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  1. 1. A REPORT ONSubmitted to - Submitted by - VIPUL SIR SUBHOJIT DEY PGDM 4th SEM. 1
  2. 2. ACKNOWLEDGEMENTIt is my pleasure to be indebted to various people, who directly or indirectly contributedin the development of this work and who influenced my thinking, behavior, and actsduring the course of study.As a student specializing in Finance, I came to know about the ground realities incomplex topics like Foreign institutional investor and Indian capital market. For this I amindebted to VIPUL SIR who took personal interest in my project and bore the associatedheadachesLastly, I would like to thank the almighty and my parents for their moral support and mycolleagues with whom I shared my day-to-day experience and received lots offsuggestions that improved my work quality. 2
  3. 3. PREFACEThe Indian capital markets may appear mysterious and puzzling to many foreigninvestors and even to domestic Indian investor. To my knowledge, however, there is nocurrent information material that comprehensively addresses invertors’ concerns aboutthis rapidly growing market. I have no power to solve its inherent problems; but what Ihave tried to do is shed some light on practices and rules in the Indian market, includingproblematic ones, so that foreign as well as Indian investors can look at the market morerationally for their portfolio investments in Indian securities.The Indian financial system is a vast universe. This universe is regulated and supervisedby two government agencies under the Ministry of Finance.(i). The Reserve bank of India, India’s Central Bank, and(ii). The Securities Exchange Board of India, the country’s capital market regulator.All parts of the system are interconnected with one another, and the jurisdictions of thecentral bank and the capital market regulator overlap in some fields of Indian financialactivities. This research focuses on the FII (foreign institutional investor) flows to Indiancapital market, its portfolio investment and determinants of investing in Indian marketand deciding the portfolio preferences. This research also gives the suggestions on theinvestment avenues available for the FII in Indian with the help of Gap analysis. 3
  4. 4. The Indian capital market changes amazingly quickly. Some part of this research may beout-of-date by the time of completion. Therefore, please do not assume that theinformation in this research continues to be correct or remains unchanged. This researchis originally focused on foreign investor and its role and impact on Indian capital market. SYNOPSISTITLE OF THE PROJECT: - Foreign institutional investors and Indian capitalmarket (its determinants and avenues of investment).OBJECTIVE OF THE RESEARCH: - To study the role and impact foreign institutionalinvestor on Indian capital market and find out the factors that determines the flow of FIIs: INTRODUCTIONSince the beginning of the liberalization of investment policies. Flows FIIs in Indiasteadily grown in importance. Paper covers the flow of FII in India and their relationshipwith other economic variables. In this paper I’m particularly covering the relationshipbetween FII and stock market. It covers the investment trend of FII and the variousissues related to the FII investment in the domestic market.BACKGROUND: - 4
  5. 5. The national common minimum programmed of the present UPA government envisagespolicies, which encourage foreign institution investors (FIIs), but reduce exposure to theIndian financial system to speculative capital flowsAn FII means an entity established or incorporated outside India, which proposes toundertake investment in India; while an FII sub-account includes those foreign corporate,foreign individuals, institutions, funds or portfolios established or incorporated outsideIndia on whose behalf investments are proposed to be made in India by an FIIRESEARCH METHODOLOGYResearch is often described as active; diligent and systematic process of inquiry aimed atdiscovering, interpreting and revising facts. This intellectual investigation produces agreater understanding of events, behaviors or theories and makes practical applicationthrough laws and theories. In other words we can say, the purpose of research is todiscover answers to the questions through the application of scientific procedures. Themain aim of research is to find out the truth which is hidden and which has not beendiscovered as yet.Research methodology is a way to systematically solve the research problem. It may beunderstood as a science of studying how research is done scientifically. In it we study thevarious steps that are generally adopted by a researcher in studying his research problemalong with the logic behind them.OBJECTIVE: -The main objective of the research is to show that Supply ChainManagement is the key tool in the brand building of any company. Especially in thesectors like retailing, FMCG, consumer durables etc. it is the key differentiator amongstrong brands and weak brands.To carry out my project I have used the exploratory research. 5
  6. 6. Exploratory research includes surveys and fact-finding enquiries of different kinds. Themajor purpose of exploratory research is to explore the facts which are existing but newfor everyone.The main characteristic of this method is that the researcher has no controlover the variables; he can only report what has happened or what is happening. It is alsocalled as ex post facto research. Most ex post facto research projects are used fordescriptive studies in which researcher seeks to measure such items as, for example,frequency of shopping, preferences of people, or similar data.DATA SOURCE: - To carry out the project work I have consulted the various secondarysources of data such as Magazines, Journals and websites.SCOPE OF THE STUDY: - The research will be covering whole capital market andinvestment made by FIIs. This research is helpful for investors who made the largeinvestment in the market and too much bothered about the volatility because of FII.DESCRIPTIVE WORKThe subtopics, which will be covered as a part of the study can be given in the followingpoints:  Flow of FII in India.  Regulatory information about FII.  Liberalization of foreign investment policy.  Flow of FII: its nature and causes.  Determinants of flow of FII.DATA ANALYSIS AND INTERPRETATIONTo analyze the data that are collected from the various secondary sources, I haveimplemented some statistical tools. I am using two model, one is for analyzing thedeterminants of FII flow and second is for analyzing the avenues of investment for FIIthrough Cap and Gap analysis. 6
  7. 7. SUGGESTIONS AND CONCLUSIONThis section of the report will show all the conclusions and suggestions that I will bedrawing from the above analysis.BIBLIOGRAPHY AND ANNEXURE CONTENTS i) CERTIFICATE………………………………………………….2 ii) ACKNOWLEDGEMENT ……………………………………...3 iii) PREFACE ……………………………………………………….4 iv) SYNOPSIS ………………………………………………………5 V) CONTENT……………………………………………………….8INTRODUCTION ………………….……………………………………………….9 i) Background ii) Research ReviewRESEARCH METHODOLOGY ……………………..………………………...18 i) Research Process ii) Scope of the studyDESCRIPTIVE WORK ………………………..…………………………….26 i) Regulatory information. ii) FII flow to India: nature and causes. iii) Liberalization of foreign institutional investor in India. iv) Foreign institutional investment in India. v) Determinants of foreign institutional investor. DATA ANALYSIS AND INTERPRETATION ………. …………78 7
  8. 8. i) Conceptual model for analysis ii) Gap analysis for investment avenues iii) FindingsSUGGESTIONS AND CONCLUSION ……………………………..94BIBLIOGRAPHY……………………………………………………….98ANNEXURE..…………………………………………………………..100 INTRODUCTION OF THE TOPIC 8
  9. 9. INTRODUCTIONForeign investment refers to investments made by the residents of a country in thefinancial assets and production processes of another country. After the opening up of theborders for capital movement, these investments have grown in leaps and bounds. Theeffect of foreign investment, however, varies from country to country. It can affect thefactor productivity of the recipient country and can also affect the balance of payments.In developing countries there has been a great need for foreign capital, not only toincrease the productivity of labor but also because foreign capital helps to build up theforeign exchange reserves needed to meet trade deficits. Foreign investment provides achannel through which developing countries can gain access to foreign capital. It cancome in two forms: foreign direct investment (FDI) and foreign institutional investment(FII). Foreign direct investment involves in direct production activities and is also of amedium- to long-term nature. But foreign institutional investment is a short-terminvestment, mostly in the financial markets. FII, given its short-term nature, can havebidirectional causation with the returns of other domestic financial markets such asmoney markets, stock markets, and foreign exchange markets. Hence, understanding thedeterminants of FII is very important for any emerging economy as FII exerts a largerimpact on the domestic financial markets in the short run and a real impact in the longrun. The present study examines the role, impact and relationship of FII’s and Indiancapital market, and also determinants of foreign institutional investment in India, acountry that opened its economy to foreign capital following a foreign exchange crisis.India, being a capital scarce country, has taken many measures to attract foreigninvestment since the beginning of reforms in 1991. Up to the end of January 2003, Indiasucceeded in attracting a total foreign investment of around U.S.$48 billion out of whichU.S.$12 billion was in the form of FII. These figures show the importance of FII in theoverall foreign investment program. India is in the process of liberalizing its capitalaccount, and this has a significant impact on foreign investment and particularly on FII,which affects short-term stability in the financial markets. 9
  10. 10. Hence, there is a need to determine the push and pull factors behind any change in theFII, so that we can frame our policies to influence the variables that attract foreigninvestment. Also, FII has been the subject of intense discussion, as it is held to beresponsible for having intensified the currency crises of the 1990s in East Asia andelsewhere in the world.The present study aims to examine the role, impact, determinants and avenues ofinvestment for FII in the Indian context.We attempt to analyze the effect of return, risk, and inflation, which in the research areconsidered to be the major determinants of FII. The proposed relationship among thefactors (discussed in detail later) is that inflation and risk in the domestic country andreturn in the foreign country adversely affect the FII flowing to the domestic country,whereas inflation and risk in the foreign country and return in the domestic country havea favorable effect on the flow of FII. In the next section we will briefly consider theexisting studies of this topic. In Section III, we discuss the theoretical model. Section IVbriefly assesses the trends in FII in India. The database and methodology adopted in thisstudy are explained in Section V. In Section VI, we discuss the estimated results of thestudy, and appropriate conclusions are drawn in the last section.There is another concept called “foreign portfolio investments” (FPI), which is a broaderone compared to FII. Foreign portfolio investments include FII and other componentslike GDR (Global Depositary Receipts), ADR (American Depositary Receipts), and off-shore funds and others. As the components in FPI other than FII are not dependent onmarket forces and they are not volatile, we consider only FII in this study. 10
