Long-term flow hinges on quick nod, say FIIs

A forced unwinding of the participatory notes (P-notes) exposure in the derivatives market would significantly reduce incremental flows from foreign investors into the Indian stock markets in 3 to 6 months, but the long-term flows will depend on the pace at which FII registrations are cleared by the Securities and Exchange Board of India (Sebi), say top foreign brokerages.

If the proposals are implemented by the Sebi in total, a chunk of holdings of Indian equities through P-notes will have to be wound up over an 18-month period.

Brokerages Citigroup, CLSA and Lehman Brothers have opined that the measures may not have a big impact on the markets, or the foreign inflows, during the medium and long term.

"Longer-term impact on flows will depend on the pace of FII registrations received by hedge funds, which are the main users of P-notes," said Rohini Malkani, economist at Citigroup India, one of the top issuers of P-notes.

The value of outstanding PNs with underlying as derivatives currently is Rs 1,17,071 crore, which is about 30 per cent of total PNs outstanding, according to the Sebi.

The Sebi proposal comes after the value of PNs zoomed 51.6 per cent to Rs 3,53,484 crore (over $88 billion in August 2007) within three years from Rs 31,875 crore in March 2004.

In a note to clients, CLSA, another P-note issuer, said: "A forced selling of this magnitude (in derivatives) would have a substantial negative impact on the market in the short term and the expectation of continued selling would remain a technical overhang on the market until virtually all the existing positions are unwound."

Sonal Varma, India economist at Lehman Brothers, said, India's economic growth would attract players into the domestic markets through the direct FII route.

"The unwinding of P-notes with derivatives as underlying could involve an outflow of around $4-7 billion, while the unwinding of P-notes issued by sub-accounts could well be larger. Despite the 18-month window available, the risk remains that much of the unwinding could be concentrated in a short period in the near term." said Rajeev Malik, Asia Economic Research, JP Morgan Chase Bank, Singapore.