Sebi shuts back door, opens many in front

Is the market ignoring the regulator’s move of imposing curbs on P-Notes? Especially when Sebi itself admitted that half of FII investments are through PNs? The reason for the continuing exuberance in the market could be that the regulator has opened several “front doors” while shutting the “back door” to foreign investors. Many US-based hedge funds, which are not regulated in their own country, won’t be able to invest in Indian markets as the Indian regulator has stipulated that only funds that are regulated in their own country will be allowed to issue P-Notes for investments in India.

However, Sebi’s move making it easier for FIIs to come in through the front door — like permanent registration, changing the track record norms, and bringing new categories of foreign investors like pension funds, universities and charitable societies — will neutralise the impact of the P-Notes proposals to some extent.

“I believe the steps taken are going to bring higher transparency and better financial discipline. This is important for ensuring stability in the Indian financial markets. I disagree that this move will have a dampening effect on capital flows into the country. In fact, this will only help increase capital flows due to better transparency and financial stability,” said Dun & Bradstreet president and CEO Manoj Vaish.

That said, there may be some short-term churning and unwinding as foreign funds will have to exit their PN positions in stocks. There may be a small decline in interest in initial public offers (IPOs) as a sizeable chunk of qualified institutional buyer (QIB) applications used to come through PNs.

“Over the long term, the improved transparency will be positive for the health of the market…. If these measures are followed by rapid FII registration, they would improve disclosure and transparency within the market, which would be welcome,” said Citigroup India economist Rohini Malkani. However, Malkani added that given the limited headroom available due to the 40 per cent limit, as well as the time it might take for the entities to get the FII registration, the measures may reduce near-term flows significantly.

In the coming 18 months, according to a note issued by Standard Chartered Bank, inflows may slow down or even turn negative for a few months, but any huge immediate outflows are unlikely to take place. So far, foreign investors have not headed for the exit door.

FIIs pulled out $1.5 billion in the four days after Sebi proposed the PN ban on October 16. But the selling stopped after Sebi issued clarifications and assurances. FIIs then brought in $700 million in the last three days of last week.

In any case, savvy investors always go to a market where the growth story is strong. Leading foreign investment banks like Merrill Lynch and Lehman Brothers have forecast that India and China will see high growth of 9-11 per cent against 1.4 per cent GDP growth for the US next year, 1 per cent for Japan, and 2.3 per cent for Europe.

India Inc has not showed any signs of a slowdown so far — top companies have posted 20-25 per cent growth in their bottomlines in the second quarter of the current fiscal (2007-08). The sustained growth in earning per share (EPS) will remain an attraction for all investors, not FIIs alone. India’s P-E ratio is 22.4x forward earnings, still low when compared to bubbles in Asian markets like Japan’s 70x earnings in 1989, 100x earnings in Taiwan in 1990, and 30x earnings in South Korea in 1991.

Moreover, with the US sub-prime drama still unfolding, there may be another interest rate cut from the US Federal Reserve. This means more US funds will exit that country in search of growth markets like India and China where foreign investors have reaped a bonanza in the last two or three months. They have preferred India over other Asian markets like Taiwan, South Korea and Thailand. Foreign funds even pulled out around $16 billion from South Korea this year.

So valuations here can go only forward unless something dramatic happens and the investment climate changes.

Unregulated Entities

UK: The FSA regulates hedge fund managers in the UK but does not regulate the funds themselves

USA: Unlike MFs, hedge funds are not regulated or required to make detailed financial disclosures. SEC regulations, therefore, usually prohibit investments in such funds by individuals with net worth less than $1 million