14th September 2009


Report Submitted to Prof C. D. Sreedharan
In partial fulfilment of requirement of

International Finance Course Prepared By
Lopamudra Biswas Manas Jain Nikhil Jain Deepak Kumar Rakshak Lodha Ashit Shetty (307) (324) (327) (333) (338) (355)

Foreign Institutional Investors September 14, 2009

Table of Contents
Introduction................................................................................................................................................... 2 Differences between FII & FDI .................................................................................................................... 3 Types of FIIs ................................................................................................................................................. 4 Eligibility criteria for applicant seeking FII registration............................................................................... 9 FII Regulations............................................................................................................................................ 11 Offshore Derivatives Instruments (Participatory Notes)............................................................................. 16 Double Taxation Avoidance Agreement (DTAA)...................................................................................... 20 Advantages and Disadvantages of FIIs....................................................................................................... 23 Trends in FIIs.............................................................................................................................................. 25 Recent Developments ................................................................................................................................. 30 Recommendations....................................................................................................................................... 33 References................................................................................................................................................... 34


Foreign Institutional Investors September 14, 2009

The economic landscape of India underwent a paradigm change when the economy was liberalized in 1991. It also laid the foundation for a strong regulatory network. India witnessed stellar economic performance through the period 2003-09 .This was manifested through an average 8.5 – 9 percent GDP growth rates, rising domestic savings and investment levels and the amount of foreign capital flowing into the country. Foreign investments can any of the three forms:    Portfolio investments in Indian companies Foreign Institutional Investor (“FII”) route – essentially entailing transactions executed on stock exchanges in India; Direct investment into Indian companies Foreign Direct Investment – (“FDI”) route; Private Equity investments – Foreign Venture Capital Investor (“FVCI”) route

Foreign Institutional Investors have been a major source of funds into the Indian Capital Markets in the past few years. Foreign Institutional Investors are defined under SEBI Regulations as “an institution that is a legal entity established or incorporated outside India proposing to make investments in India only in securities.” Foreign institutional investors also include domestic asset management companies or domestic portfolio managers who manage funds raised or collected or bought from outside India for the purpose of making investment in India on behalf of foreign corporate or foreign individuals. These investments are governed by the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995. Potential investors also have to get approval from the Reserve Bank of India to operate foreign currency accounts to bring in and take out funds and rupee bank accounts to pay for transactions. The Reserve Bank of India also regulates the activities of FIIs, through exchange control regulations.


Foreign Institutional Investors September 14, 2009

Differences between FII & FDI
FDI and FIIs are two important sources of foreign financial flows into a country. FDI (Foreign Direct Investment) the acquisition abroad of physical assets such as plant and equipment, with operating control residing in the parent corporation. It is an investment made to acquire a lasting management interest (usually 10 percent of voting stock) in an enterprise operating in a country other than that of the investor, the investor’s purpose being an effective voice in the management of the enterprise. It includes equity capital, reinvestment of earnings, other long-term capital, and short-term capital. Usually countries regulate such investments through their periodic policies. In India such regulation is usually done by the Finance Ministry at the Centre through the Foreign Investment Promotion Board).

Types of Investments
FDI typically brings along with the financial investment, access to modern technologies and export market. The impact of the FDI in India is far more than that of FII largely because the former would generally involve setting up of production base - factories, power plant, telecom networks, etc. that enables direct generation of employment. There is also multiplier effect on the back of the FDI because of further domestic investment in related downstream and upstream projects and a host of other services. Korean Steel maker Posco’s USD 8 billion steel plant in Orissa would be the largest FDI in India once it commences. Maruti Suzuki has been an exemplary case in the India's experience. However, the issue is that it puts an impact on local entrepreneur as he may not be able to always successfully compete in the face of superior technology and financial power of the foreign investor. Therefore, it is often regulated that Foreign Direct Investments should ensure minimum level of local content, have export commitment from the investor and ensure foreign technology transfer to India. FII investments into a country are usually not associated with the direct benefits in terms of creating real investments. However, they provide large amounts of capital through the markets. The indirect benefits of the market include alignment of local practices to international standards in trading, risk management, new instruments and equities research. These enable markets to become more deep, liquid, feeding in more information into prices resulting in a better allocation of capital to globally competitive sectors of the economy.


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Since, these portfolio flows can technically reverse at any time, the need for adequate and appropriate economic regulations are imperative.

Government Preference
FDI is preferred over FII investments since it is considered to be the most beneficial form of foreign investment for the economy as a whole. Direct investment targets a specific enterprise, with the aim of enhancing capacity and productivity or changing its management control. Direct investment to create or augment capacity ensures that the capital inflow translates into additional production. In the case of FII investment that flows into the secondary market, the effect is to increase capital availability in general, rather than availability of capital to a particular enterprise. Translating an FII inflow into additional production depends on production decisions by someone other than the foreign investor — some local investor has to draw upon the additional capital made available via FII inflows to augment production. In the case of FDI that flows in for acquiring an existing asset, no addition to production capacity takes place as a direct result of the FDI inflow. Just like in the case of FII inflows, in this case too, addition to production capacity does not result from the action of the foreign investor – the domestic seller has to invest the proceeds of the sale in a manner that augments capacity or productivity for the foreign capital inflow to boost domestic production. There is a widespread notion that FII inflows are hot money — that it comes and goes, creating volatility in the stock market and exchange rates. While this might be true of individual funds, cumulatively, FII inflows have only provided net inflows of capital

FDI tends to be much more stable than FII inflows. Moreover, FDI brings not just capital but also better management and governance practices and, often, technology transfer. The knowhow thus transferred along with FDI is often more crucial than the capital per se. No such benefit accrues in the case of FII inflows, although the search by FIIs for credible investment options has tended to improve accounting and governance practices among listed Indian companies.

