Attracting Sovereign Wealth Funds

Although there had been a great amount of discussion a couple of years ago regarding soverign wealth funds (SWFs), both in terms of their investments in the Indian markets and to to whether India should create one for itself, that seemed to have died down. This was largely because SWFs were expressly recognized in 2008 as foreign institutional investors (FIIs) under the SEBI FII Regulations, and many SWFs indeed registered themselves as FIIs.

Now there is a proposal (reported here and here) to provide some relaxations to SWFs both under the FII Regulations as well as the Takeover Regulations. While this is expected to increase the flow of funds from SWFs into India, there are also questions raised as to the need for separate treatment of SWFs as a category of foreign investors, as this debate suggests.

SWFs as FIIs; Other Amendments to FII Regulations

SEBI has announced a fairly detailed set of amendments to the SEBI (Foreign Institutional Investors) Regulations, 1995.

One of the key amendments relates to the recognition of sovereign wealth funds (SWFs) as a category of investors eligible to invest into the Indian markets as FIIs. This marks a significant move because it makes clear the Indian regulators’ policy approach towards SWFs in the Indian markets. It is also remarkable in a sense because several other countries are yet undecided as to their precise policy of regulating SWFs. The registration of SWFs with SEBI as FIIs would introduce transparency as they would be required to submit the requisite information to SEBI regarding their organisation and operations both at the time of registration and thereafter on a continuing basis. This would help overcome one of the key criticisms of SWFs that they are relatively opaque to the outside world. Further, limitations on FII investments in Indian companies such as the fact that they cannot invest more than 10% in a single company would operate as checks and balances against assertion of excessive influence by SWFs in the Indian marketplace.

However, the current policy pronouncement also leaves some matters open for interpretation. For instance, there seems to be nothing that requires SWFs to invest only through the FII route as a mandatory matter. This is only an option available to SWFs and they may possibly continue to invest under the foreign direct investment (FDI) route otherwise available to foreign investors, in which case they may not be subject to the 10% cap on investment in single companies and other transparency requirements. This dual regime available to SWF (i.e. both the FII route as well as the FDI route) may still leave room for ambiguity and interpretation, and hence a clarification on these matters would be most desirable.

Apart from enabling SWFs to invest as FIIs, the new amendments bring about some further changes to the FII Regulations, which are as follows (quoted from the SEBI circular):

* The policy measures on Offshore Derivative Instruments (Participatory Notes) and changes to the registration criteria specified in SEBI Press Release dated October 25, 2007 have been incorporated in the regulations.

* In order to streamline the process of registration, the Application Forms for grant of registration as a FII and Sub Account have been modified.

* An asset management company, investment manager or advisor or an institutional portfolio manager set up and/ or owned by non resident Indians (NRIs) shall be eligible to be registered as FII subject to the condition that they shall not invest their proprietary funds. This has been enabled by suitable modification to Explanation II under Regulation 13 of the said regulations.

* The type of securities in which FIIs are permitted to invest has been widened to include schemes floated by a Collective Investment Scheme.

Some press reports are available here: The Economic Times, IndianExpress.com.

SWFs and Capital Flows

The Indian Government’s latest position on sovereign wealth funds (SWFs) can be gathered from a recent speech delivered by the Governor of the Reserve Bank of India, Dr. Y.V. Reddy at a session on ‘The Role of Government-owned Investment Vehicles in Global Capital Flows’ in the International Capital Markets and Emerging Markets Roundtable held at Washington DC on April 14, 2008.

His speech covers flow of capital from SWFs in two directions, (i) investments by foreign SWFs into India, where India is the host country, and (ii) potential investments by an Indian SWF (were one to be created) into other countries, where India will be the home country. Here are some salient features:

1. SWF Fund Flows into India

The Governor’s speech largely states the existing position regarding foreign investments into India, which is that foreign investors can come into the country either through the foreign direct investment (FDI) route or the foreign institutional investment (FII) route. Under the FDI route, most industry sectors are eligible for foreign investment under the automatic route, while the others require prior approval of the Foreign Investment Promotion Board. FDI is also subject to applicable caps on foreign investment in certain sectors. Under the FII route, the investing entities need to be registered with the Securities and Exchange Board of India (SEBI) either as FIIs or sub-account, and here too there are limits up to which FIIs and sub-account can invest in each company.

SWFs can come either under the FDI route or the FII route. In other words, there is no separate policy formulated for investment of foreign SWFs in Indian securities, and they are treated like any other foreign investor. Some SWFs have been investing for years now under this general policy, with Temasek (of Singapore) being the best example.

It is clear from this that the Government is yet to come out with a policy on accepting SWF investments into India. What it seems to be carrying out though is to keep a close watch on developments elsewhere (such as IMF, OECD, etc.) before taking policy measures specific to India.

2. SWF Fund Flows out of India

This would essentially require India to set up its own SWF so as to invest its surpluses in other countries in order to derive returns on those. Although Dr. Reddy’s speech appears to be quite balanced at first blush in pointing out both the advantages and disadvantages of establishing an Indian SWF, the disadvantages appear far in excess of the advantages. This seems to signal the Government’s current thinking, which is to wait and watch and not hurry to set up its own SWF.

Although there were early calls from the financial services industry and commentators for setting up an Indian SWF, those have gradually died down, and the current opinion increasingly seems to be against setting up an Indian SWF. For example, Vinay Nair, a senior fellow with the Wharton Financial Institutions Centre vehemently opposes the idea of an Indian SWF in an article in India Knowledge@Wharton. He says:

“… it is also important to remember that a democratic government has a mandate to play a role in promoting public welfare. Governments have a responsibility to invest in projects that generate public good. It is no secret that India needs massive investment in infrastructure, education and health care projects. It is useful to note that among most sovereign funds that have non-oil-based revenue sources, such domestic investment needs are minimal. Governments in China, Singapore and Australia, for example, have addressed these issues.

In my view, India should come up with a two-pronged approach. First, the country should develop a plan where excess reserves are used to fund infrastructure, education and health care needs in a non-corrupt and efficient manner. This would decrease the government’s reliance on tax revenues and provide an effective tax cut. Second, India should start building the country’s ability to detect high-potential investment opportunities overseas, just as the government of Singapore did. Such a project should start at a small scale and then be developed over time. This dual approach to managing the country’s national savings would serve India much better than rushing to set up a sovereign wealth fund to buy energy assets.”

This also marks a clear change in sentiment over the last few months relating to SWFs. Perhaps, this is owing to the lacklustre performance of SWF investments (primarily in distressed assets) during 2007.