The Hindu Business Line : No backdoor entry to Street party, please!

Of the $17 billion received as foreign investment till date this year, $7 billion has come in the last one month alone. SEBI has rightly acted to regulate such investments. The regulator’s job though is a thankless one; if you act to prevent trouble you will be accused of being a party pooper and if you sit back and trouble breaks out you will be blamed for inaction.

Mr M. Damodaran, Chairman, SEBI.

Raghuvir Srinivasan

It is never an easy job for a policeman to walk into a boisterous midnight party and break it up before it turns unruly.

Ask SEBI’s Chairman, Mr M. Damodaran, who did that to perfection with his proposal to regulate foreign investment through participatory notes, in the process calling a halt to the euphoria in the stock market that did seem to be getting a bit ou t of hand.

SEBI’s proposals have come under intense scrutiny by market participants with some of them subjecting the regulator to a lot of flak. At the end of the day, what has the regulator done?

Cutting out the jargon

Shorn of all mumbo-jumbo, SEBI has said that investment by unidentified, faceless investors is not welcome. “You are welcome to participate in the party but before that identify yourself please,” is what SEBI is demanding. Surely not an unreasonable one, especially when it comes from a policeman vested with the job of maintaining order.

Second, the regulator has said that if you want to invest in the Indian market, then you should already be under the watch of the regulator of the country you come from. “You cannot walk in from the wilderness and join what is already a roaring party. I need to be satisfied of your antecedents,” SEBI seems to be implying. Unexceptionable policing, isn’t it? You can be a hedge fund or someone with a more radical investment philosophy, but if you want to profit from the Indian market, then you better be someone who another regulator can vouch for.

Third, SEBI has decreed “sorry, no participatory notes with derivatives as the underlying investment”. The objective is to control and regulate leveraged investments where you use a small amount of your own money to leverage and raise funds and invest in the derivatives market where you do not have to commit your entire investment up front. Simply put, building up speculative positions through complex instruments where nobody knows either the beneficial owner or the extent of leveraging is not welcome, SEBI seems to suggest.

Of course, speculation is an essential element of any market but excessive speculation is not. What is “excessive”? Now, that’s something that no regulator worldwide has been able to define. It is left to the comfort level of each country, each market and each regulator to make its own definitions of “excessive”. Complex derivative instruments that frankly, few in the market understand, are the most difficult to regulate and SEBI has said, sorry, please don’t expose our market to such instruments

Finally, the regulator has capped the amount for which an investor can issue participatory notes. They can account for 40 per cent of the value of assets in your custody, says SEBI, and has also set a date (September 30) based on which such calculation will be done.

Need for regulation

Why did the regulator have to do all this now? Participatory notes have been under the regulatory lens for years — the first ever study on them was done in 2003. The answer is the fear that a bubble could be building up in the market which, when it bursts, could take a lot of investors down with it.

Just consider this. Since the beginning of this year, the Indian market has received a whopping $17 billion as foreign investment; the median figure for the last four years is around $8 billion. With a couple of months still to go this year, we have already got more than double of what we normally get as foreign institutional investment.

Crucially, a little more than $7 billion of this came in the last one month. In other words, what India normally gets as FII investment in a year came in a month! That should set the alarm bells ringing in any regulator’s office and it did.

Regulator’s dilemma

How do you cope with and manage such a deluge of funds? Inaction in the face of such a build-up in the market could be dangerous. As the market adage goes, a bubble is not proven till it bursts. Should SEBI have sat back and waited for that? Playing party pooper is not exactly a popular job but not acting and by that, exposing the average investor to a bubble would have proved unpardonable.

So SEBI picked on participatory notes which were under the scanner already. Interestingly, almost half of all foreign investment in India is in the form of participatory notes, making it the obvious first choice for regulation. That the market has settled down and discounted the “negative” effects of the regulatory move shows that the initial noise against the move was not well-founded.

There is a lot of money sloshing around in the worldwide financial system and like water that finds its own level, such money will naturally gravitate to the market that is most attractive; India is one such.

What the regulator has now done is not raise a barrier to such funds flowing in but channel them in through the main door where it can keep a watch. Even the most vocal of those complaining now will agree that in the long term these regulations are good for the market.

Managing the markets, which have a mind of their own, is not easy. The regulator’s job is also a thankless one; if you act to prevent trouble you will be accused of being a party pooper and if you sit back and trouble breaks out you will be blamed for inaction. Ask Mr Damodaran and he would tell you.