Sebi doesn’t like PNs for many reasons. As derivative products that buy underlying Indian shares and derivatives, such as futures and options, they are mostly used by foreign hedge funds to make short-term bets on India’s bourses, including the booming Sensex index.
In India, this short-term style of investing is widely considered to cause turbulence in both the local markets and in India’s currency. The rupee has gained 11% in value this year, a trend that has punished the country’s burgeoning information technology and business outsourcing industries, and again PNs take a lot of the blame for this rise from politicians of all hues.
Finally, India’s financial market overseers, from Sebi chairman M Damodaran to the country’s finance minister, P Chidambaram, seem determined to stem an inrush of foreign institutional investment into the Indian market – the capital source that provided the building blocks of India’s present bull run.
Understandably, the markets were spooked by the rumours, not least because PNs provide a welcome liquidity fillip to India’s equity markets. Indeed, some reckon that inflows through the PN route have accounted for $10 billion out of the roughly $17.5 billion invested by foreign institutional investors in India this year.
Just a minute
Sitting in the offices of up-and-coming Indian investment bank Edelweiss Capital on the morning of the crash, everything went from peaceful to utter chaos in a single minute – the amount of time after the opening bell that it took the Sensex to fall 1,507 points, or nearly 8%. The market closed and then reopened an hour later, recovering to end the day down just 1.8% after Chidambaram made soothing noises about participatory notes, suggesting they were not about to be banned in the near term, and saying the intention was to "moderate capital inflows" but not to ban the notes completely.
Later on, Sebi made it clear that there would be a grace period on PNs, expected to be around 18 months, with Damodaran saying that foreign investors "should come in, but please do so through the front door".
The message was clear: Sebi was ready to tighten the liquidity tap but not turn it off completely, helping to bring a bit of sobriety to a market that has recently become drunk on its own roaring success. Politicians from all walks of life lined up to applaud the move – India is gradually clanking up the gears in preparation for a general election in 2008 or 2009, and a bit of foreigner-bashing never hurt a political campaign.
Too much, too fast
Analysts largely reacted well to the news. Deepak Lalwani, a director at London-based brokerage Astaire & Partners, which closely tracks the Indian markets, said the proposal by Sebi to curb participatory notes over the medium term was "reasonable", helping to "wind down a segment of overseas investment that is considered opaque, [helping to] blow some of the froth off the market." Lalwani noted that the Sensex had added about 4,000 points in just four weeks: "too much, too fast, and liquidity driven, mainly by overseas money".
India’s investors, predictably, were dismayed by Sebi’s move. The markets went from a dizzying climb into free fall for the rest of the week. On October 18, the markets opened up strongly, and continued to climb during the morning. In the afternoon session, though, investors realized belatedly that Sebi was serious with its plan, and started to factor in a future without a daily PN-related capital fix. By the end of the week, the market had again plunged nearly 8%, or 1,500 points, despite hitting an all-time-high on Monday, with overseas funds selling $125 million-worth of Indian stocks since the announcement. "It’s the curse of October," noted one investment banker on the Wednesday. "Now India knows what it’s like to see a market crash." The move may also put a crimp in some upcoming listing plans, notably the expected $2.5 billion initial public offering of Reliance Power, a division of Anil Ambani’s burgeoning business empire, slated for late November or early December.
Yet despite the move, India’s markets are unlikely to slump for long. Investors remain bullish on a market that despite the week’s thrills and spills had at close of trading on October 19 still risen 27.36% on the year, although many predict that further market uncertainty remains ahead. "Expect further intense volatility" in the days ahead, warned Astaire & Partners’ Lalwani, adding that the "India growth story is intact".