Q.3 Critically evaluate participatory notes. Detail the regulatory aspects on it.
Ans:
International entrance to Indian capital market is limited to Foreign Institutional Investors (FIIs). The market has found a way to avoid the limitation by creating an instrument called Participatory Notes (PNs). PNs are basically contract notes.
Indian traders buy securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the primary securities are returned back to the investors. Any entity investing in PNs may not register with SEBI, whereas all FIIs have to register compulsorily.
The benefits of PNs are as follows:
Entities route their investment through PNs to extract advantage of the tax laws system.
It provides a high degree of secrecy, which enables large funds to carry out their operations without revealing their identity.
Investors use PNs to enter Indian market and shift to fully fledged FII structure when they are established.
In the case of Participatory Notes (PNs), the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs. These PNs are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner. It is also not possible to prevent trading in PNs as the entities subscribing to the PNs cannot be restrained from issuing securities on the strength of the PNs held by them. The Committee is, therefore, of the view that FIIs should be prohibited from investing fresh money raised through PNs. Existing PNholders may be provided an exit route and phased out completely within one year.
Non-resident investments in India and use of Participatory Notes (P-Notes)
All things considered, both the non-resident foreigner and Non-resident Indian pay a hefty premium to a firm which has managed to get the license to operate in the Indian stock market i.e. an FII. Instead of moving towards decreasing these transaction costs, the Committee recommends two actions that will further increase these costs: first, by delaying entry of individuals into the Indian market until 2008/9, and second by recommending a ban on Participatory notes or P-notes. The license raj has shifted from the industrial sector to the financial sector. Instead of reforming this “license raj”, the Committee, by recommending a ban on P-notes, is recommending a significant move backwards.
So as water finds its way, so do investors. The report reveals a lack of understanding of the underlying fundamentals, and reality, of stock market transactions. It is the bans and controls on investment by foreign based individuals and corporates that has created the off-shore P-notes market in Indian securities. P-notes primarily exist because of the large transaction costs that the Indian system imposes on foreign residents and corporates, and because of higher capital gains taxes in India than in other emerging markets. Most important, comparator emerging markets have zero short and long term capital gains taxes. (India has a 10 % tax on short-term gains and a 33 percent tax rate on short-term gains made via futures markets. Unfortunately, the Report did not deem it appropriate to discuss the influence of such differential tax rates on human and investment behavior).
Regrettably, P-Notes (an appropriate response to controls) is considered by the Committee to be of such an undesirable nature that it is recommended that they be banned immediately. That this might be a “politically correct” conclusion, at least in some institutions in India, is irrelevant. Like the FCAC committee, the government of India had also constituted an expert group to look at the issue of “Encouraging FII Flows and checking the vulnerability of capital markets to speculative flows”. This GOI report was published in November 2005; it reached the opposite conclusion on P-Notes than that reached by the FCAC Committee.
The Committee’s haste towards an immediate ban of P-Notes, and immediate reversal of existing GoI policy, without any documentation or evidence, suggests an ideological bureaucratic predisposition. And is in complete contrast, and perhaps out of character, with the Reports endorsement of a new policy, with immediate implementation, of industrial houses owning commercial banks – a policy, incidentally, I support. My only issue is that the Report is inconsistent in its recommendations. The recommendation on industrial houses does not come with any strings attached – somewhat surprising, given the extreme “caution” with which the report proceeds on other matters.
Ans:
Participatory notes
International entrance to Indian capital market is limited to Foreign Institutional Investors (FIIs). The market has found a way to avoid the limitation by creating an instrument called Participatory Notes (PNs). PNs are basically contract notes.
Indian traders buy securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the primary securities are returned back to the investors. Any entity investing in PNs may not register with SEBI, whereas all FIIs have to register compulsorily.
The benefits of PNs are as follows:
Entities route their investment through PNs to extract advantage of the tax laws system.
It provides a high degree of secrecy, which enables large funds to carry out their operations without revealing their identity.
Investors use PNs to enter Indian market and shift to fully fledged FII structure when they are established.
In the case of Participatory Notes (PNs), the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs. These PNs are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner. It is also not possible to prevent trading in PNs as the entities subscribing to the PNs cannot be restrained from issuing securities on the strength of the PNs held by them. The Committee is, therefore, of the view that FIIs should be prohibited from investing fresh money raised through PNs. Existing PNholders may be provided an exit route and phased out completely within one year.
Non-resident investments in India and use of Participatory Notes (P-Notes)
All things considered, both the non-resident foreigner and Non-resident Indian pay a hefty premium to a firm which has managed to get the license to operate in the Indian stock market i.e. an FII. Instead of moving towards decreasing these transaction costs, the Committee recommends two actions that will further increase these costs: first, by delaying entry of individuals into the Indian market until 2008/9, and second by recommending a ban on Participatory notes or P-notes. The license raj has shifted from the industrial sector to the financial sector. Instead of reforming this “license raj”, the Committee, by recommending a ban on P-notes, is recommending a significant move backwards.
So as water finds its way, so do investors. The report reveals a lack of understanding of the underlying fundamentals, and reality, of stock market transactions. It is the bans and controls on investment by foreign based individuals and corporates that has created the off-shore P-notes market in Indian securities. P-notes primarily exist because of the large transaction costs that the Indian system imposes on foreign residents and corporates, and because of higher capital gains taxes in India than in other emerging markets. Most important, comparator emerging markets have zero short and long term capital gains taxes. (India has a 10 % tax on short-term gains and a 33 percent tax rate on short-term gains made via futures markets. Unfortunately, the Report did not deem it appropriate to discuss the influence of such differential tax rates on human and investment behavior).
Regrettably, P-Notes (an appropriate response to controls) is considered by the Committee to be of such an undesirable nature that it is recommended that they be banned immediately. That this might be a “politically correct” conclusion, at least in some institutions in India, is irrelevant. Like the FCAC committee, the government of India had also constituted an expert group to look at the issue of “Encouraging FII Flows and checking the vulnerability of capital markets to speculative flows”. This GOI report was published in November 2005; it reached the opposite conclusion on P-Notes than that reached by the FCAC Committee.
The Committee’s haste towards an immediate ban of P-Notes, and immediate reversal of existing GoI policy, without any documentation or evidence, suggests an ideological bureaucratic predisposition. And is in complete contrast, and perhaps out of character, with the Reports endorsement of a new policy, with immediate implementation, of industrial houses owning commercial banks – a policy, incidentally, I support. My only issue is that the Report is inconsistent in its recommendations. The recommendation on industrial houses does not come with any strings attached – somewhat surprising, given the extreme “caution” with which the report proceeds on other matters.
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