Types of FIIs
FII investments in India can be of the two types:


Foreign Institutional Investors September 14, 2009

1. Normal FIIs: FII allocation of its total investment between equity and non-equity instruments (including dated government securities and treasury bills in the Indian capital market) should not exceed the ratio of 70:30. Equity related instruments would include fully convertible debentures, convertible portion of partially convertible debentures and tradable warrants. 2. 100% Debt FIIs: FII that can invest the entire corpus in dated government securities including treasury bills, non-convertible debentures/bonds issued by an Indian company subject to limits, if any. A FII needs to submit a clear statement that it wishes to be registered as FII/sub-account under 100% debt route.

Entities which can register as FIIs:
Entities who propose to invest their proprietary funds or on behalf of "broad based" funds (fund having more than twenty investors with no single investor holding more than 10 per cent of the shares or units of the fund) or of foreign corporate and individuals and belong to any of the under given categories can be registered for FII. Pension Funds Mutual Funds Investment Trust Insurance or reinsurance companies Endowment Funds University Funds Foundations or Charitable Trusts or Power of Attorney Holders Banks Foreign Government Agency Foreign Central Bank International or Multilateral Organization or an Agency thereof

Charitable Societies who propose to invest on their own behalf, and Asset Management Companies Nominee Companies Institutional Portfolio Managers Trustees


Some of the above mentioned types are described below: Pension funds A pension fund is a pool of assets that form an independent legal entity that are bought with the contributions to a pension plan for the exclusive purpose of financing pension plan benefits. It manages pension and health benefits for employees, retirees, and their families. FII activity in India gathered momentum mainly after the entry of CalPERS (California Public Employees’ Retirement System), a large US-based pension fund in 2004. Mutual funds A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, or other such securities. The mutual fund will have a fund manager that trades the pooled money on a regular basis. The net proceeds or losses are then distributed to the investors. Investment trust An Investment trust is a form of collective investment .Investment trusts are closed-end funds and are constituted as public limited companies. A collective investment scheme is a way of investing money with others to participate in a wider range of investments than feasible for most individual investors, and to share the costs and benefits of doing so Investment banks An investment bank is a financial institution that raises capital, trades in securities and manages corporate mergers and acquisitions. Investment banks profit from companies and governments by raising money through issuing and selling securities in capital markets (both equity, debt) and insuring bonds (e.g. selling credit default swaps), as well as providing advice on transactions such as mergers and acquisitions. Hedge funds A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of investment and trading activities than other investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and

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the methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of investments including shares, debt and commodities. Many hedge funds investments in India were facilitated by global investors borrowing at near zero interest rates in Japan and investing the proceeds in High interest markets like India. University Fund The purpose of investments of these funds is to establish an asset mix for each of the University funds according to the individual fund’s spending obligations, objectives, and liquidity requirements. It consists of the University’s endowed trust funds or other funds of a permanent or long-term nature. In addition, external funds may be invested including funds of affiliated organizations and funds where the University is a beneficiary. Endowment fund It is a transfer of money or property donated to an institution, usually with the stipulation that it be invested, and the principal remain intact in perpetuity or for a defined time period. This allows for the donation to have an impact over a longer period of time than if it were spent all at once. Insurance Funds An insurance company's contract may offer a choice of unit-linked funds to invest in. All types of life assurance and insurers pension plans, both single premium and regular premium policies offer these funds. They facilitate access to wide range and types of assets for different types of investors. Asset Management Company An asset management company is an investment management firm that invests the pooled funds of retail investors in securities in line with the stated investment objectives. For a fee, the investment company provides more diversification, liquidity, and professional management consulting service than is normally available to individual investors. The diversification of portfolio is done by investing in such securities which are inversely correlated to each other. They collect money from investors by way of floating various mutual fund schemes.


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Nominee Company Company formed by a bank or other fiduciary organization to hold and administer securities or other assets as a custodian (registered owner) on behalf of an actual owner (beneficial owner) under a custodial agreement. Charitable Trusts or Charitable Societies A trust created for advancement of education, promotion of public health and comfort, relief of poverty, furtherance of religion, or any other purpose regarded as charitable in law. Benevolent and philanthropic purposes are not necessarily charitable unless they are solely and exclusively for the benefit of public or a class or section of it. Charitable trusts (unlike private or non-charitable trust) can have perpetual existence and are not subject to laws against perpetuity. They are wholly or partially exempt from almost all taxes. An application for registration has to be made in Form A, the format of which is provided in the SEBI (FII) Regulations, 1995.


Foreign Institutional Investors September 14, 2009

Eligibility criteria for applicant seeking FII registration
As per Regulation 6 of SEBI (FII) Regulations, 1995, Foreign Institutional Investors are required to fulfil the following conditions to qualify for grant of registration:   The applicant should have track record, professional competence, financial soundness, experience, general reputation of fairness and integrity; The applicant should be regulated by an appropriate foreign regulatory authority in the same capacity/category where registration is sought from SEBI. Registration with authorities, which are responsible for incorporation, is not adequate to qualify as Foreign Institutional Investor.      The applicant is required to have the permission under the provisions of the Foreign Exchange Management Act, 1999 from the Reserve Bank of India. The Applicant must be legally permitted to invest in securities outside the country or its in-corporation / establishment. The applicant must be a "fit and proper" person. The applicant has to appoint a local custodian and enter into an agreement with the custodian. Besides it also has to appoint a designated bank to route its transactions. Payment of registration fee of US $ 5,000.00

Sub account
A ‘Sub-account’ is the underlying fund on whose behalf the FII invests. Sub- Accounts can include those foreign corporate, foreign individuals, and institutions, funds or portfolios established or incorporated outside India on whose behalf investments are proposed to be made in India by a FII. It is possible for a registered sub-account to transfer from one FII to another. In such a case, the FII to whom it is proposed to be transferred has to request SEBI with the following documentation.   A declaration that it is authorised to invest on behalf of the sub-account. A no-objection letter for the transfer of the sub-account from the transferor FII.


