This document provides an overview of foreign portfolio investment (FPI) in India. It discusses the origin and composition of FPI flows, including foreign institutional investments, depository receipts, and offshore funds. It explains that FPI consists of passive investments in stocks, bonds, and other securities, as opposed to foreign direct investment which involves ownership and management of firms. The document outlines the benefits of FPI to India's economy as well as trends in FPI over time. It also analyzes the determinants and impacts of FPI flows, including both risks and benefits. In summary, the document serves as a comprehensive introduction to the topic of foreign portfolio investment in the Indian financial market.

1. INDEX
Sr. No. Topic Page No.
1 Introduction
2 Origin of FPI
3 Composition of Foreign PortfolioFlow
4 Benefits of FPIto the Economy
5 Trends In PortfolioFlows
6 Impact of PortfolioFlows
7 Conclusion

2. Foreign Portfolio Investor (FPI)
FPI is securities and other financial assets passively held by foreign investors.
Foreign portfolio investment (FPI) does not provide the investor with direct ownership
of financial assets, and thus no direct management of a company. This type of
investment is relatively liquid, depending on the volatility of the market invested in. It is
most commonly used by investors who do not want to manage a firm abroad.
Foreign portfolio investment typically involves short-term positions in financial assets
of international markets, and is similar to investing in domestic securities. FPI allows
investors to take part in the profitability of firms operating abroad without having to
directly manage their operations. This is a similar concept to trading domestically: most
investors do not have the capital or expertise required to personally run the firms that
they invest in.

3. Origin of FPI
After the Second World War, the developing countries are making concerted efforts to
achieve rapid economic growth so as to alleviate problems of poverty and
unemployment. Besides, there has been rapid growth of international trade. The
developing countries like India have been facing the problem of shortage of capital. To
meet this shortage, capital flows from the developed countries to the developing
countries in the last two decades have substantially increased.
Immediately after the Second World War, capital flows were largely in the form of
foreign aid from the governments of the developed countries and international
institutions such as IMF and World Bank to the Governments of the developing
countries.
In the last two decades the capital flows in the form of foreign aid on Government to
Government basis have dried up, whereas aid from IMF and World Bank is based on
certain conditionality’s of undertaking some structural economic reforms which the
developing countries often find them difficult to implement to the entire satisfaction of
these institutions.
Besides, the capital needs of the developing countries are so large that IMF and World
Bank alone cannot meet them. Therefore, there is great need for capital flows on private
account on a large scale. Fortunately, capital flows on private account have substantially
increased in the last two decades.
These capital flows on private account are of the following two types:
1. Foreign Portfolio Investment
2. Foreign Direct Investment
Foreign Investment in
India
Foreign Portfolio
Investment
Foreign Direct
Investment

4. The roles of the above two types of capital flows are:
1. Foreign Direct Investment:
The foreign direct investment (FDI) is the investment in the construction of physical
capital such as building factories and infrastructure (i.e., power, telecom, ports etc.) in
the capital- importing country. It may be done in several ways. Companies or
corporations may be specially set up for the purpose in the capital-exporting country to
carry out trade and industry in an under-developed country.
For example, Imagine that you are a multi-millionaire based in the U.S. and are looking
for your next investment opportunity. You are trying to decide between (a) acquiring a
company that makes industrial machinery, and (b) buying a large stake in a company or
companies that makes such machinery. The former is an example of direct investment,
while the latter is an example of portfolio investment.
Now, if the machinery maker were located in a foreign jurisdiction, say Mexico, and if
you did invest in it, your investment would be considered as FDI. As well, if the
companies whose shares you were considering buying were also located in Mexico, your
purchase of such stock or their American Depositary Receipts (ADRs) would be
regarded as FPI.
Although FDI is generally restricted to large players who can afford to invest directly
overseas, the average investor is quite likely to be involved in FPI, knowingly or
unknowingly. Every time you buy foreign stocks or bonds either directly or through
ADRs, mutual funds or exchange-traded funds, you are engaged in FPI. The cumulative
figures for FPI are huge. According to the Investment Company Institute, for the week
ended December 23, 2013, domestic equity mutual funds had inflows of $254 million,
while foreign equity funds attracted six times that amount, or $1.53 billion.
This is how the East Company operated in India or railways were constructed in India.
The head office is in the investing country and the operations are in the developing
country. Another method is that an already existing corporation spreads out its
business in another country by establishing branches.
Thus, many foreign companies producing cars, colour TVs have set up branches in India
and are producing these items in India. There is another way open to the foreign
entrepreneur, that is, to form companies and register them in the borrowing country
without having any connection in the lending country.
When India adopted protection, it became profitable and quite fashionable too, for the
foreign entrepreneurs to set up so called “India limited,” to jump over the tariff wall and
to avail themselves of the various concessions which the government extended to
national concerns.
These were in fact disguised branches of the foreign firms. The Indian match industry,
for instance, is dominated by Swedish concerns. There is still another possibility which
is now becoming common in India, viz., of joint ventures or joint participation.

