Foreign direct investment (FDI) flows into the primary market whereas foreign institutional investment (FII)

flows into the secondary market, that is, into the stock market.

All other differences flow from this primary difference. FDI is perceived to be more beneficial because it
increases production, brings in more and better products and services besides increasing the employment
opportunities and revenue for the Government by way of taxes. FII, on the other hand, is perceived to be
inferior to FDI because it only widens and deepens the stock exchanges and provides a better price
discovery process for the scrips.

Besides, FII is a fair-weather friend and can desert the nation which is what is happening in India right now,
thereby puling down not only our share prices but also wrecking havoc with the Indian rupee because when
FIIs sell in a big way and leave India they take back the dollars they had brought in.

Indian Rupee rise or fall is primarily due to demand and supply of this currency in the market.
Liberalization has essentially allowed investments by foreign companies (in the form of FDI) and
foreign investor (in the form of FII).

Initially, we wanted inflow of dollars as our Balance of Payment (BOP) was not in
good shape. However, over a period of time, we have managed to attract foreign fund
inflow in match to that of China. In recent times, Indian economy is facing the problem of surplus
for the first time. Then, we should be happy about it, as we have successfully solved the problem
of BOP. But unfortunately, its not so simple, as rise in foreign fund inflow (in the form of FII or
FDI) will impact our currency valuation, which further affects Indian economy as a whole, and the
job of RBI is to take care of the turmoil and keep balance in the system.

So we have gone though a couple of issues here which would help us in analyzing this issue in a
better manner. It is seen that the following would be the issues primarily that would be getting
affected: -

 FDI Vs FII

It is most important to understand distinction between these two. When FDI comes in the country
then it is essentially in the form of long term investment which will not only bring funds but create
job opportunity too. Whereas when FII brings fund in the country, it is essentially for short term
and primarily invested in capital markets but will not lead to any other economic activity like job
creation, etc. It is clear from this as to which mode of fund flow is intended and why. However,
some believe capital markets are indications of how good or well the development is happening in
the country.

 Fluctuation in Rupee due investment in Dollar (FII or FDI)

It is seen that for every dollar invested, the equivalent amount of rupee (either Rs. 45 or Rs. 40) is
pumped in the system. As a result of this, increase in fund flow in India results in rupee
appreciation. This appreciation in rupee can be curtailed by RBI by using a method called as
MSS (Market Stabilization Scheme) which helps in sucking-up excess liquidity from the system.

 Impact on Import due to Fluctuation in Rupee

It is seen that as rupee appreciates, the imports become cheaper, which in turn leads to increase
in imports, and vice-versa is also true. Some say this is good as we will get less burden of crude
oil bill, especially when experts predict crude oil price might reach $100 a barrel.
 Infact, that is one of the reasons that in recent times Energy Companies (Power
Sector-Imports Coal and Oil Marketing Companies-Imports Crude Oil) stocks have
risen in capital markets.

 Impact on Export due to Fluctuation in Rupee

It is seen that as rupee appreciates, the exports drop due to relative cost of Dollar viz-a-viz Rupee
decreasing. However, this can be reduced by a concept of Currency Hedging.

 Impact on Inflation due to Fluctuation in Rupee

Inflation in simple terms means excess of liquidity. Often it is seen that when inflation is high, the
cost of goods start increasing, and vice versa is also true. When there is excess dollar in market,
it increases the rupee circulation in the system which in turn increase inflation. However, this can
be curtailed by RBI as mentioned above.

 Impact on Interest Rate due to Fluctuation in Inflation

It is seen that when inflation increases, interest rate increases, and vice-versa is also true. This is
because if interest rate is high, people would like to save from their surplus income due to high
return, and would not borrow as well because of high cost of fund.

