"If devils were to rule, Laws would devour corpses." -- Mahakavi Subramaniya Bharathi
First the context. Ever since adopting the new economic policies in the early nineties, successive Indian finance ministers have been fixated with just one crucial index to benchmark their performance: the performance of the Sensex.
Never mind that less than 2 per cent of Indians are actively linked to the stock markets and, perhaps, less than 10 per cent of the GDP directly correlated to it.
The obsession with Sensex by policy framers seems on an objective analysis, extremely puerile. But this is how we Indians have influenced successive finance ministers to fashion the economic policy of the nation. Yatha prajha, thatha raja (people get the government they deserve) , isn't it?
Participatory Notes: Who are the ultimate beneficiaries?
Now to the text. As a subset of the policy on foreign direct investment, India allowed investments by foreign institutional investors (FIIs) directly into the stock markets, provided these FIIs register with the Securities and Exchange Board of India and be subjected to its rules and regulations.
India is estimated to have attracted approximately $50 billion on this count since liberalisation. Of this, 50 per cent, that is, $25 billion, is estimated to have come to India as Participatory Notes (PNs).
Readers may be aware that PNs are derivative instruments issued by FIIs to foreign investors -- individuals or corporates -- who want exposure to Indian equities but do not want to register with the Sebi. Further, FIIs are not allowed to issue PNs to Indian nationals, Persons of Indian Origin or Overseas Corporate Bodies (a majority of which are controlled by NRIs).
Thus it is a contract between a foreign institution and a foreigner to invest into India. However, the underlying securities of PNs are Indian stocks.
In contrast to the stringent Know Your Customer (KYC) norms laid out for resident Indians even for opening a bank account (this is correctly done to prevent money laundering while simultaneously ensuring a trail for tax and other authorities), the norms for PNs are relatively lax. But foreigners have to be treated differently in India. Isn't Athithi Devo Bhava (a guest is like God) our motto -- more so if the athithi (guest) is a foreign investor? True to this, it has to be noted that under the existing framework, FIIs are not bound to reveal the names of PN holders.
Ergo, KYC norms do not strictly apply to these investors of PNs. That makes transactions relating to PNs incomprehensible. The net result: Indian regulators do not know the names of such investors, the origin and sources of such funds. Crucially, they can do precious little.
Obviously, suspicions about terrorists operating from some tax haven and routing their investments into the Indian stock market remain. The irony is that if such investments are routed through Mauritius, the Indo-Mauritius DTAA ensures that even short-term capital gains are tax free -- both in India and Mauritius -- again a benefit denied to resident Indians.
Consequently, not only is the identity of the investor a secret but also the investment is insulated against any forms of taxation. What more could a terrorist want?
Further, another criticism against PNs is that these are predominantly round-tripping of Indian capital, moved out and routed back through the hawala route, taking advantage of the tax-breaks provided by the Indo-Mauritius DTAA.
Finance ministry overrules RBI's objections on PNs
Given this background, the finance ministry had constituted a high-power committee comprising senior officials and experts from the Ministry as well as from the Sebi and the Reserve Bank of India in 2005 to look into these issues. In this connection 'The Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative flows' was submitted in November 2005, precisely dealing with these issues.
The report had listed out concerns arising from the anonymity afforded by the PN route. Crucially the 'first' concern of this group was that 'some of the money coming into the market via PNs could be the unaccounted wealth of some rich Indians camouflaged under the guise of FII investment.'
Associated with these concerns was that the capital flows might even be tainted and linked with illegal activities, viz., narco-terrorism.
Interestingly, despite such apprehensions, the conclusion of the expert group was to allow investments through PN route.
However, the RBI, which was a part of this committee, held a contrary view. In a dissenting note to the expert group, it had stated, "The Reserve Bank's stance has been that the issue of Participatory Notes should not be permitted. In this context we would like to point out that the main concerns regarding issue of PNs are that the nature of the beneficial ownership or the identity of the investor will not be known, unlike in the case of FIIs registered with a financial regulator."
Further RBI apprehended that "trading of these PNs will lead to multi-layering, which will make it difficult to identify the ultimate holder of PNs. Both conceptually and in practice, restriction on suspicious flows enhance the reputation of markets and lead to healthy flows. We, therefore, reiterate that issuance of Participatory Notes should not be permitted."
Subsequently, the Tarapore Committee, set up by RBI in 2006 to recommend steps to usher in Capital Account Convertibility, reiterated its earlier views of banning PNs.
In this connection, the report stated, "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. The Committee is, therefore, of the view that FIIs should be prohibited from investing fresh money raised through PNs. Existing PN-holders may be provided an exit route and phased out completely within one year."
Needless to emphasise, the Finance ministry did not find this idea appealing for obvious and not so obvious reasons. After all when did our government respect institutions?
The net result is that even the Sebi is unable to details of PNs from FIIs. Readers may recall that when the United Progressive Alliance government took office in May 2004, a huge fall in the stock markets greeted it. In view of this crash the Sebi examined the dealings in securities by various entities. It was found by the Sebi that one FII UBS Securities Asia Limited -- was one of the important players responsible for the said crash.
During the course of investigation, the Sebi called for information from UBS relating to its major PN clients in terms of their addresses, the names of their directors, fund managers, major shareholders and top 'five' investors.
Strangely, UBS did not furnish the complete information citing client confidentiality to the Sebi. And all of us thought that the Sebi is armed with enormous powers to regulate the market!
Two intelligent Malayalees and three opinions?
What further added fuel to the fire has been the divergent opinion of two men at the helm of affairs -- the National Security Advisor M K Narayanan and Sebi chief M Damodaran. Speaking at the 43rd Munich Conference on Security Policy in February 2007, Narayanan highlighted eleven common methods employed by terrorist outfits to generate funds.
Dwelling on the seventh method -- the stock markets -- he stated: "Isolated instances of terrorist outfits manipulating the stock markets to raise funds for their operations have been reported. Stock exchanges in Mumbai and Chennai (India) have, on occasions, reported that fictitious or notional companies were engaging in stock-market operations. Some of these companies were later traced to terrorist outfits."
The crucial issue to note here is that the NSA's apprehension were not hypothetical. Rather they seemed to be based on hard facts and experiences. Importantly, the language used clearly indicates a temporal link between past, present and future.
In direct contrast, responding to the queries of an anxious press the Sebi chief is reported to have summarily dismissed the views of NSA. Stating that the NSA's remarks were used by the media out of context he opined: "We do not have any evidence that money raised from the Indian capital market has been used for terrorist activities," and went on to compound the confusion by adding, "His comments were not country-specific."
While one is indeed tempted to feed on this confusion between the government and the Sebi, responsible journalism dissuades me from doing so as it involves the crucial issue of national security. Or is it merely a case of two intelligent Malayalees (both the dramatis personae are from Kerala) and three opinions? Readers may decide themselves.
To conclude, terrorists seem to have foothold in our stock markets. Crucially, no modern State would have ever dealt with its own security in such a lackadaisical manner, as successive Indian governments seem to have done.
Though not meeting the exacting standards of a banana republic, it is very apparent that we are very close becoming one. That the BSE Sensex is above 13,000 points is no consolation for victims of terrorism or their family.
The argument -- made repeatedly by government, media, analysts and beneficiaries of the stock market boom -- that if PNs are withdrawn the markets will collapse is specious and perverted. After all, the alternative is much worse: we have in best of circumstances got a deck seat in the Titanic. Haven't we?
The author is Chennai based Chartered Accountant. He can be contacted at email@example.com