5. The foreign firms start industrial concerns in collaboration with Indian firms. This form
of foreign investment has some special advantages. The standing and reputation of
foreign firms inspire confidence in the domestic and foreign capital.
The long experience and efficient techniques are placed at the disposal of the domestic
companies. It avoids evils of absentee ownership; it provides full opportunities for
developing local skills, and also a large proportion of profits are retained in the country.
It is also advantageous to the foreign investor. He is able to ward off in this manner any
danger of discriminatory treatment by the government. A developing country lacks
capital for development and it will have to depend on foreign capital.
2. Foreign Portfolio Investment:
This is important type of capital flow under which foreign institutions such as banks,
insurance companies, companies managing mutual funds and pension funds purchase
stocks and bonds of companies of other countries in the secondary markets (i.e., stock
markets).
They get returns in the form of capital gains and yearly payable dividends but do not
exercise any direct control in running these companies. Pension funds, mutual funds
and insurance companies have been very active in moving portfolio capital in the last
two decades because restrictions on foreign equity investment by various countries
have been reduced or removed in recent years allowing pension and mutual funds and
insurance companies to diversify their portfolio in order to reduce risk.
Besides, the growth of portfolio foreign capital in the last two decades has also been due
to the policies of liberalization followed by the developing countries. In India following
the adoption of policy of liberalization the flow of portfolio capital was permitted in
1991.
Consequently, foreign portfolio capital flows have come to India in large amounts in the
last ten years (1991- 2001). However, Mexico has been the chief beneficiary of portfolio
capital flows. Portfolio capital flows now account for one third of net capital flows to the
developing countries.
FPI consists of FII, ADRs/ GDRs. Though FPI is desirable as a source of investment
capital, it tends to have a much higher degree of volatility than FPI. In fact, FPI is often
referred to as “hot money” because of its tendency to flee at the first signs of trouble in an
economy. These massive portfolio flows can exacerbate economic problems during periods
of uncertainty.
Foreign Portfolio
Investments
FII ADRs/ GDRs

6. This international flow of capital is expected to benefit both the source as well as the
host country. However, the historical and recent financial crises have also brought into
focus the fact that these flows can expose the countries to new risks. Hence it is
important to understand the risks associated with these flows and the factors that drive
flows into India, so that policy reactions can be formulated in advance to avoid any
imbalances arising out of extremely high capital inflows or sudden reversal of capital
flows in future, whatever the case may be.
The recent volatility in capital flows, especially when periods of high capital inflows
were followed by periods of huge reversal in these flows, has posed macroeconomic
challenges to countries across the world. India has not remained untouched by the
developments in the global financial markets due to greater linkages of the Indian
markets with the international markets. The recent volatility in capital flows to India
can mainly be attributed to volatility in foreign portfolio investment flows and
especially the foreign institutional investment flows. Hence it is important to analyse
the determinants of portfolio flows in this uncertain global scenario.
The expected return from investing in the host country, adjusted for credit worthiness
of the country should be equal to the opportunity cost i.e. returns from investing in
home country. The capital flows are a function of economic factors in the host and the
source country and also of the factors that influence creditworthiness of host country.
These factors include domestic stock market performance, exchange rate, foreign
exchange reserves to imports ratio, volatility in exchange rate, interest rate differential
and domestic and foreign output growth.
The disaggregated components of FPI flows i.e. determinants of Foreign Institutional
Investment flows (FIIs) and American/Global Depository Receipts (ADRs/ GDRs) which
have been the major components of FPI flows to India are also analyzed. It is important
to do so in order to assess whether different components of portfolio flows are driven
by the same or different factors.
A well performing domestic stock market, an appreciating exchange rate and strong
domestic economic growth attracts portfolio flows. Greater volatility in the exchange
rate discourages these flows. If the overall stock market performance of emerging
markets in general is good then the flows received by India decline indicating that India
competes with other emerging economies in terms of receiving portfolio flows. A higher
interest rate differential between domestic and foreign interest rates attracts FPI flows.
Prior to this, in December 2012, SEBI had constituted a “Committee on Rationalization
of Investment Routes and Monitoring of Foreign Portfolio Investments” under the
chairmanship of Shri K. M. Chandrasekhar with a view to rationalize/harmonize various
foreign portfolio investment routes and to establish a unified, simple regulatory
framework. The Committee had submitted its report in June, 2013 to the Government of
India.
Based on the committee report, on 7th January, 2014 the FPI Regulations, 2014 were
notified in the Gazette of India.

