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RBI's opposition to P-Notes works, finally

BS Reporter  |  Mumbai 

First steps at curbing portfolio inflows via participatory notes (P-Notes) are being taken almost one-and-a-half decade after some foreign investors starting using P-Notes "" a form of overseas derivative instrument (ODI) "" to invest in Indian equities.
The restrictions suggested by the Securities and Exchange Board of India (Sebi) on investments through P-Notes on Tuesday could be seen as "close to culmination" the Reserve Bank of India's (RBI) years of opposition to this opaque route for portfolio flows into India.
The move to curb inflows via P-Notes has not been initiated out of any undesirability of such inflows, but because of concerns at the unmanageability of the copious foreign capital inflows.
The RBI has been calling for taking a view on the quantity and quality of FII flows and had even suggested in January 2005 that there is merit in India keeping open the option of selectively using quotas or ceilings on FII flows, after due notice to the FIIs.
The S S Tarapore Committee on Fuller Capital Account Committee, in its report submitted in July 2006, had recommended that foreign institutional investors (FIIs) be prohibited from investing fresh money through P-Notes, allow existing P-Note holders an exit route and phase out P-Notes completely within one year.
The Tarapore committee's recommendation on P-Notes were contrary to what the Lahiri Committee on Encouraging FII flows and checking the vulnerability of capital to speculative flows" had suggested.
The Lahiri committee had taken note of the possibility of the misuse of P-Notes but favoured their continuation with conferring of full power to Sebi to obtain information on the final holder/beneficiaries or of any holder at any point of time in case of any investigation or surveillance action.
The Tarapore committee had stated that the nature of beneficial ownership or the identity of the beneficiary of the P-Notes is not known unlike in the cast of FIIs and that the P-Notes are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner.
It is also not possible to prevent trading in P-Notes as the entities subscribing to the P-Notes cannot be restrained from issuing securities on the strength of the P-Notes held by them.
The RBI Governor, Y Venugopal Reddy, had In 2005 said that India's emphasis in management of capital account was generally on external debt, but needs to explore an appropriately active but nuanced management of non-debt flows. He had then said that the magnitudes of FDI/FII flows are tending to be large and volatility has perhaps increased.
The RBI governor had then listed possible issues that need to be considered if one were to achieve a better management of non-debt components of capital flows that will address emerging concerns. Those included:
  • A view needs to be taken on the quantity and quality of FII flows. While quotas or ceilings, as practised by certain countries, may not be desirable at this stage, there is merit in our keeping such an option open and exercising it selectively as needed, after due notice to the FIIs.
  • There is scope for enhancing quality of flows through a review of policies relating to eligibility for registration as FIIs, and assessment of risks involved in flows through hedge funds, participatory notes, subaccounts, etc. Strict adherence to 'Know Your Investor' principle, especially in regard to flows from tax-havens, including beneficial ownership would enhance quality. Third, price-based measures such as taxes could be examined though their effectiveness is arguable and hence may not be desirable.
  • FDI flows, as currently defined, also include transfer of equity from residents to non-residents and a disaggregated analysis of FDI through several routes could enable a policy intervention, as appropriate on quantities and quality.
  • First Published: Fri, October 19 2007. 00:00 IST