  11. 11. THE BACKGROUNDAn FII means an entity established or incorporated outside India, which proposes toundertake investment in India; while an FII sub-account includes those foreign corporate,foreign individuals, institutions, funds or portfolios established or incorporated outsideIndia on whose behalf investments are proposed to be made in India by an FIIThe national common minimum programmed of the present UPA government envisagespolicies, which encourage foreign institution investors (FIIs), but reduce exposure to theIndian financial system to speculative capital flows.The character of global capital flows to developing countries underwent significantchanges on many counts during the nineties. By the time the East Asian financial crisissurfaced, the overall size of the flows more than tripled. It stood at US$ 100.8 bn. in 1990and rose to US$ 308.1 bn. by 1996. The increase was entirely due to the sharp rise in theflows under private account that rose from US$ 43.9 bn. to 275.9 billion during the sameperiod. In relative terms the percentage of private account capital flows increased from43.55 to 89.55 per cent. Simultaneously, the Official Development Assistance (ODA),declined both in relative and absolute terms. All the main components of the privateaccount capital transfers, namely, (a) commercial loans, (b) foreign direct investments(FDI), and (c) foreign portfolio investments (equity and bonds) (FPI) recorded significantincreases. Portfolio flows increased at a faster rate than direct investments on privateaccount. As a result, starting with a low level of 11.16 per cent, the share of capital flowsin the form of portfolio investments quadrupled to reach 37.22 per cent in 1996 reflectingthe enhanced emphasis on private capital flows with portfolio investments forming thesecond important constituent of the flows during the nineties. In this process multilateralbodies led by the International Finance Corporation (IFC) played a major role.Following the East Asian financial crisis, initially there was a slow down followed, by adecline in private capital flows. While bonds and portfolio equity flows reacted quickly 11
  12. 12. and declined in 1997 itself, loans from commercial banks dropped a year later in 1998.Decline in FDI was also delayed. But the fall in FDI was quite small compared to theother three major forms of private capital flows. While flows on official accountincreased, following the crisis, they continue to constitute only a small portion of the totalflows. Thus, starting with the resolve by the developed countries to provide one per centof their GNP as developmental aid, the industrialised world preferred to encourageprivate capital transfers through direct investments instead of official assistance. Thedeclining importance of official development finance is attributed to budgetaryconstraints in donor countries and the optimism of private investors in the viability of thedeveloping countries. 12
  13. 13. Portfolio investments spread risk for foreign investors, and provide an opportunity toshare the fruits of growth of developing countries, which are expected to grow faster.Investing in emerging markets is expected to provide a better return on investments forpension funds and private investors of the developed countries. For developing countries,foreign portfolio equity investment has different characteristics and implicationscompared to FDI. Besides supplementing domestic savings, FDI is expected to facilitatetransfer of technology, introduce new management and marketing skills, and helpsexpand host country markets and foreign trade. Portfolio investments supplement foreignexchange availability and domestic savings but are most often not project specific. FPI,are welcomed by developing countries since these are non-debt creating. FPI, if involvedin primary issues, provides critical risk capital for new projects. Since FPI takes the formof investment in the secondary stock market, it does not directly contribute to creation ofnew production capabilities. To enable FPI flows which prefer easy liquidity, multilateralbodies, led by the International Finance Corporation (IFC), have been encouragingestablishment and strengthening of stock markets in developing countries as a mediumthat will enable flow of savings from developed countries to developing countries.FPI, it is expected, could help achieve a higher degree of liquidity at stock markets,increase price-earning (PE) ratios and consequently reduce cost of capital for investment.FPI is also expected to lead to improvement in the functioning of the stock market, asforeign portfolio investors are believed to invest on the basis of well-researched strategiesand a realistic stock valuation. The portfolio investors are known to have highlycompetent analysts and access to a host of information, data and experience of operatingin widely differing economic and political environments. Host countries seeking foreignportfolio investments are obliged to improve their trading and delivery systems, whichwould also benefit the local investors. To retain confidence of portfolio investors’ hostcountries are expected to follow consistent and business friendly liberal policies. Havingaccess to large funds, foreign portfolio investors can influence developing country capitalmarkets in a significant manner especially in the absence of large domestic investors.Portfolio investments have some macroeconomic implications. While contributing tobuild-up of foreign exchange reserves, portfolio investments would influence the 13
  14. 14. exchange rate and could lead to artificial appreciation of local currency. This could hurtcompetitiveness. Portfolio investments are amenable to sudden withdrawals and thereforethese have the potential for destabilizing an economy.The volatility of FPI is considerably influenced by global opportunities and flows fromone country to another. Though it is sometime argued that FDI and FPI are both equallyvolatile, the Mexican and East Asian crises brought into focus the higher risk involved inportfolio investments. The present paper has two objectives. One, to assess theimportance of different types of foreign portfolio investments in capital flows to India.And two, to understand the investment behaviour of foreign portfolio investors throughan analysis of the portfolios of US-based India specific funds. Such an exercise, it ishoped, would explain the relationship between foreign institutional investments andtrading pattern in the Indian stock market better than aggregate level analysis. 14
  15. 15. RESEARCH REVIEWThere have been several attempts to explain FII behavior in India. All the existing studieshave found that equity return has a significant and positive impact on FII (Agarwal 1997;Chakrabarti 2001; Trivedi and Nair 2003). But given the huge volume of investments,foreign investors can play the role of market makers and book their profits, that is, theycan buy financial assets when the prices are declining, thereby jacking-up the assetprices, and sell when the asset prices are increasing (Gordon and Gupta 2003). Hence,there is a possibility of a bidirectional relationship between FII and equity returns.Following the Asian financial crisis and the bursting of the info-tech bubbleinternationally in 1998/99, net FII declined by U.S.$61 million. This, however, exertedlittle effect on equity returns. This negative investment might possibly disturb the long-term relationship between FII and other variables such as equity returns, inflation, and soon. Chakrabarti (2001) has perceived a regime shift in the determinants of FII followingthe Asian financial crisis and found that in the pre–Asian crisis period, any change in FIIhad a positive impact on equity returns. But it was found that in the post–Asian crisisperiod, a reverse relationship has been the case, namely, that change in FII is mainly dueto change in equity returns. This is a fact that needs to be taken into account in anyempirical investigation of FII. Investments, either domestic or foreign, depend heavily onrisk factors. Hence, while studying the behavior of FII, it is important to consider the riskvariable. Further, realized risk can be divided into ex-ante and unexpected risk. Ex-anterisk is an observed component and is negatively related to FII. But the relationshipbetween unexpected risk and FII is obscure. Therefore, while examining the impact ofrisk on FII, one needs to separate the unobserved component from the realized risk.Trivedi and Nair (2003) have used only the realized risk. Another possible determinant ofFII is the operation of foreign factors such as returns in the source country’s financialmarkets and other real factors in the source economy. So far, however, studies havefound that both return in the source country stock market and the inflation rate have notexerted any impact on FII. Agarwal (1997) found that world stock market capitalizationhad a favorable impact on the FII in India. 15
  16. 16. A survey of the literature shows that existing studies do not account for volatility, whichcan be expected in most of the monthly financial time series data. Yet given the increasein financial market integration, both domestically and in foreign financial markets,accounting for volatility is unavoidable. Further, the existing studies either do notincorporate risk in foreign and domestic markets or make use of realized risk, anapproach that does not always yield robust results.This is because standard deviation/variance (realized risk variable) increases irrespectiveof the direction in which stock returns move, while movement of FII is determined bybull/bear phases. It is preferable, therefore, to divide the realized risk into ex-ante riskand unpredictable risk. Since investment in stock markets is sentiment driven, and isaffected more or less by everything, the crucial task is to identify a few criticaldeterminants. This research makes a modest attempt to explore the relation between FIIand its pivotal determinants, for the particular case of India. More specifically, a fewimportant variables believed to be affecting FII are chosen and then a theoretical model isbuilt and empirically tested for India. The focus of this research is the study of the criticaldeterminants of FII, so as to provide a better understanding of FII behavior that helpswhile liberalizing the capital account and investment avenues for FII in Indian capitalmarket. We hope that the study will be important from a policy perspective, as FIIconstitutes an important element for the smooth functioning of domestic financialmarkets. 16
