AUTHOR: Rama Krishna Vadlamudi vrk_100@yahoo.co.

in
MUMBAI
October 18th, 2007

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 Equity investors in India had been jolted out of their smug comfort, a minute after markets
opened on 17.10.07. The benchmark Sensex had fallen by 1,507.71 points and touched
17,544.15 as soon as the opening of the market. Nifty had fallen by 524.15 points to touch
5,143.90. As the circuit filters were triggered, trading was suspended for an hour. The markets
reopened at 10.55 a.m. and made a smart and surprising recovery. At the end of the day, Sensex
closed at 18,715.82, down 336.04 points down from the previous day; while Nifty closed at
5,559.30, down 108.90 points.

The turmoil in the markets was caused by a SEBI proposal to regulate the foreign inflows
through Participatory Notes, popularly known as P-Notes or PNs. We present an analysis about
them as below:

WHY THE SUDDEN INTEREST

SEBI issued a discussion paper on 16.10.07 and the proposals are as follows:

1. FIIs and sub-accounts will not issue/renew PNs issued against derivatives. They have to
wind up their current positions over 18 months.
2. Sub-accounts can not issue PNs; have to wind up their current positions over 18 months
3. An incremental rate of 5% for issue of PNs for FIIs with less than 40% of their Assets
under custody (AUC) in PNs
4. FIIs with more than 40% of assets in PNs will issue PNs only against
redemption/cancellation

Currently, 34 FIIs and their sub-accounts issue PNs and the notional value of outstanding
PNs has risen from Rs 31,875 crore (March 2004) to Rs 3,53,000 crore (August 2007),
constituting 51.6% of Assets under custody of all FIIs/sub-accounts. The value of outstanding
PNs with underlying as derivatives stands at Rs 1,17,071 crore, approximately 30% of total PNs
outstanding. The notional value of outstanding PNs, excluding derivatives as underlying, is 34.5%
of AUC.

For quite a long time, RBI, SEBI and Ministry of Finance have been expressing their
concerns about the possible misuse of P-Notes. The authorities have been making all-out efforts-
through curbing ECB inflows or raising limits on outflows-to control capital inflows. The anonymity
and opacity of P-Note investors and the source of their funds has been engaging the attention of
the government for quite some time.

RBI and the Ministry of Finance have been concerned about the sudden surge of portfolio
inflows in the last one-month. Due to the gargantuan foreign inflows, the rupee has been
appreciating against the US dollar, which has been affecting the export competitiveness of Indian
companies belonging to employment-generating sectors, like, Textiles, leather, gems and
jewellery, etc.

The new proposed policy is a result of lot of careful deliberations among RBI, SEBI and
Ministry of Finance with a view to reining in surging stock markets and copious foreign inflows.

DEFINITION and MECHANISM

Participatory Notes are offshore derivative instruments (ODIs) issued, by SEBI-registered

Foreign Institutional Investors (FIIs) in India, against an underlying security, which entitles the
holder to a share in the income, either dividend or capital gain, from the underlying security.
These are issued to foreign investors, which may be hedge funds, foreign pension and mutual
funds, or other High Net worth Individuals abroad. They are issued outside of India to people
outside of India. The underlying securities, shares of listed companies in India, are held in the
custody of FIIs on behalf of the P-Note holders.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 18th, 2007 Page 2 of 4

 FII brokers buy and sell securities on behalf of their clients on their proprietary account
and issue such notes in favour of their foreign clients. P-Notes are mostly used by hedge funds
(that are not welcome by SEBI) and non-resident Indians. P-Notes are transferable. The Indian
regulation says that FIIs ought to give monthly reports on the identity of the holders of P-Notes.
But some FIIs argue that they do not know about the identity of the ultimate beneficiaries, as P-
Notes are transferable instruments. P-Notes have been in existence in India for more than 10 to
12 years.

