P-Notes & Sebi

R.I.P.: P-Notes?

Market regulator, Securities and Exchange Board of India (SEBI) has upped its ante on Participatory Notes (P-notes). In its two successive board meets of April and June, SEBI has announced measures aiming to clamp down foreign investments through P-notes.

Off shore derivatives instruments (ODIs) or P-notes, as they are generally referred to, are issued by SEBI-registered foreign portfolio investor (FPI) and are subscribed by foreign investors that either want to hide their identity or doesn’t like the unnecessary compliance cost.

In the Indian context, over the years, P-notes are seen as opaque structures hiding the identity of the ultimate investor. Allegedly P-notes are often misused to avoid taxes, increase speculation, round tripping and money laundering. Indian regulators dislike P-notes and have taken many measures to tame it.

In April, SEBI prevented resident and non-resident Indians (NRIs) to use P-notes for investment into Indian markets. SEBI also restricted entities that are beneficially owned by NRIs from subscribing to ODIs.

Further, in June, the regulator proposed to levy a fee of $1000 on each P-note issued by FPI once every three years retrospectively from April 1, 2017. The regulator also prohibited issuance of P-notes by FPI that has no underlying in the cash market.

Simultaneously, the regulator plans to liberalize its registration process. More recently on June 28, SEBI came out with a consultation paper with an aim to ease access for FPIs in India. All the recent moves are in line with the regulator’s aim to make Indian market transparent and make P-notes less attractive as aninvestment route.

Dying specie

P-notes as an investment route for foreign investors will eventually become irrelevant. This is because the compliance and regulatory cost will slowly kill them.

Foreign investments through P-notes are already on the downward trajectory. In 2007, 50% of all foreign investments into India were through P-notes. In 2017, P-notes route comprised only 6% of all foreign investments. In absolute terms, in 2007 the outstanding value of these instruments stood at around Rs4.1 trillion. This has fallen to Rs1.7 trillion in April 2017.

Policy measures

Globally, there has been increased sensitivity about opaque tools of investments like P-notes. Even Indian government, with its mission to finish black money, has been wary about p-notes.

Rules on p-notes have been tightened several times in recent years. Tightening of norms on P-notes by SEBI intensified after suggestions from Supreme Court-appointed Special Investigation Team (SIT) on black money in July 2015.

The SIT was set up to address the issue of black money and untaxed wealth. SIT flagged P-Notes, issued by foreign institutional investors as a possible conduit for illegal funds in the capital market. The SIT report suggested increased regulation of fund flows through this route. SEBI has been on the edge to contain P-notes.

In May last year, SEBI made Indian know your client (KYC) and anti money laundering (AML) norms applicable to all P-note issuers. SEBI mandated P-note issuer to report any suspicious transactions to Indian authorities. Transfer of P-note was also made difficult. Further, the P-note issuer also needed to report the trail of P-note exchanges over the month to the regulator. The P-note issuer had to also identify the subscriber.

Current clampdown

While SEBI doesn’t desire a complete clampdown on P-notes, the regulator through its various policy measures has already succeeded in reducing the attractiveness of P-Notes. The measures announced in the past few weeks will also make indulgence in P-notes cumbersome.

Prevent resident/ non resident Indians (NRIs) to use P-notes: SEBI prevented resident and non resident Indians (NRIs) to use P-notes for investment into Indian markets. SEBI also restricted entities that are beneficially owned by NRIs from subscribing to P-notes.

Analysis: There have been cases of round tripping of black money of resident or NRIs via P-notes. In the past also, SEBI has expressed its dislike for NRIs using the P-Note route to invest in India. Many big FPIs that issue P-notes have already restricted NRIs to subscribe to P-notes. Now, issuers will also have to prevent entities that are beneficially owned by NRIs from subscribing to ODIs.

With NRI related entities within the ambit, the practice of round tripping of black money will be prevented in the truest sense.

$1000 fee per P-note for 3 years: SEBI has levied a fee of $1000 on each P-note issued by FPI for a period of three years retrospectively from April 1, 2017. Simply put, if a subscriber uses three FPIs for subscribing to p-notes, he will have to pay $3000 as regulatory fees to SEBI.