  18. 18. RESEARCH MATHEDOLOGYThe purpose of research is to discover answers to the questions through the application ofscientific procedures. The main aim of research is to find out the truth which is hiddenand which has not been discovered as yet. Though each research study has its ownspecific purpose, we may think of research objectives as falling into a number offollowing broad categories: 1) To gain familiarity with a phenomenon or to achieve new insights into it. 2) To portray accurately the characteristics of a particular individual, situation or a group. 3) To determine the frequency with which something occurs or with which it is associated with something else. 4) To test a hypothesis of a casual relationship between variables.Research methodology is a way to systematically solve the research problem. It may beunderstood as a science of studying how research is done scientifically. In it we study thevarious steps that are generally adopted by a researcher in studying his research problemalong with the logic behind them.Research methodology has many dimensions and research methods do constitute a part ofthe research methodology. The scope of research methodology is wider than that ofresearch methods. Thus, when we talk of research methodology we not only talk of theresearch methods but also consider the logic behind the methods we use in the context ofour research study and explain why we are using a particular method or technique andwhy we are not using others so that research results are capable of being evaluated eitherby the researcher himself or by others. Why a research study has been undertaken, whatdata have been collected and what particular method has been adopted, why particulartechnique of analyzing data has been used and a host of similar other question are usuallyanswered when we talk of research methodology concerning a research problem or study. 18
  19. 19. Research Process Research process consists of series of actions or steps necessary to effectively carry out research and the desired sequencing of these steps. Review the Literature Feed forward Review concepts &Define theoriesresearch Formulate hypotheses Design Collect Analyzeproblem research data data Review previous research & findings Feed back Interpret and report A brief description of the above steps is stated below: 1) Formulating the research problem At the very outset the researcher must single out the problem he wants to study, i.e. that is he must decide the general area of interest or aspect of a subject matter that he would like to inquire into. Initially the problem may be stated in a broad general way and then the ambiguities, if any, relating to the problem be resolved. Then the feasibility of a particular solution has to be considered before a working formulation of the problem can be set up. In fact, formulation of the problem often follows a sequential pattern where a number of formulations are set up, each formulation more specific than the preceding one, each one phrased in more analytical terms, and each more realistic in terms of the available data and resources. In this research the problem that I have formulated is ‘role and impact of foreign institutional investor on Indian capital market.’ 19
  20. 20. 2) Extensive literature survey Once the problem is formulated, a brief summary of it should be written down. Atthis juncture I have undertaken extensive literature survey connected with the problem.The earlier studies, which are similar to the study in hand have been carefully studied. 3) Development of the working hypothesis After extensive literature survey, researcher should state in clear terms theworking hypothesis or hypotheses. Working hypothesis is tentative assumption made inorder to draw out and test its logical or empirical consequences. The manner in whichresearch hypothesis are developed is particularly important since they provide the focalpoint for research. They also affect the manner in which tests must be conducted in theanalysis of the data and indirectly the quality of data, which is required for the analysis. 4) Preparing the research designThe research problem having been formulated in clear-cut terms, the researcher will berequired to prepare a research design i.e. he will have to state the conceptual structurewithin which research would be conducted. In other words the function of researchdesign is to provide for the collection of relevant evidence with minimal expenditure ofeffort, time and money.The preparation of the research design, involves usually the consideration of thefollowing: a) The means of obtaining the information: b) The availability and skills of the researcher and his staff; c) Explanation of the way in which selected means of obtaining information will be organized and the reasoning leading to the selection; 20
  21. 21. d) The time available for research; and e) The cost factor relating to research. 5) Determining sample designAll the items under consideration in any field of inquiry constitute a ‘universe’ or‘population’. Quite often we select only a few items from the universe for our studypurposes. The items so selected constitute what is technically called a sample.The researcher must decide the way of selecting a sample or what is popularly known asthe sample design. In other words, a sample design is a definite plan determined beforeany data are actually collected for obtaining a sample from a given population 6) Collecting the dataIn dealing with any real life problem it becomes necessary to collect data that areappropriate. There are several ways of collecting the appropriate data.Primary data can be collected either through experiment or through survey.but in case ofsurvey; data can be collected by any one of the following ways: a) By observation. b) Through personal interview. c) Through telephone interview. d) By mailing of questionnaires. e) Through schedules.The researcher should select one of these methods of collecting the data taking intoconsideration the nature of investigation, objective and scope of the inquiry. 21
  22. 22. 7) Execution of the projectExecution of the project is a very important step in the research process. The researchershould see that the project is executed in a systematic manner and in time. A carefulwatch should be kept for unanticipated factors in order to keep the survey as muchrealistic as possible. 8) Analysis of the dataAfter the data have been collected, the researcher turns to the task of analyzing them.theanalysis of data requires a number of closely related operations such as establishment ofcategories, the application of these categories to raw data through coding, tabulation andthen drawing statistical inferences.Analysis work after tabulation is generally based on the computation of variouspercentages, coefficients, etc. in brief the researcher can analyse the collected data withthe help of various statistical tools. 9) Hypothesis-testingAfter analyzing the data, the researcher is in a position to test the hypothesis, if any, hehad formulated earlier. Do the facts support the hypothesis or they happen to be contrary?This is the usual question, which should be answered while testing the hypothesis. 10) Generalisations and interpretation If a hypothesis is tested and upheld several times, it may be possible for theresearcher to arrive at generalization, i.e., to build a theory. As a matter of fact, the realvalue of research lies in its ability to arrive at certain generalization. 22
  23. 23. 11) Preparation of the report Finally the researcher has to prepare the report of what has been done by him.Writing of report must be done with great care keeping in view the following: 1) In its preliminary pages the report should carry the title and data followed by acknowledgements and foreword. 2) Report should be written in a concise and objective style. 3) Charts and illustrations in the main report should be used only if they present the information more clearly and forcibly. 23
  24. 24. SCOPE OF THE STUDYA number of studies in the past have observed that investments by FIIs and themovements of Sensex are quite closely correlated in India and FIIs wield significantinfluence on the movement of sensex. There is little doubt that FII inflows havesignificantly grown in importance over the last few years. In the absence of any othersubstantial form of capital inflows, the potential ill effects of a reduction in the FII flowsinto the Indian economy can be severe. From the point of attracting foreign capital, theinitial expectations have not been realised. Investment by FIIs directly in the Indian stockmarket did not bring significantly large amount compared to the GDR issues. GDRissues, unlike FII investments, have the additional advantage of being project specific andthus can contribute directly to productive investments. FII investments, seem to haveinfluenced the Indian stock market to a considerable extent.Results of this study show that not only the FIIs are the major players in the domesticstock market in India, but their influence on the domestic markets is also growing. Dataon trading activity of FIIs and domestic stock market turnover suggest that FII’s arebecoming more important at the margin as an increasingly higher share of stock marketturnover is accounted for by FII trading. Moreover, the findings of this study also indicatethat Foreign Institutional Investors have emerged as the most dominant investor group inthe domestic stock market in India. Particularly, in the companies that constitute theBombay Stock Market Sensitivity Index (Sensex), their level of control is very high. Dataon shareholding pattern show that the FIIs are currently the most dominant non-promotershareholder in most of the Sensex companies and they also control more tradable sharesof Sensex companies than any other investor groups. 24
  26. 26. REGULATORY INFORMATIONFII flows to India formally began in September 1992 under the foreign portfolioinvestment (FPI) scheme, when the Government of India issued the Guidelines forForeign Institutional Investment. In November 1995, the Securities and Exchange Boardof India (SEBI) 6 enforced the Securities and Exchange Board of India (ForeignInstitutional Investors) Regulations, 1995 (henceforth, referred to as SEBI FIIRegulations) to regulate matters relating to FII investment flows. At present, investmentby FIIs is jointly regulated by this and Regulation 5(2) of the Foreign ExchangeManagement Act (FEMA), 1999. The SEBI regulations require FIIs to register with theSEBI and also obtain approval from the Reserve Bank of India (RBI) under the FEMAfor securities trading, operating foreign currency and rupee bank accounts and remittingand repatriating funds. In the entire process of FII registration and regulation, the SEBIacts as the nodal authority and once SEBI registration has been obtained, an FII does notrequire any further permission for trading securities or for transferring funds into or outof India. The SEBI FII Regulations and RBI policies are amended and modified fromtime to time in response to the gradual maturing of the Indian financial market andchanges taking place in the global economic scenario. Such modification, needless tomention, is required to be done to ensure quantitative as well as qualitative improvementsin the portfolio flows through the FII route, as India has to compete with other Asiannations and other emerging markets of the world for global capital inflows.In India, FII investment (in shares and debentures) started in January 1993. FIIregulations by the SEBI were first introduced on November 14, 1995 in the form of theSEBI FII Regulations. Over the years, the SEBI and the RBI together, through a varietyof measures, are trying to improve the scope, coverage and quality of FII investment.These measures include (a) widening the array of instruments in whichFIIs are allowed to trade, (b) expanding the list of the types of funds that can beregistered as FIIs in India and the entities on behalf of whom they can invest, (c) raisingthe caps for FII investment in different sectors and companies, (d) easing the norms forFII registration, reducing procedural delays, lowering fees, etc., and (e) mandating stricter 26
