Sucheta Dalal :Just why PNs attract such strong views
Sucheta Dalal

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Just why PNs attract such strong views  

Sep 4, 2006

The S.S. Tarapore Committee has drawn a 5-year roadmap for capital account convertibility with wide ranging suggestions and recommendations. However, the issue of Participatory Notes (PNs) seems to have once again attracted strong views and two of the six members have recorded dissent notes.


The main report says that global integration of capital markets require tax policies to be harmonised and discriminatory tax treaties eliminated. One of the recommendations in this direction is to prohibit Foreign Institutional Investors (FIIs) from raising fresh money through Participatory notes (PNs) and to phase out existing PNs within a year by providing them with an exit route. This is consistent with the Reserve Bank of India’s (RBI) long-held view on PNs.


Dissenting Member A.V. Rajwade has said that the PN issue has already been extensively debated by the Lahiri Committee. But it must be remembered that the RBI had also recorded a dissent to Lahiri committee’s recommendations. Moreover, the Lahiri committee, which was mandated to check the “Vulnerability of Capital Markets to Speculative Flows”, had also recommended setting up another “Special group to study measures to contain large volatility in FII flows” and on-going research on the subject.


What exactly are PNs, and why do they attract such strong reactions from people? The Lahiri committee described PNs as akin to ‘contract notes issued against an underlying security, usually to investors that are not otherwise eligible to invest in India’. The problem, as this definition suggests, is that they are not a direct and transparent investment and can sidestep the stringent Know Your Customer (KYC) rules that are required to be followed by Indian investors in the domestic markets.


We know nothing about the beneficial owners of PNs, the quality of their money, their motivations and investment horizon; and this raises fears and concerns about their potential to influence specific stock prices or destabilise the market. Most of all, investment through PNs creates an unequal playing field between Indian and overseas investors in terms of disclosure, identification and transparency.


It is estimated that over Rs 40,000 crore of PNs have been issued abroad by foreign brokers and are actively traded in some markets. Anecdotal reports say that a significant chunk of PN subscriptions come from tax-evaded domestic money which round-trips its way to the Indian capital market. This is done through friendly overseas banks which route the investment through layers of investment entities and overseas tax havens to hide beneficial ownership. Often the investment is routed through unregulated hedge funds, which in turn channel funds through PNs.


The Securities and Exchange Board of India (Sebi) is relatively muted in its opposition to PNs, but is not comfortable with them either. Over the years, Sebi has tried to improve transparency by mandating (February 2004) that PNs can only be issued to regulated entities with “no further downstream issuance to unregulated entities”. It also demands a basic level of disclosure of beneficial ownership. However, it is obviously unable to dig deep enough because the link between certain industrialists, politicians and businessmen with specific FII sub-accounts (representing billions of dollars of investment) is an open secret in the market.


That is why, the policy debate has always recommended phasing out of PNs, but in reality, their issuance has been rising continuously. From just around 15 to 20% of net FII inflows coming through PNs in 2002-03, the figure rose to 47% in April last year and jumped further to 52% in March 2006. One corporate restructuring alone was apparently responsible for a substantial jump investment through PNs.


The dissenting views of the Tarapore Committee members are bound to find a lot of support among capital market intermediaries who have been arguing for hedge funds to be allowed to invest directly in India. They are of course, unconcerned about regulatory issues or the fact that hedge funds are notoriously secretive about their investors.


At its core, the large proportion of domestic money that is apparently hiding behind PNs exposes bad policy making, poor revenue collection systems and the Finance Ministry’s double standards. The Ministry is so focussed on squeezing more taxes out of legitimate domestic tax payers (fringe benefit tax, cash withdrawal tax, cash-flow statements and passing on tax collection responsibility to the people) that the bigger leakage of taxable income apparently escapes its attention. Consequently, industrialists and traders continue to find it profitable and exceedingly easy to keep billions of dollars abroad and also to route it back to India in order to profit again from our monster bull market. Worse, they enjoy tax exemptions by routing money through tax havens.


Only last week, an industrialist blew up Rs 50 million on his birthday bash in London when his Indian companies are on the verge of sickness despite a corporate debt restructuring exercise that saw several lenders sacrificing several hundred crore rupees each just a few years ago. What better evidence does the government need about the ease with money is transferred overseas and flaunted?


The biggest beneficiaries of our bad policies are indeed foreign banks and intermediaries who earn hefty fees for channelling this money through appropriate vehicles and concealing true ownership. The question is, how much should we worry about the fees earned by foreigner intermediaries on this money? Won’t direct investment by hedge funds only put domestic investors at a disadvantage? Hedge funds are unregulated in most markets, completely non-transparent about their investors as well as their fee structure and many of them have questionable investment practices. Giving them a free run of our market mocks domestic investors who have to adhere to strict disclosure norms and KYC rules. It is especially unfair since Indian investors are still not allowed to invest abroad, except in a limited way through mutual funds.


-- Sucheta Dalal