7. Categories of FPI
As part of Risk based approach towards customer identity verification (KYC), FPIs have
been categorized into three major categories:
 Category I (Low Risk) which would include Government and entities like Foreign
Central banks, Sovereign wealth Funds, Multilateral Organizations, etc
 Category II (Moderate Risk) which would include Regulated entities such as banks,
Pension Funds, Insurance Companies, Mutual Funds, Investment Trusts, Asset
Management Companies, University related endowments (already registered with
SEBI)
 Category III (High Risk) which would include all other FPIs not eligible to be
included in the above two categories
FPI Investment restrictions
FPIs are not allowed to invest in unlisted shares. However, all existing investments
made by the FIIs are grandfathered. In respect of those securities, where FPIs are not
allowed to invest no fresh purchase shall be allowed as FPI. They can only sell their
existing investments in such securities.
However, an exception has been made by permitting them to invest in unlisted non-
convertible debentures/bonds issued by an Indian company in the infrastructure sector,
where ‘infrastructure’ is defined in terms of the extant External Commercial Borrowings
(ECB) guidelines;
FPIs are permitted to invest in Government Securities with a minimum residual
maturity of one year. However, FPIs have been prohibited from investing in T-Bills.
FPI can invest in privately placed bonds if it is listed within 15 days.
The same debt allocation mechanism that is in place for FIIs/QFIs will be followed for
FPIs.

8. Composition of Portfolio Flows
Foreign Portfolio Investment consists of Depository Receipts (DR), Foreign Institutional
Investment (FII) in debt and equity (direct purchase of shares).
Depository Receipts:
These are equity instruments issued outside the country to non-resident investors by
authorized overseas depository banks.
A negotiable financial instrument issued by a bank to represent a foreign company's
publicly traded securities. A depository receipt trades on a local stock exchange, but a
custodian bank in the foreign country holds the actual shares. Depository receipts can
be sponsored or unsponsored depending on whether the company that issued the
shares enters into an agreement with the custodian bank that issues the depository
receipt.
Depending on the location in which these receipts are issued they are called as ADRs or
American Depository Receipts (if they are issued in USA on the basis of the
shares/securities of the domestic (say Indian) company), IDR or Indian Depository
Receipts (if they are issued in India on the basis of the shares/securities of the foreign
company; Standard Chartered issued the first IDR in India) or in general as GDR or
Global Depository Receipt.
When a foreign listed company wants to create a depository receipt abroad, it follows a
standard process. The firm will likely hire a financial advisor to help it navigate
regulations, and will then choose a domestic custodian bank. A broker in the target
country will purchase shares of the firm in the country where the firm is located, and
then the domestic bank will register the shares on behalf of the broker. The bank then
issues the depository receipt to the broker. The broker can have the shares listed on a
local exchange, such as the BSE/NSE, as an ADR.
For example, a firm based in Kenya looking to list shares in the United States through an
ADR will pick a Kenyan bank to serve as a custodian of the firm's shares. Once the bank
is chosen, the firm will decide how many shares will be represented by the depository
receipt, referred to as the depository receipt ratio, and will find an American broker
willing to purchase the shares to be held by the custodian bank. Once the bank issues
depository receipts, the American broker can sell those shares domestically.