Analysis: Quite a few P-note subscribers invest through multiple issuers. Now, the regulatory fee will discourage the ODI subscriber from taking ODI route and encourage them to directly take registration as an FPI. Also, SEBI incurs a significant capital (mostly information technology and systems) and man power expenditure in monitoring P-notes. The regulatory fees will make P-notes expensive on one side and also subsidise SEBI’s expenses.

Prohibit naked derivates position on which P-notes are issued: SEBI has prohibited P-notes from being issued against derivatives on which there is no cash market underlying. Typically, issuer takes a position in the Indian derivatives market and issues P-notes on that position. But, that position may not have any cash market co-relation. Now, SEBI mandates P-notes on derivatives only if there is cash market underlying.

Analysis: FPI issuer may have no cash position, but an unlimited derivative position on which it can issue P-notes. This is highly speculative. SEBI now prohibits such naked positions in the market. FPI's can continue to issue P-Notes against cash positions. All existing naked derivatives positions on which P- notes were issued will have to be unwound. This can be done on the immediate expiry day or before Dec 2020.

This move by SEBI is disruptive. As of April 2017, P-notes issued against derivatives had a notional value of Rs 40,165 Cr which is 24% of the total notional value of all outstanding P-notes. So, all the naked positions will be unwound as early as possible.


Although SEBI is trying to discourage usage of P-notes; it does not want to repel genuine foreign investors. With an aim to encouraging FPIs to invest directly, SEBI has come out with a consultation paper on easing of entry norms for FPIs. SEBI proposes to expand eligible jurisdictions for registration of FPIs. The regulator also proposes to rationalizing eligibility criteria for existing FPIs. SEBI also proposes to simplify regulatory requirements for FPIs. With some relaxations in the pipeline, many foreign investors will shun the P-notes route and register themselves as FPI with SEBI.


RBI’s Financial Stability Report & Change in base year for IIP and WPI

RBI’s FSR: Banks NPA may further rise

Reserve Bank of India (RBI) released its 15 th financial stability report (FSR) on July 2. According to the FSR, the domestic and global economic outlook remains positive. But, bad debt of Indian banks may rise in FY18.

What is RBI’s FSR?

The global financial crisis of 2008 has prompted global regulators to mandate banks to undertake stress tests to see if their risk appetite matches their risk taking capacity. Financial regulators and central banks in over 60 countries publish FSR bi-annually about the health of their banking, financial and systems. In line with this global trend, RBI has also been publishing FSR bi-annually since 2009.

Broadly, what does the FSR intend to do?

FSR throws light on the risk to the entire financial system. FSR assess the resilience of the financial sector through stress tests. FSR also focuses on emerging issues of systemic importance to the economy. It also outlines regulatory and consumer protection measures taken in the recent past by all financial regulators. Thus, broadly FSR aims to enhance transparency in the system.

Why is the FSR widely tracked by experts and markets?

The FSR reviews the nature, magnitude, and implications of risks on the macro environment. This has a direct or indirect bearing on various asset classes. RBI’s commentary on macro outlook is important.

So, what does FSR say on the global macro environment?

While the FSR is positive on the global growth scenario it is worried about elevated geopolitical risks and weakening of international institutional mechanisms to deal with them. RBI is also taking a wait-and- watch approach to assess the rhetoric on protectionism and populism globally.

What is the outlook for the domestic economy?

FSR is positive on domestic economic growth prospects on the back of political expected to be at 7.3 per cent in 2017-18. Going forward, FSR says, reforms in foreign direct investment, implementation of goods and services tax (GST), and revival in external demand are likely to contribute to a better growth outlook.

However, FSR says, for sustainability of higher growth rates, revival in investment demand of private sector is essential.

What does FSR say on the fiscal deficit?

FSR has acknowledged that government’s commitment to fiscal discipline had a positive impact on macroeconomic outlook. But, RBI is worried about fiscal positions of some States and the stretched debt capacities of some state owned enterprises.

