Has Sebi's P-Note move really worked?

It's been a phenomenal year for the Indian stock markets. Nearly 16 billion dollars have flown into India till December and the Sensex has scaled the 20,000 mark. But from a market regulation standpoint, the year 2007 would be remembered for Sebi’s restrictions on participatory notes or P-Notes. This move was to moderate capital flows and deal with the issue of anonymous investors. But has it really worked? CNBC-TV18’s Abhijit Neogy finds the answer...

The bulls have been on a rampage through the year and the dollar inflows become a deluge by October this year. While the unrelenting rally pleased the investor community and made for eye-catching headlines, the government was getting uncomfortable with each passing day.

Apart from the pressure it exerted on the rupee, there were fears that PNotes were being used a vehicle to bring in illegitimate funds from abroad. In a defensive move, the government finally intervened-their argument to moderate capital flows. Soon after the Finance Minister’s statement, market regulator SEBI stunned the markets with what are now being viewed as landmark proposals to regulate PN route and force foreign investors to use the front door.

As per the new regulations, PNotes with stocks as underlying could be issued by FIIs subject to a maximum of 40% of overall assets under custody. SEBI also proposed that where PNotes have equity derivates as underlying, these instruments cannot be issued anymore

Such existing positions would have to be wound up over the next 18 months.

Incase a FII wants to increase the share of PNotes in his assets under custody, the FII can raise the share of PNotes to the extent of 5% at a time this caused confusion and even temporary panic. The markets tanked, hitting the 10% lower circuit-trading had to be halted for about an hour. Finance Minister Chidambaram was then forced to step out to calm the markets and lift investor sentiment

P Chidambaram, Finance Minister, said, “We have not banned PNotes. In the recent months, fund flows had become copious; the idea is to moderate these flows.”

In the past the RBI had come out in favour of banning PNs altogether but this is a view that had not found favour with the Finance Ministry for fear of hurting investor sentiment.

Chidambaram said, “We are not against anybody investing in our markets. But we want everybody through the front door.”

The question that begged an answer- what was the real motive behind the p-note controls? Was it a means to control capital flows or was it apprehension over the identity of the ultimate beneficiary in the case of a PNote.

I don't think that we have said that it's only the anonymity that has been bothering SEBI or anyone else. What we have spoken about are a number of issues that have come up in the inter-regulatory consultative process over a period of time and during examinations within SEBI itself. There is clearly a question of flows coming in that the Finance Minister described as copious inflows into the Indian market. There were also issues that we have had with what we need to do to tweak the regulations regarding ODI.

M Damodaran, Chairman, SEBI, said, “I don't think that it’s just the anonymity issue which concerns us. This is the outcome of a lot of deliberations; there is clearly a question of flows coming into the market as the FM has described; there have also been issues regarding the tweaking of ODI guidelines which we wanted to look at.”

Analysts say hedge funds may not be too keen to register with the market regulator though at least 20 sub-accounts had applied for FII status. But despite all the controversy surrounding the new PN regulations, the dollar inflows haven't really stopped. Till December, FIIs had pumped in a whopping 16 billion dollars into India and the markets have since breached the psychological 20000 mark. This may make the government become cagey again but investors are not complaining.