  27. 27. disclosure norms, etc. A summary of the major regulatory changes relatingto FIIs along with their reference dates is presented in Table 1.The hypothesis underlying the present empirical analysis is essentially thatboth strengthening of the regulatory infrastructure by the SEBI and the RBIon the one hand and further liberalisation and easing of regulatory curbs forFIIs at various time points in history on the other have had a positive impacton the flows to the national stock markets. 27
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  31. 31. THE PRE- AND POST-FII REGULATION PERIODSThe SEBI FII Regulations, introduced in mid-November 1995, formally set forth indetail:• Conditions and procedures for grant or renewal of certificates to FIIs (and their sub-accounts) permitting them to operate directly in the Indian stock market. (This includesthe eligibility criteria for being permitted to be registered as an FII in India; verificationof whether it is legally permissible for the applicant to invest in securities outside thecountry of its incorporation; whether the applicant has been registered with any statutoryauthority in that country; and whether any legal proceeding has been initiated by anystatutory authority against the applicant.)• Conditions for and restrictions on investment, which include the type of instruments anFII is allowed to invest in, and the applicable caps or ceilings in respect of different typesof instruments (or sectors), etc.• General obligations and responsibilities, which include appointment of a domesticcustodian; appointment of a branch of a bank approved by the RBI for opening of foreigncurrency denominated accounts and special non-resident rupee accounts; maintenance ofproper books of accounts, records, etc.• Procedure for action in case of default and suspension/cancellation of certificate.• The fees and taxes to be paid.• Provisions for appeal in case of any grievances. 31
  32. 32. It is obviously of interest to see whether the introduction of the SEBI FII Regulations hadany immediate repercussions on FII equity investments, causing a major gap between thepre- and post- regulation flows. We use the monthly data series of FII net equity inflows(FIINM) to study this impact. However, in the post-regulation period, the Asian currencycrisis had a very strong negative effect on global capital flows, particularly to emergingAsian economies. In order to filter out this effect, we compare our pre-regulation periodwith the post-regulation period up to the beginning of the Asian crisis (which is taken tobe up to June 1997). Comparing the monthly inflows prior to the introduction of the SEBIRegulations with the corresponding post regulation (pre-Asian crisis) period inflows, it iseasy to see that the average (and median) monthly inflows during these two sub-periodswere quite different, with the post-regulation period having a much higher average (andmedian) inflow. A research confirms that the difference between the means (andmedians) of the two sub-periods are indeed statistically significant with the post-regulation period experiencing much higher flows on an average. Next we consider theresult of a Chow break point test, which helps us detect any significant shift in the flowsimmediately after the introduction of the SEBI FII Regulations. To carry out this test, weregress the monthly net equity flows (FIINM) (for the 54-month preceding the Asiancrisis) on returns on the BSE Sensex (BSER). The result of the Chow test stronglysuggests existence of a structural break in the time series data on FII flows underconsideration at the time point of the introduction of the SEBI Regulations in November1995, thus confirming that the introduction of a comprehensive set of laws to govern FIIflows had definitely helped to attract more foreign portfolio investment flows into thecountry until the onset of the Asian financial crisis. 32
  33. 33. FII FLOWS TO INDIA: NATURE AND CAUSESPortfolio investment flows from industrial countries have become increasingly importantfor developing countries in recent years. The Indian situation has been no different. In theyear 2000-01 portfolio investments in India accounted for over 37% of total foreigninvestment in the country and 47% of the current account deficit. The correspondingfigures in the previous year were 59% and 64% respectively. A significant part of theseportfolio flows to India comes in the form of Foreign Institutional Investors’ (FIIs’)investments, mostly in equities. Ever since the opening of the Indian equity markets toforeigners, FII investments have steadily grown from about Rs. 2600 crores in 1993 toover Rs.11,000 crores in the first half of 2001 alone. Their share in total portfolio flowsto India grew from 47% in 1993-94 to over 70% in 1999-20001. The nature of the foreigninvestor’s decision-making process, which lies at the heart of the portfolio flows, isbriefly described bellow.The International Portfolio Investor’s decision-making problemInternational portfolio flows, as opposed to foreign direct investment (FDI) flows, refer tocapital flows made by individuals or investors seeking to create an internationallydiversified portfolio rather than to acquire management control over foreign companies.Diversifying internationally has long been known as a way to reduce the overall portfoliorisk and even earn higher returns. Investors in developed countries can effectivelyenhance their portfolio performance by adding foreign stocks particularly those fromemerging market countries where stock markets have relatively low correlations withthose in developed countries. For instance, according to Morgan Stanley CapitalInternational’s estimates, between 1985 and 1990, an investor holding an all-US portfoliocould improve her returns by over 25% by holding the MSCI world index instead and atthe same time, reduce her risk by about 2%.The portfolio investor’s problem may be thought of as deciding upon appropriate countryweights in the portfolio so as to maximize portfolio returns subject to a risk constraint, orin the absence of a pre-specified risk level, to reach the optimum portfolio, that which hasthe highest Sharpe ratio, S where the Sharpe ratio is the ratio of expected excess return(excess over the risk-free rate) to the dispersion (standard deviation) of the return. 33
  34. 34. While it is generally held that portfolio flows benefit the economies of recipientcountries, policy-makers worldwide have been more than a little uneasy about suchinvestments. Portfolio flows – often referred to as “hot money” – are notoriously volatilecompared to other forms of capital flows. Investors are known to pull back portfolioinvestments at the slightest hint of trouble in the host country often leading to disastrousconsequences to its economy. They have been blamed for exacerbating small economicproblems in a country by making large and concerted withdrawals at the first sign ofeconomic weakness. They have also been held responsible for spreading financial crises– causing ‘contagion’ in international financial markets. In the wake of the Asian crisis,prominent economists have, for these reasons, expressed doubts about the wisdom of theIMF view of promoting free capital mobility among countries.International capital flows and capital controls have emerged as an important policyissues in the Indian context as well. The danger of Mexico-style ‘abrupt and suddenoutflows’ inherent with FII flows and their destabilizing effects on equity and foreignexchange markets have been stressed. Some authors have argued that FII flows have, infact, had no significant benefits for the economy at large.While these concerns are all well-placed, comparatively less attention has been paid sofar to analyzing the FII flows data and understanding their key features. A properunderstanding of the nature and determinants of these flows, however, is essential for ameaningful debate about their effects as well as predicting the chances of their suddenreversals. In an attempt to address this lacuna, this paper undertakes an empirical analysisof FII investment flows to India.The broad objective of the present paper is to gain a better understanding of the natureand determinants of FII flows. Towards this end we first take a look at the FII investmentflow data to bring out the key features of these flows. Next we study the relationshipbetween FII flows and the stock market returns in India with a close look at the issue ofcausality. Finally we study the impact of other factors identified in the portfolio flowsliterature on the FII flows to India. In all of these investigations we make a distinctionbetween the pre-Asian crisis period and the post-Asian crisis period to checkif there was a regime shift in the relationships owing to the Asian crisis. 34
  35. 35. The paper is arranged as follows. The next section sketches a brief review of the recentliterature in the area. The third section provides an overview of the nature and sources ofportfolio flows in India pointing out their main characteristics. The fourth section probesinto the possible determinants of FII flows to India. The fifth and final section concludeswith a summary of the major findings and their policy implications.International Portfolio FlowsInternational portfolio flows are, as opposed to foreign direct investment, liquid in natureand are motivated by international portfolio diversification benefits for individual andinstitutional investors in industrial countries. They are usually undertaken by institutionalinvestors like pension funds and mutual funds. Such flows are, therefore, largelydetermined by the performance of the stock markets of the host countries relative toworld markets. With the opening of stock markets in various emerging economies toforeign investors, investors in industrial countries have increasingly sought to realize thepotential for portfolio diversification that these markets present. While the Mexican crisisof 1994, the subsequent ‘Tequila effect’, and the widespread ‘Asian crisis’ have hadtemporary dampening effects on international portfolio flows, they have failed to counterthe long-term momentum of these flows. Indeed, several researchers5 have foundevidence of persistent ‘home bias’ in the portfolios of investors in industrial countries inthe 90’s. This ‘home bias’ – the tendency to hold disproportionate amounts of stock fromthe ‘home’ country – suggests substantial potential for further portfolio flows as globalmarket integration increases over time.It is important to note that global financial integration, however, can have two distinctand in some ways conflicting effects on this ‘home bias’. As more and more countries –particularly the emerging markets – open up their markets for foreign investment,investors in developed countries will have a greater opportunity to hold foreign assets.However, these flows themselves, along with greater trade flows will tend to causedifferent national markets to increasingly become parts of a more unified ‘global’ market,reducing their diversification benefits. Which of these two effects will dominate is, of 35
