PNs & One Day Internationals
My neighbour’s seven-year old son, Rohit, heard me talking furiously on the phone the night SEBI announced its draft proposals on Participatory Notes (PNs). He heard me talking “PN, FII, ODI, Sebi etc”. Fascinated by the word “PN”, he mustered some courage and asked me in his innocent voice, “What are you talking about, PNs and ODIs?” I was tempted to give him an incorrect explanation, PNs are promissory notes, and it constitutes “a promise that we will not divulge any details, we won’t stay invested for long”. And ODI is one day international (investments)! But in fact, it stands for ‘overseas derivative instruments’.
But I explained, “Say your school is doing extremely well and wanted to expand. It decided to admit new foreign students (at a higher fee) in Class I without going through background checks, or filling up of any forms, and they want to be in the school only for short term etc” And these foreign students run in and out of classes, disturb the school and other students who are keen to remain in school throughout the next ten years and reap the benefit.
These students were spending loads of money, which raised the prices of all the essential items around the school, taking them out of reach of the other normal students. The principal of the school on realising that his school’s stability is at risk decides to stop the menace. So, here SEBI is the Principal, the foreign students are PNs, and the school is the Indian stock markets.
Rohit seemed to have understood and went on to ask me another question: “If these rich students leave, will the school shut down?” My answer was “The school is too big for such students to enforce a shut down.”
Coming back to the real world, Sebi proposed that FIIs and their sub-accounts shall not issue or renew ODIs, including PNs, with underlying as Indian stock derivatives with immediate effect. Further issuance of ODIs by the sub-accounts of FIIs will be discontinued and will be required to wind up the current position over 18 months. PNs are instruments used by foreign funds/ investors who are not registered with the Sebi but are interested in taking exposure in Indian securities. FIIs that do not wish to register and keep their name anonymous, but would like to invest in India also use the PN route. And why do policy makers not particularly like such notes? Simple - anonymity, fear of unknown owners, and abnormally high size. If PN funds fly away in a herd, how much damage will it do the markets, the currency and the economy? And this is the unknown risk of financial instability that’s confronting the policy makers.
Following the foreign exchange crisis India faced in 1991, the Centre had opened up this easiest route to bolster foreign exchange inflows. This channel accounted for 70 per cent of foreign inflows since then. Funds flowed in through PNs are estimated to own about $100 billion (Over Rs 40,000 crore) of Indian equity assets.
All these short term and speculative flows were not necessarily chasing the fundamentals, since nothing had changed significantly in Indian economy for the last month.
If the current proposal is approved by SEBI, there might be a knee-jerk reaction in asset markets, but after realignment and rebalancing of the portfolios, there will be a refocus on fundamentals rather then liquidity.
The author is the CEO & CIO of Quantum Asset Management Company Pvt Ltd.