P Notes: A move to attract Long-Term Funds by Ajit Dayal
Source: Economic Times

The 'FII' policy was created to ensure that India received long-term capital from known users to fund its long-term economic development. Inadvertently, this policy got hijacked and India got carried away into accepting unknown short-term money via P-notes. As per statistics there are 1,056 foreign institutional investors (FIIs) registered with Sebi and they have an exposure of $172 billion in India (around 15% of India’s market cap). But 34 FIIs (3% of the total number of FIIs) have issued P-notes worth $89 billion (52% of the total money invested by all FIIs). Rather than showing the love for India that this small group of 34 FIIs may have, the statistics indicate the extent to which a ‘back door’ method has been used by short-term investors to buy India exposure. The statistic also indicates the confusion in the nomenclature and a gap in the understanding of how global markets operate. An FII is supposed to be an investor — a mutual fund, a direct investor, or someone who has control over how to deploy the money. However, an issuer of P-notes is a broker — an arranger, someone with no discretionary powers on where the money ends up or for how long that money will stay invested. Rather than being a destination for long-term capital via genuine FIIs, India has been a destination for flourishing deal makers — the brokers (under the guise of FIIs) that issue P-notes. The P-note issue is being painted in the media as a fight against excessive inflows of capital. This is wrong. The Reserve Bank of India (RBI) has consistently asked for a ban on P-notes since December 2003 when the total value of FII capital into India was less than $20 billion. Today it is around $172 billion. RBI has long argued that there is a defined process for entering India — what the Sebi chairman refers to as the ‘front door’— and this must be followed. However, P-notes are profitable for brokers who issue them because the commission on P-notes is 4 times the commission earned on a trade by a registered long-term FII who come in via the ‘front door’. The lobbying power of issuers of these P-notes is huge. The stakes are high — at least $1 billion in commissions have been earned by arrangers of these P-notes. To prevent this ban on P-notes, hedge fund associations have already written to Sebi pointing that hedge funds have been praised by reputed person like US Federal Reserve chairman Ben Bernanke for enhancing the ‘liquidity, efficiency and risk-sharing capabilities of our financial system’. Well, Mr Bernanke now has to deal with a housing bubble in the US. which, one could argue, was fuelled by speculative and irrational money. And while not doubting the innovation of hedge funds, the point to focus on is that India has stated it needs long-term capital. For all their innovation and risk-taking capabilities, hedge funds are not long-term investors. The recent Sebi proposals are a belated recognition of the fact that India has failed to attract serious long-term money. In addition to shutting down the ‘back door’ process completely, the ‘front door’ process must be simplified. I know of well-known endowments that have had to wait for over six months to get their FII approvals. With lawyers charging by the hour, any delay is welcome! Sebi’s front door is narrow and much of it is located in Mauritius. The FII approval should be automatic. If any applicant who submits the papers does not hear from Sebi within 3 weeks, they should be deemed to be an approved FII. And this special tax status for Mauritius and Singapore should be widened to all countries. This will remove the need for another layer of organisation and legal costs imposed on FIIs entering India. There is long-term money waiting to commit hundreds of billions to India. The dominance of short-term money has scared these investors. Sebi, RBI, and ministry of finance must stand firm against all pressures.

Author is Director, Quantum Asset Management.