The Indian stock market fell by 3.8% yesterday, as foreign investors sold stocks on the expectation that new rules for offshore shareholders will be imposed next week. The benchmark Bombay Stock Exchange Sensex has fallen by more than 5% since Tuesday, when the Securities Exchange Board of India (Sebi), the securities regulator, announced draft rules for offshore investors not registered in India. After the Federal Reserve’s rate cut on September 18, the stock market had risen by a dizzying 19.5% by the beginning of this week. Foreign investors have poured around $18 billion into Indian stocks this year, compared with $8.6 billion they invested last year. Worried about the impact of a fast-rising rupee, the Indian government stepped in to temper what appeared to be an inflow of speculative capital.
The proposal aims to restrict the issuance of participatory notes, or derivative instruments sold to offshore investors.
These notes are popular among hedge funds and others, because they afford exposure to Indian equity without registering with the regulator or submitting to local rules. Their issuance has soared ten-fold to 3.5 trillion rupees ($89.5 billion) in the last three and a half years. Sebi intends to restrict the issuance of new P notes linked to shares, which account for over two-thirds of the P notes by face value.
Limits have also been imposed on the amount registered foreign institutions may invest in P notes. Five of them – Morgan Stanley, Merrill Lynch, Citigroup Global Markets, Goldman Sachs and Credit Lyonnais Securities – reportedly account for 60% of the P notes. The proposal also seeks to bar the issue of new P notes linked to equity derivatives and to wind down outstanding positions over the next 18 months. These restrictions will encourage more foreign investors, as Sebi chairman M Damodaran put it, to come in “through the front door”. It is still unclear whether hedge funds will be able to register in India.
Finance Minister Palaniappan Chidambaram said the new rules would help moderate the copious inflow of capital into India, and be good for the capital market in the long-term. YV Reddy, governor of the Reserve Bank of India, has also robustly defended capital account management. Good macroeconomic management demands that an emerging market’s foreign exchange reserves cover up to one year’s short-term liabilities, he pointed out in a recent interview with Emerging Markets. “How can we be expected to follow that rule unless we manage the capital account?”
Reddy returned to the theme at a lecture he delivered in Washington DC on Wednesday. “We are talking of capital flows in the order of 4-5% of GDP,” he said. India had “something like Dutch disease” in the capital account – and needed something similar to commodity exporting nations’ stabilization funds to deal with it.