Column : PN doesn’t hurt

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The inexperience of the Indian economic policy making establishment was on display in October 2007 when ‘participatory notes’ were banned. This decision has been rightly reversed through a joint decision between RBI and SEBI. Banning or unbanning PNs does not impact on capital flows. It impacts on the market share of India as a centre for financial trading in India-related financial products. At the same time, the damage done in October 2007 will not be undone immediately.

Participatory notes are as old as the FII framework. They reflect the international reality of an OTC derivatives market, where derivatives are privately negotiated, that co-exists with the exchange-traded spot and derivatives markets. Internationally, financial firms stand ready to sell a variety of products to customers based on private negotiation. Once an OTC derivative is sold, positions are adopted on exchanges in order to hedge away this exposure. This rhythm has been a humdrum reality ever since foreign investment into India commenced.

In recent years, extravagrant claims were made about the non-transparency of PNs, about income tax evasion caused by PNs, the use of PNs for market manipulation, etc. These claims had no factual foundation. But in India, it is generally easy to whip up opposition against a target that is foreign and ill-understood, particularly if this target is well paid.

What was actually going on was RBI’s craving for capital controls. RBI was keen to push India back into being a closed economy. The biggest single chink of openness— the capital account convertibility that has been given to FIIs—was hence in the gunsights. RBI (incorrectly) felt that banning PNs would help retard India’s integration into the world economy.

In October 2007, an important blunder was made with restrictions being brought against PNs. The document that SEBI put out at the time reflected a lack of knowledge about PNs; it underlined the weaknesses of human capital at RBI and SEBI. It required (a) Winding down all PNs by a stated date, (b) Forcing an FII to not issue PNs in excess of 40% of their investment in India and (c) Banning PNs issued ‘against’ derivatives in India.