The introduction of reverse fungibility will benefit both companies and investors by improving liquidity and reducing the price differential.
Unlike the telecom industry debacles in America and Europe, which were largely caused by unrealistic growth projections and a mountain of debt totalling an astronomical sum of $1 trillion plus, the changing regulatory environment has been perceived as one of the biggest risks for the players in the Indian telecom industry. Given the importance of regulations in determining business returns, regulatory about-turns have only resulted in scaring away some potential investors.
The Union Budget for 2001-2002 has been notable for its progressive steps on the reforms process. One of the important features of the Budget was the government's decision to permit limited two-way fungibility for ADRs/GDRs (also called as DRs).
Before delving into the details, let's get the basics cleared. What is fungibility? In general terms, fungibility means interchangeability of any security of any class. They could be bearer instruments, securities and goods that are substitutable.
In the past, only one-way fungibility was allowed. Investors in DRs could convert their shares (through the depository) into underlying domestic shares, without the freedom to reconvert it back into DRs. This effectively meant that once the DRs were converted into domestic shares, they were redeemed by the depository. Only a fresh issue of DRs could reinstate that loss of liquidity in the overseas markets.
In what can be seen as another step towards achieving capital account convertibility, following approval by the government, the Reserve Bank of India (RBI) issued necessary guidelines (on February 13, 2002) to make limited two-way fungibility operational. Under the guidelines, re-issue of DRs would be permitted to the extent that they have been redeemed and the underlying shares sold in the domestic market.
The process flow : A non-resident investor places a request with his foreign broker or an Indian local broker for DRs through the re-issuance route. The foreign broker contacts his counterpart in India to repurchase the local shares for conversion. The broker approaches the domestic custodian for approval under the available Head Room (see Safe Head Room). The domestic custodian verifies the available Head Room and sectoral limit and grants approval (in the conversion ratio) and earmarks the limit against the local broker (Day 1). The said approval is valid for a period of three trading days.
The broker buys shares from the domestic stock exchange during the validity of the approval. The broker is required to submit the copy of the contract note to the domestic custodian latest by T+1 (11 am) along with the beneficiary's details (such as beneficiary name, depository name, beneficiary account number). The broker will deposit the shares with the domestic custodian on or before T+4 days, or in the case of auction, on or before T+7 days. In turn, the domestic custodian will intimate the overseas depository to issue proportionate DRs to the beneficiary.
Benefits of fungibility : The key benefits that could accrue to investors (both DR holders and domestic investors) and companies from two-way fungibility are -- improvement in liquidity and elimination of arbitrage. Liquidity is the ease with which an asset can be bought or sold quickly with relatively small price changes. In other words, a liquid market for a security must have depth and breadth, and aid speedy price recovery. A liquid market is said to have depth if buy and sell orders exist both above and below the price at which a stock or a DR is trading. Similarly, the market is said to have breadth if buy and sell orders exist in good volume.
In the one-way fungibility regime, DRs suffer from price volatility and liquidity problems. Low issue size, which results in low free-float and consequently low trading volumes, is one of the prime culprits. For instance, the ADR offer size of both Infosys and Wipro accounts for less than 4 per cent and 2 per cent of the total equity, respectively. The introduction of two-way fungibility is expected to substantially improve liquidity in most of the DRs, owing to the option to have them re-issued. "It has come as a lease of life," said Vijay Kulkarni, vice-president, securities country manager with Citibank, at a recent seminar on reverse fungibility in Mumbai.
In an efficient market, two assets with identical attributes must sell for the same price, and so should an identical asset trading in two different markets. If the prices of such an asset differ, there is an obvious scope for making profits through arbitrage. In the one-way fungibility regime, though there existed scope for profiting through arbitrage, opportunities used to go abegging, thanks to restrictions on capital account. As Kulkarni puts it, "Two-way fungibility presents an opportunity for the investor to arbitrage, thus narrowing the unrealistic price differential between DRs and domestic stock prices."