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Investment by FII is restricted to 24% of paid-up capital of the company which can be extended up to 49% per sectoral cap by board resolution followed by special resolution. Single FII investment can’t exceed 10% of paid-up capital of the company and single subaccount investment can’t exceed 5% of the paid-up capital.

Eligible Securities
A FII can make investments only in the following types of securities  Securities in the primary and secondary markets including shares, debentures and warrants of unlisted , to- be-listed companies or companies listed on a recognized stock exchange  Units of schemes floated by domestic mutual funds including Unit Trust of India, whether listed on a recognized stock exchange or not, and units of scheme floated by a Collective Investment Scheme.   Government Securities Derivatives traded on a recognized stock exchange – like futures and options. FIIs can now invest in interest rate futures that were launched at the National Stock Exchange (NSE) on 31st August, 2009.   Commercial paper Security receipts


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FII Regulations
Investment by FIIs is regulated under SEBI (FII) Regulations, 1995. Following are some of important regulations by SEBI and RBI:   A Foreign Institutional Investor may invest only in the instruments mentioned earlier. The total investments in equity and equity related instruments (including fully convertible debentures, convertible portion of partially convertible debentures and tradeable warrants) made by a Foreign Institutional Investor in India, whether on his own account or on account of his sub- accounts, should be at least seventy per cent of the aggregate of all the investments of the Foreign Institutional Investor in India, made on his own account and through his sub-accounts.  The cumulative debt investment limit for FII investments in Corporate Debt is USD 15 billion. The amount was increased from USD 6 billion to USD 15 billion in March 2009.  USD 8 billion will be allocated to the FIIs and Sub-Accounts through an open bidding paltform while the remaining amount is allocated on a ‘first come first served’ basis subject to a ceiling of Rs.249 cr. per registered entity.  The debt investment limit for FIIs in government debt in G-secs currently capped at $5 billion and cumulative investments under 2% of the outstanding stock of G-secs and no single entity can be allocated more than Rs. 1000 cr of the government debt limits. With regard to investments in the secondary market SEBI states that:   the Foreign Institutional Investor is allowed to transact business only on the basis of taking and giving deliveries of securities bought and sold short selling in securities is not allowed. However, in December 2007, abroad regulatory framework enabling short selling by FIIs was put in place. Which stipulated that naked short selling was not permitted and settlement of securities sold short would be through a mechanism for borrowing of securities     FIIs are not permitted to short sell equity shares which are in the caution list of RBI; Equity shares can be borrowed by FIIs only for the purpose of delivery into short sale. No transactions on the stock exchange can be carried forward Transaction of business in securities can be carried out only through stock brokers who has been granted a certificate by the Board


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A Foreign institutional Investor or a sub-account having an aggregate of securities worth rupees ten crore or more, as on the latest balance sheet date, can settle their only through dematerialised securities.

Securities have to be registered in the name of the Foreign Institutional Investor, if he is making investments on his own behalf or in his name on account of his sub-account, or in the name of the sub-account, in case he is investing on behalf of the sub-account. The purchase of equity shares of each company by a Foreign Institutional Investor investing on his own account can not exceed ten percent of the total issued capital of that company. Investment by individual FIIs cannot exceed 10% of paid up capital. Investment by foreign registered as sub accounts of FII cannot exceed 5% of paid up capital. All FIIs and their subaccounts taken together cannot acquire more than 24% of the paid up capital of an Indian Company. An Indian Company can raise the 24% ceiling to the Sectoral Cap / Statutory Ceiling by passing a resolution by its Board of Directors followed by passing a Special Resolution to that effect by their General Body. For FIIs investing in the equity shares of a company on behalf of his sub-accounts, the investment on behalf of each such sub-account can not exceed ten percent of the total issued capital of that company. SEBI has also placed the position limits in derivatives contracts :  The FII position limits in a derivative contracts (Individual Stocks)

The FII position limits in a derivative contract on a particular underlying stock i.e. stock option contracts and single stock futures contracts are: For stocks in which the market wide position limit is less than or equal to Rs. 250 Cr, the FII position limit in such stock is 20% of the market wide limit. For stocks in which the market wide position limit is greater than Rs. 250 Cr, the FII position limit in such stock is Rs. 50 Cr.  FII Position limits in Index options contracts

FII position limit in all index options contracts on a particular underlying index is Rs. 250 Crore or 15 % of the total open interest of the market in index options, whichever is higher,


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per exchange. This limit is applicable on open positions in all option contracts on any underlyring index.  i. FII Position limits in Index futures contracts FII position limit in all index futures contracts on a particular underlying index is Rs. 250 Crore or 15 % of the total open interest of the market in index futures, whichever is higher, per exchange. ii. This limit is applicable on open positions in all futures contracts on a particular underlying index. In addition to the above, FIIs can take exposure in equity index derivatives subject to the conditions that : iii. iv. Short positions in index derivatives (short futures, short calls and long puts) cannot exceed (in notional value) the FII’s holding of stocks. Long positions in index derivatives (long futures, long calls and short puts) can not exceed (in notional value) the FII’s holding of cash, government securities, TBills and similar instruments.  i. ii. FII Position Limits in Interest rate derivative contracts At the level of the FII - The notional value of gross open position of a FII in exchange traded interest rate derivative contracts is US $ 100 million. In addition to the above, FIIs cany take exposure in exchange traded in interest rate derivative contracts to the extent of the book value of their cash market exposure in Government Securities. iii. At the level of the sub-account - The position limits for a Sub-account in near month exchange traded interest rate derivative contracts is the higher of: Rs. 100 Cr Or 15% of total open interest in the market in exchange traded interest rate derivative contracts. Investments by the Foreign Institutional Investor are also be subject to Government of India Guidelines. A foreign Institutional Investor or sub-account may lend securities through an approved intermediary in accordance with the stock lending scheme of the Board. Regulations for Portfolio Investments by NRIs/PIOs include:  Non Resident Indian (NRIs) and Persons of Indian Origin (PIOs) can purchase/sell shares/convertible debentures of Indian companies on Stock Exchanges under


