Ending round-tripping

Time for a road map on abolition of participatory notes

The special investigation team (SIT) set up by the Supreme Court to unearth black money has come up with recommendations to curb the menace of participatory notes or P-Notes, which are derivative instruments issued by foreign portfolio investors against underlying Indian securities. The P-Notes allow these investors to earn returns on investment in the Indian market without incurring the costs of directly investing in India. The SIT's advice to the Securities and Exchange Board of India (Sebi) includes scrutiny of the final beneficiaries of P-Notes, as well as curbing their transferable nature given such transfers make tracing beneficiaries more difficult. It is often argued that much of this money actually belongs to Indians who had stashed their wealth abroad at a time when the government used to have strict restrictions on foreign exchange transactions. Such funds are now returning to India through tax havens - "round-tripping", as it is called. The white paper on black money tabled in Parliament in 2012 also mentioned P-Notes as one of the instruments for re-investing black money in India. There have been many instances where foreign institutional investors have been found guilty of withholding disclosures relating to the ultimate beneficiaries. It is also an established fact that whenever the market rallies, it attracts a lot of hot money from hedge funds and other short-term investors looking to ride the wave.

Sebi has taken some actions already on black money entering the country through the offshore derivative instrument (ODI) route. It has set out stringent eligibility requirements for buying ODIs; these instruments can only be issued to entities from countries that have signed a multilateral agreement to combat money laundering and for exchange of information with the International Organisation of Securities Commission. Besides, Sebi has specified that the place of origin should not be a jurisdiction deficient in implementing systems to combat money laundering, according to the list put out by the public statement of the Financial Action Task Force. Additionally, the market regulator has said that fund structures need to be transparent, and two or more P-Notes subscribers with the same beneficiary will be considered as one subscriber. Many other provisions such as a faster and easier registration process have been laid down with the objective of encouraging more FIIs to come through the front door. These may have contributed to P-Notes, which in 2007 accounted for over 50 per cent of total foreign holdings, now having a share of only slightly over 10 per cent.

Yet, the total investment by foreign institutional investors through P-Notes in India till this month has risen to Rs 2.75 lakh crore, of which as much as Rs 1.78 lakh crore has been made in equity. The rise in such investments in the last one year has been 32 per cent. Given the many problems associated with P-Notes and their growing popularity in spite of the many steps Sebi has taken, a sensible strategy would be to abolish them. A clear and transparent road map for this needs to be laid out as soon as possible, so that the market has time to adjust. It would not be wise to leave any announcement to the last minute, as this would enhance volatility and uncertainty. In 2007, the Sensex tanked over nine per cent after Sebi suddenly announced a string of measures to tighten norms on P-Notes without taking the intermediaries into confidence. This is a good time for the finance ministry, the Reserve Bank of India and Sebi to lay a road map to phase out P-Notes.