The government had announced in this year's budget that it would allow foreign individuals to invest in equity schemes of Indian mutual funds as part of a move to diversify the class of overseas investors in the local equities market. Securities market regulator Sebi, Reserve Bank of India and finance ministry have been in talks to operationalise a scheme for this, and the central bank has suggested that as a prudential measure, there should be a ceiling on foreign investments, two senior officials with knowledge of the development said. Under the scheme, a foreign investor will have to open a demat account and a bank account here for which the Know Your Customer, or KYC, norms-a form of due diligence-will be followed by a local bank or intermediary registered with the regulators. Once this is done, foreign investors can buy into over 400 equity schemes. Foreign funds and non-resident Indians registered with Sebi are currently allowed to invest in equity mutual funds, but there has hardly been any investment except in select exchange-traded funds.

In the Indian equities market, there are no fetters on foreign funds in terms of investment except a limit of 10% on a single overseas investor buying into a company's capital. For investment in Indian corporate and government debt too, there are restrictions. "We need a framework for both capital inflows and outflows, and we thought that it would not only be prudent but also provide clarity up front if we say there would be a ceiling on investment," a senior official involved in the policy said. This official declined to be identified.

Volatile Capital Inflows Worry RBI

What could be of concern to the central bank is a possible surge in volatile capital inflows that could put pressure on currency and inflation management. When foreign capital inflows are robust, the Reserve Bank has to mop them up, which in turn boosts liquidity in local markets. To drain this excess liquidity, the RBI sells securities or bonds to banks and institutions through a process known as sterilisation. This, however, comes at a cost to the government, which has to service the interest cost on these bonds. Right now, such worries are overblown because excess inflows, if any, are being used to finance India's current account deficit-the excess of goods and services imports over exports. In FY11, foreign portfolio investors bought stocks and bonds of over $31 billion. In the year to date, they have been net sellers at $490 million.

Sebi has worked out a scheme for foreign investors to buy into local mutual funds that is being vetted by the government and RBI. One of the challenges in getting the scheme going is to ensure due diligence of the foreign investor. Only some of the depository participants, such as banks that have a wide global network, may be in a position to carry them out. Indian institutions may either have to forge tie-ups with foreign partners or open offices abroad if they want to woo higher foreign investment. If the scheme takes off-as policymakers are hoping-it will be a boost for India's mutual fund industry, which manages assets of over Rs 7,00,000 crore but has been weighed down by lack of interest from distributors ever since Sebi banned entry fees on schemes.

Another option being considered is to introduce the concept of a unit confirmation receipt, similar to American Depositary Receipts or Global Depository Receipts, that is not tradable overseas and not transferable but is issued in the name of the enduser. An overseas depository would then be able to confirm the KYC details of the beneficial user and inform the Indian partner.

The scheme to allow overseas investors to subscribe to units of Indian mutual funds is part of a broader recommendation of a governmentsponsored committee headed by UK Sinha, now the chairman of Sebi, to allow foreign individual investors to buy into stocks in India after strengthening of KYC norms.

Source : ET