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Portfolio Investment Scheme. For this purpose, the NRI/PIO has to apply to a designated branch of a bank, which deals in Portfolio Investment. All sale/purchase transactions are to be routed through the designated branch.  An NRI or a PIO can purchase shares up to 5% of the paid up capital of an Indian company. All NRIs/PIOs taken together cannot purchase more than 10% of the paid up value of the company. (This limit can be increased by the Indian company to 24% by passing a General Body resolution).  The sale proceeds of the repatriable investments can be credited to the NRE/NRO etc. accounts of the NRI/PIO whereas the sale proceeds of non-repatriable investment can be credited only to NRO accounts.  The sale of shares is subject to payment of applicable taxes.

For ascertaining the track record in case of a newly established fund, the track record of the investment manager of the fund who has promoted it will be considered. Such investment manager has to furnish the details in respect of disciplinary action, if any, taken against it. University Funds, Endowments, Foundations, Charitable Trusts and Charitable Societies may be considered for registration even if they are not regulated by a foreign regulatory authority. An asset management company, investment manager or advisor or an institutional portfolio manager set up and / or owned by Non Resident Indians are eligible to be registered as FII. However, they shall not invest their proprietary funds. Additional restrictions for FII/sub-account registration  Nominee Company and a Power of Attorney holder are not eligible to be registered as FII. Where the applicant for FII or sub-account registration is a University fund, Endowments, Foundations or Charitable trusts or charitable societies, SEBI will also consider whether the applicant has been serving public interest. Applicants for registration as sub-account in category of “foreign corporate” and “foreign individual” will have to meet the specified requirements. These are as under:     In case of a “Foreign Corporate” means a body corporate incorporated outside India and fulfils the following conditions: Its securities are listed on a stock exchange outside India; It has asset base of not less than US $ 2 billion; It had an average net profit of not less than US $ 50 million during the 3 financial years preceding the date of the application.


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    

In case of a “ Foreign Individual” means a foreigner who fulfills the following conditions: Has a net worth of not less than US $ 50 million; Holds the passport of a foreign country for a period of at least 5 years preceding the date of application; Holds a certificate of good standing from a bank; The client of the FII or any other entity which belongs to the same group as the FII, for a period of at least 3 years preceding the date of the application.

Conditions for issuance of offshore derivative instruments    Offshore derivative instruments are issued only to persons who are regulated by an appropriate foreign regulatory authority; after compliance with the stated ‘know your client’ norms


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Offshore Derivatives Instruments (Participatory Notes)
Offshore derivatives instruments (ODIs) are investment vehicles used by overseas investors not registered with the SEBI for an exposure in Indian equities or equity derivatives. They may not be registered with SEBI, either because they do not want to, or due to regulatory constraints for which they are not allowed to. It is a registered FII that makes purchases on behalf of these investors and the FII s affiliate issues those ODIs. ODIs include equity-linked notes, capped return notes, participating return notes, etc. Participatory Notes (P-Notes) is one of the categories of ODIs. The underlying asset class could be stocks, and returns would be directly related to the appreciation in prices of those stocks. India based brokerages to buy India-based securities / stocks and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors. Since international access to the Indian capital market is limited to FIIs. The market has found a way to circumvent this by creating participatory notes

Eligibility for Investment
Any entity incorporated in a jurisdiction that requires filing of constitutional and/or other documents with a registrar of companies or comparable regulatory agency or body under the applicable companies legislation in that jurisdiction; Any entity that is regulated, authorized or supervised by a central bank, such as the Bank of England, the Federal Reserve, the Hong Kong Monetary Authority, the Monetary Authority of Singapore or any other similar body provided that the entity must not only be authorized but also be regulated by the aforesaid regulatory bodies; Any entity that is regulated, authorized or supervised by a securities or futures commission, such as the Financial Services Authority (UK), the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Securities and Futures Commission (Hong Kong or Taiwan), Australian Securities and Investments Commission (Australia) or other securities or futures authority or commission in any country, state or territory; Any entity that is a member of securities or futures exchanges such as the New York Stock Exchange (Sub-account), London Stock Exchange (UK), Tokyo Stock Exchange, NASD (Sub-account) or other similar self-regulatory securities or futures authority or commission within any country, state or territory provided that the aforesaid organizations which are in


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the nature of self regulatory organizations are ultimately accountable to the respective securities / financial market regulators. Any individual or entity (such as fund, trust, collective investment scheme, Investment Company or limited partnership) whose investment advisory function is managed by an entity satisfying the above criteria P-Notes are issued to the real investors on the basis of stocks purchased by the FII. The registered FII looks after all the transactions, which appear as proprietary trades in its books. However, it is not obligatory for the FIIs to disclose their client details to the SEBI, unless asked specifically. P-Notes with stocks as underlying assets can be issued by an FII, subject to a limit of 40% of the overall assets under the custody of that FII

