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requirement for the MBA degree course of Bangalore University By NITHYASHREE .T. Reg. No. 03VWCM6067 (2003-2005) Under the guidance and support of Prof. R.Narayanaswamy Faculty Alliance Business Academy
ALLIANCE BUSINESS ACADEMY BANGALORE – 560 076 2003-05
of MBA IV Semester, studying at Alliance Business
Academy, Bangalore, hereby declare that this project titled “Foreign Institutional Investments and Influence of Foreign Institutional Investments on the Equity Stock Market of India ” has been prepared by me in partial fulfillment of the requirements of the Bangalore University MBA programme during 2003-2005. I further declare that this project has not been submitted earlier in any other university or institution for the award of any degree or diploma.
DATE: PLACE: BANGALORE NITHYASHREE.T.
GUIDE CERTIFICATION This is to certify that NITHYASHREE T. student of MBA IV semester of our Institute has completed her DISSERTATION on the topic “FII investments and its influence on Indian Stock Market”, under my guidance, and that no part of this report has been submitted for the award of any other Degree or Diploma to any other Board or University by any one else.
Date: Place: Bangalore Prof.R.Narayanaswamy Faculty Alliance Business Academy
The satiation and euphonies that accompany the success completion of a task would be incomplete without a mention of people who made it possible. So, with immense gratitude, I acknowledge all those, whose guidance and encouragement served as a beacon light and crowned my effort with success.
I thank Mr. R.Narayanaswamy, Faculty of Alliance Business Academy and my project guide for his valuable guidance and suggestions, which were vital inputs towards the completion of the project. I am indebted to Dr. Mihir Das, Faculty of Alliance Business Academy for his help in analysing, interpreting the data and for the stimulating discussion which has greatly added to the study. Lastly, I would like to thank all those who have directly or indirectly helped me complete the project successfully.
RESEARCH ABSTRACT Since the beginning of liberalization FII flows to India have steadily grown in importance. In this paper we analyze these flows and their relationship with Indian equity market. Foreign capital flows have come to be acknowledged as one of the important sources of funds for economies that would like to grow at a rate higher than what their domestic savings can support. Foreign capital flows have particularly become prominent after the advent of globalization liberalization programmes and financial reforms in various countries across the globe in 1990s. This resulted in the integration of global financial markets. As a result, capital started flowing freely across national borders seeking out the highest rate of return. Foreign portfolio inflows through FIIs, in India, are important from the policy perspective, especially when the country has emerged as one of the most attractive investment destinations in Asia. This paper reveals if the FIIs influence the Indian Equity Market. that has led to widespread implementation of
CHAPTER 1 THEORETICAL BACKGROUND Introduction When people think about globalization, they often first think of the increasing volume of trade in goods and services. Trade flows are indeed one of the most visible aspects of globalization. But many analysts argue that international investment is a much more powerful force in propelling the world toward closer economic integration. Investment, often alters entire methods of production through transfers of know-how, technology and management techniques, and thereby initiates much more significant change than the simple trading of goods. Over the past ten years, foreign investment has grown at a significantly more rapid pace than either international trade or world economic production generally. From 1980 to 1998, international capital flows, a key indication of investment across borders, grew by almost 25% annually, compared to the 5% growth rate of international trade. This investment has been a powerful catalyst for economic growth. But as with many of the other aspects of globalisation, foreign investment is raising many new questions about economic, cultural and political relationships around the world. Flows of investment and the rules that govern or fail to govern it can have profound impacts upon such diverse issues as economic development, environmental protection, labour standards and economic stability. Forms of Foreign Investment International investment or capital flows fall into four principal categories: Commercial loans: These primarily take the form of loans by banks to foreign businesses or governments. Official flows: This category refers generally to the forms of development assistance given by developed countries to developing ones.
