Friday, October 19, 2007

The Sebi and the Finance Minister have stated the policy intention to moderate foreign inflow into India through the PN route. While sub-accounts are being discouraged due to the significant rise in proportionate terms, funds are free to invest in the country by registering as FIIs.   v       Issue of fresh PN restricted and some of the existing positions to be wound up in 18 months v       PN issuance on Nifty futures /options and other Indian derivatives to be banned v       Has got RBI support as government hopes to offset appreciating rupee v       Capital flight and a continuous overhang for next 18 months if policy implemented without modifications, destabilizing the market v       Sell off likely unless clarity emerges. Stocks with large PN holdings should be exited   Sebi’s proposal to check PN issuances   v       FIIs and their sub-accounts not allowed to issue new ODIs with underlying as derivatives with immediate effect. Current ODI positions to be would up over a period of 18 months v       Additional 5% of total AUC is cap on ODI issuance, if notional value of PN issued (excluding derivatives) by FIIs is less than 40% of AUC v       Fresh PN issuance allowed in case of cancellation/redemption of existing PN up to same amount, if notional value of PN outstanding (excluding derivatives) higher than 40% of AUC   Offshore derivatives instruments (ODI) are derivative tools used by overseas investors to trade in markets in which they are not registered (Sebi in case of India). These instruments are issued by registered FIIs in a particular country through sub-accounts. Participatory notes (PN), participating return notes, capped return notes and equity linked notes are examples of ODIs.   Asset under custody (AUC) implies assets of all FIIs and their sub-accounts (In India). Not yet clear if assets of management companies will be clubbed in this.    Policy intends to stem the Rupee rise in disguise   The Sebi and the Finance Minister have stated the policy intention to moderate foreign inflow into India through the PN route. While sub-accounts are being discouraged due to the significant rise in proportionate terms, funds are free to invest in the country by registering as FIIs.    Rise in share of ODIs in India     March 2004 August 2007 FIIs/Sub-accounts issuing ODIs (Nos) 14 34 Notional value of PNs outstanding (Rs bn) 319 3,535 PNs outstanding as a % of AUC 20 52 Source: Sebi discussion paper on ODIs   In reality however, this move is more an attempt by the government and RBI to support the unabated rise in the value of the Rupee in recent months. The government’s currency management effort is a pursuit to protect industries like textiles, jewelry and leather that now face international competition, falling export market share and margin erosion.    With money moving out of Dollar assets post the 50bp cut by the US Fed on September 18, 2007, India has witnessed massive money inflow from overseas. A record US$7.5bn has been invested into India after the fed rate cut. A similar move was attempted in the past (in vain) with the issuance of PNs only to regulated entities subject to know your client (KYC) requirements.      Sharp Rupee appreciation vis-à-vis the US Dollar     Source: OANDA   Net FII inflows into Indian equities Source: India Infoline Research   Markets jolted – Severe fall on consecutive days   The market crashed within the initial few minutes of trade on October 17, hitting a 10% lower circuit filter on the proposal to restraint PNs to slow down capital inflows. On reopening, after an hour’s halt in trade, the market covered part losses on clarifications by the Finance Minister and the Sebi chief. The severity of the implications of the restriction on PNs was probably not understood. However, a large wave of institutional selling during late hours of trade on October 18 reversed all gains.    Policy implications – Can India afford to lose money?   If the policy is introduced, then in effect, PNs will be severely restricted from the market. There are a handful of registered FIIs who handle the bulk of the sub-accounts issuances in India. Most of these players have PN accounting for over 40% of their total AUC. Therefore, any fresh PN money can be raised only on exit of an existing PN.    Capital controls could possibly lead to capital flight   v       Risk-averse players dislike capital controls and may opt out of the country v       Hedge funds are typically registered in tax havens and therefore, not necessarily regulated in any country (Hedge funds account for US$1.5tn of world equity corpus) v       Sub-accounts give a mandate to their main account to invest in a number of countries. Some could choose to strike-off India from the list (Estimated US$90bn PN invested in India through cash and futures presently) v       Sub-accounts wanting to sell securities may fear non availability of limits with registered FIIs, in case they wish to buy another set of securities    Capital tends to move into countries where it can move in and out easily. Malaysia and Thailand past experiences disclose the futility of capital controls. These measures might still not be effective in giving support to the Dollar vis-à-vis the Rupee, but could potentially destabilize the market scenario, for the near term at least.     The caveat however, is that this is a draft paper for discussion and the policy can undergo a change. The government has called for suggestions from market participants by October 20, on the proposed measures. An extension given for a period of 2-3 months could help cool the market. But implementation of the policy on October 25, without modifications, could have hazardous impact on the outlook.       Sell off likely – Market outlook cloudy   Unless clarity emerges, the market is likely to witness huge sell-off. Institutional investors may continue to offload heavily. We recommend investors to book profits and exit all leveraged positions. Stocks like Axis Bank, Tata Steel, ICICI Bank, HDFC and Jaiprakash Associates, which have large FII holding through PNs, could witness heavy bouts of selling.

More News.... Source:  India Infoline Research Team