The Issues with P-Notes
As per SEBI rules, the FII issuing ODIs/P-Notes should know the eventual beneficiary to whom the instruments were being issued to. Though FIIs, which had to comply with the ‘know-your customer’ norms, are usually aware of the identity of the investor to whom the note was issued, it is possible for the investor to sell the notes to another player resulting in multi-layering. There were apprehensions among tax officials that PNs were becoming popular among Indian money launderers who used the instrument to first take out funds out of the country, through the hawala route, and then get it back using P Notes. Consequently, there were fears that P-Notes are being used as a vehicle by promoters, market operators, and politicians to repatriate illegitimate funds parked abroad. There were also concerns that too much money flowing into the derivatives segment through the P-Note route is adding to volatility, and pressures on the currency. There were also concerns that terrorist organizations were channelling money through these offshore derivatives instruments and using the profits to fund their activities. In October 2007, SEBI proposed a ban on fresh issue of PNs which had equity derivatives are the underlying assets, and required the existing positions to be unwound over a period of the following 18 months. The total amount for which P-notes could be issued by each FII was also capped at 40 per cent of the total assets under the custody of the respective FII. This was a step to ensure transparency in the flow of funds. Despite the P-note ban, Indian stock markets continued to rally in the period following this move for a full four months until January 2008. This was when the credit crisis unleashed


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itself first in the US and then spread into a global credit and liquidity cru crunch, triggering a reversal in FII flows from the Indian market. As global liquidity dried up, FII flows reduced dramatically. In an effort to contain the situation, SEBI announced the lifting of all its earlier restrictions on p notes in October 2008. p-notes Foreign institutional investors can now issue P notes with derivative as underlying. The 40 ign P-notes per cent cap on P-note issue was removed and P Note holders are no longer required to wind removed up their positions in Indian stocks. The SEBI’s move to ease the curbs on P-Notes was aimed at shoring up market sentiments Notes and arrests the outflow of funds from the Indian Capital Market. The reversal, thou it took though immediate effect, hadn’t helped reverse the direction of fund flows immediately. It is only in n’t reverse the last few months of 2009 that the stock markets are beginning to look up again. hs The lifting of the ban has, however, not lead to an increase in the number of P , P-Notes investing in the country. P-note investments had hit peak in September 2007 with 51 per cent note of the Assets under management of FIIs entering through the P Notes route While Portfolio ts P-Notes investments through P-notes route witnessed a sharp decline from 48% in October 2007 to notes 29.8% in October 2008 when there were restrictions on this route, the total share of P P-note investments fell from 19.8 per cent in October 2008 to 15.5 per cent in August 2009. The following graph shows the proportion of Assets under management of FIIs coming through the Participatory Notes route.

PN Investnents as % of FII AUM

50 40 30 20 10 0


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Hedge Funds and P-Notes:
A significant portion of the global portfolio investments made in India have come in via the hedge fund route Hedge funds are not regulated in their home country. Therefore they do not qualify for registration as an FII under SEBI’s regulations. Hedge funds and other foreign investors, due to confidentiality concerns among others, have used the P-notes route. Hedge fund managers wanting exposure to Indian securities have two ways to do so. The first is to register with SEBI as an FII, through a Mauritius based operating company. This is not feasible for a hedge fund, since it has a high probability of being denied and also would not benefit from the regulatory and disclosure requirements that FIIs must comply with. Moreover, due to investment restrictions on FIIs, registering as an FII would not be in-line with investment strategies and styles that most hedge funds follow. The most common route taken by hedge fund managers wanting exposure to Indian securities is via the P-notes route. For example, a North American hedge fund wanting to hold Indian securities would place an order with a large brokerage house for P-notes in the underlying security. The brokerage house would have an operation in Mauritius, which in turn would be registered as an FII with SEBI. The order placements, the issuance of the P-notes and the final clearing of the trade would take place through internal systems of the brokerage house. The large broker in essence would act like the market itself.


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Double Taxation Avoidance Agreement (DTAA)
A major portion of international capital flows entering the Indian economy is aided by taxation laws and systems among countries like the Double Taxation Avoidance Agreement. The phenomenal growth in international trade and commerce and increasing interaction among nations, citizens, residents and businesses of one country has extended their sphere of activity and business operations to other countries. A person earning any income has to pay tax in the country in which the income is earned (as Source Country) as well as in the country in which the person is resident. As such, the income is liable to be taxed in both the countries. To avoid this hardship to individuals and also with a view to ensure that national economic growth does not suffer, the Central government under Section 90 of the Income Tax Act has entered into Double Tax Avoidance Agreements (DTAA) with other countries. Definition: Double taxation can be defined as the levy of taxes on income or capital in the hands of the same tax payer in more than one country, in respect of the same income or capital for the same period DTAAs provide for the following reduced rates of tax on dividend, interest, royalties, technical service fees, etc., received by residents of one country from those in the other. Where total exemption is not granted in the DTAAs and the income is taxed in both countries, the country in which the person is resident and is paying taxed, the credit for the tax paid by that person in the other country is allowed.

DTAT with Mauritius
The Indo-Mauritius DTAT was first signed in 1983. The main provision of the agreement was that no resident of Mauritius would be taxed in India on capital gains arising out of sale of securities in India. The treaty gives capital gains exemption for investments if routed via Mauritius. The treaty remained on paper until 1992 when FIIs were allowed into India. The same year, Mauritius passed the Offshore Business Activities Act which allowed foreign companies to register in the island nation for investing abroad. Registering a company in Mauritius has obvious advantages such as, total exemption from capital gains tax, quick incorporation, total business secrecy and a completely convertible currency. For foreign investors willing to invest in India, it made sense to set up a subsidiary in Mauritius and route their investments through that country. By doing so, they would avoid paying capital gains tax all together -- India won't tax because the company is based in