  36. 36. course, an empirical issue, but given the extent of the ‘home bias’ it is likely that for quitea few years to come, FII flows would increase with global integration.In recent years, international portfolio flows to developing countries have received theattention of scholars in the areas of finance and international economics alike. In the 90’sseveral papers have explored the causes and effects of cross-border Portfolio investment.While papers in the finance tradition have focused on the nature and determinants ofportfolio flows from the perspective of the diversifying investors, those from theinternational macroeconomics perspective have focused on the recipient country’ssituation and appropriate policy response to such flows. For the present purposes, weshall focus only on papers that address the issue of portfolio flows exclusively.Previous research has also attempted to identify the factors behind these capital flows.The main question is whether capital flew in to these countries primarily as a result ofchanges in global (largely US) factors or in response to events and indicators in therecipient countries like its credit rating and domestic stock market return. The question isparticularly important for policy makers in order to get a better understanding of thereliability and stability of such flows. The answer is mixed – both global and country-specific factors seem to matter, with the latter being particularly important in the case ofAsian countries and for debt flows rather than equity flows.As for the motivation of US equity investment in foreign markets, recent research8suggest that US portfolio managers investing abroad seem to be chasing returns inforeign markets rather than simply diversifying to reduce overall portfolio risk. Thefindings include the well-documented ‘home bias’ in OECD investments, high turnoverin foreign market investments and that, in general, the patterns of foreign equityinvestment were far from what an international portfolio diversification model wouldrecommend. The share of investments going to emerging markets has been roughlyproportional to the share of these markets in global market capitalization but the volatilityof US transactions were even higher in emerging markets than in other OECD countries.Furthermore there was no relation between the volume of US transactions in thesemarkets and their stock market volatility.The Mexican and Asian crises and the widespread outcry against international portfolioinvestors in both cases have prompted analyses of short-term movements in international 36
  37. 37. portfolio investment flows. The question of ‘feedback trading’ has received For therelated literature on international capital flows in general (comprising both FDI andportfolio flows) considerable attention. This refers to investors’ reaction to recentchanges in equity prices. If a gain in equity values tends to bring in more portfolioinflows, it is an instance of ‘positive feedback trading’ while a decline in flows followinga rise in equity values is termed ‘negative feedback trading’. Between 1989 and 1996unexpected equity flows from abroad raised stock prices in Mexico with at the rate of 13percentage points for every 1% rise in the flows. There has been, however, no evidenceof ‘feedback trading’ among foreign investors in Mexico. In the period leading to theAsian crisis, on the other hand, Korea witnessed positive feedback trading and significant‘herding’ among foreign investors. Nevertheless, contrary to the belief in some segments,these tendencies actually diminished markedly in the crisis period and there has been noevidence of any ‘destabilizing role’ of foreign equity investors in the Korean crisis. WhileFII flows to the Asian Crisis countries dropped sharply in 1997 and 1998 from their pre-crisis levels, it is generally held that the flows reacted to the crisis (possibly exacerbatingit) rather than causing it.More recent studies find that the effect of ‘regional factors’ as determinants of portfolioflows have been increasing in importance over time. In other words portfolio flows todifferent countries in a region tend to be highly correlated. Also the flows are morepersistent than returns in the domestic markets. Feedback trading or return-chasingbehavior is also more pronounced. The flows appear to affect contemporaneous andfuture stock returns positively, particularly in the case of emerging markets. Finally stockprices seem to behave on the assumption of persistent portfolio inflows. It is commonlyargued that local investors possess greater knowledge about a country’s financial marketsthan foreign investors and that this asymmetry lies at the heart of the observed ‘homebias’ among investors in industrialized countries. A key implication of recent theoreticalwork in this area is that in the presence of such information asymmetry, portfolio flows toa country would be related to returns in both recipient and source countries. In theabsence of such asymmetry, only the recipient country’s returns should affect theseflows. 37
  38. 38. FOREIGN INSTITUTIONAL INVESTMENT IN INDIA: AN OVERVIEWIndia opened its stock markets to foreign investors in September 1992 and has, since1993, received considerable amount of portfolio investment from foreigners in the formof Foreign Institutional Investor’s (FII) investment in equities. This has become one ofthe main channels of international portfolio investment in India for foreigners. In order totrade in Indian equity markets, foreign corporations need to register with the SEBI asForeign Institutional Investors (FII). SEBI’s definition of FIIs presently includes foreignpension funds, mutual funds, charitable/endowment/university funds etc. as well as assetmanagement companies and other money managers operating on their behalf. 38
  39. 39. The trickle of FII flows to India that began in January 1993 has gradually expanded to anaverage monthly inflow of close to Rs. 1900 crores during the first six months of 2001.By June 2001, over 500 FIIs were registered with SEBI. The total amount of FIIinvestment in India had accumulated to a formidable sum of over Rs. 50,000 croresduring this time (see Fig. 1). In terms of market capitalization too, the share of FIIs hassteadily climbed to about 9% of the total market capitalization of BSE (which, in turn,accounts for over 90% of the total market capitalization in India). 39
  40. 40. The sources of these FII flows are varied. The FIIs registered with SEBI come from asmany as 28 countries (including money management companies operating in India onbehalf of foreign investors). US-based institutions accounted for slightly over 41%, thosefrom the UK constitute about 20% with other Western European countries hostinganother 17% of the FIIs (Fig. 2). It is, however, instructive to bear in mind The closed-end country fund, “The India Fund” launched in June 1986 provided a channel forportfolio investment in India before the stock market liberalization in 1992. GlobalDepository Receipts, American Depository Receipts, Foreign Currency ConvertibleBonds and Foreign Currency Bonds issued by Indian companies and traded in foreignexchanges provide other routes for portfolio investment in India by foreign investors. It isalso possible for foreigners to trade in Indian securities without registering as an FII butsuch cases require approval from the RBI or the Foreign Investment Promotion Board.that these national affiliations do not necessarily mean that the actual investor funds comefrom these particular countries. Given the significant financial flows among the industrialcountries, national affiliations are very rough indicators of the ‘home’ of the FIIinvestments. In particular institutions operating from Luxembourg, Cayman Islands orChannel Islands, or even those based at Singapore or Hong Kong are likely to beinvesting funds largely on behalf of residents in other countries. Nevertheless, theregional breakdown of the FIIs does provide an idea of the relative importance ofdifferent regions of the world in the FII flows. 40
  41. 41. FACTORS AFFECTING FII FLOWSIn this section we shall study the relationship between FII flows and possible economicfactors affecting it, particularly stock returns in the Indian market.FII flows and stock returns – determining the cause and the effectFII flows and contemporaneous stock returns are strongly correlated in India. Thecorrelation coefficients between different measures of FII flows and market returns on theBombay Stock Exchange during different sample periods are shown in the differentpanels of Table 1. While the correlations are quite high throughout the sample period,they exhibit a significant rise since the beginning of the Asian crisis. 41
  42. 42. These positive correlations have often been held as evidence of FII actions determiningIndian equity market returns. However, correlation itself does not imply causality. Apositive relationship between portfolio inflows and stock returns is consistent with atleast four distinct theories: 1) the “omitted variables” hypothesis; 2) the “downwardsloping demand curve” view; 3) the “base-broadening” theory; and 4) the “positivefeedback strategy” view.The “omitted variables” view is the classic case of spurious correlation – that thecorrelated variables, in fact, have no causal relationship between them but are bothaffected by one or more other variables missed out in the analysis. The “downwardsloping demand curve” view contends that foreign investment creates a buying pressurefor stocks in the emerging market in question and causes stock prices to rise much in thesame way as suddenly higher demand for a commodity would cause its price to rise. The‘base-broadening’ argument contends that once foreigners begin to invest in a country,the financial markets in that country are now no longer moved by national economicfactors alone but rather begin to be affected by foreign market movements as well. As themarket itself is now affected by more factors than before, its exposure to domestic shocksdecline. Consequently the ‘risk’ of the market itself falls, people demand a lower riskpremium to buy stocks, and stock prices rise to higher levels. Finally the ‘positivefeedback view’ asserts that if investors ‘chase’ returns in the immediate past (like theprevious day or week) then aggregating their fund flows over the month can lead to apositive relationship in the contemporaneous monthly data. In the present context, bothdirections of causation are equally plausible.Further returns on the BSE Index explain close to a third of the total variation in FIIflows during the entire period. They also indicate, however, that the Asian crisis markeda regime shift in the relationship between FII flows and Indian stock market return.During and after the crisis, the returns explained about 40% of the total variation in FIIflows. The positive relationship between market return and FII flows, however, servesonly as a first-pass in understanding the nature of such flows and their implications forthe Indian markets. Since the FII flows essentially serve to diversify the portfolio offoreign investors, it is only normal to expect that several factors – both domestic as well 42
