On Thursday evening, the Securities and Exchange Board of India, or SEBI, completed rules governing foreign participation in this fast-growing market, giving clarity to a closely watched situation that has disrupted the exchanges.
The board reiterated some hard-line proposals first floated last week, which caused the Bombay Stock Exchange’s Sensex index to decline more than 9 percent the next day, and hinted at further oversight. “This is not the last set of decisions that you would see regarding foreign investment in India,” the SEBI chairman, M. Damodaran, said in a news conference in Mumbai.
Foreign investors have bought some $16.7 billion in Indian shares this year, according to Bloomberg, 43 percent of that since the Federal Reserve lowered its benchmark interest rate on Sept. 18.
Foreign investors who have not registered with Indian regulators, a sometimes cumbersome process, can no longer use popular financial instruments known as participatory notes to invest in the market, Mr. Damodaran said on Thursday.
In essence, the move eliminates anonymous investors from the market, which could drive out short-term, speculative cash coming from hedge funds and banks. About half of all foreign investment in India’s stock markets is in the form of participatory notes. There was $89.8 billion in participatory notes outstanding in August, up from $8.1 billion in March 2004, SEBI reported on Oct. 16.
The board also said that entities that were not regulated in their home market could not use these notes, another potential blow to hedge funds, which often face little or no regulation. The regulator said investors using participatory notes based on derivatives would need to unwind their positions in 18 months. In addition, SEBI opened the markets slightly to possible long-term investors, saying that pension funds, endowments and university trusts could become registered foreign investors.
The rules go into effect Friday, Mr. Damodaran said.
Indian market regulators are facing what is becoming a common predicament in emerging markets: too much money. There is no perfect way to let the air out of a stock market bubble, say analysts and former regulators. Heavy-handed measures often drive too many investors away, while verbal warnings have little impact.
“There is no evidence I can think of where regulators have successfully intervened” to curb fast-growing stock markets, said Lynton Jones, a founder of Bourse Consult, a London-based adviser to stock exchanges.
“The trouble with markets that are emerging or have just emerged is that the government seems to feel that it can control everything,” Mr. Jones said. In the West, most participants think “markets are markets and they have to sort themselves out.”
Some economists think the impact from SEBI’s hard-line stance will be short term.
“Unless you make controls really draconian, they won’t have any lasting effect,” said Willem H. Buiter, a professor at the London School of Economics and an adviser to Goldman Sachs. “When people believe there is money to be made, they’ll find a way around them.”
When Thai regulators introduced new capital controls in December, the stock market plunged 15 percent the next day, its largest drop in about a decade. Regulators were hoping to cool appreciation of the baht and the stock market by forcing foreign investors to put 30 percent of all incoming investment cash into reserve accounts that earned no interest.
After the market drop, regulators quickly altered their rule, omitting stock market investments.
Chinese regulators have raised interest rates four times this year, hoping to slow appreciation in the country’s stock market, with little effect.
“Can you manage a market? Not really,” said Thomas Krantz, the secretary general of the World Federation of Exchanges, a trade group for financial markets based in Paris. “The market is a force in its own right. You can only do your best to make clear rules, say what you want and why you are doing it.”
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