Foreign Institutional Investors September 14, 2009

Mauritius and Mauritius had anyway exempted investors from capital gains tax. In the last few years Mauritius has emerged as the largest foreign investor [analysts estimate about 25% of all inbound FII money is routed thorough Mauritius] in India thus clearly indicating that it has become a tax haven for foreign investors. This indicates the route investors are taking into India to avoid otherwise due taxation. There are allegations that foreign companies are using ‘notional residence’ in Mauritius to avoid paying taxes in India. It has even been claimed that tax losses to India are more than incoming investments. In spite of the controversies generated, it has been kept in its present form. As it was felt that changing its clauses would lead to flight of capital from the country, slowing down foreign investment inflows and may lead to a significant stock market crash. It is reported that Indians used Mauritius-registered companies and Mauritius offshore trusts to hold assets abroad beyond the reach of Indian tax laws. This is called 'round-tripping', where Indians re-route their money stashed abroad through the Mauritius route. It is now hoped that the Treaty, duly modified, will help encourage Indian investments in Mauritius, rather than the other way around. It is expected that Mauritius will agree to the changes as having signed similar DTATs with other ASEAN countries, it will be able to highlight its attraction as a tax haven and also plug gaps to stop both ‘round tripping’ and ‘treaty shopping’. The list of FIIs that have preferred to invest in India via Mauritius includes Aberdeen Asset Management, Citi Group Global, CLSA Merchant Bankers, Deutsche Securities, Emerging Markets Management LLC, Fidelity Assets Management, Golden Sachs Investments, HSBC Global Investment, JP Morgan Fleming Asset Management, Merrill Lynch Investment Managers and UBS Securities Asia

DTAA with Singapore – Lesson Learnt
Under the India Singapore DTAA (2005), a Singapore tax resident is not subject to Indian taxes on capital gains derived from the sale of shares in an Indian company. The changes introduced in 2005 put the Singapore DTAA on par with the India-Mauritius DTAA with respect to tax exemption on capital gains but include two important limitations on beneficial treatment for capital gains: First, investors from Singapore do not receive an exemption from Indian capital gains tax if the affairs of the company were arranged with the "primary purpose" of taking advantage of


Foreign Institutional Investors September 14, 2009

the capital gains exemption (the so-called "limitation on benefits"). Specifically, a "shell/conduit" company cannot avail itself of the capital gains exemption, but provides a safe harbour for companies listed in India or Singapore or a company with more than S$200,000 or Rs. 5 million of total annual expenditures on operations in Singapore in the preceding 24month period. A second important limitation ties the fate of the capital gains exemption under the Singapore DTAA to the India-Mauritius DTAA. Investors from Singapore will lose their capital gains exemption if India and Mauritius amend their DTAA to take away the corresponding exemption. The Indian Government has entered into similar DTAAs with 79 countries including Cyprus (renegotiated now), UAE, Spain, Luxembourg etc. and other courtiers such as Saudi Arabia and Kuwait are eager to have such agreements with India in place.


Foreign Institutional Investors September 14, 2009

Advantages and Disadvantages of FIIs
FII flows into a country are associated with several advantages and disadvantages. The advantages of FII flows into the country include:

 Enhanced flows of equity capital  FIIs have a greater appetite for equity than debt in their asset structure. The opening up the economy to FIIs has been in line with the accepted preference for non-debt creating foreign inflows over foreign debt. Enhanced flow of equity capital helps improve capital structures and contributes towards building the investment gap.  Managing uncertainty and controlling risks  FII inflows help in financial innovation and development of hedging instruments. Also, it not only enhances competition in financial markets, but also improves the alignment of asset prices to fundamentals.  Improving capital markets  FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets.  Equity market development aids economic development.  By increasing the availability of riskier long term capital for projects, and increasing firms’ incentives to provide more information about their operations, FIIs can help in the process of economic development.  Improved corporate governance  FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms’ operations, improve corporate governance. Bad corporate governance makes equity finance a costly option. Also, institutionalization increases dividend payouts, and enhances productivity growth.

 Problems of Inflation: Huge amounts of FII fund inflow into the country creates a lot of demand for rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created  Problems for small investor: The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high then they can bring in huge amounts of funds in the country’s stock markets and thus have great influence on the way the stock markets


Foreign Institutional Investors September 14, 2009

behaves, going up or down. The FII buying pushes the stocks up and their selling shows the stock market the downward path. This creates problems for the small retail investor, whose fortunes get driven by the actions of the large FIIs.  Adverse impact on Exports: FII flows leading to appreciation of the currency may lead to the exports industry becoming uncompetitive due to the appreciation of the rupee.  Hot Money: "Hot money" refers to funds that are controlled by investors who actively seek short-term returns. These investors scan the market for short-term, high interest rate investment opportunities. "Hot money" can have economic and financial repercussions on countries and banks. When money is injected into a country, the exchange rate for the country gaining the money strengthens, while the exchange rate for the country losing the money weakens. If money is withdrawn on short notice, the banking institution will experience a shortage of funds.


Foreign Institutional Investors September 14, 2009

Trends in FIIs
In 1993, when investments in FII s were introduced, Pictet Umbrella Trust Emerging Markets’ Fund, an institutional investor from Switzerland, was the only FII to enter the Indian market. While in 1994, no new registrations were reported, between 1995 and 2003, an average of 51 new FIIs began operations in the country each year. The graph below clearly indicates the steep increase in number of FIIs since the year 2003. (The data in the chart refer FIIs to the number of registered FII’s at the end of each calendar year). Currently, there are 1,695 registered FIIs and 5,264 registered sub accounts (As on 11th September, 2009). sub-accounts
Number of Registered FIIs 1800 1600 1400 1200 1000 800 600 400 200 0 1594 1219 823 517 637 993 1695








Since 1993 when FII’s were first allowed to enter the India, there has always been a preference towards investing in equity than debt. The following graph shows the debt and equity FII flows from
N e 15000 t I 10000 n v e 5000 s t 0 m e n -5000 t
8698.4 6628.5 2806.6 1675.2 1433.6 749 37.1 48.6 11.7 27.1

