CLSA: SEBI discussion paper on Participatory Notes (P-Notes)

Whats is this all about :

  • Market regulator Securities and Exchange Board of India (SEBI) has released a discussion paper on offshore derivative instruments (ODIs) including P-Notes.
  • The paper proposes a freeze in fresh issuance of ODIs with underlying as derivatives and all ODI issuances by sub-accounts of Foreign Institutional Investors (FIIs); existing positions will need to be wound down in 18 months.
  • Per Securities and Exchange Board of India (SEBI), the aggregate outstanding position for P-Notes (including those with derivatives as underlying) in Aug-07 was a substantial Rs3.5tn (US$88bn), which highlights a significant level of foreign holding of Indian equities (est. US$220bn in Aug-07) through P-Notes.
  • Large-caps such as Axis Bank, India Bulls Financial, IndiaBulls Real Estate and HDFC have significant share of FII holding through P-Notes.
  • Implementation of Securities and Exchange Board of India (SEBI)’s proposals, in this form, could thus not only have a significant adverse impact on near-term flows, but also dampen sentiment of foreign investors towards Indian equities longer-term.
  • Securities and Exchange Board of India (SEBI) has invited comments from market participants until Oct 20 and will likely take a final decision only after considering the feedback. Given the potential magnitude of the impact, we believe that implementation of all the proposals in toto looks an unlikely option.
  • Uncertainty on this issue will trigger off near-term weakness in the market. However, a dramatic sell-off in the market could provide attractive entry points in some stocks; our preference is clearly for quality stocks that play into the strong domestic growth story such as BHEL, United Spirits, Bharti, Maruti and ITC.

Securities and Exchange Board of India (SEBI) has released a discussion paper on P-Notes, reviving the debate among various regulatory bodies on the need for control on inflows into equity markets through participatory notes. While Securities and Exchange Board of India (SEBI) had contemplated steps to ban/control such flows on many occasions in the past, they had favoured maintaining the status quo, albeit with enhanced disclosure requirements. The recent surge in foreign inflows into Indian equities, especially through the P-Note route, appears to have precipitated the issuance of the discussion paper. While 2007 has seen record US$16.5n net inflow from FIIs, the flows have surged since September (US$8.1bn).

The discussion paper proposes that; 1) “FIIs and their sub-accounts shall not issue/renew ODIs with underlying as derivatives with immediate effect. They are required to wind up the current position over 18 months, during which period Securities and Exchange Board of India (SEBI) will review the position from time to time”. Securities and Exchange Board of India (SEBI) has revealed that about 30% of P-Notes outstanding relates to such investments.

2) “Further issuance of ODIs by the sub-accounts of FIIs will be discontinued with immediate effect. They will be required to wind up the current position over 18 months, during which period Securities and Exchange Board of India (SEBI) will review the position from time to time”

3) “The FIIs who are currently issuing ODIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of less than 40% shall be allowed to issue further ODIs only at the incremental rate of 5% of their Accounts under Custody (AUC) in India”.

4) Those FIIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40% shall issue PNs only against cancellation / redemption / closing out of the existing PNs of at least equivalent amount.

A substantial share of Our interpretation of the proposals suggests that if these are implemented in to, foreign investments would be impacted a substantial chunk of holdings of Indian equities through P-Notes will need to be wound down over an 18month period. Securities and Exchange Board of India (SEBI)’s own figures reveal the aggregate outstanding positions in P-Notes to be a substantial Rs3.53tn (c.US$88bn, of which US$29bn in derivatives) as of Aug-07, a 11x jump since Mar-04 and significant in the context of c.US$220bn stock ownership by FIIs at that point of time. A forced selling of this magnitude 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 unwiund.

The stocks that have a substantially higher component of holding through P-Notes have large holdings through P-Notes could be more severly impacted. While HDFC, ICICI Bank, Bharti, Axis Bank and Tata Steel have the largest holding through P-Notes in absolute terms, as a % of total market caps the biggest holding through P-Notes are for Axis Bank, India Bulls Financial, IndiaBulls Real Estate and HDFC. Clearly, the impact of a forced unwinding of P-Note holdings, in the event of the proposals being implemented in toto, will be significant for these stocks.

In our view, there could be also be an adverse impact on longer-term sentiment towards investing in India, if such harsh measures are implemented in their entirety. The experience of Malaysia, which had seen indifferent stock market performance and depressed trading volume for much of the period following imposition of capital controls in Sep-98 does provide some perspective on this.

Page 2 Contains How it will effect the securities market…