/renew/cancel/redeem P-Notes need to report details about the P-Notes on a monthly basis not later than 7 th of the following month. FII’s investing/subscribing to the P-Notes -- are required to report on quarterly basis.
SEBI has given some guidelines as to who can invest in P-Notes:
• Company incorporated according to the local laws in the country of registration
• Financial institution, such as bank which is monitored by a central bank
• Securities or futures commission
• Member of a recognized stock exchange
According to SEBI Chairman M Damodaran, 25 to 30 per cent of the foreign investment is through issuance of participatory notes.
Proposal by SEBI:
On October 16, the SEBI made a proposal to tighten the regulations for P-Notes. On October 17, trading at the Indian stock markets were halted few minutes after opening as the Nifty plunged to hit the 10% lower circuit limit. This was only the third time trading was halted for one hour in the last 3 years. After resumption, the Nifty gradually recovered from the day’s low and closed at 5559, losing about 1.92%. For those who are interested in candlestick patterns, a “hammer” was formed today at the top of an uptrend.
The Finance Minister, Palaniappan Chidambaram clarified on television channels that SEBI would attempt to moderate foreign fund inflows. The SEBI Chairman said later that “the proposal to bar sub-accounts from issuing participatory notes will help make the system more efficient and transparent.” He was also of the opinion that if an entity has exposure in stocks, the pressure on the market would be less in the event of a downtrend since stocks need not necessarily be sold; but exposure in derivatives, with stocks or indices as underlying assets would be critical in case the market falls, more selling may take place to minimize the losses.
Business Standard has reported that HDFC has the highest P-Notes holding (14.2 per cent) followed by ICICI Bank (9.1 per cent).
The P-Notes will not be banned, however. The FII’s do some proprietary trading and they issue the P-Notes within themselves. By moderating the P-Notes, FII’s will be required to register with SEBI so that their underlying assets can be estimated.
Are the P-Notes being discussed for the first time?
No. The SEBI investigated P-Notes in 2001 stock scam and based on the recommendations of a joint parliamentary committee on the stocks scam, the government banned few overseas corporate bodies from operating in the primary and secondary markets.
In 2003, a technical committee with representatives from SEBI, Reserve Bank of India and Finance Ministry was set up to look into the P-Notes issue.
The Hindu Businessline reported in 2005 that the RBI was concerned about the FII fund inflow through P-Notes.
Is this really a crisis to Indian stock markets?
No. FII money is certainly needed for the Indian stock markets. Without FII’s one could not have thought about the Sensex reaching 19000. With more FII’s certainly the indices are poised to reach higher levels.
However, the regulators’ concern about the genuiness of such inflows is certainly a valid one. SEBI has all the interest and authority to add, amend or modify regulations to the investing and trading procedures at Indian stock markets. So, their action too, should be welcomed, since this will protect the interests of the investors.
Where does the Indian retail investor stand?
The Finance Minister said, “Do your homework or trust someone who can do it for you”. In a market that has been rallying non-stop, definitely retail investors are at a risk since their money is hard earned and they don’t possess the flexibility the FII’s have.
We have mentioned in our weekly and monthly reviews that the market appears to violate the technicals and hence the investors need to be cautious. Though the P-Notes issue is an old one, the market has overreacted to it.

SEBI justifiably nervous of Participatory Notes
Markets have pronounced their judgment. After the mayhem in the stock markets last week, there’s no doubt they’ve condemned the Securities and Exchange Board of India’s (SEBI) move to regulate participatory notes (PNs). And they’ve done it in the way they know best, by voting with their feet to pull the Sensex down 7.83% (1,492 points) in just three trading sessions after the regulator made its draft proposal on regulating participatory notes public. But markets are fickle creatures. So while market reaction is important, it is seldom a good measure of long-term policy soundness. Hence it would be inadvisable to pay undue attention to it.

The more important question is how posterity will judge the regulator. And here the consensus opinion, once the hullabaloo has died down, will be far more forgiving. The reason is that SEBi's proposals are in the long-term interests of the market. To understand why it is necessary to look beyond and see why is the Indian stock market out of bounds to PN-holding investors. Is it cussedness on the part of the authorities? Red tape? No. Because if that were so, we would not have more than 1,500 FIIs and close to 3,500 sub accounts registered with FIIs. Rather, the reason why some investors resort to the PN route is because they are unwilling to comply with simple regulatory requirements.

Today, any entity regulated overseas can register as an FII in India. There are no onerous obligations. All it entails is some minimal disclosures about track record, top five investors and other such details that investors should normally not have any problems disclosing. The basic distinction between funds that come through the PN route and through FIIs, therefore, is that there is no audit trail in the case of the former. There is no knowing either the quality of the money or the ultimate beneficial interest. Which is why when FIIs and PNs come to dominate the market—75% of the floating stock is reportedly now in FII hands, with as much as 52% of the assets under custody of FIIs being in the form of PNs—there is reason for concern.

Like the dog that did not bark in Silver Blaze, Sherlock Holmes’ story of the racehorse that disappeared, the existence of a class of investors unwilling to comply with simple disclosure requirements is reason to doubt its motives. More so when the rise in the number and amount of PNs outstanding has gone in tandem with the ‘excessive’ rise in the Sensex. Admittedly, it is always difficult to say at what point a market is over-valued. But there’s no denying the Sensex has run up faster than warranted by historical trends.

