## _wp07291

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### I. Introduction — Market context and key exposures
- FIIs have been overweight the MSCI index since 2003.
- Market capitalization of the large Indian stock exchanges is about 100 percent of GDP (around $1.3 trillion).
- FIIs hold about 25 percent of the market if cumulative dividends that are rolled over are included.
- Around 50 percent of FII flows have been via participatory notes (PNs).
- NRIs (non resident Indians) are not permitted to use PNs.
- Origins of PN flows are linked to the bilateral tax treaty between India and Mauritius (1983): no resident of Mauritius would be taxed in India on capital gains arising from the sale of securities in India.

### II. Use of Participatory Notes (PNs) — Mechanics, strategies, and macro implications
Findings and context
- Since 1992 an offshore market for PNs developed as a primary conduit for foreign investors to invest in India.
- The Mauritius Treaty allowed ‘certified residents’ of Mauritius to pay corporate taxes in Mauritius that are effectively zero.
- Onshore transactions historically faced short-term capital gains tax as high as 40 percent and long-term capital gains tax between 10–20 percent; since July 2004 there is no long-term capital gains tax and only a 10 percent short-term tax.
- Double taxation avoidance agreements now also exist with Singapore and a few other countries.
- Estimates suggest cumulative tax losses by not having FIIs invest from onshore may have been about $10 bn.
- Reserve Bank of India has consistently asked for a ban on PNs since December 2003 when the total FII capital was around $20 billion.
- Portfolio investment is primarily in the India equity market; FIIs hold less than 1 percent of the local debt market.

Mechanics and hedge strategies using PNs
- PNs are offshore instruments against underlying Indian securities; they can be issued as derivatives or cash.
- PNs allow investors to enter and exit the India market while avoiding registration, settlement and other issues.
- PNs on derivatives are reportedly used primarily by hedge funds.
- Hedge fund strategy example:
  - Assume PNs on derivative positions are about $30 billion.
  - If the hedge fund is short the Nifty and Nifty increased 40 percent this year, the loss from being short in Nifty is around $12 billion (40 percent × $30 billion).
  - Gains from offshore short-term tax arbitrage in this example amount to the 10 percent on being long in a blue chip.
  - If the trade was long Nifty/short blue chip, gains from offshore derivative tax arbitrage would be 33 percent.
- Hedge funds sometimes take larger exposures offshore than allowed onshore and use netting/reporting practices that obscure gross exposures.

Macro implications of PN usage
- A sizable part of capital flows since 2003 have been portfolio related, not FDI related.
- May 2004 and May/June 2006 sell-offs by FIIs may have been triggered primarily by sell-off by PN investors, resulting in sharp declines in the SENSEX/NSE index.
- Equity flows and the rupee have had a high positive correlation since 2003; many PN holders were also long on the rupee.
- India has had a sizable build-up in reserves while continuing to have a (modest) current account deficit, making monitoring equity inflows/outflows crucial.
- PN structures can generate rupee-denominated margin inflows: margins roughly about 25–30 percent imply $7.5–$9 billion (i.e., 25–30 percent of $30 billion PN derivatives) has come into India from such margin accounts due to losses on futures positions, without the initial transaction being closed yet.

Box — Bilateral Tax Treaty (India–Mauritius, summary points)
- The 1983 treaty exempted entities based in Mauritius from capital gains tax arising from their investments in India.
- Registering a company in Mauritius was (and is) expensive and cumbersome, but avoided capital gains tax that has been as high as 40 percent in the past.
- Derivatives are taxed at 33 percent onshore but tax-free offshore, creating tax arbitrage and sizable positions via PN issue on derivatives.
- SEBI classifies PN inflows that are not registered in India under the ‘FII inflows’ category.
- Despite reduced capital gains tax arbitrage and expensive registration in Mauritius, many FIIs continue to use PNs.

### III. Indian regulators' proposal on PNs — Measures, transmission channels, and expected impact
Current PN scale (reported)
- SEBI’s discussion paper states the notional value of PN issued is around $90 billion.
  - PNs on derivatives: around $30 billion.
  - PNs on underlying securities/cash: around $60 billion.

Regulatory measures adopted (as reported)
- Discontinue new issuance of PNs on derivatives by FIIs (and their sub-accounts) with immediate effect.
- Existing PN on derivative positions required to wind up within 18 months.
- FIIs that have issued PNs on cash will need to bring the notional value outstanding to no more than 40 percent of their assets under custody (AUC) in India, as such positions expire/close out.
- FIIs with current positions below 40 percent of their AUC can issue only at the incremental rate of 5 percent of their AUC.

