Reversing the capital controls against PNs

Financial Express, 8 October 2008

The inexperience of the Indian economic policy making establishment was on display in October 2007 when `participatory notes' were banned. This decision has been rightly reversed through a joint decision between RBI and SEBI. Banning or unbanning PNs does not impact on capital flows. It impacts on the market share of India as a centre for financial trading in India-related financial products. At the same time, the damage done in October 2007 will not be undone immediately.

Participatory notes are as old as the FII framework. They reflect the international reality of an OTC derivatives market, where derivatives are privately negotiated, that co-exists with the exchange-traded spot and derivatives markets. Internationally, financial firms stand ready to sell a variety of products to customers based on private negotiation. Once an OTC derivative is sold, positions are adopted on exchanges in order to hedge away this exposure. This rhythm has been a humdrum reality ever since foreign investment into India commenced.

In recent years, extravagrant claims were made about the non-transparency of PNs, about income tax evasion caused by PNs, the use of PNs for market manipulation, etc. These claims had no factual foundation. But in India, it is generally easy to whip up opposition against a target that is foreign and ill-understood, particularly if the target is well paid.

What was actually going on was RBI's craving for capital controls. RBI was keen to push India back into being a closed economy. The biggest single chink of openness -- the capital account convertibility that has been given to FIIs -- was hence in the gunsights. RBI (incorrectly) felt that banning PNs would help retard India's integration into the world economy.

In October 2007, an important blunder was made with restrictions being brought against PNs. The document that SEBI put out at the time reflected a lack of knowledge about PNs; it underlined the weaknesses of human capital at RBI and SEBI. It required (a) Winding down all PNs by a stated date, (b) Forcing an FII to not issue PNs in excess of 40% of their investment in India and (c) Banning PNs issued `against' derivatives in India.

The poor policy analysis that lay beneath this decision became visible in following months. The ban on PNs did nothing to change FII inflows or outflows into India, so RBI's purpose - of impeding India's international economic integration - was not achieved. PNs were not an issue in terms of enforcing against market manipulation. Tax evasion, drug running or terrorism were not adversely affected.

The impact was felt with the Indian financial sector losing ground in international competition. The Indian index futures market, which had hitherto been dominated by NSE, became a duopoly with roughly two-thirds of the positions being on NSE and one-third of the positions springing up at the Singapore exchange (SGX). Foreign investors who were buying PNs were more inclined to trade in ADRs, GDRs, or exchange traded funds (ETFs) on Indian indexes that are available outside the country. The depth of the Indian market was reduced and the depth of offshore trading venues improved.

With the change in leadership at RBI and SEBI, this entire episode will happily now become a bad memory. The decisions of October 2007 have been reversed. Transparency and enforcement against market manipulation is improved because a bigger part of the market will do KYC under SEBI regulation.

However, bringing back the liquidity into India is not easy. In the onshore vs. offshore competition, there are several other constraints weighing against the onshore: the securities transaction tax, the FII regime, the difficulties faced by Direct Market Access in India, and the tax treatment of capital gains. As long as offshore venues had negligible liquidity, India dominated the business. But now that liquidity has been created offshore, through the trigger of October 2007, many customers will choose to simply stay on there even though the restriction against PNs is gone, owing to these other constraints. In other words, the damage done by the decisions of October 2007 will not be undone by reversing those decisions.

Some observers claim that SEBI and RBI have been spooked by recent market fluctuations into reversing the decisions of October 2007. This is factually incorrect, because the file trail that leads up to such a decision would have begun many months ago. Further, in the short run, just as banning PNs had no impact on capital flows into India, unbanning PNs will have no impact on capital flows into India.

What is at stake is a bigger role for India in financial markets on Indian underlyings, and achieving deep and liquid financial markets in India. What is now required is not just reversing the decision of October 2007. Policy makers need to now take on the remaining barriers that impede onshore financial intermediation: the securities transaction tax, the FII regime, Direct Market Access, and the tax treatment of capital gains.

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