Foreign Direct Investment (FDI): This category refers to international investment in which the investor obtains a lasting interest in an enterprise in another country. FDI is calculated to include all kinds of capital contributions, such as the purchases of stocks, as well as the reinvestment of earnings by a wholly owned company incorporated abroad (subsidiary), and the lending of funds to a foreign subsidiary or branch. The reinvestment of earnings and transfer of assets between a parent company and its subsidiary often constitutes a significant part of FDI calculations. An investor's earnings on FDI take the form of profits such as dividends, retained earnings, management fees and royalty payments. Foreign Portfolio Investment (FPI): FPI is a category of investment instruments that are more easily traded, may be less permanent, and do not represent a controlling stake in an enterprise. These include investments via equity instruments (stocks) or debt (bonds) of a foreign enterprise which does not necessarily represent a long-term interest. The returns that an investor acquires on FPI usually take the form of interest payments or non-voting dividends. Investments in FPI that are made for less than one year are distinguished as short-term portfolio flows. Until the 1980s, commercial loans from banks were the largest source of foreign investment in developing countries. However, since that time, the levels of lending through commercial loans have remained relatively constant, while the levels of global FDI and FPI have increased dramatically. Over the period 1991 - 1998, FDI and FPI comprised 90% of the total capital flows to developing countries. Similarly, when viewed against the tremendous and growing volume of FDI and FPI, the funds provided in the past by governments through official development assistance, or lending by commercial banks the World Bank or IMF, are diminishing in importance with each passing year. When one talks about the recent phenomenon of globalization therefore, one is referring in large part to the effects of FDI and FPI, and these two instruments will therefore be the primary focus of this issue brief.
Calculating Investment: Calculations of FDI and FPI are typically measured as either a "flow," referring to the amount of investment made in one year, or as "stock," measuring the total accumulated investment at the end of that year. Differences Between Portfolio and Direct Investment One of the most important distinctions between Portfolio and Direct investment to have emerged from this young era of globalisation is that portfolio investment can be much more volatile. Changes in the investment conditions in a country or region can lead to dramatic swings in portfolio investment. For a country on the rise, FPI can bring about rapid development, helping an emerging economy move quickly to take advantage of economic opportunity, creating many new jobs and significant wealth. However, when a country's economic situation takes a downturn, sometimes just by failing to meet the expectations of international investors, the large flow of money into a country can turn into a stampede away from it. By contrast, because FDI implies a controlling stake in a business, and often connotes ownership of physical assets such as a equipment, buildings and real estate, FDI is more difficult to pull out or sell off. Consequently, direct investors may be more committed to managing their international investments, and less likely to pull out at the first sign of trouble. This volatility has effects beyond the specific industries in which foreign investments have been made. Because capital flows can also affect the exchange rate of a nation's currency, a quick withdrawal of investment can lead to rapid decline in the purchasing power of a currency, rapidly rising prices (inflation) and then panic buying to avoid still higher prices. In short, such quick withdrawals can produce widespread economic crisis. This was partly the case in the Asian Economic Crisis that began in 1997. Although the economic turmoil began as a result of some broader shifts in international economic policy and some serious problems within the banking and financial sectors of the affected East Asian nations, the capital flight which ensued -some compared it to the great financial panics which took place in the United States during the 19th century -- significantly exacerbated the crisis.
Why Do Companies Invest Overseas? Companies choose to invest in foreign markets for a number of reasons, often the same reasons for expanding their operations within their home country. The economist John Dunning has identified four primary reasons for corporate foreign investments: Market seeking - Firms may go overseas to find new buyers for goods and services. Market-seeking may happen when producers have saturated sales in their home market, or when they believe investments overseas will bring higher returns than additional investments at home. This is often the case with high technology goods. Resource seeking - Put simply, a company may find it cheaper to produce its product in a foreign subsidiary- for the purpose of selling it either at home or in foreign markets. The foreign facility may be able to obtain superior or less costly access to the inputs of production (land, labor, capital and natural resources) than at home. Strategic asset seeking - Firms may seek to invest in other companies abroad to help build strategic assets, such as distribution networks or new technology. This may involve the establishment of partnerships with other existing foreign firms that specialize in certain aspects of production. Efficiency seeking - Multinational companies may also seek to reorganize their overseas holdings in response to broader economic changes. Fluctuations in exchange rates may also change the profit calculations of a firm, leading the firm to shift the allocation of its resources.
