India's stockmarket watchdog has tabled a proposal curtailing unregistered foreign investors from trading in Indian securities. Equities lost ground in early trading on Wednesday but made a significant intra-day recovery as specialists endorsed the logic behind the move.

Equity investors panicked after the Securities and Exchange Board of India (SEBI) issued proposed new guidelines governing foreign investment in stockmarkets. The main stock index, the Sensex, lost 9.15% after markets opened on Wednesday to fall to 17,308 points, triggering a circuit breaker which saw authorities suspend trading for an hour.

Comments were made that the correction was one of the largest in the history of the Sensex but equally, to put the fall in perspective, the Sensex has never scaled the levels at which it currently trades. If anything, the situation reinforced how vulnerable over-heated markets across Asia are to any signs of bad news.

The Sensex recovered during the course of the day to close at 18,715 points, a decline of less than 2% over Tuesday's close, as investors digested the news and realised their initial reaction was knee-jerk. But some nervousness persisted during trading for the better part of the day.

SEBI's proposal, which was tabled in consultation with the government of India, was released after trading ended on October 16. SEBI has invited comments on the proposal until October 20. It will review, and perhaps incorporate, the comments and the proposal will pass into legislation thereafter.

Observers say that the small window of four days which is afforded for participants to comment suggests SEBI is paying lip service to investor concerns on this issue, as it has been mandated by the Ministry of Finance (MoF) to make the measures effective as soon as possible.

The policy changes affect offshore derivatives instruments (ODIs) which include participatory notes (PNs), equity-linked notes, capped return notes and participating return notes. The instrument which is used extensively by foreign investors to buy stocks in India is PNs.

Investopedia defines participatory notes as ôfinancial instruments used by investors who are not registered with SEBI to invest in Indian securities. India-based brokerage firms buy Indian securities and issue PNs to foreign investors.ö Dividends or capital gains accrue to the underlying owner namely the foreign institutional investor (FII). Hedge funds are large users of PNs.

The proposal suggests FIIs should stop issuing or renewing PNs on underlying derivatives and wind up outstanding positions on PNs over the next 18 months. FIIs can issue new PNs but this will be limited by the value of notes outstanding relative to the assets the FII manages in the country.

The Reserve Bank of India (RBI) has been voicing a concern that the usage of PNs has grown to a level where currently more then 50% of the inflow into Indian stock markets is by way of PNs. The RBI is concerned the investors whose inflows are pushing up Indian stock markets are shrouded in a cloak of anonymity. If this is ôhot moneyö the stock market could be at danger of collapsing as quickly as it has gone up. The RBI is also concerned that the PN route is being used for money laundering.

But hitherto, the MoF has not favoured any measures to control the stock market which could be deemed interventionist. The new proposal suggests the MoF is now backing the RBI.

IndiaÆs finance minister, Chidambaram defended the proposed legislation and suggested it was a means to ensure all investment into India came under the registered FII route. He also clarified that the move should not be seen as a ban on PNs rather as a cap on the amount of money that came in via the PN mechanism. Chidambaram suggested the bigger picture motivation was to moderate capital inflows into India, in the interest of both capital markets and investors.

Opinions were divided on the move.

Some investors are said to be hard at work with their solicitors and political advisers to lobby SEBI to dilute the proposal. ôMarkets may well be over-heated but they have to correct on their own and the correction should not be driven by regulation,ö says one banker.

Other investors, both domestic and foreign, were in agreement with SEBIÆs move, citing a government's right to know the identity of the investors that buy into its stockmarkets.

Further, specialists suggest the move is primarily driven by the government trying to curtail capital flows into India.

The rupee has appreciated to levels below Rs40 to the US dollar from levels of around Rs45 only a year ago. This is causing exports from India to become uncompetitive to some of its main export destinations like the US and Europe. Some other Asian currencies from countries which India competes with for export orders have not appreciated as dramatically, either because of controlled exchange rates or because the economies have not been registering robust double-digit growth rates like India.

The export slowdown is causing turmoil across Indian industry and both the information technology and outsourcing industries are being adversely affected. In IndiaÆs small and medium enterprises sector specifically, unemployment is on the rise as businesses which are becoming uncompetitive shut down. IndiaÆs government, which has not been very successful in implementing welfare measures, is bearing the brunt of the criticism.

ôIndia has been dealing with the large capital inflows through sterilisation,ö commented Eswar Prasad, chair professor at Cornell University at a talk in Hong Kong yesterday on the broader topic of whether India's growth miracle is built to last.

Sterilisation refers to efforts by a central bank of a country to manage the currency by controlling the demand-supply situation. So, for example, to ensure the rupee does not appreciate further against the dollar, the RBI will buy dollars to reduce the supply. But sterilisation comes at a cost. When the government buys dollars, it issues rupees and this causes inflationary and other pressures thereby limiting how much this method can be effectively used.

The government is now having to think creatively to achieve its desire to curb capital inflows. The SEBI proposal may be part of a larger policy initiative aimed at this goal.

And indeed, the rupee shed some gains to close around Rs39 to the dollar yesterday. Unlike the stockmarket losses, these losses may have been an outcome the government hoped for.

Some sources suggest the stockmarket just happens to be in the line of fire. Indeed, the move to regulate PNs follows increased restrictions on external commercial borrowings introduced in India in August. And some market commentators expect real estate investment in the country to be the next area to see some increased legislation.

The consensus among strategists is that FII investment in India could slow in the short term due to the SEBI move. Pessimists predict this could cause the Sensex to shed its entire last quarter gains and fall to levels around 15,000.

This could certainly affect the IPO pipeline and plans of some Indian companies to do follow-on offerings and convertibles. But sources say the government is expecting the stockmarkets to correct and, indeed, many observers feel some correction is desirable as markets are over-heated. And strategists are confident that the underlying growth story which is driving up earnings of Indian companies continues unchanged.

The government is adopting a course of action with a larger goal in mind. Strategists agree that, in the long term, such steps should prove beneficial for the country. It is apparent that managing growth in the worldÆs largest democracy has no easy solutions.