P-notes: A need for moderation on other side, too

Enforcing compliance is fine, but there’s a fine divide between regulation and anachronism

Comment
Alok Sama
Founder & president, Baer Capital

My last visit to Mumbai coincided with the Securities and Exchange board of India’s (Sebi) announcement of the proposed (and now adopted) measures to curtail the issuance of participatory notes (p-notes) by FIIs.

The nature of the questions I have received, and the misconceptions and lack of understanding of the issues even among investment professionals has prompted me to highlight what I believe are the underlying issues.

To start with, one need not look beyond the finance minister’s initial remarks to understand exactly what drove the announcement.

With carefully chosen words, and a real sense of ownership of the Sebi announcement, the FM clarified that the objective of the proposals was to “moderate foreign capital flows” into the stock market, with repeated emphasis on the word “moderate.”

In an open discussion with institutional investors the following day in New York, the FM - with a great deal of humility, I might add - pleaded with investors to understand his plight and that of the RBI.

India had been the unintended victim of the Fed’s decision to once again open the floodgates of liquidity; dealing with the unprecedented and accelerating flows (I believe the word he used was “copious”) into the stock market was proving to be overwhelming, and the implications for the rupee and/or monetary policy and inflation were approaching scary proportions.

The proposed measures provide Sebi with an additional tool to regulate the pace of flows.

Therein lies the answer to the obvious question of what the impact of the new guidelines will be.

Given that the intent was always to “moderate the pace of flows,” it’s a safe bet that Sebi will be in no desperate hurry to “rubber stamp” the flood of FII applications it will inevitably now receive.

Investors that operate from an unregulated jurisdiction might be altogether excluded; to that extent, the measure will go beyond moderating and actually eliminate some foreign flows into the market.

If Sebi further attempts to apply a more subjective screen to some of the applicants (e.g. hedge funds that might be deemed to be “short-term and speculative” in terms of investment style) the impact will be correspondingly greater.

In any case, the point is a simple one - controlling who gets to play and when they start is now firmly in Sebi’s control, which is just the way it was intended.

One could get philosophical and debate whether these measures smack of capital controls.

The answer is they do, though to be fair, the appropriate analogy is more speed breakers than outright roadblocks.

This approach is consistent with other measures being contemplated (for example, the proposed requirement that FDI investments in real estate take the FIPB route) or previously implemented (the ECB guidelines, for example).

As Hank Paulson pointed out on the eve of his trip to India, such measures are “blunt instruments” of public policy; at best, they buy some time, but then again, that is perhaps all that the policymakers intend.

Given the seriousness of the underlying issues, particularly the rupee, I take a fairly sympathetic view of the actions of the bureaucracy.

A perhaps-unintended consequence of their actions may be to head off what I believe might have been an explosive rally in a market where valuations are rapidly approaching bubble proportions.


In a recent meeting with one of the most highly regarded global hedge fund managers, indeed one of the deans of the New York hedge fund community, I was intrigued that his two biggest long positions globally were Chinese H-shares and Indian large-cap stocks, which he viewed as a momentum play with a 6-12 month horizon.

Interestingly, there was no talk of 40% EPS growth or 10% GDP growth, just a conviction that this was 1999 over again, only this time the party was in Shanghai and Mumbai instead of Menlo Park.

While bubbles can last a long time, as Keynes famously observed, “markets can remain irrational longer than you can remain solvent.” 

However, I do believe the FM and Sebi have somewhat disingenuously positioned the “40% of AUC” issue. Surely they always appreciated that while in aggregate there may be headroom up to 40%, in reality the constraint is a binding one for all the major players in the P-note marketplace.

Much has been written and said on the subject over the last few days, particularly issues of ‘transparency’ and ‘anonymity’ and how a screening by Sebi is somehow in the “long-term interest” of the investor.

This proposition is a much tougher sale. To be fair, neither the FM nor Sebi has promoted this notion, rather it seems to be the domestic brokerage community and the vested interest is clear.

P-notes represent a wonderful 0.25%-0.40% annuity (on what was a growing pool in excess of $75 billion) for the handful of foreign brokerage firms that dominate the business.

Domestic firms are almost completely excluded from this business; hence the enthusiastic show of support.

By the way, one of the questions I have been asked repeatedly is whether any other markets have a “P-note” type concept.

The real question to ask is, whether any other market has a FII type regime. I am not personally aware of any.

Of course, in every case, it is incumbent on the regulator to ensure the brokers dealing in a marketplace follow strict KYC and other compliance standards, but beyond this, as a few have rightly highlighted, these rules are rapidly becoming anachronistic, near-term effects and monetary policy considerations notwithstanding.

Bottom line, no doubt we will see a moderation in the pace of FII fund flows into India.

Of course, in the medium term, all this will be forgotten very quickly. By and large, foreign investors have confidence in India’s regulators.

To the extent we stop at what may best be described as “bureaucratic tinkering,” no real damage is done to the credibility and integrity of these markets and the focus will shift rapidly back to where it belongs - on the fundamentals.