Implications and transmission channels (analysis from source)
- Demand for PNs on underlying securities/cash is from investors awaiting license or those not regulated in a SEBI recognized jurisdiction, including hedge funds.
- The 40 percent cap on AUC could impact inflows for two reasons:
  - Ambiguity regarding terms such as ‘registered entity’ and ‘regulated entity’ may prevent some hedge funds from coming onshore.
  - FIIs who hedged with one leg in PN derivatives and the other via cash may unwind positions as the PN derivative leg is no longer available.
- SEBI’s ban on issuance of PNs on derivatives will reshuffle the investor base on portfolio inflows:
  - May increase onshore inflows from real money accounts registering onshore (pension, endowments, charitable trusts).
  - Inflows from margin accounts (investors using PN derivatives) are likely to disappear, along with some investors from the PN cash market.
  - Inflows from PNs on derivatives will not be replaced since this route allowed transactions that cannot be mimicked onshore.
- Near-term impact depends on how staggered the unwinding is likely to be.
- Once reshuffling toward real money accounts takes place over the next 18 months, capital flows are likely to be more stable.
- The 18 month window for unwinding PN derivatives: market sources suggest the 18 month window from September 30, 2007 implies March-end 2009. Regulators had earlier stated (February 3, 2004 under Sec 15 A) they would phase out PNs issued to entities not regulated overseas in 5 years (or by February, 2009).

Regulation 15(A) (key provisions quoted)
- 15(A).(1) FII or sub account may issue, deal in or hold, off-shore derivative instruments such as PNs, equity-linked notes, or any other similar instruments against underlying securities, listed or proposed to be listed on any stock exchange in India, only if in favor of those entities which are regulated by any relevant authority in the countries of their incorporation or establishment, subject to compliance of ‘know your client’ requirement.
- Provided that if any such instrument has already been issued, prior to February 3, 2004 to a person other than a regulated entity, contract for such a transaction shall expire on maturity of the instrument or within a period of five years from February 3, 2004 whichever is earlier.
- 15(A).(2) A FII or sub account shall ensure that no further down stream issue or transfer of any instrument referred to in sub-regulations (i) is made to any person other than a regulated entity.

### Appendix I — Offshore demand for rupee-linked securities (structure, issuances, and market signals)
Offshore demand overview
- Only around 1 percent or less of the Government of India debt securities (Gsec) market is with foreigners.
- Demand for offshore rupee-linked paper is primarily from real money accounts that cannot take exposure via derivative markets.
- Market sources indicate sizable demand for offshore-rupee exposure by real money accounts that are not allowed to take a derivative position via the rupee NDF market or do not want to take Gsec exposure due to liquidity, credit or other reasons.
- The AAA rating of International Financial Institutions (IFIs) permits investors to take currency risk while eliminating credit risk.

Recent IFI issuances (AAA credits)
- Inter-American Development Bank (IADB): February issue — Rupees 1 billion, 3-year tenor.
- IADB: May issue — Rupees 1.5 billion, 8.25 percent, 10 years.
- World Bank: June issue — Rupees 1.25 billion, 7.25 percent coupon, 3 year.
- EBRD: July issue — Rupees 1 billion, 7 percent coupon, 5 year.

Structure and settlement mechanics (typical transaction)
- Foreign investor buys a rupee-linked bond issued by an IFI and takes rupee risk.
- IFI issues the bond and passes rupee risk to a counterparty (via a swap).
- Counterparty (offshore) takes the reverse rupee risk for hedging purposes.
- No rupee changes hands: dollars received from foreign investors and the rupee risk are passed by the IFI to an offshore counterparty.
- Coupons and principal are paid by the counterparty, in dollars to the IFI and passed on to the investors.
- All coupon and principal payments are in dollars at the prevailing rupee/dollar exchange rate on the day such payments are due.
- If the counterparty misses payment, the IFI is liable to the investors.
- If the counterparty were onshore (in India), the counterparty would need a domestic license and the transaction would come under local derivatives and debt regulations.

Pricing signals and market implications
- Such issues incorporate information from comparable issues on the onshore Gsec curve and the rupee NDF swap market.
- All supranational issues’ coupons have come inside comparable Gsec issues — on average about 50–60 basis points lower — reflecting credit enhancement valued by investors.
- The first IADB issue came “inside” the 3 year comparable Gsec in part because international investors could participate without local restrictions.
- The IFI rupee-linked issuance has developed a shadow GSec offshore curve up to 10 years.
- Market sources indicate that regulators do not explicitly recognize the almost $1 billion daily volume in the NDF market (50 percent Singapore; 25 percent HK and rest New York and others).

