Market’s mysteries

What sort of funds are exactly flowing into the Indian market?

By KS Chalapati Rao Delhi

Early in February, the leading indicator of stock prices in India, the 30-share Sensex, crossed the 10,000 mark.  The Sensex has risen almost continuously since May 2005 from a level of about 6,200, except for a fall during October-November 2005.  In fact, after the mayhem of May 2004, but for some intermediate corrections, the rise in the index has been almost gradual. Many reasons have been attributed to this performance, which include increased investments by Foreign Institutional Investors (FIIs), entry of new investors from countries like Japan, performance of the economy, a market-friendly government notwithstanding the occasional pulls and pressures applied by the Left, good show by corporates, efforts to improve corporate governance, low interest rates in developed countries, falling interest rates in India and favourable fiscal measures.  On the flipside, there have been rumblings about the nature of foreign funds, the damage that could be caused by their sudden withdrawal, laundering of money stashed abroad by resident Indians, increased volatility, etc.  There is no doubt that since the new government was formed at the centre, in mid-2004, there has been a surge in new FII registrations. Out of the present 837 FIIs, as many as 327 (39 per cent) were registered after May 2004.  Similarly, 45 per cent of the 2,305 FII sub-accounts have been registered after 2003.  There definitely has been an increased FII interest on India.

It needs to be underlined that India is not alone in experiencing galloping share prices since the beginning of 2005. The 10,000 mark may just be an important milestone for the Indian stock market. A comparison of Sensex with some of the emerging market indices shows amazing resemblance. While the Sensex increased by 58.37 per cent between  January 5, 2005 and  February 20, 2006, Bovespa of Brazil, Kospi (composite) of Korea and IPC of Mexico also moved in tandem. On the other hand, China, Taiwan, Malaysia, Indonesia, Hongkong, and Thailand have been major laggards. Obviously stock market performance is no reflection on China's economic performance and its future prospects. Given the view that FIIs create and thrive in waves one can assume that India is presently among the chosen ones for special treatment by the foreign portfolio investors.   It then follows that a change in their strategy could halt or seriously dent the share price increase.  

Is India's case so simple and straightforward? Are the doubts expressed about the nature of funds flowing in baseless?  Past experience and some scattered evidence do suggest that there may be more to it than meets the eye.  Following its investigations into the role of participatory notes (PNs) and NRIs in the boom of 2003-04, Securities and Exchange Board of India (SEBI), said that there were several layers (with a minimum of three) of investors in the PNs and this information was generally given by FIIs only up to the next layer and "what lies beyond this level is not known".  SEBI was supposed to investigate further into the phenomenon. We are, however, not aware of the outcome of any such follow up exercise.  Interestingly, SEBI also said, at that time,  about private companies, the third largest category of FII investors as "generally broad based, but not listed on any exchange" — an obvious contradiction.   What one knows is that SEBI tightened the reporting system and made 'Know Your Client' norms mandatory for the FIIs.  SEBI's experience in the UBS case exposed the shortcomings of India's regulations.  The Securities Appellate Tribunal, in September 2005, even termed SEBI's 'Know Your Client' requirements as vague.  On its part, the Expert Group of the Ministry of Finance, in its November 2005 report on FII flows said that: "SEBI should have full powers to obtain information regarding the final holder/beneficiaries or of any holder at any point of time in case of any investigation or surveillance action. FIIs should be obliged to provide the information to SEBI".   

In the context of suspicions about money laundering, round tripping and market manipulation, one needs to consider a few points.  Since the new government at the centre has taken over, non-resident Indian (NRI) deposits have practically stagnated especially in the context of steady increase till the early 2004.  Is it possible that NRI (for that matter resident Indians') money is getting into the stock market, side-stepping the banking channels for better returns?  It should be underlined that the term NRI has become so amorphous that many Indian businessmen, who are actively involved in managing large Indian companies, acquired the status of NRIs.  According to press reports, sometime back, out of about 500 letters sent to Overseas Corporate Bodies(OCBs), (OCBs are entities owned 60 per cent or more by NRIs), in more than 300 cases, the letters came back as the addresses were fake!  Indeed, the distinction between Foreign Direct Investment (FDI) and FII investment appears to be diminishing.  How should one interpret when some Indian promoters hold shares not only through their India-incorporated companies but also through entities incorporated in tax havens and which are known to be closely associated with them? Isn't there a fairly good chance of such promoters bringing in some funds through the FII route whereby they can escape the takeover code on one hand and insider-trading regulations on the other?

It is becoming increasingly difficult to distinguish between FDI and NRI investments especially in the IT industry. A few erstwhile Foreign Exchange and Regulation Act (FERA) companies have since come under control of Indians but the investments are held through foreign companies controlled by them. The government has rejected in 2001 share transfer among group companies, saying that such round tripping of FDI would have negative tax implications.  What is the source of such funds?  Does the issue bother anyone?

