At the time of going to press the markets had recovered to 18364.

Curbing the flow of hot money into the country has side effects. Bulls discovered this to their cost, when market regulator SEBI placed limits on participatory notes. Ashwin Tombat reports

India''s stock market benchmark Sensex crashed by 1,743 points within the first few minutes of opening this morning (17 October 2007), prompting the suspension of trade for an hour. The BSE announced trading would be suspended for the day if the fall reached 15 per cent The National Stock Exchange''s (NSE''s) wide-based index Nifty also plunged 9.25 per cent to 5,658.90 points.

This is fallout of market regulator Securities and Exchange Board of India (SEBI) clamping down on anonymous participatory notes (PNs) to arrest the flood of foreign inflows. The fall came just days after finance minister P Chidambaram expressed surprise at shooting stock prices - the Sensex had shot up by 5,000 points in less than two months - and hoped that things would cool down.

Soon after the stock markets closed on hitting the down-circuit, Chidambaram said in a live telecast that the government was neither against PNs, nor was it banning them. Proposals to moderate portfolio investment by foreign investors were part of a series of steps to moderate capital inflows, he emphasised.

He said foreign investors were still welcome to invest in India through participatory notes, but it was important to moderate inflows at present and the decision was good for markets in the long term.

The finance minister reiterated that the basic fundamentals of the economy were strong, and said that the systems put in place by SEBI have worked.

The markets reopened after one hour of closure at the down circuit, after which both the Sensex and the Nifty recovered marginally as some amount of buying was seen. However, all the indices remained in the red and the market breadth was extremely negative.

As trades resumed at 11.10 am, the Sensex had recovered but was still down 1,283 points or 6.74 per cent at 17767, and the Nifty was down 320 points or 5.65 per cent at 5347. About 776 scrips had advanced, 2,209 had declined, and 64 were unchanged.

Earlier, on Tuesday, SEBI proposed partial restrictions on investment through offshore derivative instruments, including participatory notes (PNs), equity linked notes and capped return notes - all used by foreign institutional investors (FIIs) to invest in Indian stocks.

SEBI issued a discussion paper suggesting that FIIs and their sub-accounts should not issue or renew offshore derivative instruments (ODIs) with underlying 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," the paper said, inviting comments from the public about the new proposals.

FIIs currently issuing ODIs the with notional value of PNs outstanding (excluding derivatives) as a percentage of their assets under custody (AUC) in India of less than 40 per cent should be allowed to issue further ODIs only at an incremental rate of 5 per cent of their AUC in India.

Those FIIs with a notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40 per cent should issue PNs only against cancellation or redemption or closing out of the existing PNs of at least equivalent amount.

Though only a proposal, the SEBI move effectively halted the FII-led rally. FIIs invested over $5.45 billion in October alone, taking their total investment for 2007 to $17.69 billion.

The huge inflows have pushed up the value of the rupee against the dollar. The year-on-year increase in ODIs, the anonymity that it provides to investors, and the copious inflows into the country from foreign investors have been areas of concern for the government and regulators like the Reserve Bank of India (RBI) and SEBI.

Earlier, the High Level Committee on Capital Markets (HLCC), as well as various committees set up by the government and regulators had made recommendations that included issuing of PNs only to regulated entities subject to know-your-customer (KYC) requirements.

Main causes for concern

• The notional value of PNs outstanding, which was Rs31,875 crore (20 per cent of AUC) in March 2004 has grown over 10 times to Rs3,53,484 crore (51.6 per cent of AUC) by August 2007
• The value of outstanding ODIs with underlying derivatives is Rs1,17,071 crore - about 30 per cent of total PNs outstanding
• The notional value of outstanding PNs - excluding those with underlying derivatives - as a percentage of the AUC was 34.5 per cent in August 2007
• At present, 34 FIIs and sub-accounts issue offshore derivative instruments (ODIs), against 14 in March 2004

SEBI discussion paper''s recommendations in summary

• FIIs and their sub-accounts should not issue or renew ODIs with underlying derivatives. They should wind up their present positions in 18 months
• The further issue of ODIs by FII sub-accounts to be discontinued. Current positions to be wound up over 18 months
• FIIs issuing ODIs with notional value of PNs outstanding (excluding derivatives) less than 40 per cent of AUC can issue ODIs only at an incremental rate of 5 per cent of AUC
• FIIs with notional value of PNs outstanding (excluding derivatives) more than 40 per cent of AUC can issue PNs only against cancellation or redemption of existing PNs