The bilateral tax treaty between India and Mauritius has helped attract FIIs to the Indian equity markets especially after the balance of payments crisis in the early 1990s.

Entities based in Mauritius are exempted from capital gains tax arising from their investments in India. This resulted in several offshore funds registering in Mauritius. Despite the reduction of most capital gains taxes onshore since July 2004, there is still tax arbitrage as derivatives are taxed at 33 per cent onshore, but are tax-free offshore.

• What are P-Notes?

This had led to sizable FIIs positions, especially via Participatory Notes (PNs), an offshore instrument against underlying Indian securities. Although there was limited use of PNs by FIIs in the 1990s and early 2000s, about 40-50 per cent of FII flows between 2004 and 2007 had been via PNs.

PNs allow such investors (primarily hedge funds, other leveraged investors and high net worth individuals) to enter and exit the India market without the need to register and establish settlement facilities and other requirements. Since it has been difficult for regulators to know those using PNs, questions on the source of such funds have risen.

From a macro-stability point of view, a sizable part of capital flows since 2004 have been portfolio related, and not FDI-related.

Market sources and Indian regulators investigating PN flows suggest that the May 2004, May/June 2006 and October 2007 sell-off by FIIs may have been triggered primarily by sell-off by PN investors and this resulted in sharp declines in the Sensex/Nifty. Since equity flows and the rupee have had a high positive correlation since 2003, many PN holders were also long on the rupee.

Sebi's October 2007 discussion paper on PNs estimated the notional value of PNs issued at around  $90 billion, including: (i) PNs on derivatives ($30 billion); and (ii) PNs on underlying securities/cash  instruments ($60 billion). The PNs on derivatives are used primarily by hedge funds. Typically, a hedge fund strategy is to hedge exposure in a single security by taking a short position in the futures or options markets.

Hedging strategies are seen to favor offshore investors for tax reasons. As an example, the profit (whenever the position is closed) from being long in a blue chip and short the Nifty index, would be the mark-to market value of the long cash position in the blue chip less the cost of purchase of the blue chip holding, minus the amount lost on the index hedge (the increase in the index times the size of the position).

Therefore, assuming PNs on derivative positions were about $30 billion last year, the loss from being short in Nifty was around $12 billion (or the 40 percent increase in Nifty this year times $30 billion). In this example, the gain from the long blue chip/short Nifty trade was the short-term tax arbitrage offshore of 10 per cent. It is important to note that Nifty losses have to be paid via the 'margin' accounts as the losses accrue, even if the above trading strategy is not closed or unwound.

However, if the trade was long Nifty/short blue chip, gains from offshore derivative tax arbitrage would be 33 per cent!

Regulators and market sources argued that PNs on derivatives are used to circumvent ECB rules, avoid taxes and allow "round-tripping" of copious monies.

These types of structures also result in some capital inflows that emanate from PN derivatives positions that are hedged in the Indian futures market -- the Nifty Index. Market sources suggest that margins (down payments on futures positions in the Nifty Index) are about 25-30 per cent of the notional face value.

Although counterintuitive, last year $7.5 billion to $9 billion (about 25-30 per cent of $30 billion PN derivatives) of inflows stem from such margin accounts due to losses on futures positions, without the initial transaction being closed yet. These inflows, added to the appreciation pressures on the Indian rupee in 2007.

The impact of Sebi's October, 2007 measures:

New issuance of PNs on derivatives was discontinued by FIIs and their sub-accounts effective and existing positions were required to be wound up by March, 2009. Market sources indicate that these PNs on derivatives remain valuable for FIIs' offshore trades and thus many PNs on derivatives position continue to be rolled over after the regulatory change. However, the global risk aversion since January 2008 may have expedited the unwinding in the PN market.

FIIs that issued PNs on cash were required to bring down the notional value outstanding to a maximum of 40 per cent of their assets under custody in India. The 40 per cent cap on AUC on foreign flows impacted inflows for two reasons. Initially, there remained some ambiguity regarding certain terms (such as "registered entity," and "regulated entity"); since only regulated entities could be registered, many hedge funds did not come onshore. Secondly, FIIs who have hedged with one leg of the transaction in PN derivatives and the other via cash PNs unwound their positions as the PN derivative leg is no longer available.

Volume on Singapore Nifty futures (SGX) benefited as a substitute for investors who prefer not to register onshore. Cash PNs along with Singapore's Nifty allows completing and replicating the derivative PN trades that were difficult to originate after the October 2007 regulatory changes.

Low transaction cost, absence of securities transaction tax--a key advantage over using onshore Nifty trades taxed at 33 per cent--and the reduction in the contract size from $10 to $2 since November 2007 have boosted the Singaporean Nifty volumes significantly; also with the rupee slipping lately, there is less currency risk.

The increased liquidity in Singapore also stems from the relative advantage of incorporating US and late European news of the previous day and executing trades a few hours prior to the opening of the Indian markets; this year's global linkages has made the time advantage even more important. Also, hedge funds invest globally via one primary broker only.

The preference to stay with one primary broker allows to 'net' gains/losses from a non-Indian account (for example, Brazil) against that; else losses via a specific Indian account would require additional margin monies for such funds. 

In light of the acute global risk aversion now affecting all major emerging markets, the October 6, 2008 decision to reverse last year's ban on PNs will initially have a muted impact but is an incentive for FIIs not to move to another offshore center like Singapore (especially those who have kept rolling their PN derivative positions since they expire in March '09).

Looking ahead, as long as there remains a tax disadvantage in trading stock futures onshore, FIIs will prefer to stay offshore .

The author is Senior Economist, Sovereign Asset & Liability Management Division, IMF. The views expressed in this article are of the author only and do not represent those of the IMF or IMF policy.

• What are P-Notes?