Sometimes, an academic approach to issues can suppress warning signals of systemic weaknesses by dismissing these as one-off aberrations.
The report of the expert group on ‘Encouraging FII flows and checking the vulnerability of capital markets to speculative flows’ (Lahiri committee) may be guilty of doing exactly this on the issue of participatory notes (PNs).
Fortunately, a dissent note by the Reserve Bank of India (RBI) has flagged important concerns that have been buried by the majority view with the bland suggestion to set up another ‘special group to study measures to contain large volatility in FII flows’ and conduct ongoing research on the subject.
Research is no substitute for hard market intelligence and yet another study will only delay important decisions. The Lahiri committee itself was supposed to complete its report within a month (in November 2004), but dissenting views dragged its deliberations for a year. The Sensex has now crossed 9,000 and worries expressed by RBI’s chief general manager, Vinay Baijal, about participatory notes and hedge fund operations are greater than ever. Hedge funds operate in a regulatory grey area around the world, so the committee merely recommends a watch on global developments. It is common knowledge that these funds are active in the Indian market. The Securities and Exchange Board of India (Sebi) does not register hedge funds directly and checks out suspicious-looking applicants. However, anecdotal reports suggest that these checks have had limited success.
On participatory notes, the RBI is clear that these must be phased out immediately and there is plenty of reason to back its demand. The Lahiri committee describes PNs as akin to contract notes issued against an underlying security, usually to investors that are not otherwise eligible to invest in India. In February 2004, Sebi decided PNs can only be issued to regulated entities and that there can be no further downstream issuance to unregulated entities. But the real beneficial ownership is so well camouflaged that there is reason to suspect that Sebi’s additional checks have had little impact. Only last week, Sebi barred two sub-accounts that did not meet its regulatory norms.
• Evidence for the rapid proliferation of investments through PNs is clear
• Sebi’s tracking system on flows and PN ownership has wide gaps
• The time to heed the RBI’s demand to bar PNs without more delay is now
Also, as the RBI suspects, trading of these PNs will lead to multi-layering and further bury the identity of beneficial ownership. The report itself details the rapid proliferation of investment through PNs. Data provided until August 2005 shows that PN issuance rose dramati-cally from 30.6% of net FII investment in April 2005 (the Sensex was 6,605 on April 1) to 46.73% in August (the Sensex was 7,805 on August 31). Since then, the Sensex has crossed 9,000 and FII investment is up by at least a billion dollars.
The dependence on foreign regulators is also misplaced. They are not too keen on following up cases referred by Indian regulators. Although Sebi is part of the International Organisation of Securities Commissions (IOSCO) and has signed information-sharing agreements with leading regulators, there is little evidence of any clear benefits. In the past, international regulators have ignored letters sent out by a former Sebi chairman. We now have specific evidence that even highly regarded regulators such as the Financial Services Authority (FSA) of the UK make no effort to check the antecedents of registered entities. How else would an Indian on the run, with an Interpol alert against him, end up heading the compliance function at a FSA regulated entity?
When it comes to unaccounted Indian money (not necessarily scamsters’ money) coming back to the market through FII sub-accounts, the committee makes vague noises about vigorous investigation and maintaining a negative list of tax havens, without once referring to Sebi’s failed attempt at getting answers from the blue-blooded UBS Securities or punishing it for failing to provide information. The RBI is perfectly right when it says that in order to maintain the financial integrity of the Indian market, there is need to take suitable measures to address the growing international concerns regarding origin and source of investment funds flowing into the country.
The easiest way to do this is to ban dubious and non-transparent sources of funds coming in through PNs. The time to initiate such drastic action is now, when Sebi has already improved the FII registration process and there is tremendous global investment interest in India from broad-based blue chip investment funds.