Graphic: Vipul Sharma/Mint
Graphic: Vipul Sharma/Mint

P-note investments may fall further next year, but unlikely to impact stock market

P-notes investments in domestic capital markets declined to Rs1.79 trillion in November, the lowest in 2016

It has not been a great year for the once popular participatory notes (P-notes).

Investments in domestic capital markets through P-notes declined to Rs1.79 trillion in November, the lowest in 2016.

According to Securities and Exchange Board of India (Sebi) data, in November 2007, the share of P-notes accounted for more than 40% of the total foreign portfolio investments that came into the Indian markets. In November 2007, the number stood at Rs4.17 trillion.

The share was as high as 55.7% near the peak of the last stock market bull run, in June 2007. The share of P-notes has now fallen below 10%.

P-notes are offshore derivative instruments (ODIs). They are issued by Sebi-registered foreign portfolio investors (FPIs) to other overseas entities that are looking for exposure to Indian markets without getting registered directly.

This helps them to save on costs and time on procedures. Also, P-note holders are exempt from capital gains tax.

In the recent past, P-notes have lost their charm and a couple of factors have contributed to this. In May this year, Sebi tightened P-note norms making it compulsory for P-note holders to follow Indian KYC (know-your-customer) and anti-money laundering laws. It also issued curbs on the transferability of P-notes between foreign investors.

This was done with the objective of identifying the end beneficial owner and ensure the controversial P-notes are not used for money laundering.

Another factor, the plugging of loopholes by renegotiating the tax treaty between India and Mauritius, has also led to investors opting out of the instrument.

In early 2017, the tax treaty between India and Singapore, another tax haven, will be reworked and could further dent investment in this instrument.

“With this, it would become difficult for issuers to pass on tax liabilities to P-note holders. FPI regulations are also getting simplified. So it is very likely that a foreign investor would directly invest in India rather than opting for P-notes," said Suresh Swamy, partner, financial services, PwC India.

Given the aforesaid factors, investment in Indian markets through P-notes is likely to remain weak going into 2017 as well.

As far as impact on the stock market is concerned, some analysts said, it is a myth that P-notes are used to park funds only in mid-cap and small-cap stocks and a decline in fund flow via P-notes would lead to a decline in these stocks going ahead.

“Over the past decade, although we have seen investments via P-notes into the Indian stock market decline, as long as a tax advantaged offshore route to enter the market exists, P-notes will exist even as the quantum of funds that come via P-notes falls. P-notes are used to invest not only in mid-caps but large-cap stocks as well and the fact that fund flow via this route may reduce is well discounted by the market, hence it is unlikely to impact the stock market significantly," Saurabh Mukherjea, CEO, institutional equities, Ambit Capital, said.

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