WHY FOREIGN INVESTORS USE P-NOTE ROUTE

There are some genuine reasons why some foreign investors prefer the P-Note route to
invest in Indian securities:

• It is more convenient and easy to invest and exit

• Some genuine investors who either cannot qualify to register as FIIs for some technical
reasons, or otherwise prefer the less cumbersome and more cost effective P-Note route
• Registration of some FIIs has been pending with SEBI, hence they are taking this P-Note
route to invest in Indian stock market

CONCERNS ABOUT P-NOTES

• Anonymity of investors-difficulty in fulfilling KYC (Know Your Client) and FTAF (Financial
Action Task Force) norms for P-Notes, the Anti-Money Laundering issues and difficulty in
tracing the identity of the funds
• Lack of transparency and anonymity worries the government authorities
• There are fears that P-Notes are ideal money-laundering vehicles
• Some reports suggest that some FIIs created their own separate and parallel offshore
market for Indian securities in derivative form-which will develop and this will take
volumes and revenues from our markets
• About 50% of the portfolio inflows into India come in the form of P-Note
• There are some apprehensions, and some evidence, that the P-Note route was being
used for “round-tripping” resident Indians’ money-going out by questionable means and
coming back through the P-Note route

BACKGROUND TO REGULATION OF P-NOTES

The Tarapore Committee II on Fuller Capital Account Convertibility (FCAC), report

submitted in September 2006, recommended that fresh inflow via P-Notes be banned and that
the existing P-Notes holders might be provided an exit route so that it would be phased out
completely within one year. The committee’s central concern on P-Notes was the anonymity of
transactions and the repercussions thereto.

However, a member of the committee, A.V.Rajwade suggested, in his dissenting note to

the FCAC, that P-Notes be continued; efforts must be focused on stopping money from going out-
not on banning its reentry. Prior to the Committee on FCAC, one more committee, namely, the
Ashok Lahiri Committee, had dealt in detail about P-Notes and the impact of capital flows.

RBI and SEBI find it easy to regulate investors when they come in directly rather than
through P-Notes. The big five FIIs-Morgan Stanley, Merrill Lynch Capital Markets Espana,
Citigroup Global Markets, Goldman Sachs and CLSA Merchant Bankers-account for 60% of PNs
issued in India.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 18th, 2007 Page 3 of 4

WHAT OF THE FUTURE ?

Some have welcomed SEBI’s latest move on regulating PNs, while some have
expressed their reservations about the efficacy of such measures. Doubts have also been
expressed about the ability of FIIs to unwind their positions in the next 18 months. With the Indian
economy growing (despite the problems of talent crunch, poor healthcare, malnutrition, land
rights, etc.) at a steady 8-9% annual growth, it may not be tempting for FIIs to exit Indian equities.
With the near-closing of P-Note route, foreign investors’ ability to hedge their risks will be
curtailed. The big moot point is whether the authorities will be able to ‘moderate control inflows’
as has been stated by the Finance Minister. Countries, like, Thailand, had tried to prevent capital
inflows, to arrest the appreciation of their local currencies, but with little success. Thailand had put
curbs on foreign inflows in December 2006 to stop the appreciating Baht, but was forced to
withdraw the controls a day after.

The clarity on the above issues will come to light on October 25th when SEBI board will
be meeting. Till that time, it will be a wait-and-watch game for investors. After October 25th, FIIs
may have to reposition their portfolios and this may create a flutter in the stock market over the
next few weeks. FIIs have been the prime movers of this structural bull market rally, which began
in April 2003. Any adverse reaction from FIIs is likely to spook the markets in a big way.

Note: FII means an entity established or incorporated outside India, which proposes to make investment in
India. Sub-account includes those foreign corporates, and institutions, funds or portfolios established or
incorporated outside India on whose behalf investments are proposed to be made in India by an FII. Some
examples of FIIs are Pension funds, mutual funds, insurance/reinsurance companies, investment trusts,
banks, university funds, charitable trusts, etc. The registration fee charged by SEBI is USD 10,000 for FIIs
and USD 2,000 for sub-accounts.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 18th, 2007 Page 4 of 4