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Why Participatory Notes are dangerous
R. VAIDYANATHAN
The PN system is discriminatory and seems to favour ghost investors.
Participatory Notes (PN) a general name used for the
investment by Foreign Institutional Investors (FIIs) through
Offshore Derivative Instruments (ODIs) such as Participatory
Notes, Equity-Linked Notes, Capped Return Notes and
Participating Return Notes have created a storm in the
stock market, with SEBI coming out with a draft for discussion
to regulate them, the RBI suggesting that they be phased out,
and the Finance Minister assuring that the Government is not
going to phase them out.
First things first. Let us clearly understand the fundamental
issues. The PNs are a slap on the face of every citizen who is
an investor. For a person to invest even in one share, several
KYC (know your customer) forms have to be filled up, and PAN
numbers and proof of address, etc., provided. For the PN
investor the system is totally silent on even elementary
information. The FIIs issue PNs to funds/companies whose
identity is not known to the Indian authorities.
Hence, the PN system is blatantly discriminatory and seems to
favour ghost investors. Any self-respecting market, if it
discriminates at all, does so against outsiders. But we have
done the unthinkable.
We should recognise and internalise the fact that funds are in
search of markets, and not the other way. Given the
demographic shift in the developed markets (where pension
funds have to locate markets to get returns for longer periods)
Participatory Notes are a slap on the face of every citizen who
is an investor. To invest in shares one has to fill up umpteen
forms and provide proof of residence, PAN number, and so
on. But for PN investors, the system is totally silent, even on
basic information. Why not have confidence in the India story
and realise that we can get funds with addresses without
offering such anonymity, asks R. VAIDYANATHAN.
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02/04/2012 http://www.thehindubusinessline.in/2007/10/24/stories/2007102450800800.htm
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and the lack of huge opportunities in long-term projects, it is
natural that global funds are in search of markets.
The PN route, through which a section of investors is
participating in our markets, is a mystery wrapped in a puzzle,
crammed inside a conundrum and delivered through a riddle.
These are address-less funds that could be from dubious
sources and the clamour for it is intriguing, if not outright
suspicious.
Current Scenario
According to the SEBI Web site, the current position of these
instruments is as follows: Currently, 34 FIIs / Sub-accounts
issue ODIs. This number was 14 in March 2004. The notional
value of PNs outstanding, which was at Rs 31, 875 crore (20
per cent of Assets Under Custody of all FIIs/Sub-Accounts) in
March 2004, increased to Rs 3,53,484 crore (51.6 per cent of
AUC) by August 2007.
The value of outstanding ODIs, with underlying as derivatives,
currently stands at Rs 1,17,071 crores, which is approximately
30 per cent of total PNs outstanding. The notional value of
outstanding PNs, excluding derivatives as underlying as a
percentage of AUC is 34.5 per cent at the end of August
2007. (SEBI Paper for Discussion on ODIs).
This implies that more than 50 per cent of the funds are
flowing through this anonymous route which needs a re-think
on this entire issue. This brings us to the question about who
are the investors interested in Indian Papers.
Who uses the PN route?
The first category is the regular funds whose twin objectives
are returns and more returns on a 21*7*365 basis. They are
interested in India since the India story is very good and
returns are attractive compared to developed markets. The
second category is prodigal money returning. It is not a secret
that a large number of politicians/bureaucrats/business-
persons have accumulated wealth abroad. This has been
accumulated by under-invoicing/over-invoicing, by corruption
in contracts and gifts from abroad; and by not bringing in
legitimate receipts.
The third category is those foreign governments/entities who
would like to acquire/control Indian entities by taking them
over.
The fourth category is the terror financiers who could find this
route attractive and simple. The first category does not have
any reason to use the anonymous route since the aim is to
earn returns /repatriate and benefit out of interest rate and
currency value arbitrage. They enter and exit as per these
calculations and are not shy about the greed for maximum
returns. They pay the taxes applicable and laugh all the way to
the bank with bonus incentives.
The only issue is that currently the stock market is the only
route for investing while several other unlisted sectors, such
as trade, transport, restaurants and other services are starved
of funds. Maybe methods should be evolved to get these
regular global funds to invest not just in the top ten shares of
the stock market but in the needs of the large non-corporate
or unlisted segments of the economy, through NBFCs. That
would ease the volatility in the market since currently large
funds are chasing too few shares of the Sensex or Nifty.
No more safe havens
The second category will be enthusiastic in bringing the money
back into India since the KYC (Know your Customer) norms in
many so-called safe territories like Switzerland are becoming
tougher particularly after 9/11 and the India story is very
interesting and the returns and growth prospects are very
good. The Government can always think of an Amnesty
Scheme for such prodigal funds in the form of no questions
Page 2of 4 The Hindu Business Line : Why Participatory Notes are dangerous
02/04/2012 http://www.thehindubusinessline.in/2007/10/24/stories/2007102450800800.htm
asked about the source. But, once the funds are brought in,
then all the KYC norms must be followed, with minimum legal
and tax hassles. After all, such amnesty schemes for the
domestic black-money holders in the past have met with
reasonable success. Otherwise, a Special Purpose Vehicle
(SPV) can be created which can be dollar-denominated to hold
these funds at attractive rates and which are converted over a
period of time to minimise the flow impact.
Harmful for companies
The third category spells danger for domestic companies since
the unknown entity may be targeting the local company
without its knowledge. With reasonable control they can
pressure the current owners to settle with them or even try
taking over.
This becomes more ominous in the context of several
sovereign funds, like that of China, using the private equity
companies to manage their funds which are non-transparent.
These PEs could use other vehicles to acquire on behalf of
these sovereign funds and it may be possible that Chinese or
West Asian sovereign funds may hold indirectly shares in
Indian companies, particularly in software or oil or telecom,
which are critical sectors.
The fourth category is the one to be worried about. The terror
financier will be happy on two counts, namely the anonymity
provided by these instruments and the domestic regulations
on gifting the shares.
Also important is the issue of the sale of these PNs to entities
that could be inter-connected to the original buyers.
In other words, the original buyer and to whom he sells could
belong to inter-connected terror entitities, in which case the
global entity could have succeeded in transferring funds to
India with ease and anonymity.
It is not without basis that the National Security Advisor (NSA)
has cautioned against terror-financing through the banking
and stock market channels.
That is a cause for concern. Why are we insisting on the
anonymity of the investor and the sources? Why not have
confidence in the India story and realise that we can get funds
with addresses since we have arrived on the global arena?
We should distinguish between clean global flows and dubious
flows as a responsible country with a remarkable growth story.
(The author is Professor of Finance and Control, IIM-
Bangalore. His views are personal and do not reflect those of
his organisation.)
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Page 4of 4 The Hindu Business Line : Why Participatory Notes are dangerous
02/04/2012 http://www.thehindubusinessline.in/2007/10/24/stories/2007102450800800.htm