Thursday, April 17, 2008

P-Notes & Regulatory Shocks

Stunning the market: How not to regulate
Better ways to change the rules, perhaps?

Shyam Ponappa / New Delhi October 31, 2007

Cutting through the consternation and confusion after the regulatory shock on P-notes, let’s pick our way through the pieces.


The government’s/Sebi’s objectives are, presumably, to reduce capital inflows into the stock market and change their mix to curb liquidity pressures raising (a) asset prices, (b) the rupee value, and (c) prices in general (inflation), and to increase transparency to discourage speculative circular trading, whether for profits or for sinister purposes such as inducing instability. Let us examine if these objectives are desirable, and why or why not.

Votaries of open markets want free capital flows even into developing markets such as India. Leaving orthodoxy aside, consider the benefits and costs. International capital seeking high returns in India’s stock markets have the effect of raising the perceived value of shares overall. In other words, from a staid forward PE of around 15-18, the tide can rise so that buyers will pay PE multiples of 22-24 or more, because of an upbeat interpretation of fundamental factors that augur high growth. This can be beneficial or detrimental depending on who gets to capture the value.

The Invisible Hand In Emerging Markets

If offshore hedge funds capture all the business and take out all the profits, the primary gainers are the funds and their investors. Such funds are best placed to capitalise on a quick runup, with their ready capital for precisely such purposes, as well as their agility in evaluation and execution. The companies they buy into also gain directly for purposes such as acquisitions through stock swaps, and broader, cheaper access to capital.

Apart from this, there is the wealth effect for these enterprises, a sort of increased “gravitational pull” of a well-regarded enterprise seeking opportunities and attracting resources (people as well as capital).

The losers are Indian investors, both institutional and retail, who could have otherwise captured the gains, as well as local service providers who would be involved in the execution. With local involvement, there are additional benefits from taxes collected from end to end, and the multiplier effect from the local increase in income and wealth.

However, it is likely that without offshore capital, the higher-order multiples would not be realised, because the same set of cash flows can elicit differing perceptions of value. In times of secular prosperity, the potential for high growth over a long period justifies the higher valuations, whereas difficult circumstances can circumscribe and constrain valuations and behaviour for the same data.

Positive outcomes are more likely if corporate profits continue to grow, local interest rates moderate, and more domestic funds and pension funds move into equities, as also more retail investment. These issues are left to market forces in OECD countries characterised by well-developed, liquid markets with a variety of instruments and intermediaries. In India, where a minuscule percentage of people’s money is in equity, few companies have liquid shares, and markets are not well formed with limited investment products and services broadly available, we are at a more formative stage of market evolution. In such circumstances, investment access for the public is closer to a public good, part of the financial infrastructure at the next level beyond basic infrastructure. Therefore, government and regulatory activism in facilitating investment is necessary in the public interest. Those who yearn for America’s markets should be aware of the years of strong intervention it took to develop them.*

Consequences Of The Government’s/Sebi’s Actions

(i) Capturing Value Locally

The shock announcement may reduce FII flows in the next few months; the question is by how much. If inflows were to be reduced by half and skewed towards a longer term, it would probably be a sufficient fillip to prices, while allowing room for local investors to enter and capture the value of the ride up the curve. If this were to happen, it would be very desirable for the public interest in India; otherwise, most of the benefit would go to offshore investors. If the reduction and change in the composition of inflows is insignificant, the government/regulator need to design other appropriate intervention; and if investments drop by too much, ameliorative measures with more time for adjustment would be advisable.

Why should the government or the regulator care whether or not the Indian public derives significant benefits? First, the public interest is the responsibility of the government and the regulator. Second, there are the local benefits and multiplier effects referred to earlier. These are akin to the revenue sharing gains in telecommunications, whereas FIIs booking profits spirit the gains away, yielding fewer local benefits.

(ii) Roiling the Markets

Now to the way changes are initiated. It is presumably the government’s and the regulator’s aim to maintain stable markets while effecting desirable changes. To the extent that markets have been unnecessarily roiled, there are clearly better ways of initiating change. The key is the government’s/regulator’s stance. To the extent the attitude is supportive and understanding towards market players, there are likely to be less ructions than if it is adversarial, as it appears now. Even if P-notes are to be phased out completely, there are better ways of doing it than a sudden announcement with the threat of limited time for discussion and implementation.

(iii) A Better Way?

For stability, a constructive attitude of open communication, problem definition, and resolution is most important. This is not to say that positions considered harmful to the public interest must be accommodated, or that India has an obligation to support FIIs running offshore trades (my view is that it is not in India’s interests to have extensive hedge fund participation in its markets). However, the process of arriving at conclusions after eliciting views from the players, and then communicating and implementing decisions in a manner that is least disruptive, is very important. Exploratory consultations in direct discussions and through the Internet are not that difficult to devise and implement. Also, if changes are conceived and executed in an end-to-end, systematic, integrated and phased manner, there are likely to be better outcomes than patchy interventions. Otherwise, the opacity and apparent capriciousness of our regulatory environment will constrain our ability to grow and prosper at a pace and to a level that exploits our potential fully.

* Rendezvous With Destiny; A History of Modern American Reform, Eric F Goldman, Alfred A. Knopf, 1952

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