What is the outlook for inflation?

According to FSR, CPI inflation is expected to be in the range of 2.0–3.5 per cent in the first half of the fiscal year and 3.5–4.5 per cent in the second half.

What is the outlook on banking sector?

FSR has acknowledged that more and more borrowers are relying on other-than-banking sources like mutual funds and bond market for their borrowing needs. While banks capital position is sound, stress test has indicated that under the baseline scenario, gross non-performing assets (GNPAs) of banks may rise from 9.6 per cent in March 2017 to 10.2 per cent by March 2018. This number can worsen if the macroeconomic conditions deteriorate.

So, what are other important takeaway from the FSR?

The report has highlighted that Indian banks will need higher provisioning from April 2018 due to transition to new Indian Accounting Standard (Ind AS). This will lower bank’s profitability.

Re-basing IIP and WPI

Recently the base year for calculating Index of Industrial Production (IIP) and Wholesale Price Index (WPI) was changed from 2004-05 to 2011-12. IIP gives us an idea about growth or fall in industrial activity in the country. WPI gives us an idea about growth or fall in wholesale inflation in the country. Both are important for policy makers and markets.

Why change base year for WPI and IIP?

A change is base year for IIP and WPI was needed to capture structural changes in the economy and improve the quality, coverage, and representativeness of the data. With the change in the base year, IIP and WPI are now aligned with base years for Consumer Price Index (CPI) and Gross Domestic Product (GDP).

What are IIP and WPI?

IIP denotes the growth of the various sectors of the economy including mining, electricity and manufacturing, while WPI is the price representative of a basket of wholesale goods divided into primary articles, fuel & power, and manufactured products.

Who compiles WPI and IIP?

Office of the Economic Adviser, Department of Industrial Policy & Promotion is entrusted with the task of releasing WPI. Central Statistics Office (CSO), Ministry of Statistics and Programme Implementation releases IIP. These data are released monthly. The series with a new base year has been revised after eight years.

What is a base year?

The base year is nothing but the starting point from when an index is constructed. At that starting point, the index is assigned a value of 100. Now if the index (it could be a stock market, WPI, CPI, IIP or GDP) goes up to 102, the index is said to have gone up by 2%. Remember, the index can have different components. These components can be given different weights.

Why change the base year?

Often, economist and analysts complain that economic data is not in sync with reality on the ground. Base years are thus periodically revised to keep data relevant. Even components and weights assigned to those components are changed to reflect the true picture.

So, what are the changes in components for calculating WPI?

Apart from a change in base year, in the new series of the WPI, the number of items covered are increased from 676 to 697. In all, 199 new items have been added and 146 old items have been dropped. Weight for primary articles has been increased while weights for fuel and power basket have been reduced.

What are the changes in components for calculating IIP?

IIP in the revised series will continue to represent mining, manufacturing and electricity sectors, but weights for the manufacturing sector and mining sector has been increased. Weights for electricity have been pruned. Total item groups covered under the new series has been increased to 407 from 399 earlier.

So, how does the data look like for new IIP series?

The index of industrial production expanded slower by 1.7 per cent in May, as against the expansion of 2.8 per cent in April. Interestingly, the IIP data on new series shows that in none of the months in FY17 did the IIP contract. If old series is considered, IIP declined in six months — April, July, August, October, December, and February in FY17. Clearly, the industrial production was not as bad as was reflected by the old series.

How does the data look like for new WPI series?

As per the new series, WPI inflation was at 2.17% in May 2017 as compared to 3.85% in April 2017 and (-) 0.9 percent in May 2016. Interestingly, as per new series, WPI inflation stood at 1.7% in FY17 as compared to 3.7% under the old series. Clearly, WPI inflation was lower in the economy in FY17 than what was reflected by the old series.

What does this mean for over GDP data?

The new series will improve the accuracy of the data. It will also make them comparable to GDP. WPI is used as a deflator for deriving real GDP values from nominal data. Various components of the IIP are used to derive GDP. Since WPI is lower and IIP higher as per the new series, there are chances that GDP can be revised upwards.