Mumbai: India’s capital market regulator is likely to revisit regulations for foreign institutional investors (FIIs) over concerns that stringent rules may lead to an exodus of overseas investors, the key drivers of domestic stocks.
In an attempt to enhance transparency, lower liquidity risks and reduce the volatility of fund flows from FIIs, the Securities and Exchange Board of India (Sebi) had asked the foreign funds to have at least one so-called broad-based sub-account for retaining their licences.
The regulator had given them a year, or until January 2012, to comply with the norms.
India’s bellwether equity index, the Sensex, touched its lifetime high of 21,005 in November and has since then lost at least 21%, technically making India a bear market, amid the debt crisis in Europe and the US downgrade.
The rules may need to be revised to avoid discouraging them in the current market conditions, said a person familiar with the development.
According to him, all options are open. “One needs to see whether the new norms can be deferred or even revised,” said the person on condition of anonymity as no formal decision has been taken.
Broad-based sub-accounts of FIIs are typically those of large overseas wealth funds and have a wide investor base.
A sub-account under an FII is classified as broad-based when it has at least 20 investors, with none holding more than 49% of the funds.
Typically, funds under broad-based accounts are long-term in nature.
Currently, a significant part of trading takes place through proprietary sub-accounts, which have a smaller investor base, with a single or a small group of rich individuals holding a majority. Proprietary sub-accounts are shown as the FIIs’ own.
The transparency of broad-based sub-accounts is much higher than that of proprietary sub-accounts, negating the possibility that the money being invested is that which went out of India illegally, and ensuring that its source is a bona fide overseas investor.
Sebi’s interpretation is that since an FII has been registered as an investment manager, it should be managing clients’ money, not just its own.
There are 1,736 registered FIIs and 5,958 registered sub-accounts in India. The number of FIIs has come down by five since last November when they were asked to comply with the new rules. This is in sharp contrast to a net addition of 36 FIIs in calendar year 2010, 124 additions in 2009 and 408 in 2008.
Currently, nearly 40% of FII sub-accounts are proprietary accounts. In addition, 30% of FIIs that are investment managers operate only through proprietary accounts. They are not willing to comply with Sebi’s new guidelines. In fact, a few hundred of these FIIs and close to 40% of the sub-accounts are set to exit India with the new rules coming into effect.
FIIs say no new registrations are being made. As the deadline to comply with the new rules approaches, many foreign entities have also not sought renewal of their registration.
“Providing a very small window of one year is asking for a bit too much, given the weak domestic and international market conditions,” said Tejesh Chitlangi, senior associate at Finsec Law Advisors. “Even large FIIs are facing a practical hardship in creating a broad-based sub-account within such a small span of time. There is a lack of interest in seeking new registrations given such requirements.”
Licences for FIIs and their sub-accounts are valid for three years, but they need to renew these at least three months prior to expiry. If Sebi revisits the rules, it wont be the first time it is changing norms governing FIIs.
In 2008, the regulator lifted the ban on so-called participatory notes (P-notes) to shore up slumping domestic markets. P-notes are contracts issued by FIIs, registered in India, to their offshore clients. Such P-notes enable the overseas investors to buy Indian equities through the FII.
It has also selectively waived the investment norms for Singapore investors in Indian firms.
Under the norms, no FII can hold more than 10% stake in any Indian company. If a promoter has backed more than one FII, this ceiling is applicable at the promoter level (and not the FII level).
Sebi recently waived the norm for investors from Singapore with which India has an agreement for opening up the trade and financial sector.
The new rules “may compel many of the genuine FIIs and, in turn, their proprietary sub-accounts to give away their registration and either stop investing in India or come via the (P-notes) route, both of which Sebi and the markets may not want”, said Chitlangi of Finsec Law Advisors.
While global markets have slumped over worldwide uncertainty, experts rule out a repeat of 2008 as there is no liquidity crisis in sight.
Nonetheless, an exodus of FIIs will dent sentiment and reverse foreign capital flows.
In late 1990s, a few years after India opened its capital markets for foreign investments, FIIs were allowed to have proprietary accounts and that is when firms and individuals started coming in.
Later, the rules were tightened and only FIIs with broad-based sub-accounts were given licences. “But around 2004-05, Sebi again started clearing applications with non-broad-based sub-accounts. Now, again, they want broad-based accounts,” said a person familiar with the Sebi circular.
As investors migrate to safer assets over concerns of prolonged turbulence, FIIs have been selling equities heavily across emerging markets, including India. They sold Indian stocks worth $1.67 billion (around Rs7,630 crore today) in August so far. Since January, net equity investments by FIIs have fallen to $326.9 million from $29.36 billion in 2010.
Vyas Mohan contributed to this story.