  43. 43. as external to India – are likely to affect them along with the expected stock returns inIndia. Past research suggests that the declining world interest rates have been among theimportant “push” factors for international portfolio flows in the early 90’s. The “usualsuspects” in the literature include US and world equity returns, changes in interest rates,stock market volatility, some measure of the country risk and the exchange rate. In theIndian case, however these factors do not appear to have had a prominent role inmotivating FII flows. Finally it also appears that there has been no significantinformational disadvantage for FIIs vis-à-vis the local investors in the Indian market.Other factors that may affect FII flowsCountry risk measures, that incorporate political and other risks in addition to the usualeconomic and financial variables, may be expected to have an impact on portfolio flowsto India though they are likely to matter more in the case of FDI flows. In order to checkthe impact of such country risk on FII flows, semi-annual country risk scores for Indiawere taken from the Institutional Investor magazine, an important country-rating agency.These raw ratings were then divided by the world average rating to obtain normalizedratings. The intuition behind this normalization is as follows. IfIndia’s credit rating improves but that of other countries improve even more, then Indiamay not improve its relative attractiveness as a destination of investment flows. Therelation between the normalized country rating and the average monthly FII flows (as aproportion of the preceding month’s BSE capitalization) is shown in Figure 5. Thecorrelation between the two variables is –0.15. No relationship is evident from the figureitself and statistical testing confirms this view. Thus we can conclude that broadlyspeaking there is no evidence of India’ credit rating affecting FII flows. 43
  44. 44. It is also conceivable that the extent to which the Indian market moves out of step withthe world market is a factor in determining its attractiveness to foreign investors.The lower the co-movement, the greater the protection that investment in India providesto investors against world market shocks. 44
  45. 45. LIBERALISATION OF FOREIGN INSTITUTIONAL INVESTMENTFollowing the announcement by the Government in the Budget 2002-03 that suggestedthose foreign institutional investors’ (FII) portfolio investments would not be subject tothe sectoral limits for foreign direct investment except in specified sectors, a Committeewas constituted with representation from the Department of Economic Affairs as well asthe Department of Industrial Policy and Promotion.The Committee was reconstituted twice. After the second reconstitution, the Committeehad 5 meetings, the last being held on June, 24, 2004. The report gives an evolution ofFII policy in India, examines the pros and cons of FII investment, especially in an erawith no balance of payment pressures, and also provides a perspective on FII investmentrestrictions in peer countries in Asia. The recommendations are as follows:A. (i) In general, FII investment ceilings, if any, may be reckoned over and aboveprescribed FDI sectoral caps. The 24 per cent limit on FII investment imposed in 1992when allowing FII inflows was exclusive of the FDI limit. The suggested measure will bein conformity with this original stipulation.(ii) Special procedure for raising FII investments beyond 24per cent upto the FDI limit ina company may be dispensed with by amending the relevant SEBI (FII) Regulations.(iii) In order to provide dispersed investments and prevent concentration, the existinglimit of 10per cent by a FII in a single company may continue.B Recommendations in para A above would apply, in general, to all sectors.Specific recommendations are being made for the following sectors with overallcomposite caps :a. Telecom services.b. Defence productionc. Public sector banks.d. Insurance companies.FII investments are currently not permitted in print media, sectors which are not yetopened for private investment and in gambling, betting, lottery. The Committeerecommends the same may continue. 45
  46. 46. FDI investment in retail trading is prohibited. FII investments, however, are permitted upto 24 per cent in all listed companies, except in print media companies. The Committeerecommends the same may continue as this would help in developing supply chains in awide range of products including that of agriculture.In his Budget Speech on February 28, 2002, the Finance Minister announced that:“Foreign Institutional Investors (FIIs) can invest in a company under the portfolioinvestment route beyond 24 per cent of the paid-up capital of the company with theapproval of the general body of the shareholders by a special resolution. I propose thatnow FII portfolio investments will not be subject to the sectoral limits for foreign directinvestment except in specified sectors. Guidelines in this regard will be issuedseparately.”2. Following this announcement, with the approval of Finance Minister, a committee wasset up on March 13, 2002 to identify the sectors in which FIIs’ portfolio investments willnot be subject to the sectoral limits for Foreign Direct Investment (FDI).Evolution of FII Investment PolicyIndia embarked on a gradual shift towards capital account convertibility with the launchof the reforms in the early 1990s. Although foreign natural persons – except NRIs – areprohibited from investing in financial assets, such investments were permitted by FIIsand Overseas Corporate Bodies (OCBs) with suitable restrictions. Ever since September14, 1992, when FIIs were first allowed to invest in all the securities traded on the primaryand secondary markets, including shares, debentures and warrants issued by companieswhich were listed or were to be listed on the Stock Exchanges in India and in the schemesfloated by domestic mutual funds, the holding of a single FII and of all FIIs, Non-residentIndians (NRIs) and OCBs in any company were subject to the limit of 5 per cent and 24per cent of the company’s total issued capital, respectively. Furthermore, funds investedby FIIs had to have at least 50 participants with no one holding more than 5 per cent toensure a broad base and preventing such investment acting as a camouflage for individualinvestment in the nature of FDI and requiring Government approval. 46
  47. 47. Initially the idea of allowing FIIs was that they were broad-based, diversified funds,leaving out individual foreign investors and foreign companies. The only exceptions werethe NRI and OCB portfolio investments through the secondary market, which weresubject to individual ceilings of 5 per cent to prevent a possible “take over.” Individualswere left out because of the difficulties in checking on their antecedents, and of their lackof expertise in market matters and relatively short-term perspective. OCB investmentsthrough the portfolio route have been banned since November, 2001. In February, 2000, the FII regulations were amended to permit foreign corporates andhigh net worth individuals to also invest as sub-accounts of Securities and ExchangeBoard of India (SEBI)-registered FIIs. Foreign corporates and high net worth individualsfall outside the category of diversified investors. FIIs were also permitted to seek SEBIregistration in respect of sub-accounts for their clients under the regulations. Whileinitially FIIs were permitted to manage the sub-account of clients, the domestic portfoliomanagers or domestic asset management companies were also allowed to manage thefunds of such sub-accounts and also to make application on behalf of such sub-accounts.Such sub-accounts could be an institution, or a fund, or a portfolio established orincorporated outside India, or a broad-based fund, or a proprietary fund, or even a foreigncorporate or individual. So, in practice there are common categories of entities, whichcould be registered as both FIIs and sub-accounts. However, investment in to a subaccount is to be made either by FIIs, or by domestic portfolio manager or assetManagement Company, and not by itself directly.In view of the recent concerns of some unregulated entities taking positions in the stockmarket through the mechanism of Participatory Notes (PNs) issued by FIIs, the issue wasexamined by the Ministry of Finance in consultation with the Reserve Bank of India(RBI) and SEBI. Following this consultation, in January 2004, SEBI stipulated that PNsare not to be issued to any non-regulated entity, and the principle of "know your clients”may be strictly adhered to. SEBI has indicated that the existing non-eligible PNs, will bepermitted to expire or to be wound-down on maturity, or within a period of 5 years,whichever is earlier. Besides, reporting requirement on a regular basis has been imposedon all the FIIs. 47
  48. 48. The following entities, established or incorporated abroad, are eligible to be registered asFIIs:(a)Pension Funds,(b)Mutual Funds,(c)vestment Trusts,(d) Asset Management Companies,(e) Nominee Companies,(f) Banks,(g) Institutional Portfolio Managers,(h) Trustees, (i) Power of Attorney holders,(j) University funds, endowments, foundations or charitable trusts or charitable societies. Besides the above, a domestic portfolio manager or domestic asset managementcompany is now also eligible to be registered as an FII to manage the funds ofsubaccounts.The FIIs can also invest on behalf of sub-accounts. The following entities are entitled tobe registered as sub-accounts: i) an institution or fund or portfolio established orincorporated outside India, ii) a foreign corporate or a foreign individual.FIIs registered with SEBI fall under the following categories:(a) Regular FIIs – those who are required to invest not less than 70 per cent of theirinvestment in equity-related instruments and up to 30 per cent in non-equity instruments.(b) 100 per cent debt-fund FIIs – those who are permitted to invest only in debtinstruments.A Working Group for Streamlining of the Procedures relating to FIIs constituted in April,2003 by the Government, inter alia, recommended streamlining of SEBI registrationprocedure, and suggested that dual approval process of SEBI and RBI be changed to asingle approval process of SEBI. This recommendation has since been implemented.Forward cover in respect of equity funds for outstanding investments of FIIs over andabove such investments on June 11, 1998 was permitted. Subsequently, forward cover upto a maximum of 15 per cent of the outstanding position on June 11, 1998 was also 48