Foreign Investment Increased so Dramatically in recent Decades? As stated earlier in this brief, international investment levels have exploded in recent decades. These increases in the flows of foreign investment have themselves marked a new and distinct phenomenon in the era of globalisation. Several factors have helped drive this growth:
1) Technology. Telecommunications and transportation advances have simply made it easier to do business across large distances. As former President Clinton once pointed out, in the 1960s, transatlantic telephone lines could only accommodate 80 simultaneous calls between Europe and the United States. Today, satellites and other telecommunications infrastructure can handle one million calls at one time. Fax machines, email and the drop in the cost of air travel have also contributed significantly to the growth of FDI. As you can imagine, a business owner might think twice about trying to run an affiliate in a foreign country if communication with that office were not both easy and cheap. Changes in practices tend to be driven by changes in capabilities, and these new methods to communicate have unquestionably helped drive much of the subsequent desire to promote economic integration. 2) The lure of higher profits. Many countries in East Asia had built their phenomenal growth on a foundation based on greater integration into the international economy, particularly emphasizing export-led growth. Investors from around the world realized that access to East Asian markets and their trading partners might help them attain much higher returns on their investments than they could obtain at home. 3) Financial liberalization. Prior many countries imposed strict limits on the rights of companies and individuals to invest overseas, to purchase foreign securities, or even to hold foreign currencies. Many of these restrictions were put in place following the Great Depression of the 1930's, which had produced volatile movements of capital, triggering financial panics in some cases. Financial liberalization has been the most direct, and probably the single biggest, factor accounting for the growth of international investment flows over the past several decades. Factors Influencing Foreign Investment Decisions Now that you understand the basic economic reasons why companies choose to invest in foreign markets, and what forms that investment may take, it is important to understand the other factors that influence where and why companies decide to invest overseas. These other factors relate not only to the overall economic outlook for a country, but also to economic policy decisions taken by foreign governments, aspects that can be very political and controversial.
The policy frameworks relating to FDI and FPI are relatively similar, although there are a few differences. The determinants of FPI are somewhat complex because portfolio investment earnings are more likely to be tied to the broader macroeconomic indicators of a country, such as overall market capitalization of an economy, they can be more sensitive to factors such as:
• • • • • • •
high national economic growth rates exchange rate stability general macroeconomic stability levels of foreign exchange reserves held by the central bank general health of the foreign banking system liquidity of the stock and bond market interest rates
In addition to these general economic indicators, portfolio investors also look at the economic policy environment as well, and especially at factors such as:
• • • • • •
the ease of repatriating dividends and capital taxes on capital gains regulation of the stock and bond markets the quality of domestic accounting and disclosure systems the speed and reliability of dispute settlement systems the degree of protection of investor's rights
SURVEY OF LITERATURE:
Balance of Payments is a statistical record of ALL of a country's int'l transactions with the rest of the world, over a certain time period (quarter or year), using doubleentry bookkeeping. (private transactions and government transactions). Examples of International Transactions in BALANCE OF PAYMENT: 1. Imports (M) and Exports (X) of a) goods/merchandise and b) services 2. Cross-border Financial flows (investments in foreign stocks and bonds, real estate, interest/DIV income, business investment, FDI, etc.) 3. Foreign Aid
BALANCE OF PAYMENT ACCOUNTS 1. CURRENT ACCOUNT Exports (X) / Imports (M) of: a) Merchandise, b) Services, c) Factor income and d) Unilateral (one way) government transfers. Balance on Current Account (CA) = X + M + Net Transfer 2. CAPITAL ACCOUNT Record of the Sales of Indian Assets (Stocks, bonds, real estate, businesses) to foreigners, X of assets, resulting in a capital inflow, or a Credit (cash inflow); and the Purchases of Foreign assets by Indians, M of assets, capital outflow, Debit (cash outflow). Specifically: a. Foreign Direct Investment (FDI) Refers to international investment in which the investor obtains a lasting interest in an enterprise in another country. Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of property, plants or equipment. b. Portfolio Investment:
Purchases/sales of stocks, bonds, notes, mutual funds, money market securities, options, etc., in foreign capital markets not involving controlling interest. International portfolio investments have increased significantly recently due to a) relaxation/deregulation of capital controls (increased capital mobility) and b) a desire for International portfolio diversification (most security returns have a low correlation among countries, resulting in risk reduction). 3. OTHER ACCOUNTS HOME BIAS IN PORTFOLIO HOLDINGS Despite significant and obvious gains from International portfolio diversification, investors demonstrate a "home bias" and allocate a disproportionate share of funds to domestic securities. Excessive transactions costs: 1. Information costs, language barriers 2. Possible unfavorable tax treatment 3. Legal barriers to foreign investment 4. Currency, inflation risk FII flows and contemporaneous stock returns are strongly correlated in India. The correlation coefficients between different measures of FII flows and market returns on the Bombay Stock Exchange during different sample periods. Positive correlations have often been held as evidence of FII actions determining Indian equity market returns. However, correlation itself does not imply causality. A positive relationship between portfolio inflows and stock returns is consistent with at least four distinct theories: 1) the “omitted variables” hypothesis; 2) the “downward sloping demand curve” view; 3) the “base-broadening” theory; and 4) the “positive feedback strategy” view.
