Impact of reversing the ban on PNs
Manmohan Singh
The bilateral tax treaty between India and Mauritius has helped attract FIIs to
the Indian equity markets especially after the balance of payments crisis in
the early 1990s.
Entities based in Mauritius are exempted from capital gains tax arising from
their investments in India. This resulted in several offshore funds registering
in Mauritius. Despite the reduction of most capital gains taxes onshore since
July 2004, there is still tax arbitrage as derivatives are taxed at 33 per cent
onshore, but are tax-free offshore.
This had led to sizable FIIs positions, especially via Participatory Notes
(PNs), an offshore instrument against underlying Indian securities. Although
there was limited use of PNs by FIIs in the 1990s and early 2000s, about 40-50
per cent of FII flows between 2004 and 2007 had been via PNs.
PNs allow such investors (primarily hedge funds, other leveraged investors and
high net worth individuals) to enter and exit the India market without the need
to register and establish settlement facilities and other requirements. Since
it has been difficult for regulators to know those using PNs, questions on the
source of such funds have risen.
>From a macro-stability point of view, a sizable part of capital flows since
>2004 have been portfolio related, and not FDI-related.
Market sources and Indian regulators investigating PN flows suggest that the
May 2004, May/June 2006 and October 2007 sell-off by FIIs may have been
triggered primarily by sell-off by PN investors and this resulted in sharp
declines in the Sensex/Nifty. Since equity flows and the rupee have had a high
positive correlation since 2003, many PN holders were also long on the rupee.
Sebi's October 2007 discussion paper on PNs estimated the notional value of PNs
issued at around $90 billion, including: (i) PNs on derivatives ($30 billion);
and (ii) PNs on underlying securities/cash instruments ($60 billion). The PNs
on derivatives are used primarily by hedge funds. Typically, a hedge fund
strategy is to hedge exposure in a single security by taking a short position
in the futures or options markets.
Hedging strategies are seen to favor offshore investors for tax reasons. As an
example, the profit (whenever the position is closed) from being long in a blue
chip and short the Nifty index, would be the mark-to market value of the long
cash position in the blue chip less the cost of purchase of the blue chip
holding, minus the amount lost on the index hedge (the increase in the index
times the size of the position).
Therefore, assuming PNs on derivative positions were about $30 billion last
year, the loss from being short in Nifty was around $12 billion (or the 40
percent increase in Nifty this year times $30 billion). In this example, the
gain from the long blue chip/short Nifty trade was the short-term tax arbitrage
offshore of 10 per cent. It is important to note that Nifty losses have to be
paid via the 'margin' accounts as the losses accrue, even if the above trading
strategy is not closed or unwound.
However, if the trade was long Nifty/short blue chip, gains from offshore
derivative tax arbitrage would be 33 per cent!
Regulators and market sources argued that PNs on derivatives are used to
circumvent ECB rules, avoid taxes and allow "round-tripping" of copious monies.
These types of structures also result in some capital inflows that emanate from
PN derivatives positions that are hedged in the Indian futures market -- the
Nifty Index. Market sources suggest that margins (down payments on futures
positions in the Nifty Index) are about 25-30 per cent of the notional face
value.
Although counterintuitive, last year $7.5 billion to $9 billion (about 25-30
per cent of $30 billion PN derivatives) of inflows stem from such margin
accounts due to losses on futures positions, without the initial transaction
being closed yet. These inflows, added to the appreciation pressures on the
Indian rupee in 2007.
The impact of Sebi's October, 2007 measures:
New issuance of PNs on derivatives was discontinued by FIIs and their
sub-accounts effective and existing positions were required to be wound up by
March, 2009. Market sources indicate that these PNs on derivatives remain
valuable for FIIs' offshore trades and thus many PNs on derivatives position
continue to be rolled over after the regulatory change. However, the global
risk aversion since January 2008 may have expedited the unwinding in the PN
market.
FIIs that issued PNs on cash were required to bring down the notional value
outstanding to a maximum of 40 per cent of their assets under custody in India.
The 40 per cent cap on AUC on foreign flows impacted inflows for two reasons.
Initially, there remained some ambiguity regarding certain terms (such as
"registered entity," and "regulated entity"); since only regulated entities
could be registered, many hedge funds did not come onshore. Secondly, FIIs who
have hedged with one leg of the transaction in PN derivatives and the other via
cash PNs unwound their positions as the PN derivative leg is no longer
available.
Volume on Singapore Nifty futures (SGX) benefited as a substitute for investors
who prefer not to register onshore. Cash PNs along with Singapore's Nifty
allows completing and replicating the derivative PN trades that were difficult
to originate after the October 2007 regulatory changes.
Low transaction cost, absence of securities transaction tax--a key advantage
over using onshore Nifty trades taxed at 33 per cent--and the reduction in the
contract size from $10 to $2 since November 2007 have boosted the Singaporean
Nifty volumes significantly; also with the rupee slipping lately, there is less
currency risk.
The increased liquidity in Singapore also stems from the relative advantage of
incorporating US and late European news of the previous day and executing
trades a few hours prior to the opening of the Indian markets; this year's
global linkages has made the time advantage even more important. Also, hedge
funds invest globally via one primary broker only.
The preference to stay with one primary broker allows to 'net' gains/losses
from a non-Indian account (for example, Brazil) against that; else losses via a
specific Indian account would require additional margin monies for such funds.
In light of the acute global risk aversion now affecting all major emerging
markets, the October 6, 2008 decision to reverse last year's ban on PNs will
initially have a muted impact but is an incentive for FIIs not to move to
another offshore center like Singapore (especially those who have kept rolling
their PN derivative positions since they expire in March '09).
Looking ahead, as long as there remains a tax disadvantage in trading stock
futures onshore, FIIs will prefer to stay offshore .
The author is Senior Economist, Sovereign Asset & Liability Management
Division, IMF. The views expressed in this article are of the author only and
do not represent those of the IMF or IMF policy.
http://www.rediff.com/money/2008/oct/20guest.htm
Patience is beautiful.
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