Hedge funds will have to cool their heels - DNA

The government has shelved the idea of allowing hedge funds to participate directly in the Indian market despite market regulator Sebi’s keenness to let at least the established hedge funds in.

The finance ministry, officials in the know said, is wary of opening up the market to hedge funds for two reason: maintaining financial stability and avoiding political criticism. The ministry does not want to take any chances - at this point of time - with highly volatile hedge funds, especially since the Reserve Bank of India (RBI) has advocated a closer watch on short-term capital inflows. The RBI has even sought a review of existing regulations on short-term portfolio flows to avoid assets price bubbles and financial instability.

The ministry does not view foreign portfolio investments as “hot money” and is unlikely to resort to measures that would discourage foreign institutional investors (FIIs) from investing here. However, it has much less confidence in hedge funds, on which international regulation is either weak or non-existent.

The RBI is concerned over large capital inflows which are fuelling domestic inflation. As the country’s foreign exchange reserves have swelled to just under $200 billion, the RBI’s task of managing liquidity in the monetary system is becoming tougher. The RBI wants a relook at the Foreign Exchange Management Act (FEMA) to get a tighter grip over short-term capital flows.

The finance ministry shares the central bank’s view that in case there is an economic downturn, there is considerable risk of foreign funds quickly withdrawing from India and putting financial stability in jeopardy. The government would thus like to avoid a crisis like the east Asian currency crisis of 1997-98.

Earlier, the government had been toying with the idea of letting hedge funds in with a view to further augmenting liquidity and deepening the market. But it had not come out with a comprehensive policy as a detailed examination of the emerging global regulatory framework governing these funds was underway.

Officials said hedge funds worldwide are largely unregulated and lack transparency. A policy that allows hedge funds into stock markets would face political resistance from the government’s Left allies, which have been critical of what they see as inflows of speculative foreign capital into the Indian capital market.

At the behest of Prime Minister Manmohan Singh, an expert group headed by the chief economic advisor in the finance ministry, Ashok Lahiri, had examined the issue of whether the existing regulatory framework adequately covers the aspect of reducing the vulnerability of capital markets to the flow of speculative capital.

The group, comprising representatives from the RBI, Sebi and the department of economic affairs, had recommended that the policy on hedge funds should be put on the hold till regulatory developments in the US and elsewhere are available. The National Common Minimum Programme of the UPA government states that FIIs will continue to be encouraged while the vulnerability of the financial system to the flow of speculative capital will be reduced.

At present, while international hedge funds are not allowed to directly invest in Indian stock markets, they continue to put in money through participatory notes (PNs) issued by registered FIIs. The Lahiri committee had recommended that the current dispensation for PNs should continue though Sebi should have full powers to obtain information regarding the final beneficiary, or any holder, in the case of any investigation or surveillance action. FIIs should be obliged to provide full information to Sebi.

Sebi, according to officials, already had the necessary powers to ask FIIs to give details of PN holders. It, however, needs to be verified if any change in Sebi regulations relating to FIIs, issued in 1995, is required. The data on PNs do not show any substantial increase in their value as a proportion of total FII investment. The government has, therefore, taken the view that there is no concern over their disproportionate influence on market behaviour.

The RBI-appointed Tarapore committee, which recently came up with a roadmap for capital account convertibility of the rupee has, however, recommended the discontinuance of PNs.