Market conditions, demand dynamics, and potential scale
- If the rupee hovers around 40/U.S. dollar, market sources envisage a longer tenor and a larger bond issue soon.
- Presently, with no clear direction for the rupee since April, larger Indian corporates such as Infosys, TCS, Satyam have doubled (and some have tripled) their foreign exchange hedges; however, due to domestic regulations these are unlikely to be candidates as the offshore counterparty via their offshore affiliates.
- The domestic institutional investor base (insurance companies, provident funds, and banks) is described as a captive audience for Indian GSecs at almost all points of the curve.
- Demand from offshore real money investors is a useful barometer for pricing the GSec curve and may be a useful signal as regulators contemplate opening the market to foreigners, especially to finance infrastructure projects.

Market instruments and onshore derivative context
- The overnight-interest swap curve (OIS) is noted as an onshore derivative play.
- Foreign investors take a position on the policy rate via the short end of the OIS curve that is liquid and can be rolled to almost 3 years.

### Key statistics and figures (verbatim)
- Market capitalization of large Indian stock exchanges: about 100 percent of GDP (around $1.3 trillion).
- FIIs hold about 25 percent of the market (including rolled-over cumulative dividends).
- Around 50 percent of FII flows have been via participatory notes (PNs).
- Short-term capital gains tax historically as high as 40 percent.
- Long-term capital gains tax historically between 10–20 percent; presently no long-term capital gains tax and only a 10 percent short-term tax.
- Reserve Bank of India requested ban on PNs since December 2003 when total FII capital was around $20 billion.
- SEBI’s discussion paper: total PN notional value around $90 billion (PN derivatives around $30 billion; PN cash/underlying around $60 billion).
- Margin inflows estimated at $7.5–$9 billion (25–30 percent of $30 billion PN derivatives).
- Example market movement: 40 percent increase in Nifty used in illustrative calculation.
- Regulatory unwind window referenced: 18 months (from September 30, 2007 implying March-end 2009); prior phasing out deadline by February, 2009 under Sec 15 A.

*Source: _wp07291 - References (excerpt provided).*

### References..............................................................................................................

### _wp07291 - References

### I. Introduction
- FIIs have been overweight the MSCI index since 2003.
- Market capitalization of the large Indian stock exchanges is presently about 100 percent of GDP (around $1.3 trillion).
- FIIs hold about 25 percent of the market if cumulative dividends that are rolled over are included.
- Around 50 percent of FII flows have been via participatory notes (PNs).
- NRIs (non resident Indians) are not permitted to use PNs.
- Origins of PN flows are linked to the bilateral tax treaty between India and Mauritius (1983): no resident of Mauritius would be taxed in India on capital gains arising from the sale of securities in India.

### II. Use of Participatory Notes by Foreign Investors in Indian Equity Market
Findings and context
- Since 1992 an offshore market for PNs developed as a primary conduit for foreign investors to invest in India.
- The Mauritius Treaty allowed ‘certified residents’ of Mauritius to pay corporate taxes in Mauritius that are effectively zero.
- Onshore transactions historically faced short-term capital gains tax as high as 40 percent and long-term capital gains tax between 10–20 percent; since July 2004 there is no long-term capital gains tax and only a 10 percent short-term tax.
- Double taxation avoidance agreements now also exist with Singapore and a few other countries.
- Estimates suggest cumulative tax losses by not having FIIs invest from onshore may have been about $10 bn. (cite in text: "Estimates suggest cumulative tax losses by not having FIIs invest from onshore may have been about $10 bn.")
- Reserve Bank of India has consistently asked for a ban on PNs since December 2003 when the total FII capital was around $20 billion.
- Portfolio investment is primarily in the India equity market; FIIs hold less than 1 percent of the local debt market.

Mechanics and strategies using PNs
- PNs are offshore instruments against underlying Indian securities; they can be issued as derivatives or cash.
- PNs allow investors to enter and exit the India market while avoiding registration, settlement and other issues.
- PNs on derivatives are reportedly used primarily by hedge funds.
- Hedge fund strategy example: long in a blue chip and short the Nifty index via PN structures.
  - Assuming PNs on derivative positions are about $30 billion, the loss from being short in Nifty is around $12 billion (or the 40 percent increase in Nifty this year times $30 billion).
  - Gains from offshore short-term tax arbitrage in this example amount to the 10 percent on being long in a blue chip.
  - If the trade was long Nifty/short blue chip, gains from offshore derivative tax arbitrage would be 33 percent.
- Hedge funds sometimes take larger exposures offshore than allowed onshore and use netting/reporting practices that obscure gross exposures.

