Open it up further

The Securities and Exchange Board of India (Sebi) has done well to call a halt to the rapidly expanding role of participatory notes in overseas portfolio investment into India, along the lines proposed in its discussion paper issued early last week. Market players have been given an 18-month lead time to unwind their positions on those P-notes which have derivatives as underlying, as also to stop the sub-accounts of foreign institutional investors (FIIs) issuing such P-notes. This category of P-notes accounts for 30 per cent of all P-notes, and amount to nearly $30 billion in current value (about 2.5 per cent of the market's total). When this entire category disappears in 18 months, the stock market would have become more transparent than it is today, and also a more level playing field in that FIIs will be subject to the same 'know your customer' requirements that are imposed on domestic portfolio managers. The decision to force the broad-basing of sub-accounts with FIIs is also to be welcomed.

These steps will improve the transparency of investment flows, hopefully impede the round-tripping of domestic money (widely suspected to have been taking place in recent weeks), and help to ensure that money coming in through the FIIs is from genuine portfolio investors. If these changes are not to force a wave of sustained selling as 30 per cent of all P-note holdings get unwound over the coming months, Sebi needs to simultaneously make good on its promise to make it easier and faster to register as FIIs, and indeed, as the Sebi chairman has indicated, to allow foreigners to invest directly in the Indian market (the minimum threshold suggested is $50 million).

All of these will help to at least partially undo a situation in which capital market activity related to India had effectively been exported to Mauritius and elsewhere; indeed, the rules that are now being phased out had enabled FIIs to run mini-exchanges overseas as one P-note holder would sell to another through the books of the FII. This made some FIIs unintended gatekeepers for the Indian market; indeed, brokerage charges for such transactions have been more than double those prevailing in the onshore market""and so some of the FIIs and their broking houses had developed a vested interest in maintaining a situation where they could play the arbitrage game with impunity and charge excessive fees for providing access to the Indian market.

Sebi's ultimate objective should be clear""the full development of the Indian capital market. If Mumbai occupies a decent ranking as a financial centre today, it is largely because stock market regulation has served to develop a capital market that deals with trading volumes and achieves market efficiencies that compare very well with other global markets. If this process is to be taken forward, which is in a sense Sebi's remit, then the restrictions that apply""and FII registration is a procedural constraint""will have to go completely, if not today then tomorrow. There is no particular reason why market intermediaries (Indian as well as foreign) should not service foreign portfolio investors from Mumbai or from any other Indian city, instead of this activity having to be routed through Mauritius or some other tax haven; in the same way, Indian companies should not need to issue GDRs and ADRs in order to access international capital. The issue goes beyond Sebi, of course, involving as it does the Reserve Bank of India and the government, which have to take the basic policy decisions. But having taken the first steps towards bringing the exported portion of the capital market back into India, and also moved towards greater transparency when it involves foreign investment in Indian shares, it must be hoped that the capital market will be taken further down this road without delay.