The “omitted variables” view is the classic case of spurious correlation – that the correlated variables, in fact, have no causal relationship between them but are both affected by one or more other variables missed out in the analysis. The “downward sloping demand curve” view contends that foreign investment creates a buying pressure for stocks in the emerging market in question and causes stock prices to rise much in the same way as suddenly higher demand for a commodity would cause its price to rise. The ‘base-broadening’ argument contends that once foreigners begin to invest in a country, the financial markets in that country are now no longer moved by national economic factors alone but rather begin to be affected by foreign market movements as well. As the market itself is now affected by more factors than before, its exposure to domestic shocks decline. Consequently the ‘risk’ of the market itself falls, people demand a lower risk premium to buy stocks, and stock prices rise to higher levels. Finally the ‘positive feedback view’ asserts that if investors ‘chase’ returns in the immediate past (like the previous day or week) then aggregating their fund flows over the month can lead to a positive relationship in the contemporaneous monthly data. In the present context, both directions of causation are equally plausible. The positive relationship between market return and FII flows, however, serves only as a first-pass in understanding the nature of such flows and their implications for the Indian markets. Since the FII flows essentially serve to diversify the portfolio of foreign investors, it is only normal to expect that several factors – both domestic as well as external to India – are likely to affect them along with the expected stock returns in India. The declining world interest rates have been among the important “push” factors for international portfolio flows in the early 90’s. The “usual suspects” in the literature include: US and world equity returns, changes in interest rates, stock market volatility, some measure of the country risk and the exchange rate. Other factors that may affect FII flows Country risk measures, that incorporate political and other risks in addition to the usual economic and financial variables, may be expected to have an impact on portfolio flows to India though they are likely to matter more in the case of FDI flows.
CHAPTER 2 DESIGN OF THE STUDY TITLE OF THE STUDY “FOREIGN INSTUTIONAL INVESTMENTS AND THE INFLUENCE OF FOREIGN INSTITUTIONAL INVESTMENTS ON EQUITY STOCK MARKET IN INDIA”. STATEMENT OF THE PROBLEM In this research an effort has been made to develop an understanding of the influence of the FIIs in the Indian equity market. The Foreign Institutional Investors (FIIs) have emerged as important players in the Indian equity market in the recent past. This paper makes an attempt to understand whether there exists a relationship between FII and Equity Market returns in India. OBJECTIVES OF THE STUDY Analyse the trends of Foreign Investment flows and Foreign Institutional Inflows. Analyse the Yearly trends of FII purchases, FII sales and Net Investment. Analyse the reason for the major decline of Net Investment in the year 1998-99. Examine whether FIIs have any influence on Equity Stock Market. SCOPE OF THE STUDY The report examines The Influence of Foreign Institutional Investments on Equity Stock Market in India. The scope of the research comprises of information derived from secondary data from various websites. The various information and statistics were derived from the websites of BSE, NSE, Money Control, RBI and SEBI. Sensex and Nifty was a natural choice for inclusion in the study, as it is the most popular market indicies and widely used by market participants for benchmarking. REFERENCE PERIOD The study period covered under this is for the financial year : 1st April 2004 to 31st March 2005.
RESEARCH DESIGN: TYPE OF RESEARCH: SOURCES OF DATA The main source of obtaining necessary data for the study was Secondary Data. This study is empirical in nature and hence secondary data is used to conduct the research. The data was collected from the Internet by exploring the Secondary sources available on websites. Secondary Data: The secondary data constitutes of daily FII flows data which was collected from Money Control and Equity Master, the daily returns of SENSEX and NIFTY from BSE and NSE websites respectively. The trends in FII flows from the RBI website and information on FII from SEBI. PLAN OF ANALYSIS The data gathered from various sources were primarily studied and necessary data was sorted out sequentially keeping in mind the procedure of the study. The analysis has been made by, correlating the FII purchases, sales and net investment with equity market returns to identify whether a relation exists between them. Findings are included which transmits the important points, which were gathered from the study. METHODOLOGY 1. Form a testable hypothesis 2. Collect relevant data to test hypothesis 3. Perform statistical analysis. 4. Interpret the results. HYPOTHESIS Null Hypothesis (Ho): There is no influence of FIIs on the Stock indexes. Alternative Hypothesis (Ha): There is an influence of FIIs on Stock indexes.