9. Foreign Institutional Investment:
A foreign institutional investor (FII) is a person or a group of people operating or
registered in a country that’s not their domicile. Foreign institutional investor groups
often operate as hedge funds, pension funds, insurance companies, and mutual funds.
The term foreign institutional investment denotes all those investors or investment
companies that are not located within the territory of the country in which they are
investing. These are actually the outsiders in the financial markets of the particular
company. Foreign institutional investment is a common term in the financial sector of
India. International institutional investors must register with the Securities and
Exchange Board of India to participate in the market. One of the major market
regulations pertaining to FIIs involves placing limits on FII ownership in Indian
companies.
FIIs are mostly associated with India, which has had, until recently, very restrictive laws
on foreign investment. FIIs in India are still regulated by India’s Securities and Exchange
Board (which is similar to the Securities and Exchange Commission in the United
States). Foreign investment in India by FIIs has played a substantial part in India’s
economic growth. This was true even under India’s restrictive foreign investment laws.
Until recently, FII’s were limited as how much equity they could purchase in a domestic
Indian company. The interest was always less than 50%.
But recently, India has changed its foreign investor laws to allow FIIs to own up to
100% of Indian companies in certain industries. This change, made in 2014, brings
India into conformance with other countries foreign investment policies. Because of the
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GDR/ ADR - - 240 15202082 683 1366 645 270 768 831 477 600 459 613 255237768769
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10. change, India expects FIIs to make investments in India that will help its economy
double in size in 2015.
Since 2003, the Securities and Exchange Board of India (SEBI) has been registering FIIs
and monitoring investments made by them through the portfolio investment route
under the SEBI (FII) regulations 1995. SEBI acts as the nodal point in the registration of
FIIs.
Offshore Funds and others:
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FII - - 1 1665 1503 2009 1926 979 -390 2135 1847 1505 377 1091 8686 9926 3225 2032
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OFF 0 0 0 0 0 56 20 204 59 123 82 39 2 0 16 14 2 298
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Offshore Funds & Others

11. Investment in Offshore financial funds i.e. those funds that are supposed to provide tax
benefit to the investor are also included under the category of portfolio investment
flows. In India a few companies that have offshore mutual funds are Reliance, Kotak and
TATA.
Component wise analyse of Foreign Portfolio flow:
It helps in understanding the nature of these flows. It is depicted in the Graph. As
mentioned earlier, the foreign institutional investments into the Indian capital and
money markets, the portfolio inflow through the issuance of Global depository
receipts/American depository receipts by Indian firms and investments through the
offshore funds constitute Foreign Portfolio flows. Offshore funds were first to invest in
Indian markets since the economy was opened to portfolio flows. They began with an
investment of about 6 million US dollars in the very first year. Portfolio investments by
institutional investors and through GDRs/ADRs have begun only in 1992-93, two years
after the liberalisation of capital flows.
Graph:
However the portfolio investment through the offshore funds route has been negligible
comparing with the other two forms of foreign portfolio investments. The highest
investment through this route was in 1993-94. But exactly a decade since that, the
offshore funds investment touched nil. In the initial years, the investments by issuing
GDRs/ADRs were comparatively significant, but got reduced thereafter, especially in
comparison with the institutional investments into the Indian stock markets. The
foreign institutional investors are now the largest and most leading mode of the foreign
portfolio investment into India.

12. Benefits of Foreign Portfolio Investment
Foreign portfolio investment is the type of investment that an investor has abroad.
There are many benefits of having a foreign portfolio investment.
Portfolio Diversification
Foreign portfolio investment gives investors an opportunity to engage in international
diversification of portfolio assets, which in turn helps achieve a higher risk-adjusted
return. The global stock market operates in such a way that the factors that drive
the London Stock Exchange at any given time are different from those that prevail in
Taiwan, for example. This means that an investor who has stocks in different countries
will experience less volatility over the entire portfolio.
International Credit
Investors who have foreign investment portfolios have a broader credit base because
they can access credit in foreign countries where they have significant investments. This
is advantageous when credit sources available at home are expensive or unavailable
due to various factors. The ability to get credit on favorable terms and as quickly as
possible can determine whether a business executes a new project or not.
Benefit from Exchange Rate
International currency exchange rates keep changing. Sometimes the currency of the
investor's home country may be strong, and sometimes it may be weak. There are times
when a stronger currency in the foreign country where an investor has a portfolio may
benefit the investor.
Access to a Bigger Market
Home markets in the United States have become very competitive, as there are
many businesses offering similar services. Foreign markets, however, offer a less
competitive and sometimes larger market. A business may make more sales selling
shoes in one African country than in the entire U.S., for instance.