Box: The Bilateral Tax Treaty between India and Mauritius (summary points from source)
- The 1983 treaty exempted entities based in Mauritius from capital gains tax arising from their investments in India.
- Registering a company in Mauritius was (and is) expensive and cumbersome, but avoided capital gains tax that has been as high as 40 percent in the past.
- Derivatives are taxed at 33 percent onshore but tax-free offshore, creating tax arbitrage and sizable positions via PN issue on derivatives.
- SEBI classifies PN inflows that are not registered in India under the ‘FII inflows’ category.
- Despite reduced capital gains tax arbitrage and expensive registration in Mauritius, many FIIs continue to use PNs.

Macro implications
- A sizable part of capital flows since 2003 have been portfolio related, not FDI related.
- May 2004 and May/June 2006 sell-offs by FIIs may have been triggered primarily by sell-off by PN investors, resulting in sharp declines in the SENSEX/NSE index.
- Equity flows and the rupee have had a high positive correlation since 2003; many PN holders were also long on the rupee.
- India has had a sizable build-up in reserves while continuing to have a (modest) current account deficit, making monitoring equity inflows/outflows crucial.
- PN structures can generate rupee-denominated margin inflows: margins roughly about 25–30 percent imply $7.5–$9 billion (i.e., 25–30 percent of $30 billion PN derivatives) has come into India from such margin accounts due to losses on futures positions, without the initial transaction being closed yet.

### III. Indian Regulators' Proposal on Participatory Notes and Impact on Portfolio Flows
Current PN scale (as reported)
- SEBI’s discussion paper states the notional value of PN issued is around $90 billion.
  - PNs on derivatives: around $30 billion.
  - PNs on underlying securities/cash: around $60 billion.

Regulatory measures adopted
- Discontinue new issuance of PNs on derivatives by FIIs (and their sub-accounts) with immediate effect.
- Existing PN on derivative positions required to wind up within 18 months.
- FIIs that have issued PNs on cash will need to bring the notional value outstanding to no more than 40 percent of their assets under custody (AUC) in India, as such positions expire/close out.
- FIIs with current positions below 40 percent of their AUC can issue only at the incremental rate of 5 percent of their AUC.

Implications and transmission channels
- Demand for PNs on underlying securities/cash is from investors awaiting license or those not regulated in a SEBI recognized jurisdiction, including hedge funds.
- The 40 percent cap on AUC could impact inflows for two reasons:
  - Ambiguity regarding terms such as ‘registered entity’ and ‘regulated entity’ may prevent some hedge funds from coming onshore.
  - FIIs who hedged with one leg in PN derivatives and the other via cash may unwind positions as the PN derivative leg is no longer available.
- SEBI’s ban on issuance of PNs on derivatives will reshuffle the investor base on portfolio inflows.
  - May increase onshore inflows from real money accounts registering onshore (pension, endowments, charitable trusts).
  - Inflows from margin accounts (investors using PN derivatives) are likely to disappear, along with some investors from the PN cash market.
  - Inflows from PNs on derivatives will not be replaced since this route allowed transactions that cannot be mimicked onshore.
- Near-term impact depends on how staggered the unwinding is likely to be.
- Once reshuffling toward real money accounts takes place over the next 18 months, capital flows are likely to be more stable.
- The 18 month window for unwinding PN derivatives: market sources suggest the 18 month window from September 30, 2007 implies March-end 2009. Regulators had earlier stated (February 3, 2004 under Sec 15 A) they would phase out PNs issued to entities not regulated overseas in 5 years (or by February, 2009).

Box: Regulation 15 (A) (key provisions quoted)
- 15(A).(1) FII or sub account may issue, deal in or hold, off-shore derivative instruments such as PNs, equity-linked notes, or any other similar instruments against underlying securities, listed or proposed to be listed on any stock exchange in India, only if in favor of those entities which are regulated by any relevant authority in the countries of their incorporation or establishment, subject to compliance of ‘know your client’ requirement.
- Provided that if any such instrument has already been issued, prior to February 3, 2004 to a person other than a regulated entity, contract for such a transaction shall expire on maturity of the instrument or within a period of five years from February 3, 2004 whichever is earlier.
- 15(A).(2) A FII or sub account shall ensure that no further down stream issue or transfer of any instrument referred to in sub-regulations (i) is made to any person other than a regulated entity.

