Non-resident Indians could soon have the additional option of investing in Indian capital markets through participatory notes (PN). PN is a derivative instrument used by a foreign entity to invest in India even without registering itself with the Indian regulator. The user can be a Foreign Institutional Investor (FII) registered with the Securities and Exchange Board of India (Sebi), its sub accounts, hedge funds, pension funds among others. Business Standard recently reported that the rules governing participatory notes may be relaxed with the Reserve Bank of India initiating a review in consultation with Sebi and the government. Sources close to the developments told the newspaper that the review of the guidelines for offshore derivative instruments, including PNs, is a major agenda for the RBI under the new governor. Various options are being explored to relax the norms with proper checks and balances for ascertaining the quality and the sources of funds coming through this route.

One of the options being considered is to open up the investment route for non-resident Indians who could either invest through an FII or the PN route. The initiative to relax the PN route is a major shift in RBI's stance as the central bank has all along been advocating a ban on investments through PNs in view of the opaque nature of the instrument which makes it difficult to assess the quality of the funds. In the recent past, a lot of coverage has been given to participatory notes and they have become a matter of concern for regulatory bodies in India. They have always generated lot of debate and controversy in the financial markets circle. The participatory notes were responsible for largest fall witnessed ever in Indian stock markets. Foreign investments in the Indian markets, especially NRI investments, have seen a huge increase in recent times. PNs are derivative instruments used by foreign investors to invest in the Indian stock markets.

FIIs who are registered with Sebi issue PNs to overseas investors who wish to invest their funds in the Indian stock market without disclosing their identity to Sebi. FIIs inform overseas investors about the details of the securities, expected rate of return and more. On this basis, if the foreign investors decide to invest in the particular equities, they are required to deposit funds in the foreign branches of the FII. The FII, on its part, purchases the selected scrips in the Indian market and takes care of all the legal formalities.

PNs are popular with NRIs for three main reasons: 1. Anonymity - Investors do not have to disclose their identity to Sebi; 2. Simplicity - All the legal paperwork is handled by FIIs, and 3. Tax benefit - Unlike Indians, overseas investors do not have to pay the 33 per cent tax. According to a report by JP Morgan Chase, inflow of foreign funds in the Indian equity markets through PNs in 2007 was close to $10 bn, which is more than 50 per cent of the FDI in the domestic market. Of the $220 bn of total FII assets, approximately $88 bn is said to be from PNs.

These figures reflect the popularity of PNs as investment tools in the Indian markets. Notorious cases of money laundering using PNs have led the RBI to propose stringent restrictions, or a complete ban if possible, on their use by registered FIIs. The news of the restrictions on October 17, 2007 saw foreign investors pull out of the stock markets and a 9.15 per cent fall in the Sensex. In contrast to the impulsive reactions, the restrictions imposed by Sebi aim at providing a mature and stable Indian capital market for investment to NRIs.

Although FIIs have contributed to the Indian economy, in more ways than one, they have not been able to earn the respect they should have. The concerns of the regulators are not without reasons. In fact their concerns are very genuine and in the larger interest of the Indian markets. The feeling of the regulators that PNs can be used to destabilise the market and can be a strong source of funding for terrorist outfits is very true. The Indian financial markets can become a haven for money launderers, smugglers, drug traffickers and for anti-national elements if the route of participatory notes remains largely unregulated. Further, it can be used to destabilize the economy and to create artificial crisis in the market considering the fact that PNs constitutes major chunk of FIIs inflow into India.

Moreover, it can be used as an instrument to evade taxes, promote benami transactions, running parallel economy and most importantly act as an attractive source of investment for mafias and underworld. Under the present situation, the investment pattern of PNs does not satisfy the criteria of fair play. The Government has to give serious thought to the entire matter as it is closely related with our financial markets development as well with national security and peace. However, a cautious opening up along with proper checks and balances can provide a major boost to the capital markets as more and more FIIs and NRIs would definitely want to opt for a hassle-free participation in India's success story.

Source: The Peninsula