Impact of all this on Indian Economy

Indian economy is currently undergoing a transition phase that is from a 4-6% GDP growth in late
nineties and early millennium to 8-10% GDP since last three years. In management, we always
say "process of change is always painful". The RBI is doing a good job of maintaining balance in
the system but there is a growing concern over the quality of funds coming into the country. As
discussed earlier, whether it is FII or Hedge Fund investing through P-Notes, it is more important
to see that an inclusive growth happens in the economy.

It is India’s constant endeavour to attract foreign capital, either by allowing foreign

entities to invest here, or by permitting Indian companies to raise capital from overseas
markets. Since liberalisation in 1991, the government has been opening the Indian
marketplace for investment in a calibrated manner.

Recently, the government allowed Foreign Direct Investment (FDI) in integrated

township projects. It has expressed its intention to increase FDI cap in the insurance
sector. It is also planning to allow FDI in private FM radio, within the composite limit of
20%. Presently, only FII up to 20% is permitted.

In 1992, the government permitted Foreign Institutional Investors (FIIs) to invest in all
securities traded in the secondary and primary market and also the equity of unlisted
companies. Such investments, also known as portfolio investments, are subject to various
ceilings. FII investments are described as ‘hot money’ because of the speed at which they
can travel. FE takes a Closer Look at foreign investment and the issues involved:
What is FDI?

FDI basically means investment by a foreign company for purchase of land, equipment,
buildings etc in another country. It also refers to the purchase of controlling interest in
existing operations and businesses. It could be through mergers and acquisitions. It helps
MNCs keep production costs down by accessing low-wage labour pools in developing
countries. As for developing nations, such investments help them access technology and
ensure jobs for its unemployed population.

What is portfolio investment?

It refers to the purchase of stocks, bonds, debentures or other securities by an FII.FIIs

include pension funds, mutual funds, investment trusts, asset management companies,
nominee companies and incorporated/institutional portfolio managers.

In contrast to FDI, FIIs do not invest with the intention of gaining controlling interest in a
company. They typically make short-term inve-stments. These investments are made-to-
book profits. Compared to FDI, a portfolio investor can enter and exit countries with
relative ease. This is a major contributing factor to the increasing volatility and instability
of the global financial system. Because of the very nature of such investment, FII money
is also called ‘hot money’. The rapid outflow of ‘hot money’ ,in the recent past, has
created exchange-rate problems in Argentina and in southeast Asia. Since FIIs are very
sensitive, a mere change in perception about an economy can prompt them to pull out
investments from a country.

What are investment caps?

Cap refers to a ceiling up to which a foreign entity can invest in a company. There are
FDI caps in various sectors. It means a foreign investor is allowed to invest only a portion
of equity. The remaining portion will have to be subscribed by domestic companies or
investors, which may include banks, financial institutions or the general public. For
instance, there is a cap of 26% in the insurance sector. What it means is that in a joint
venture insurance company, say Tata-AIG, the US insurance giant AIG cannot have more
than a 26% stake. The remaining portion will be subscribed by the Tatas. FDI and FII
caps are different for different sectors. Sometimes, FDI and FII caps are the same. In
certain sectors, like oil exploration and entertainment television, 100% foreign
investment is allowed, while in others like railways, no foreign investment is permitted.

Why is there a cap on foreign investment?

Every country is a sovereign entity to the extent that its government can choose what is
best for its industry, economy and the people. Even developed countries impose caps on
foreign investment. Sometimes, security concerns prompt a country to impose such
restrictions. These caps are decided on the basis of public policy and are relaxed or
tightened with the aim of serving a country’s broader interests.
Eg, when insurance was opened to the private sector in India, the government decided to
allow 26% foreign investment in joint venture companies. The aim was to allow the
private sector to gain experience and establish a foothold in the sector. Over the past few
years, the Insurance Regulatory and Development Authority (Irda) too has been able to
gain experience in regulating the insurance sector. P Chidambaram, in his 2004 Budget,
promised to raise the foreign investment cap in the sector to 49%.

As governments function in a dynamic situation, it is imperative for them to remain alive

to the changing realities of the marketplace and respond appropriately by readjusting the
ceiling of foreign investment.