The flow of portfolio monies into the Indian equity markets is expected to taper further in the coming months.

This is mainly due to concerns over the Securities and Exchange Board of India's recently proposed model code of conduct for foreign institutional investors.

FII inflows into equity have slipped in the last two months. In March 2003, net FIIs inflow stood at Rs 252.6 crore (Rs 2.52 billion) compared Rs 473.30 crore (Rs 4.73 billion) in the corresponding pervious year. But in April 2003, FIIs net inflow stood at Rs 549.8 crore (Rs 5.49 billion) compared to an outflow of Rs 101.50.

The Sebi code recommends barring foreign funds from dealing in derivatives products issued outside India, even though these products may be based on underlying domestic securities.

Foreign funds, with more than $15 billion invested in equities and debt in India, hold considerable sway in the local markets. "There is concern about the regulator's new proposal," said a portfolio manager with a foreign brokerage house. "That has encouraged FIIs to cut positions," he added.

The FIIs move to cut positions has already affected prices of several stocks, especially those with high foreign holding.

Sebi's proposed code of conduct for market intermediaries (including FIIs) says: "It (FIIs) shall not deal with any derivative instruments issued outside India where the underlying is/are Indian securities either directly or indirectly."

Most FIIs deal through participatory notes in India. These notes are like a contract note issued by FIIs to their clients outside India. These clients may be investors who don't want to go through the various regulatory guidelines in India and make the necessary disclosures.

Sebi first raised the issue of PNs through a circular in October 2001.

The circular said it had come to the regulator's notice that some FIIs were issuing derivative/financial instruments against underlying Indian securities.

It said these instruments are known by various names such as Participatory Notes, Equity-Linked Notes, Capped Return Notes and Participating Return Notes etc. With a view to monitoring the investment by FIIs through PNs, Sebi decided that FIIs report details of these instruments along with the names of their holders.

The stock markets regulator's ruling that FIIs shall deal only with a Sebi-registered custodian has created further complications, since FIIs are globally governed by their home country regulator. Under the US Securities Exchange Commission guidelines, FIIs have to appoint their own custodian. But these custodians may or may not have Sebi approval.

Further, Sebi had said that FIIs shall not engage in securities borrowing and margin trading in the Indian securities market. FIIs feel marginalised here as Sebi has allowed stock lending for local institutions and funds.