Debt and Equity FII Flows
10706 8669.3 8106.2




1001.3 699.8

1224.8 882.5

2340.2 2636.1 -158.9

Equity Debt

-11974 11974

-10000 -15000

Figures in $ mn 1


Foreign Institutional Investors September 14, 2009

Trends in Equity
There has been a steep rise in FIIs in Equity beginning 2003. Except for 2008, since 1993, only once have foreign investors turned net sellers. This has primarily been on account of rise in global liquidity conditions primarily driven by low interest rates in US that was affected to counter recessionary condition post the dot –com bubble, a rising aversion com towards US, for its huge current account deficit and growth of the ‘emerging’ economies like China, India etc. FIIs have been progressively raising their investments in Indian market progressively since 2003, the year that saw the beginning of the bull run in the Sensex. This continued until bull-run 2008, when the recession hit. Liquidity dried up. So did the risk aversion of investors towards risk-aversion emerging markets. The year 2009 has seen a net inflow of USD 8748.2 million in equities so far. The cumulative investments in equity stand at USD 63902 million or Rs. 272772.70 crores. The graph below shows the trend in FII sales and purchases over the 1999 2009 period. As evident from 1999below, the FII activity has undertaken a beating in 2009 with lower purchases and higher net sales.
1,40,000 1,20,000 1,00,000 80,000 60,000 40,000 20,000 0 -20,000 -40,000 Net Purchase Sales Purchase

Trends in Debt Flows
Investments in Debt have been low as compared to Equity owing to the following reasons:  First, most of the investments in Government securities remain restricted in India owing to nts persistent budgetary deficits. The above 80% public debt is significant cause for concern.  Second, debt tolerance of foreign investors in emerging market economies has been low, especially during times of credit crunch. ring

Equity FII flows in Rs. Crores


Foreign Institutional Investors September 14, 2009

 Thirdly, low returns in the debt market compared to attractive returns in the equity market encouraged greater flows to domestic equity markets.  The corporate debt market is also underdeveloped. Weak market infrastructure lim limits liquidity and the price discovery process. However, the period 2003-08 witnessed relatively high debt flows as compared to the 08 preceding periods into currency bond markets owing to low inflation and high global liquidity. FII investments into Debt have been USD 514.9 million for in the month of August 2009 and USD 544.80 million in the first ten days of September, 2009. Cumulative debt FII flows till 11th September stand at the level of USD 6252.30 million or Rs. 26639.10 crores. The graph shows flows into debt from 1999 to 2009. nto
FII Debt flows ( in Rs. crores)

15,000.00 10,000.00 5,000.00 0.00 -5,000.00



Net Purchase


FIIs, Stock Markets and the Exchange Rate
FIIs are a major determinant of the direction in which the stock market moves. The following graph shows the movement of the BSE Sensex along with net FII flows from January 2004 to March 2005.


Foreign Institutional Investors September 14, 2009
25000 20000 Net FII flows( in USD mn) 15000 10000 5000 0 -5000 -10000 -15000 -20000

The Sensex achieved a peak near the end of 2007.This also coincided with huge FII oincided investments into the Indian markets as can be seen from the graph. FIIs profit from investing in emerging financial stock markets. The FII buying pushes the stocks up and their selling shows the stock market the downward path. The markets were heavily affected by the FIIs markets selling. FIIs also have an impact on to the foreign exchange rate. For every foreign currency inflow that FIIs bring in, there is demand for the domestic currency (Rupee).Consequently an increase in the demand for Rupee creates pressure for the currency to appreciate with regard Rupee to the dollar. The following chart explains the same trend in the recent months.
25000 20000 15000 60 50
Re- $ Exchange Ra te



30 10000 20 5000
Relationship between Sensex(FIIs) and Exchange Rates

10 0 Sensex Re-$ Rate



Foreign Institutional Investors September 14, 2009

The period between January 2007 and June 2007 witnessed an approximate 10% appreciation of the Rupee as the Sensex rose in response to FIIs. In the graph we see the gap widening. During the whole period between April 2008 and February 2009, a fall in Sensex due with FII outflows is associated with the depreciation of the Rupee. Considering that Sensex (stock market) movements are largely driven by movements in FIIs, the relationship between exchange rate movements and foreign institutional inflows become evident.


Foreign Institutional Investors September 14, 2009

Recent Developments
FII Index
FIIs are the most successful investors in India and their investments and also determine the direction of Indian stock market. The FIIs have outperformed the Domestic Institutions Investors by over 10 per cent in the last five years. The FIIs have also outperformed the corporate investors. A new index, namely the Instanex FII index came into existence to compete with the Nifty and Sensex. Instanex FII index tracks 15 stocks in which FII funds have been invested. These stocks account for 55 per cent of the market cap of the FII holdings in India and the top 100 stocks they own account for 90 per cent of their holdings in India. The Index has been developed by and is owned by Instanex Capital Consultants Pvt. Ltd., Mumbai, India. The Index comprises the top 15 companies by value of FII holdings subject to  Stock future listed in India,  Restriction of company weight to 20%, industry to 30% and principal shareholder to 30%. The companies included in the Index and their weights are as follows: RIL : 16.24% Bharti Airtel : 13.36% HDFC: 12.56% 8.45% BHEL : 5.44% HDFC Bank : 5.36% 4.09% SBI : 3.77% 2.13% The Index weights are based on adjusted market value of holdings. The Index is adjusted for all corporate actions, including bonus, split and rights. Reviews are conducted quarterly and companies are deleted from the Index if they are not among the top 20 FII holdings. The base date is September 30, 2003 (=100). NTPC : 2.97% L&T :2.69% TCS: 2.57% Sun Pharma : ITC : 4.59% HUL : 4.12% ONGC: Infosys: 11.66% ICICI Bank :