  49. 49. permitted. This 15 per cent limit was liberalized to 100 per cent of portfolio value as onMarch 31, 1999 in January 2003.Like in other countries, the restrictions on FII investment have been progressivelyliberalized. From November 1996, any registered FII willing to make 100 per centinvestment in debt securities were permitted to do so subject to specific approval fromSEBI as a separate category of FIIs or sub-accounts as 100 per cent debt funds. Suchinvestments by 100 per cent debt funds were, however, subject to fund-specific ceilingsspecified by SEBI and an overall debt cap of US$ 1-1.5 billion. Moreover, investmentswere allowed only in debt securities of companies listed or to be listed in stockexchanges. Investments were free from maturity limitations.From April 1998, FII investments were also allowed in dated Government securities.Treasury bills being money market instruments were originally outside the ambit of suchinvestments, but were subsequently included from May, 1998. Such investments, whichare external debt of the Government denominated in rupees, were encouraged to deepenthe debt market. From April, 1997, the aggregate limit for all FIIs, which was 24 per cent,was allowed to be increased up to 30 per cent by the Indian company concerned bypassing a resolution by its Board of Directors followed by a special resolution to thateffect by its General Body.While permitting foreign corporates/high net worth individuals in February, 2000 toinvest through SEBI registered FII/domestic fund managers, it was noted that there was aclear distinction between portfolio investment and FDI. The basic presumption is thatFIIs are not interested in management control. To allay fears of management controlbeing exercised by portfolio investors, it was noted that adequate safety nets were inforce, for example, (i) transaction of business in securities on the stock exchanges areonly through stock brokers who have been granted a certificate by SEBI, (ii) everytransaction is settled through a custodian who is under obligation to report to SEBI andRBI for all transactions on a daily basis, (iii) provisions of SEBI (Substantial Acquisitionof Shares and Takeovers) Regulations, 1997 (iv) monitoring of sectoral caps by RBI on adaily basis. 49
  50. 50. In 1998, the aggregate portfolio investment limits of NRIs/PIOs/OCBs and FIIs wereenhanced from 5 per cent to 10 per cent and the ceilings of FIIs and NRIs/OCBs weredeclared to be independent of each other.Aggregate FII portfolio investment ceiling was enhanced from 30 per cent to 40 per centof the issued and paid up capital of a company [March 01 2000]. The enhanced ceilingwas made applicable only under a special procedure that required approval by theBoard of Directors and a Special Resolution by the General Body of the relevantcompany. The FII ceiling under the special procedure was further enhanced [March 082001] from 40 per cent to 49 per cent. Subsequently, the FII ceiling under the specialprocedure was raised up to the sectoral cap in September, 2001.Sectoral CapsQuite apart from the ceilings on FII investment, there were and are ceilings on FDI, andin some cases, unified ceilings for nonresident investments. There are two types ofceilings on FII investment: statutory and administrative.Currently non-resident investments in public sector banks and insurance sector arecapped under Acts at 20 per cent and 26 per cent respectively. Accordingly, FDI plusportfolio investments by FIIs and NRIs are capped at 20 per cent and 26 per cent underthe above statutes.There are also sectors where administrative caps for non-resident investments have beenprescribed. In these sectors (viz. telecom services, media, private sector 10 banks) FDIplus portfolio investments by FIIs and NRIs cannot exceed the administrative caps fixed.Caps can be of three types:i) a separate cap on FDI,ii) a separate cap on FII, andiii) a composite caps on FDI and FII combined together. 50
  51. 51. Separate caps on FDI and FII, in turn, can be of five types:I) ban on both FDI and FII (e.g. lottery business, gambling and betting),II) non-zero separate caps on both FDI and FII ([e.g., DTH-broadcasting]), [DTH hascomposite ceiling with a sub-ceiling for FDI at 20 per cent]III) a composite non-zero cap on FDI and FII (banking, insurance, telecom)IV) ban on FDI with a non-zero cap on FII (e.g.,Terrestrial broadcasting FM,retail trading), andV) ban on FII with a non-zero cap on FDI (e.g. print media).For example, for private sector banks falling within the purview of the RBI’s regulatoryjurisdiction, no distinction is made either between different categories of nonresidentinvestors or the nature of foreign investment, whether portfolio or FDI.Similarly, no distinction is made either between different categories of sub-sectors of FMradio broadcasting and satellite uplinking, cable network and Direct-to-home. Thesectoral equity caps as of May 13, 2004 are given in Table 1 (at annex1).In August, 2002, the Steering Group on Foreign Direct Investment headed by ShriN.K.Singh, Member, Planning Commission, submitted its report.1 In this report, sixreasons given for imposing caps and bans on FDI national security, culture and media,natural monopolies, monopoly power, natural resources, and transition costs, werediscussed in some detail.The Steering Group observed that while all governments prefer vital defence industries tobe controlled by their own resident nationals, there was not much justification forrestrictions on the production of civilian goods used by the defence forces, andproduction of those goods that are either imported or are banned for exports fromdeveloped countries for strategic reasons. On culture and media, the Steering Groupobserved that there was a need for true cultural globalization – not a one-way process ofonly India having access to the culture of the rest of the world but a two-way street – andin the field of current affairs and news programmes, editorial control must vest with 51
  52. 52. Indian nationals and eventually could be replaced by limits on aggregate market share (25– 49 per cent) that can accrue to foreign controlled news/current affairs companies takentogether. As regards natural monopolies, the Steering Group observed that in the absence of aproper regulatory system with the requisite expertise, “It can be argued that when suchexpertise does not exist in the regulatory system it may be better for monopoly profits toaccrue to resident nationals than to foreigners. Though this argument has some validity inthe short term it is a defeatist approach in the long term. Domestic monopolies are morelikely to succeed in distorting the regulatory process in their favour (‘regulatory capture’)than foreign monopolies, because of their more intimate knowledge of and associationwith domestic political processes. Any such restrictions therefore must be temporary withcontinuous efforts made to improve regulatory structures and skills.” On abuse ofmonopoly power, the Steering Group argued that foreign investment can in fact enhancedomestic competition and any potential problem arising from a foreign producer withvery high global share tying up with an existing domestic producer should be addressedunder the Competition Law.With ownership of natural resources, such as, the electro-magnetic spectrum and sites fordams and harbours vesting with the people and their Government, the Steering Groupnoted that if extraction of the resource rent, which arises from the difference between themarket price and efficient costs of exploitation of the particular resource, is effectivelydesigned to maximize such resource rent to Government through appropriate tax andauction systems there would be no need to discriminate between foreign and domesticinvestments.Considerable difficulties were encountered in the monitoring of the sectorspecificcomposite ceilings on foreign investment because of the problems in identifying thesector of investment merely by the name of the company and the existence of companieswith diversified activities. 52
  53. 53. Supply and DemandVarious supply and demand factors have made investing via institutions a rapidlygrowing sector in many developed countries.2 There is enhanced supply of funds frominvestors to institutions because of the aging of population, funded pension systems, andgrowing wealth. Institutions are also able to give better services and attractive returnsbecause of ease of diversification, better corporate governance, liquidity, deregulationand fiscal incentives. Given this background, there is likely to be a large and growingdemand for Indian stocks by FIIs.It is of some importance to note that the bouts of liberalization of the FII regime hascoincided with pressure on the foreign exchange and balance of payments fronts, forexample, in the aftermath of the 1991 crisis and around the 1997 East Asian crisis. Nowthat there is no apparent balance of payments problem, the critical question is whetherthere are any reasons for liberalizing the FII regime.FIIs have a natural advantage in processing information. One of the problems noted forsuch investment in emerging markets consists in the lower amount of reliable and qualityinformation available in such countries relative to developed ones. It can be expected thatwith rapid progress in disclosure norms, accounting standards, shareholder rights, legalframework, and corporate governance in general, FII investments are going to acceleratein India. FII investments in some companies are already at their ceiling level, and theceiling is much below the stakes that FIIs have acquired in some of the top Koreanchaebols.Countries that have liberalized their FII regimes did not do it out of balance of paymentscompulsions. Taiwan, for example, removed all restrictions – previously 10 per centindividually and 25 per cent collectively until March 1998, and 15 per cent and 30 percent until January 1, 2001 – from the beginning of 2001. People’s Republic of China,without a balance of payments problem, opened itself up to FII investment in 2003. 53
