Citigroup Global Markets on Thursday said that foreign inflows into India will be negatively impacted in the next 3-6 months if Sebi's proposals on curbing Participatory Notes are implemented in the current form.
"The proposed measures can have a very significant negative impact near-term on foreign inflows into Indian equities. There has been a significant rise in the share of PNs in overall FII flows into Indian equities," Citigroup's analyst Ratnesh Kumar said in a latest report.
Users of PNs are largely hedge funds, a fast-growing asset class globally in recent years and lack of any new issuance of Offshore Derivative Instrument with underlying derivatives would take away hedging options for exposures in the cash market. This could be a deterrent for new hedge fund inflows, the report said.
Finance Minister P Chidambaram on Wednesday said that the proposals with or without some modifications would be made a regulation by October 25. The proposals also include that the additional PN issuance through sub-accounts would be stopped with immediate effect and current positions need to be wound up in 18 months.
"While we do not have an estimate on the percentage of PNs that are through sub-accounts, it could be a meaningful number and result in selling pressure over this
period, to the extent of those investors not being able to get the FII registration," Kumar said.
The proposals, which were part of a discussion paper seeking comments from the public by October 20, had triggered a more than 1,700 point crash in the market on Wednesday, prompting suspension of trade for an hour.
Meanwhile, on the positive side, the report said that it is quite likely that tighter controls on PNs will be accompanied by a more liberal FII registration process for hedge funds. But, it might take a few months for even those who apply for and are able to get the FII registration and some may choose not to apply at all.
In the long-term, the impact will greatly depend on what percentage of PN investors (and hedge funds in general) are able to get FII registration.
"With a heavy equity issuance pipeline and relatively smaller scale of domestic institutional funds versus outstanding foreign funds in the market, lesser incremental foreign flows will weigh on the Indian markets performance in the coming months," the Citi Investment Research report said.
Elaborating on the positives in the long-term, the report said if tighter controls are accompanied with more FII registration of hedge funds, it would undoubtedly improve disclosures and transparency in the Indian market, given the rising scale and significance of foreign flows through this route in recent years.
As a significant proportion of incremental foreign flows are expected to slow down in near term, Citigroup expects the market would lose a lot of its recent momentum. Yesterday, the benchmark index had crashed over 1,700 points but later recovered most of its losses by the day end.
"We think the sharp mid-day recovery in the market after a precipitous initial correction had ignored the potential damage to the scale of incremental foreign flows in the coming three-six months," the report added.
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