P-notes can take a hike

The Securities and Exchange Board of India’s recent move to tighten the rules governing the bad boys among foreign investors — those investing through offshore derivative instruments (ODI) — came as a bolt from the blue. But a closer examination shows that SEBI has timed its move very well.

We are at a juncture when the sentiment towards India has turned extremely positive among global investors. This is amply demonstrated by the statements of global fund managers as well as the record foreign portfolio flows into the country.

To tighten the regulations governing ODIs, also called P-notes, now is a smart move. Even if some global investors currently using this route decide to stop investing in India due to changed rules, inflows through the FPI route will make sure that this reduction does not hurt us.

The revised guidelines are primarily signalling that the regulator will no longer look away while black money enters the country through the ODI route. Since these instruments are issued by foreign portfolio investors registered with SEBI to investors in other countries, it was possible to conceal the identity of the ultimate owner of the P-notes.

The eligibility requirements for those subscribing to these instruments have now been lifted several notches, bringing them on a par with other foreign portfolio investors. This move appears to be yet another move in the government’s ongoing drive to identify and control the flow of black money into and out of the country.

The regulations governing P-notes had undergone an overhaul in October 2007, when SEBI under M Damodaran had temporarily banned issuance of P-notes. This was done at a time when matters came to a head; unimpeded flow of black money through this route into the country’s equity markets resulted in ODIs accounting for more than half the foreign portfolio flows into equities.

SEBI had then laid down that these instruments should be issued only to entities regulated by the regulatory authority in the country of their incorporation. More stringent disclosure requirements for foreign investors issuing ODIs were also prescribed.

The Foreign Portfolio Investor (FPI) regulations that were notified in January this year retained the changes made in 2007. The broad intent of these rules was that a route ought to be provided to entities that did not want to go through the rigmarole of registering with SEBI. It was also tacitly acknowledged that the credibility of these investors could be a few notches below the Foreign Portfolio Investors, and hence the less stringent eligibility requirements.

With the circular issued last week, SEBI has signalled that the days of lax regulations are now behind us.

The regulations have been tightened in two ways. One, the eligibility requirement for buying ODIs has been made as stringent as that for registering as FPIs. These instruments can only be issued to entities from countries that have signed a multilateral agreement to combat money laundering and for exchange of information with the International Organisation of Securities Commission. Besides, the place of origin should not be a jurisdiction deficient in implementing systems to combat money laundering, according to the list put out by the public statement of the Financial Action Task Force.

Two, ODIs can no longer be issued to entities with a multi-layered structure that hides the identity of the end beneficiary. While this rule was earlier applicable to FPIs alone, now the buyers of P-notes are also covered by this.

The question that now arises is whether the country can bear the impact if those investing through ODIs were to move to other jurisdictions with more lax regulations. We need not have any qualms on this count for two reasons.

One, the share of P-notes in assets of FPIs has been steadily declining since 2007. A lot of panic is currently being generated due to the sharp increase in the amount of outstanding P-notes in 2014. Towards the end of June, outstanding P-notes were ₹2,24,000 crore — a six-year high.

While this seems worrisome, it needs to be understood that the sum invested by foreign investors too has risen manifold times in the last six years. The share of P-notes in FPI assets is, in fact, declining. While P-notes accounted for more than 50 per cent of foreign investor assets from mid-2007 to May 2008, this ratio has fallen to about 11.5 per cent this year.

Two, foreign investors have turned extremely bullish towards both Indian equity and debt. This is reflected in the flow of more than $39 billion into the country so far this year, the highest ever in a calendar year. While expectation of policy reforms pushed forward by the change of political leadership is driving flows into stocks, the stability of the currency and attractive relative yields is attracting overseas investors into debt too.

Since this sentiment is expected to sustain, any reduction in flows due to the revised guidelines on P-notes should not hurt the country’s capital account much.

SEBI’s action to clean up the P-notes route will help once the General Anti-Avoidance Rules (GAAR) come into effect from April 2015. These rules give the tax authorities the scope to look closer at arrangements that are made specifically to avoid tax. Companies investing through offshore tax havens will now be looking for alternative routes for investing in India without revealing their identity.

Since ODIs have been left out of the ambit of the GAAR, this could become the alternate channel for such brass-plate companies.

The months ahead will show us the extent to which P-notes are misused by Indian entities camouflaged as overseas outfits. We might have to get ready for a future when flows through this route dwindle considerably. But it is all for a good cause — to plug black money channels.