  54. 54. Swiss Bank UBS, by buying into four of China’s A-share stocks – Baoshan Iron andSteel, Shanghai Port Container, Sinotrans Air, and ZTE Corp – became the first FII toenter the Chinese market on Wednesday, July 9, 2003.Pros of FII InvestmentThe advantages of having FII investments can be broadly classified under the followingcategories.A. Enhanced flows of equity capitalFIIs are well known for a greater appetite for equity than debt in their asset structure. Forexample, pension funds in the United Kingdom and United States had 68 per cent and 64per cent, respectively, of their portfolios in equity in 1998. Thus, opening up the economyto FIIs is in line with the accepted preference for non-debt creating foreign inflows overforeign debt. Furthermore, because of this preference for equities over bonds, FIIs canhelp in compressing the yield-differential between equity and bonds and improvecorporate capital structures. Further, given the existing savings-investment gap of around1.6 per cent, FII inflows can also contribute in bridging the investment gap so thatsustained high GDP growth rate of around 8 per cent targeted under the 10th Five YearPlan can materialize.B. Managing uncertainty and controlling risksInstitutional investors promote financial innovation and development of hedginginstruments. Institutions, for example, because of their interest in hedging risks, areknown to have contributed to the development of zero-coupon bonds and index futures.FIIs, as professional bodies of asset managers and financial analysts, not only enhancecompetition in financial markets, but also improve the alignment of asset prices tofundamentals. 54
  55. 55. Institutions in general and FIIs in particular are known to have good information and lowtransaction costs. By aligning asset prices closer to fundamentals, they stabilize markets.Fundamentals are known to be sluggish in their movements. Thus, if prices are aligned tofundamentals, they should be as stable as the fundamentals themselves.Furthermore, a variety of FIIs with a variety of risk-return preferences also help indampening volatility.C. Improving capital marketsFIIs as professional bodies of asset managers and financial analysts enhance competitionand efficiency of financial markets. Equity market development aids economicdevelopment.3 By increasing the availability of riskier long term capital for projects, andincreasing firms’ incentives to supply more information about themselves, the FIIs canhelp in the process of economic development.D. Improved corporate governanceGood corporate governance is essential to overcome the principal-agent problem betweenshare-holders and management. Information asymmetries and incomplete contractsbetween share-holders and management are at the root of the agency costs.Dividend payment, for example, is discretionary. Bad corporate governance makes equityfinance a costly option. With boards often captured by managers or passive, ensuring therights of shareholders is a problem that needs to be addressed efficiently in any economy.Incentives for shareholders to monitor firms and enforce their legal rights are limited andindividuals with small share-holdings often do not address the issue since others can free-ride on their endeavour. What is needed is large shareholders with leverage tocomplement their legal rights and overcome the free-rider problem, but shareholdingbeyond say 5 per cent can also lead to exploitation of minority shareholders. 55
  56. 56. FIIs constitute professional bodies of asset managers and financial analysts, who, bycontributing to better understanding of firms’ operations, improve corporate governance.Among the four models of corporate control – takeover or market control via equity,leveraged control or market control via debt, direct control via equity, and direct controlvia debt or relationship banking – the third model, which is known as corporategovernance movement, has institutional investors at its core. In this third model, boardrepresentation is supplemented by direct contacts by institutional investors.Institutions are known for challenging excessive executive compensation, and removeunder performing managers. There is some evidence that institutionalization increasesdividend payouts, and enhances productivity growth.Cons:Management Control and Risk of Hot Money FlowsThe two common apprehensions about FII inflows are the fear of management takeoversand potential capital outflows.A. Management controlFIIs act as agents on behalf of their principals – as financial investors maximizingreturns. There are domestic laws that effectively prohibit institutional investors fromtaking management control. For example, US law prevents mutual funds from owningmore than 5 per cent of a company’s stock.According to the International Monetary Fund’s Balance of Payments Manual 5, FDI isthat category of international investment that reflects the objective of obtaining a lastinginterest by a resident entity in one economy in an enterprise resident in another economy.The lasting interest implies the existence of a long-term relationship between the directinvestor and the enterprise and a significant degree of influence by the investor in themanagement of the enterprise. According to EU law, foreign investment is labeled directinvestment when the investor buys more than 10 per cent of the investment target, andportfolio investment when the acquired stake is less than 10 per cent. 56
  57. 57. Institutional investors on the other hand are specialized financial intermediaries managingsavings collectively on behalf of investors, especially small investors, towards specificobjectives in terms of risk, returns, and maturity of claims.All take-overs are governed by SEBI (Substantial Acquisition of Shares andTakeovers) Regulations, 1997, and sub-accounts of FIIs are deemed to be “persons actingin concert” with other persons in the same category unless the contrary is established. Inaddition, reporting requirement have been imposed on FIIs and currently ParticipatoryNotes cannot be issued to un-regulated entities abroad.B. Potential capital outflowsFII inflows are popularly described as “hot money”, because of the herdingbehaviour and potential for large capital outflows. Herding behaviour, with all the FIIstrying to either only buy or only sell at the same time, particularly at times of marketstress, can be rational.4 With performance-related fees for fund managers, andperformance judged on the basis of how other funds are doing, there is great incentive tosuffer the consequences of being wrong when everyone is wrong, rather than taking therisk of being wrong when some others are right. The incentive structure highlights thedanger of a contrarian bet going wrong and makes it much more severe than performingbadly along with most others in the market. It not only leads to reliance on the sameinformation as others but also reduces the planning horizon to a relatively short one.Value at Risk models followed by FIIs may destabilize markets by leading tosimultaneous sale by various FIIs, as observed in Russia and Long Term CapitalManagement 1998 (LTCM) crisis. Extrapolative expectations or trend chasing rather thanfocusing on fundamentals can lead to destabilization. Movements in the weightageattached to a country by indices such as Morgan Stanley Country Index (MSCI) orInternational Finance Corporation ( IFC) also leads to en masse shift in FII portfolios.Another source of concern are hedge funds, who, unlike pension funds, life insurancecompanies and mutual funds, engage in short-term trading, take short positions andborrow more aggressively, and numbered about 6,000 with $500 billion of assets undercontrol in 1998. 57
  58. 58. Some of these issues have been relevant right from 1992, when FII investments wereallowed in. The issues, which continue to be relevant even today, are:(i) benchmarking with the best practices in other developing countries that compete withIndia for similar investments; (ii) if management control is what is to be protected, isthere a reason to put a restriction on the maximum amount of shares that can be held by aforeign investor rather than the maximum that can be held by all foreigners put together;and (iii) whether the limit of 24 per cent on FII investment will be over and above the 51per cent limit on FDI. There are some other issues such as whether the existing ceiling onthe ratio between equities and debentures in an FII portfolio of 70:30 should continue ornot, but this is beyond the terms of reference of the Committee.It may be noted that all emerging peer markets have some restrictions either in terms ofquantitative limits across the board or in specified sectors, such as, telecom, media,banks, finance companies, retail trading medicine, and exploration of natural resources.Against this background, further across the board relaxation by India in all sectors excepta few very specific sectors to be excluded, may considerably enhance the attractivenessof India as a destination for foreign portfolio flows. It is felt that with adequateinstitutional safeguards now in place the special procedure mechanism for raising FIIinvestments beyond 24 per cent may be dispensed with. The restrictions on foreignownership of companies in emerging markets have been summarised in Annex-III. 58
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  62. 62. FOREIGN INSTITUTIONAL INVESTMENT IN INDIAIndia opened its stock market to foreign investors in September 1992 and since then hasreceived portfolio investment from foreigners in the form of foreign institutionalinvestment in equities. This has become one of the main channels of FII in India. In orderto trade in the Indian equity market, foreign corporations need to register with theSecurities and Exchange Board of India (SEBI) as foreign institutional investors. Indiaallows only authorized foreign investors to invest in pension funds, investment trusts,asset management companies, university funds, endowments, foundations, charitableinterests and charitable societies that have a track record of five years and which areregistered with a statutory authority in their own country of incorporation or settlement. Itis possible for foreigners to trade in Indian securities without registering as an FII butsuch cases require approval from the Reserve Bank of India (RBI) or the ForeignInvestment Promotion Board (FIPB).Foreign institutional investors generally concentrate on the secondary market. The totalamount of foreign institutional investment in India has accumulated to the formidablesum of over U.S.$120,243 million as of January 2007.Daily FII Activity 62
  63. 63. DATE PURCHASES (Rs m) SALES (Rs m) NET INV (Rs m)Mon, 8 Jan,2007 13,853 44,610 (30,757)Tue, 9 Jan,2007 17,520 28,588 (11,068)Wed, 10 Jan,2007 17,520 28,588 (11,068)Thu, 11 Jan.2007 24,603 23,010 1,593Fri, 12 Jan,2007 26,331 24,261 2,070Total 99,827 149,057 (49,230) 63
  64. 64. Contribution by FIIsThe diversity of FIIs has been increasing over 30 countries registered with SEBI as atmarch 31st, 2006.Of these 40% originate from 20% and US from UK. Recently FIIs fromJapan and continental Europe are increasing their India exposure. FIIs contributedapprox. 11% of the total market and approx.10% of the total market turnover.Of the new issuances in FY 2006-Domestic IPOs aggregated $5.4 billion-Overseas issuance by the way of ADRs and GDRs were $5billion-Foreign currency convertible bonds (FCCBs) were for $6 billionsFIIs contributed over 75% of the new equity and equity linked issuancesThe FII inflows into India have been on account of:· Strong economic fundamentals and attractive valuations of companies· High quality of corporate governance· Efficient market mechanisms for settlement and clearing· Product diversification and availability of active derivatives market. 64