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Tightened Rules Chill Mumbai Bourse

As regulators clamp down on offshore derivatives to deter manipulators, analysts worry they will trim the flow of foreign capital fueling India's boom

It was a shock for everyone playing the Indian stock market. On the evening of Oct. 16, the Securities and Exchange Board of India (SEBI) issued a statement on proposed policy changes. Worried about manipulation in a hot market, the regulator proposed to restrict the usage of offshore derivative instruments by foreign investors as a route to playing the Indian stock market. It gave investors till Oct. 20 to adapt to the new rules.

The suddenness of the decision took everyone by surprise, especially since billions in foreign money had entered India through these derivatives. When the market opened the next morning, Oct. 17, it fell almost immediately by 1,500 points or 9%—quite a switch from the day earlier when the Mumbai index closed at its all-time high of 19,000.

The selling was so furious that trading had to be suspended shortly after the market opened. It was only after soothing statements by the regulator and the Indian finance minister, P. Chidambaram, that New Delhi did not mean the measures to be so harsh, and that they were awaiting market feedback on the changes, that trading could be resumed. The market climbed back up, to close at 18,633, down just 360 points in total.

Concerned About Abuse

So what was all the fuss about? The regulator's intention was honorable. The derivatives in question, called participatory notes (p-notes for short) allow foreign investors to buy Indian shares easily. But because the system is so arcane, the regulator often could not trace the identity of the investor.

So SEBI was worried the route was being abused by operators who wanted to ramp up company stocks and by Indian politicians who had squirreled away ill-gotten gains overseas, and now wanted to use derivatives as a way to disguise their wealth as foreign money and bring it back to India.

The central bank was also worried about the huge inflow of foreign money into India—$956 million on Oct. 15 alone, and an estimated $6.5 billion since September. This flood of money has been driving stocks to dizzying heights, increasing the risk of a market bubble. And the inflows were pushing the rupee up—not a good thing for India's outsourcing and export industries. Already $17 billion in foreign portfolio investment has poured into India this year—more than the $8 billion in foreign stock market money India saw in 2006.

Excessive Protection Unnecessary

But many argue that Indian policymakers may now be erring too far on the side of caution. Restricting money inflows at this point in India's development may not be wise. The capital pouring in is money that is greasing the wheels of India's economy, helping entrepreneurs start innovative new businesses, and helping existing stars such as the telecom sector and new manufacturing industries grow exuberantly.

It may be time for India's regulators and finance ministry officials to accept that the Indian market is maturing and does not need excessive protection. For many years now the Indian stock market has been more advanced than the country's economy. Monies funneled through the stock market into India's dynamic, entrepreneurial, listed companies have led foreign investment in India, unlike China where easy access through the state apparatus has predominated.

Yet with the current policy change, it will become even harder for legitimate foreign players to participate in the stock market. SEBI would like to limit the number of offshore derivative accounts and instead have those determined to come to India apply to become qualified foreign institutional investors—a process that could take from eight weeks to eight months, compared to five minutes as a derivatives player.

Unlikely to Revive Soon

Surjit Bhalla, a well-known economist and manager of the $15 million Oxus Fund in New Delhi, says this restriction on foreign investment is "the last remaining licence-Raj maintained in India." As an alternative he suggests the regulator let in any entity that wants to invest. The only requirements would be to open a bank account and register with the SEBI. That way the regulator will have greater access to the identities of foreign investors. And such easy registration will eliminate the need for subterfuge through the narrow channel of offshore derivatives.

Meanwhile, until the regulator makes things easier for investors, the market is unlikely to revive substantially. "I think the India story is over for the next three to four months," says one hedge fund investor in Mumbai. Rajeev Malik, head of Asia economic research at J.P. Morgan Chase in Singapore predicts, "Investor sentiment is likely to weaken considerably, as an important source of investor inflows has likely been plugged."

Kripalani is BusinessWeek's Mumbai bureau chief . Lakshman covers India business for BusinessWeek .

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