August 27, 2012

p-notes are no longer needed

There is an unhealthy reliance among several Indian policymakers, companies and financial investors on the flows coming into India from foreign companies and foreign investors. Just as Government of India provides maximum sops, open and hidden, to large Indian corporates the same is done for all foreign investors.

Here is something connected to this issue I wrote earlier this month in an editorial contribution to the newspaper I work for.

Don't revive redundant P-notes

Re-look into recent tax policy measures should not end up prodding regressive foreign flows through P-notes

Nothing can be more un-healthy if the consequences, intended or un-intended, of the finance ministry's assurances to foreign companies investing in India of re-examining recent tax policy announcements such as the general anti avoidance rules (GAAR) if it leads to encouragement of illegitimate and tax-avoiding fund flow in the Indian securities market and financial system. 

The rise in foreign institutional investors' participatory notes exposure in June after a couple of months of subdued levels, as reported in this paper on Monday, points potentially to such an adverse encouragement. A controversial matter such as retrospective taxation has merit in being debated and revisited but surely the country can ill-afford to play a cheerleader to those who use double taxation avoidance treaties more as tax-avoiding means than as facilitators of legitimate exchange of trade and business between countries. 

The new finance minister, P Chidambaram, is an old hand in the finance ministry having been the FM during 2004-08 and earlier during 1996-97. It will be most unfortunate if he is does not sift the chaff from the wheat. He did issue a lengthy official statement on Monday with regard to bringing economy back on desired track and laying down a map for recovery and touched upon all aspects including taxation and foreign investment flows. While it is hard to predict what will be the final outcome of various recent policy measures hanging in limbo one hopes the clock is not turned backwards. 

At least on the participatory notes issue Chidambaram is on familiar ground. After all, he was the finance minister when the capital market regulator, Sebi, in October 2007, tightened the screws on FIIs issuing participatory notes. P-notes are nothing but non-exchange-traded derivative instruments issued offshore by FIIs, mostly FII sub-accounts. These have Indian equities traded on domestic exchanges as their underlying and are issued to investors and funds who for reasons good and bad do not want to go through the process of registering themselves as FIIs with Sebi and then invest directly in Indian equities. Back then their share in total FII investments exceeded 35 per cent and was generally considered a backdoor route for Indian black money flowing in from P-notes which were largely issued by Mauritius-based FIIs. 

Various analyses had at that time indicated that FIIs issuing P-notes had major investments in stocks beyond Nifty or Sensex stocks. Way back in 2006, Reserve Bank of India had in a dissent note to an government-appointed expert group's report on encouraging FII Flows and checking the vulnerability to speculative flows recommended winding down of P-notes. Sebi's later restrictions proved effective in curbing the extent of P-notes and its share to total FII investments is currently hovering between 10 and 15 per cent. 

Given that Sebi has recently opened the doors to qualified foreign investors and made it possible for genuine foreign investors to invest in Indian equities without having to register as FIIs. It is time P-notes are made redundant completely through a regulatory ban on its issuance by Sebi. But the FM in his Monday's statement has already linked exchange rate stability to a rise in capital flows through FDI and FII route and gone on to state that his ministry intends to fine tune policies and procedures that will facilitate capital flows into India. 

This may make it difficult for Sebi to hammer the final nail on the P-notes coffin. Even in October 2007 it was a fast-strengthening rupee that was hurting exporters and prompted the curbing of foreign flows through the P-note restriction. Should we keep fiddling with policies to encourage or rein in capital flows or should we have a stable regime based on intrinsically sound principles?

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