### Key statistics and figures (verbatim from source)
- Market capitalization of large Indian stock exchanges: about 100 percent of GDP (around $1.3 trillion).
- FIIs hold about 25 percent of the market (including rolled-over cumulative dividends).
- Around 50 percent of FII flows have been via participatory notes (PNs).
- Short-term capital gains tax historically as high as 40 percent.
- Long-term capital gains tax historically between 10–20 percent; presently no long-term capital gains tax and only a 10 percent short-term tax.
- Reserve Bank of India requested ban on PNs since December 2003 when total FII capital was around $20 billion.
- SEBI’s discussion paper: total PN notional value around $90 billion (PN derivatives around $30 billion; PN cash/underlying around $60 billion).
- Margin inflows estimated at $7.5–$9 billion (25–30 percent of $30 billion PN derivatives).
- Example market movement: 40 percent increase in Nifty used in illustrative calculation.
- Regulatory unwind window referenced: 18 months (from September 30, 2007 implying March-end 2009); prior phasing out deadline by February, 2009 under Sec 15 A.

*Source: _wp07291 - References (excerpt provided).*

### Appendix I. Offshore Demand for Rupee-Linked Securities

### Appendix I. Offshore Demand for Rupee-Linked Securities

### Offshore demand overview
- Only around 1 percent or less of the Government of India debt securities (Gsec) market is with foreigners.
- Demand for offshore rupee-linked paper is primarily from real money accounts that cannot take exposure via derivative markets.
- Market sources indicate sizable demand for offshore-rupee exposure by real money accounts that are not allowed to take a derivative position via the rupee NDF market or do not want to take Gsec exposure due to liquidity, credit or other reasons.
- The AAA rating of International Financial Institutions (IFIs) permits investors to take currency risk while eliminating credit risk.

### Recent IFI issuances (AAA credits)
- Inter-American Development Bank (IADB): February issue — Rupees 1 billion, 3-year tenor.
- IADB: May issue — Rupees 1.5 billion, 8.25 percent, 10 years.
- World Bank: June issue — Rupees 1.25 billion, 7.25 percent coupon, 3 year.
- EBRD: July issue — Rupees 1 billion, 7 percent coupon, 5 year.
- Many other institutions, especially investment banks and structured product boutiques below AAA, also issue rupee-linked securities for private placements; AAA issuance provides a snapshot of offshore demand.

### Structure of typical offshore-rupee transactions and settlement mechanics
- A typical transaction involves:
  - Foreign investor buys a rupee-linked bond issued by an IFI and takes rupee risk.
  - IFI issues the bond and passes rupee risk to a counterparty (via a swap).
  - Counterparty (offshore) takes the reverse rupee risk for hedging purposes.
- No rupee changes hands: dollars received from foreign investors and the rupee risk are passed by the IFI to an offshore counterparty.
- Coupons and principal are paid by the counterparty, in dollars to the IFI and passed on to the investors.
- All coupon and principal payments are in dollars at the prevailing rupee/dollar exchange rate on the day such payments are due.
- If the counterparty misses payment, the IFI is liable to the investors.
- If the counterparty were onshore (in India), the counterparty would need a domestic license and the transaction would come under local derivatives and debt regulations.

### Pricing signals and market implications
- Such issues incorporate information from comparable issues on the onshore Gsec curve and the rupee NDF swap market.
- All supranational issues’ coupons have come inside comparable Gsec issues — on average about 50–60 basis points lower — reflecting credit enhancement valued by investors.
- The first IADB issue came “inside” the 3 year comparable Gsec in part because international investors could participate without local restrictions.
- The IFI rupee-linked issuance has developed a shadow GSec offshore curve up to 10 years.
- Market sources indicate that regulators do not explicitly recognize the almost $1 billion daily volume in the NDF market (50 percent Singapore; 25 percent HK and rest New York and others).

### Market conditions, demand dynamics, and potential scale
- If the rupee hovers around 40/U.S. dollar, market sources envisage a longer tenor and a larger bond issue soon.
- Presently, with no clear direction for the rupee since April, larger Indian corporates such as Infosys, TCS, Satyam have doubled (and some have tripled) their foreign exchange hedges; however, due to domestic regulations these are unlikely to be candidates as the offshore counterparty via their offshore affiliates.
- The domestic institutional investor base (insurance companies, provident funds, and banks) is described as a captive audience for Indian GSecs at almost all points of the curve.
- Demand from offshore real money investors is a useful barometer for pricing the GSec curve and may be a useful signal as regulators contemplate opening the market to foreigners, especially to finance infrastructure projects.

### Market instruments and onshore derivative context
- The overnight-interest swap curve (OIS) is noted as an onshore derivative play.
- Foreign investors take a position on the policy rate via the short end of the OIS curve that is liquid and can be rolled to almost 3 years.

*Source: Appendix I. Offshore Demand for Rupee-Linked Securities*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07291.pdf_