P-Notes controversy back in focus

Following the Tarapore committee recommendation to ban them, P-Notes have once again become a hotly debated issue. Are they so widely misused as believed by some and should they be banned without providing an alternative?

Ever since they gained popularity among foreign investors in Indian stock markets, P-Notes have been controversial. Overseas investment flows through P-Notes have been blamed for all the major stock market crashes in recent years, including the 'Black Monday' crash in May 2004 and the recent decline in May-June 2006.

As inflows through P-Notes have gone up considerably in the recent past, the RBI has increasingly become concerned and the finance ministry has so far tried to downplay the central bank's concerns. Opinions are sharply divided on the issue and the stock markets often panic on rumours about moves to ban P-Notes.

The Tarapore committee set up to look into fuller capital account convertibility has recommended that P-Notes should be banned in a year's time and existing positions in the domestic stock markets through P-Notes should be unwound by then. This has led to a fresh wave of debates on the issue and opinions continue to be divided. Even two members of the Tarapore committee have written dissenting notes.

Behind the popularity of P-Notes
For the uninitiated, P-Notes or 'Participatory Notes are instruments issued by registered FII's to overseas investors who wish to invest in the Indian stock markets without registering themselves with SEBI. More than 50 per cent of all FII inflows into the domestic markets are estimated to be through P-Notes.

Investing through P-Notes is very simple and hence very popular among overseas investors. P-Notes are issued to the real investors on the basis of stocks purchased by the FII. The registered FII takes care of all transactions, which appear as proprietary trades in its books. Investors need not worry about regulatory filings or currency conversions and costs are also much lower than a direct entry by registering with SEBI.

FII's love P-Notes
If you thought the big rush by foreign investment companies to register with SEBI was mostly because of their interest to invest in the Indian market, you are only partly right. Registered FII's also make money by allowing unregistered investors to invest through P-Notes since it is risk-free.

Being a SEBI-registered FII is like getting a license, which gives the right to directly invest in one of the most lucrative stock markets in the world. Others who cannot register themselves, both scamsters and genuine investors, have to necessarily invest through these licensed entities. Since global investor interest in Indian markets has been quite high, these registered FII's have been making quite a tidy sum as service charges from P-Note investors over the last few years.

These FII's have a stake in the continuation of the system of P-Notes. Many suspect that every time a move to ban P-Notes is contemplated, these large foreign investment firms spread the fear that restricting or investigating P-Notes would lead to a huge market crash.

There have been some recent reports that some of these registered FIIs have started functioning like virtual stock exchanges. If a client wants to purchase a particular stock and another client is holding the same stock, the FII would complete the transaction internally. This is in violation of the guideline that all transactions should be routed through a stock exchange. Moreover, the FIIs successfully evade the securities transactions tax (STT).

Our regulators defined overseas investment bodies and gave them the nomenclature of FIIs out of their zeal to improve transparency and prevent the inflow of 'bad money'. Then they allowed instruments like P-Notes, which ironically defeated the very purpose of registering foreign investors since the source of the funds could not be identified.

If just about anybody is allowed to invest through a registered FII, then why register FIIs on the pretext of trying to keep away undesirable investors?

To make it worse, the country is losing tax revenues through this rather strange arrangement. Most of these FII's are incorporated in tax havens like Mauritius and do not pay any tax here. Considering the gains from the domestic markets over the last few years, revenue loss to the government may run into billions of dollars.

The argument that having registered entities, through whom all inflows are routed, provides better control to regulators have some merit. At least, there would be someone to blame in a crisis. But if that is the reason, why not allow domestic intermediaries to do the job? More jobs would be created within the country and the government would get additional tax revenue as well.

Are P-Notes all that evil?
The biggest argument against P-Notes is that at least part of the money that is coming in is money stashed abroad by domestic entities and individuals. Nobody knows the exact quantum, if any; of such 'round tripping' or domestic money masquerading as overseas inflows and no regulatory authority has so far cared to find out either.

Nobody disputes the fact that high domestic tax rates led to significant capital outflows from the country in the pre-liberalisation era. Over-invoiced imports and under-invoiced exports were the favoured instruments for the corporate sector and others used the hawala (money transfers through 'grey' markets) route to transfer funds overseas.

It is quite possible that a part of this money is coming back to the country through the P-Note route. Returns from the Indian stock markets have been among the best in the world for the last few years and promoters of domestic companies who had moved funds abroad earlier would have found the markets especially lucrative. They could move such funds back into stocks of their own companies, to push up the stock prices and further improve the value of their domestic holdings in such companies.

There were also cases of scamsters like Ketan Parekh, banned from the Indian stock markets earlier, who re-entered the markets through overseas investment firms. Some of these entities like Jermyn Capital, which were linked to Ketan Parekh were later banned from investing in the country, but only after operating unhindered for some time. It is possible that some of his money is still invested in India through other entities, using P-Notes.

Should P-Notes be banned?
A committee appointed by the government under the chairmanship of Ashok Lahiri to look into overseas investment inflows in detail had recommended the continuation of P-Notes. Two dissenting members of the Tarapore committee, Surjit Bhalla and A V Rajwade, also agree with the recommendations of the Lahiri committee.

Tarapore committee's justification for banning P-Notes is that, "In the case of Participatory Notes, the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs. These are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner."

But that is not entirely true. SEBI requires the registered FII to verify the identity of investors before issuing P-Notes under the 'Know Your Customer' (KYC) guidelines. Registered FIIs are also required to reveal the identities of such P-Note investors to SEBI, if asked. There have been cases of SEBI banning some FIIs from the markets for their failure to disclose the identities of final investors.

But in practice, it is impossible for any regulator to verify the identities of all these investors on a regular basis. In times of a crisis, like a severe market crash, the regulator may conduct a detailed probe. As far as tradability is concerned, it is not very difficult to hide the identity of the real investor even if the instrument is not tradable. Besides, any financial instrument, which is not tradable, is bound to be very unattractive to most investors.

It may be true that P-Notes are being misused for round-tripping, but the fact remains that such funds would find their way somehow if the returns are attractive enough. The government and regulators should focus more on easing tax rates and controls, which would ensure that there is no need to move capital out of the country.

Even with all the potential for misuse, it is not practically feasible to ban P-Notes within a year as recommended by the Tarapore committee, since unregistered foreign investors need to be given an alternate channel, which is as easy and cost effective, to route their investments.

But the report is silent on this and has not recommended any alternative to P-Notes. The report rightly says that NRIs should be allowed to invest directly in the Indian markets. It also says that overseas companies should be allowed to invest through domestic SEBI-registered intermediaries. But these should be implemented immediately, not in the future as recommended.

The bigger question here is whether we really need to check the antecedents of each and every overseas investor, big or small, who is interested in investing in the Indian markets? If NRI's and foreign companies can be allowed to invest directly, why not small individual foreign investors?

The committee has also recommended that existing positions in the markets through the P-Note route should be unwound within a year by offering an exit route to investors. If this is implemented, existing investors can either opt to register themselves or exit their positions. Considering the time and effort required for registration and the fact that a substantial part of overseas investment flows are through P-Notes, any such move would lead to a substantial liquidation of existing positions and inevitably a market crash.