The Securities and Exchange Board of India has taken the first steps towards phasing out participatory notes. The Reserve Bank of India hates them, and would long ago have liked to see an end to them. But foreign institutional investors find P-notes a great convenience; and the finance ministry, which is more sensitive to the need for a favourable investment climate, had hitherto opposed their termination. Four years ago, the ministry appointed a committee representing all contending interests. It recommended confining the issue of P-notes to “regulated entities subject to KYC requirements”. Once implemented, this recommendation should have addressed the RBI’s misgivings about the ‘quality’ of the inflows. It evidently did not. It is necessary to ask what KYC or ‘know-your-customer’ means in this context. Sebi allows only those FIIs that have its licence to trade and hold portfolio investment. To get this licence, they have to give Sebi the information it asks for. So there is no question that Sebi knows its customers, the FIIs. The concept of KYC can be an issue only with regard to the FIIs’ customers — those who hold or trade in Indian securities through FIIs.
It would be unreasonable to apply KYC requirements to each of the millions of transactions the FIIs may put through for their customers; it should be enough if they maintained a record of customers and satisfy KYC requirements for them according to Sebi’s specifications. These would be satisfied if the FIIs had the required details about the customers available for Sebi’s inspection in their Mumbai offices, and if they sent the details to Sebi and the RBI once a year. There is no such clear requirement. When Sebi asked UBS Securities for details of some customers, it refused, and appealed instead to the securities appellate tribunal. But there is no reason why Sebi should not insist on a disclosure clause in the licences of all FIIs.
Whether this practical solution was tried out or not, it is obviously not sufficient for the RBI. If Osama bin Laden wishes to invest in the National Stock Exchange, he is hardly going to do so in his own name; he would do it through Maharshi Hindutva Corporation or some such front organization. The RBI could set up a surveillance mechanism. But it finds it easier and safer simply to get paranoid. Termination of P-notes will force every FII customer to get a licence from Sebi, but that cannot allay the RBI’s fears. The only cure for it would be not to have any customers, any FIIs or foreign portfolio investment. That is what the RBI would dearly wish, but it cannot say so for fear of political incorrectness. It hates foreign portfolio investment because it adds to reserves; and it hates reserve accumulation because it makes capital controls unnecessary. The RBI is worried about being done out of its job of controlling and meddling, and will do anything to keep the job.