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?
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.
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.
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.
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.
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
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.
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.
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.
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).
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.
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?
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.
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.
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.
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.
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.
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.
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.
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."
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
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.
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.
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.
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.
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?
committee has also recommended that existing positions
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.
also see : Other
reports by Rex Mathew