Foreign Institutional Investors September 14, 2009

FII investments through QIPs
QIPs are private placements or issuances of certain specified securities by Indian listed companies to qualified institutional buyers in accordance with the provisions of SEBI guidelines. Qualified Institutional placements or QIPs were introduced in mid-2006. Indian companies that are listed on stock exchanges having nationwide terminals — the BSE and NSE have been raising capital through the QIP route. Quarterly Institutional buyers are preferred primarily because these entities have a large risk appetite, possess the general expertise and have the experience to make an informed decision. In August 2008, SEBI liberalised the pricing conditions for QIPs by reducing the period of reckoning to an average of two weeks’ stock price, prior to the relevant date, against the earlier requirement of taking the higher of the previous six months’ or 15 days’ average price. The pre-existing slowdown in the markets led to attractive valuations for the investors. Companies have taken advantage of this revision in pricing guidelines .Unitech, raised Rs 1,621 crores in April 2009 at Rs 38.50 per share, and again raised Rs. 2,760 crores in July 2009 at Rs 81 per share. Other companies which successfully raised capital through QIPs were HDIL, Shobha Developers, Network 18, Dewan Housing and Bajaj Hindustan. Most of the companies which came out with QIPs were in the real-estate/infrastructure sector. However, some companies like GMR Infrastructure were not so successful and had to withdraw their issue and GVK Power and Infrastructure had to scale down by nearly 60% due to problems in the valuations. Domestic institutional investors, especially life insurers kept away from the QIPs on valuation concerns. However, FIIs which were net sellers had purchased Rs 9,500 crores in the same period. This led several FIIs to pick up the target stocks via QIP before the July 6th Budget and offload the same after the budget session. As per a CRISIL study, 10 out of 13 QIPs are currently quoting below the offer price. Since most of QIPs were in the reality and infrastructure sectors, one explanation is that FIIs came in expecting some quick gains from significant sops to the infrastructure and housing sectors in the Budget. It is also possible that the rush for QIPs was driven largely by short-term considerations, where the FIIs hedged their bets by taking short positions in the issuers’ stock even as they bought into the offers.


Foreign Institutional Investors September 14, 2009

New sources of FII funds
The Securities and Exchange Board of India is in talks with the Cayman Islands Monetary Authority (Cima), over allowing funds based in the Caribbean into the country. Cayman Islands is one of the world’s largest tax havens and a lot of global hedge funds are based out of Cayman Islands Sebi has received numerous applications from Cayman-based funds since June when Cima was admitted as a full member of the international body of securities market regulators, the International Organisation of Securities Commissions (Iosco), Iosco's constituents regulate more than ninety percent of the world's securities markets. Funds from Cayman Islands were usually not favoured by SEBI owning to lack of transparency and difficulty in establishing the owner base. Consequently, these investments were viewed unfavourably and any Cayman fund seeking to invest in India had to be carefully examined. Post Cayman’s admission to Iosco, Sebi is now determining which grades of investment funds can be admitted expeditiously and which should be examined more carefully. Presently, there are 19 registered foreign institutional investors from Cayman Islands, taking the total to 19. The two recent additions have been Fir Tree Capital Opportunity Master Fund and Fir Tree Value Master Fund. The fund base of Cayman Islands is huge. There are about 9870 funds based there. Indian markets can expect more inflow from Cayman Island if SEBI agrees to let them come in.


Foreign Institutional Investors September 14, 2009

 Increase cap on G-Sec Bond Markets : Currently, the cap on FII investments in the bond market is USD 6 Billion. As per the new budget, proposes to borrow Rs.4.5 lakh crore in 2009-10 to support its infrastructure and other developmental projects. This could be opened up to the FIIs so that they can take part in India’s hitherto almost closed debt market. The Indian debt markets are not fully developed and see low volumes. The lifting of the cap on FIIs will increase the traded volumes and it will also help in preventing the ‘crowding out’ of investment for private enterprises.  Allow dollar settlements in India :

The suggestion by SEBI to permit dollar settlements for FIIs would revolutionise the way in which they invest in the country. This will help mitigate risks of currency fluctuations for FIIs, and help in improve the volume and liquidity of the derivatives market. With dollar settlements, many participants, who want to take exposure to Indian markets through index buying, will be able to participate freely. This, in turn, will give stability to Indian markets as there will be buying of underlying stocks by the sellers of these contracts to FIIs. At present, settlements in India are done in rupee denominations. As a result, a number of FIIs, who intend to trade in Nifty futures, take the Singapore route where CNX Nifty index futures are traded on SGX. About 50 per cent of the total open interest (OI) build-up in Nifty futures takes place on the SGX, which allows settlements in US dollar. This enables different types of FIIs to operate there. Also, low transaction costs due to the absence of securities transaction tax, stamp duty and P-note complications have resulted in a gradual shift of FIIs into offshore markets. Settlements in dollar would also help in reducing the volatility in dollar-rupee conversion value caused due to FII flows. Each time a settlement is done, a seller of futures contracts to an FII would buy an equivalent amount of underlying stocks to hedge his/her exposure due to the sale. This would increase the trading volume and liquidity of Indian markets, once dollar settlement is allowed.  Stricter implementation of regulation to curb p-notes etc.


Foreign Institutional Investors September 14, 2009

To prevent the misuse of the participatory notes, there should be stricter implementation of the regulations. Tough implementation of KYC norms should be done. In the long run, the group is of the opinion that registration procedures for FIIs should be made simpler after which P-Notes should be done away with.

www.sebi.gov.in www.rbi.org www.livemint.com http://www.economist.com http://www.ficci.com/media-room/speechespresentations/2009/jan/petro/Bhashit%20Dholakia.ppt http://blogs.livemint.com/blogs/livelounge/archive/tags/Participatory%20Notes%20policy%2 0SEBI/default.aspx http://www.business-standard.com/india/storypage.php?autono=339221


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