Another notable feature of the FII sub-accounts is that some of the investment management firms involved in India are manned and probably owned by Indians.   Whose funds would they be able to manage or, put the other way round, who will entrust their moneys to 'Indian managers' - high net worth citizens of developed countries, because Indians would know about Indian companies and entrepreneurs better or, majority of the investors would be persons of Indian origin or Indians themselves?  It is relevant to look into their sources of funds but obviously difficult to unravel.

According to the Expert Group, the share of PNs in net FII investments has increased from 27.34 per cent at the end of May 2004 to 46.73 per cent by the end of August 2005. Obviously, the role of PNs has increased substantially. Interestingly, the share of PNs was the during in April 2005.  And during the month net FII investments were also negative. Earlier in January 2004, rumours of a possible ban on PNs brought the Sensex down by 9.7 per cent in about a week's time. Following SEBIs clarification that PNs issued to unregulated entities need not have to be sold in the market immediately as they were being offered a five-year grace period and in future such notes can be issued to regulated entities only, made the Sensex jump within two days by 7.2 per cent. That is the power of PNs!  And that power seems to remain in just a few hands.  According to the Expert Group, out of the 733 entities registered as FIIs with SEBI at the end of June 2005, only 17 entities had issued PNs.

Why would the beneficiaries of PNs remain secret? From whom are they hiding? When their investment strategies can have a great influence on the market, would it be prudent to let them have a field day? In its note of dissent to the Expert Group report Reserve Bank of India (RBI) stated that:

"The Reserve Bank's stance has been that the issue of Participatory Notes should not be permitted. … the main concerns regarding issue of PNs are that the nature of the beneficial ownership or the identity of the investor will not be known, unlike in the case of FIIs registered with a financial regulator. Trading of these PNs will lead to multi-layering which will make it difficult to identify the ultimate holder of PNs. Both conceptually and in practice, restriction on suspicious flows enhance the reputation of markets and lead to healthy flows. "

The decision with regard to banning of PNs or even putting brakes on FII trades through additional taxation depend upon the policy maker's perception on the benefits flowing out of foreign portfolio investments. The Expert Group listed a number of arguments, like reduced cost of equity capital and balance of payments support, in favour of FII investments.  It also underlined that "enlarging the demand side of Indian securities is beneficial…for Indian investors".  It is a matter of debate to what extent the ordinary Indian investor is in a position to comprehend the market developments and take advantage of them. It is, however, a fact that the role of individual investor in the Indian stock market is gradually diminishing.  Market value of Indian individual investors' shareholding is less than that of FIIs.  An examination of the shareholding data of 2,862 companies suggest that during the past one year, while the share of FIIs increased from 12.96 per cent to 14.95 per cent, that of individual investors declined from 11.59 per cent to 11.03 per cent. That of mutual funds increased from 2.97 per cent to 3.52 per cent. The lost ground is just about recovered by Indian mutual funds, which are supposed to be the investment vehicles of individual investors. But given the fact that corporates have a major influence on mutual funds, it would be difficult to say whose interests these funds represent. 

Probably FIIs would have had a far greater hold on the Indian stock market but for two reasons.  One, in India, the promoters hold substantial stakes, often exceeding majority, in the companies controlled by them. Second, there are limits on FII shareholdings in individual companies. It would be instructive to quote the experience of Korea. The share of local individual investors in the country's market capitalisation came down drastically from 31.68 per cent in 1999 to 20.84 per cent by 2004. On the other hand, 'foreigners' increased their share from 18.47 per cent to 40.10 per cent during the period. While local institutions increased their shares slightly, the other categories suffered. Incidentally, the total market capitalisation in both the years was practically the same. The share of individual investors fell even in absolute terms. 

Going by the large shares of FIIs in some companies it seems India has come back to the earlier position, as it were.  For instance, one of the main objectives of FERA was to contain foreign exchange outflow on account of dividends to foreign parent companies.  The equity dilution strategy, though a flawed one, was supposed to serve this objective.  Following the dilution, many companies became 'Indian' but the management control remained outside.  Thanks to the entry of FIIs, the ownership of many Indian companies got transferred abroad (taking into account GDR issues, it would be even higher), but the control remains in India. Companies like ICICI Bank, HDFC, Satyam Computers and Infosys are more like 'foreign-owned Indian companies'.  It is the foreign shareholders who receive significant amount of the dividends — which may even exceed half.

Policies are being made in vacuum under certain expectations. The Expert Group had hardly any empirical evidence to base its arguments.  It could only report some aggregates and refer to some studies. After more than a decade of dealing with FIIs, having seen the flipside of international capital flows and having experienced serious difficulties in getting behind the ownership structures, if an official expert group involving the government and the regulators could not provide details of FII investments, how can the small investors be expected to take informed decisions?  The fast growing index entices them but its volatility baffles them. In the absence of basic steps at unravelling the market's mysteries, the exhortations by responsible persons in the government asking small investors to be cautious sound hollow.