In such a scenario, any regulator would have reason to be anxious and want to know more about the players in the market that is all. In this, SEBI is not unique. The US Securities and Exchange Commission is just as nervous of hedge funds. And if it has not acted as yet, it is only because US markets are highly developed and can deal with the large capital flows.

But as the subprime crisis has shown, even deep, well-developed markets can be laid low, especially when there is lack of transparency. So imagine how much more havoc could be caused by lack of transparency in the Indian context. Merely saying the market reflects underlying fundamentals does not make it so. The reality is that the best of markets is not immune to sudden surges of capital, inflows or outflows. Each extracts a price—inflows, in terms of a sharp appreciation of the domestic currency or if that is a no-no, of a surge in liquidity that can be as damaging. Sudden outflows, however, are far more destabilising. They can set economies back by years, as the East Asia experience showed. Do we want to go the same way? The answer must be an unequivocal ‘no’.

Sebi clamps down on participatory notes

BS Reporter in Mumbai BS October 17, 2007 08:53 IST

The Securities and Exchange Board of India (Sebi) on Tuesday proposed to tighten the rules for purchase of shares and bonds in Indian companies through the participatory note (PN) route.
The move is aimed at arresting the surge in foreign inflows through PNs, which are offshore derivative instruments that allow foreign investors to invest indirectly in a country's stock market (see table), which has seen the benchmark BSE Sensex zoom more than 5,000 points in two months.

The market regulator has proposed that foreign institutional investors (FIIs) and their sub-accounts cannot issue or renew PNs with underlying as derivatives with immediate effect. They have to unwind their current position within 18 months.
Sebi Chairman M Damodaran told Business Standard that the proposals were against PNs but not against FIIs. The procedures for registering FIIs were in fact being simplified, he said.
Sebi has also proposed a ban on all PN issuances by sub-accounts of FIIs with immediate effect. They also will be required to wind up the current position over 18 months, during which period the capital markets regulator will review the position from time to time.

PiNned down
The problem What Sebi proposes
* 34 FIIs/sub-accounts issue participatory notes (PNs) now against 14 in March 2004. * FIIs & sub-accounts will not issue/renew PNs issued against derivatives. They have to wind up their current positions over 18 months
* The notional value of PNs has zoomed from 20% of FII/sub-account assets in March 2004 to 51.6% in August 2007 ?? Rs 31,875 crore to Rs 3,53,484 crore * Sub-accounts can't issue PNs; have to wind up their current positions over 18 months
* The value of PNs with underlying shares as derivatives is Rs 1,17,071 crore, around 30% of total PNs. * An incremental rate of 5% for issue of PNs for FIIs with less than 40% of assets in PNs
* The notional value of PNs, excluding derivatives as underlying shares, as a percentage of total FII/sub-account assets, stood at 34.5% at the end of August 2007. * FIIs with more than 40% of assets in PNs will issue PNs only against redemption/cancellation
Source: SEBI

Sebi has also proposed an incremental rate of 5 per cent for issue of PNs for FIIs with less than 40 per cent of assets in PNs. Those with over 40 per cent of assets in PNs can issue PNs only against redemptions or cancellations.
PNs are issued by Sebi-registered FIIs that do not want to disclose their identity, or those who are in a rush to buy stocks and derivatives without waiting for Sebi registration.
The proposals, which have been framed in consultation with the government, will be "implemented urgently", after receiving comments from market participants within four days. The Sebi board is meeting on October 25 to take a final decision.
The big five FIIs - Morgan Stanley, Merrill Lynch Capital Markets Espana, Citigroup Global Markets, Goldman Sachs and CLSA Merchant Bankers - account for 60 per cent of PNs issued in India.
The Sebi release, issued late this evening said, "The year-on-year increase in PNs, the anonymity that they provide to investors and the copious inflows into the country from foreign investors have been engaging the attention of the government."
"There is an unprecedented surge of liquidity in the emerging markets. And apart from Brazil, the Indian equity markets are favoured the most by foreign institutional investors. However, it would be too premature to make any judgments now," said head of Korean mutual fund Mirae Asset Management Arindam Ghosh.
The proposed restrictions on participatory notes (PNs) are expected to trigger a sell-off by hedge funds, and other short-term players, experts said. As a result, the Sensex, which has risen nearly 35 per cent in the last two months, may also feel the heat when the markets open on Wednesday morning.
Indications from the kerb (unofficial deals) and the fall in Indian share prices in the US markets suggest that the NSE's Nifty Index may open at a discount of at least 150 points from Tuesday's closing of 5,668.05, said dealers.
At 9.45 pm, Dr Reddy's Lab ADR was down 5 per cent to $15.25, HDFC Bank was down 6 per cent to $111.34, ICICI Bank nearly 4 per cent to $53.32 and Infosys was down 5.8 per cent to $48.02.
Hedge funds, which account for at least 30 per cent of PN issuance, may be the first ones to exit, said dealers.
When restrictions were proposed on PNs on January 22, 2004, the Nifty closed 3 per cent lower to 1,770.
Former NSE Chairman R H Patil said, "The market is being manipulated right now and a bubble was growing rapidly. Although the Sebi proposals are late, they would help avoid a greater disaster. It is very important to know the identity of foreign investors, who have been manipulating this market."