Restrictions on capital flows- Sebi proposals

Not to sound boastful but I wasn't perturbed at all when I learnt this morning that trading had been halted after a steep fall in stock prices triggered the circuit breaker. I was awaiting "clarifications" from official sources that would calm the markets. That's exactly what happened. After the PM and the SEBI chairman came on the air, the market recovered to end the day around 400 points lower- a considerable recovery from the fall of 1700 points earlier.

The draft regulations circulated by Sebi, which will become law with or without some minor modifications by October 20, are intended to curb capital inflows into the country. It will do so by curbing the volume of Overseas Derivative Instruments (Participatory Notes), instruments through which foreign investors can invest in India even if they are not registered as Foreign Institutional Investors.

PNs constituted 51.6% of Assets under Custody (AUC) in August 2007, 30% of which had derivatives as the underlying. The RBI has long been in favour of phasing out PNs but the finance ministry was resisting because it didn't want the stock market run to stop. With the kind of rise in the Sensex we have seen in recent weeks, the ministry, no doubt, reckons that a correction is affordable.

Sebi's proposals are as follows:

1) FIIs and their sub-accounts shall not issue/renew ODIs with underlying as derivatives with immediate effect. They are required to wind up the current position over 18 months, during which period SEBI will review the position from time to time.
2) Further issuance of ODIs by the sub-accounts of FIIs will be discontinued with immediate effect. They will be required to wind up the current position over 18 months, during which period SEBI will review the position from time to time.
3) The FIIs who are currently issuing ODIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of less than 40% shall be allowed to issue further ODIs only at the incremental rate of 5% of their AUC in India.
4) Those FIIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40% shall issue PNs only against cancellation / redemption / closing out of the existing PNs of at least equivalent amount.

So, the idea clearly is to limit investment in the Indian market through PNs. There has always been a problem about the identity of investors holdings PNs. For that reason alone, restrictions on PNs are welcome. But will it help meet the objective of curbing capital inflows? In the short run, yes. In the long run, no, for the simple reason that the volumes waiting to enter India are enormous. Once PNs are barred, we should see an increase in those wanting to register as FIIs.

I am sure the finance ministry and Sebi recognise this. But a breather on the capital inflows is welcome- and the present proposals will provide just that. JP Morgan estimates that the ouflows on account of the unwinding of PNs with derivatives as underlying could be $4-7 bn; the unwinding on account of PNs issued by sub-accounts of FIIs will be even larger. Of course, all this will happen over a 18 month time horizon although it may not be evenly spaced out over that period.

Forex additions this year have been $50 bn- the addition considered comfortable was around $25 bn. In relation to overall capital inflows, the outflows that will be triggered by the Sebi move
will be a minor speed-breaker. International factors remaining the same, it will slow the rise in the Sensex over the next few months. But it does provide some breathing space for RBI in terms of managing the exchange rate- the way things were going, it appeared the rupee would soon touch Rs 35 to the dollar.

In macroeconomic terms, the Sebi move does not amount to much over the long term. It does little to alter the trend towards rupee appreciation. But, as I said, it gives a little time for adjustment to appreciation- and that is exactly what Indian industry needs and can expect at best. Rupee appreciation can be managed, not eliminated.

The combination of a rising stock market and rupee appreciation would have meant capital inflows on an uncontrollable scale. That would have had a severe impact on the Indian economy. The speed-breaker imposed by Sebi is good for the economy. It is also good for the stock market. I think the market will recognise this - and continue its climb.