MUMBAI (Reuters) - A plan by India to restrict an avenue that allows foreigners to invest anonymously in India's soaring stock market may prove effective at moderating the unwanted side-effects of an unprecedented inflow of capital.
Indian authorities have watched a tide of portfolio investment enter the world's fastest-growing economy after China with increasingly mixed feelings, ratcheting up efforts to ensure the funds don't push the rupee out of control.
Analysts say the measures, if implemented by the regulator on Thursday, could see a short-term net outflow of about $6 billion from Indian equity derivatives.
That's roughly a fifth of the underlying value of derivatives purchased through so-called participatory notes, which allow anonymity, based on regulatory figures.
When the curbs were first announced last week, stocks initially dropped a sharp 9 percent on fears that a flood of foreign investment would pull out of the market.
Reaction since has been calmer as investors tried to gauge the impact of the measures. The main Mumbai stock index .BSESN is now down a little over 4 percent since the announcement.
Participatory notes, or P-notes, are issued by foreign investors registered in India to investors overseas. See FACTBOX <ID:nBOM264132>.
The regulator, the Securities and Exchange Board of India, wants to phase out P-notes on underlying derivatives over 18 months and restrict the issuance of new P-notes on cash positions.
It wants sub-accounts -- vehicles set up by registered foreign investors to issue P-notes -- to wind up their positions altogether although it has also said some can convert to registered foreign investors. <ID:nBOM93096>.
India's finance minister says restricting P-notes is aimed at warding off a bubble in the stock market, which has jumped as much as 39 percent this year.
But many analysts believe the central bank, struggling to contain a rise in the rupee INR=IN, up 11 percent against the dollar this year, is behind the decision.
"(Flows) should moderate to the point of being less severe than before this, but I don't think it will moderate to the point of being a drag on the Indian markets," said V. Anantha Nageswaran, head of research, Asia Pacific at Bank Julius Baer.
P-notes have had a dramatic impact on India's stock trading.
Over the past 3-½ years, the number of registered foreign investors and their sub-accounts has jumped to 34 from 14.
The outstanding notional value purchased through P-notes has exploded to 3.5 trillion rupees ($88 billion) from 318.8 billion rupees.
Most of the buyers using these notes were hedge funds, Citigroup says.
WINNER AND LOSERS
Foreign holdings in local shares stood at 20 percent, or $204 billion, of total institutional holdings in August, and P-notes made up 34 percent of the foreign holdings, excluding derivatives, the U.S. bank said.
JP Morgan estimates nearly $10 billion of the $17 billion of foreign capital inflows into stocks in 2007 was purchased using P-notes.
One of the bank's economists, Rajeev Malik, wrote in a recent note that unwinding P-notes on derivatives could lead to an outflow of up to $7 billion.
The Bombay Stock Exchange says that until last Tuesday, foreign portfolio inflows had reached a net $17.9 billion so far this year. In the following three days, a net $1.2 billion had left.
The biggest beneficiary of the change is likely to be the central bank because the steps will ease some upward pressure on the rupee.
The currency has risen this year to its highest levels since 1998, an appreciation the Reserve Bank of India (RBI) has struggled to contain.
With an eye on economic stability and export competitiveness, the central bank sold as much as $40 billion worth of rupees in the first eight months of the year as the rupee was rising.
But the intervention also complicated its own anti-inflation fight by flooding the domestic money market with cash.
"If net portfolio inflows slow as a result of these measures, the need for the RBI to intervene in the currency market will also reduce, which, in turn, could slow the pace of accretion of domestic liquidity," JP Morgan's Malik said.
Still, the currency and the central bank may not be out of the woods yet.
ABN Amro said one of the main avenues of inflows was foreign direct investment, of which private equity had formed a large part this year, and in the long run upward pressure on the rupee was likely to continue, driven by a balance of payments surplus.
India attracted roughly $11.13 billion in FDI in 2006, more than almost $8 billion in portfolio investment.
ABN did not rule out more capital controls in the future.
"Continued strong foreign exchange inflows could see further controls, as large-scale sterilized intervention will likely become more and more difficult," it said.
(Additional reporting by C.J. Kurrien)