Monday, December 7, 2015



Unwinding consequences

On 17 May 2004, as it became clear that the Congress would come to power, the stock market melted down. Manmohan Singh, once finance minister and imminent Prime Minister, threatened retribution, and it came in the form of a Sebi enquiry. That enquiry never found a culprit; but at the end of a year, it invented one: It found UBS Securities to have sold 3 per cent – 3 per cent! – of the securities sold on 17 May 2004. Ignoring the rest who had sold 97 per cent, Sebi homed in on UBS Securities,and accused it of having withheld information on the investors behind the participatory notes (PNs) it had issued, and of having given misleading information. It banned UBS for a year.
This PN theme had a history even then. Reserve Bank had complained that discreditable Indian citizens had smuggled their money abroad and were reinvesting it in the Indian stock market through PNs. Why on earth might they do such a thing? It could not be to evade taxes. Dividends are not taxable in the hands of shareholders anyway, and capital gains tax can be avoided as long as securities are held for a year.
No; money was not siphoned off abroad for such a simple, economic reason; it was all about. It was promoters that were resorting to the PN trick, so that they might hold shares in the companies they controlled without having to disclose their identity. In other words, PNs were benami investments in a new guise. And then it uttered under its breath that these nameless individuals may be thieves, smugglers, racketeers and traitors too.
These frightening allegations spurred Sebi into action in February 2004. It would have been PNs; but if it had, all the money invested through PNs would have had to be disinvested; that would have caused the mother of a meltdown in the stock market. So it banned PNs with effect from 3 February 2009. 
UBS appealed against Sebi’s ban order to Securities Appellate Tribunal (SAT), which overturned it. Sebi appealed to Supreme Court, which upheld SAT’s order. Sebi has nowhere further to go; and its reverses must make it think twice. Sebi believes a foreign investor it allows into the Indian market – otherwise known as Foreign Institutional Investor (FII) – must “know his client”. But the FII may have received an order from another institution, which may be passing on an order from another institution, and so on; how many layers of investors must an FII have information on before it can invest the money in India? And how is it to ensure that the information its clients have given is correct and reliable – not “misleading” as Sebi would term it? The rest of the world does not go in for this kind of rigmarole; other regulators only require the investing institution to know its proximate client, and not go beyond him to his clients. India is not only unrealistic, but is uniquely unrealistic.
Now a committee chaired by the Chief Economic Advisor, Ashok Lahiri (the second one he chaired on this subject – the first one reported in June 2004) is deliberating the issues. Reserve Bank has told it that it wants to see an immediate ban, not just on PNs, but also on sub-accounts. In other words, it wants foreign investment to come only from FIIs registered with Sebi, and not from their clients. If introduced immediately, such a regime would cause havoc in the market. Not only is the Lahiri Committee likely to reject it, but Reserve Bank has made the recommendation to take a stand, not to see it implemented. It has simply prepared the ground for saying “I told you so” later when, as it expects, there is a debacle.
The FII category was created 13 years ago because we wanted foreign portfolio investment but were not prepared to see Arabs, Chinese and Italians in our market; we thought we would only let respectable, pre-approved institutions come in. Now we find that there is no way of checking who is investing through the institutions. So the government’s instinctive response would be to tell the institutions that they may not bring in investment from specified undesirable categories.
But this is unwise because it will create policing requirements that no one on earth can fulfil; this is the way to make sure that Sebi tries to do an impossible job, and to discredit it in the process.
The government should get clear about its objectives. If it wants to know the investor, it should throw portfolio investment open to all, and abolish the concept of an FII. But if it wants to stop benami investment by promoters, it should remove the reasons why they want to invest so. It should tell Sebi to abolish its pointless rationing of share issues between promoters, qualified institution investors, personal investors and so on. The solution either way lies in less, not in more regulation.