If we reject the Ho, then we accept the Ha, setting the significance level to 5% and 1% at Degree of Freedom = n-2. LIMITATIONS OF THE STUDY As the time available is limited and the subject is very vast the study is mainly focused on identifying whether there does exist a relationship between FIIs and Indian Equity Stock Market. • • • • • The study is general. It is mainly based on the data available in various websites; The inferences made is purely from the past year’s performance; There is no particular format for the study; Sufficient time is not available to conduct an in-depth study;
OPERATIONAL DEFINITIONS Exchange rate of a nation's currency- Currency like other commodities, rises or falls in "price" with demand. When investors leave, they sell their holdings in a country's currency and as demand falls, the "price" of that currency will also fall Gold standard-When a country is said to be on the Gold Standard, the value of its currency and the quantity of its currency in circulation is tied the nation's reserve of gold. Such a system tends to restrict the country's monetary supply. OECD-The Organization for Economic Cooperation and Development (OECD) is a descendant of the U.S.-European cooperation required to execute the Marshall Plan and rebuild Europe after World War II. A tribute to the success of that effort is the fact that the 30 or so members of the OECD now include Japan and Korea as well, are thought of as the wealthy nations of the world. Economies of Scale-Produces are often able to enjoy considerable production cost savings by buying inputs in bulk, mass-producing or retailing their end product. These lower costs achieved through expanded production are called Economies of Scale. Debt/equity ratio-The debt/equity ratio measures the extent to which a firm's capital is provided by lenders (through debt instruments such as fixed-return bonds) or owners (through variable-return stocks). A greater reliance on financing through debt can mean greater profitability for shareholders, but also greater risk in the event things go sour. International Monetary Fund-The IMF is an international organization of 183 member countries, established in 1947 to promote international monetary cooperation, exchange stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment.
Institutional Investor- An organization whose primary purpose is to invest its own assets or those held in trust by it for others. includes pension funds, investment companies, insurance companies, universities and banks. Interest rates-Interest rates have a powerful effect on the volume of a nation's money supply. By raising interest rates, i.e., making the cost of borrowing money more expensive, governments or banks can decrease the money supply. A decrease in the money supply tends to be counter-inflationary, which makes a currency more valuable compared to other currencies. Foreign Direct Investment (FDI)-This category refers to international investment in which the investor obtains a lasting interest in an enterprise in another country. Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of property, plants or equipment. Foreign Portfolio Investment (FPI)-FPI is a category of investment instruments that are more easily traded, may be less permanent, and do not represent a controlling stake in an enterprise. These include investments via equity instruments (stocks) or debt (bonds) of a foreign enterprise that does not necessarily represent a long-term interest. Most Favored Nation Treatment-The phrase "most favored nation" refers to the obligation of the country receiving the investment to give that investment the same treatment as it gives to investments from its "most favored" trading partner. Balance of payments-The Balance of Payments (BOP) is a statistical statement that summarizes, for a specific period (typically a year or quarter), the economic transactions of an economy with the rest of the world. It covers:
All the goods, services, factor income and current transfers an economy receives from or provides to the rest of the world Capital transfers and changes in an economy's external financial claims and liabilities
Portfolio investment – covers the acquisition and disposal of equity and debt securities that cannot be classified under direct investment or reserve asset transactions. These securities are tradable in organised financial markets. FDI Flows and Stocks – Through direct investment flows the investors builds up a direct investment stock (position), making part of the investor’s balance sheet. The FDI stock (position) normally differs from accumulated flows because of revaluation (changes in prices or exchange rates) and other adjustments like rescheduling or cancellation of loans, debt forgiveness or debt-equity swaps with different values. Multinational Companies (MNCs) – are incorporated or unincorporated enterprises comprising parent enterprises and their foreign affiliates. Foreign Direct Investor – A foreign direct investor is an individual, an incorporated or unincorporated public or private enterprise, a government, a group of related individuals, or a group of related incorporated and/or unincorporated enterprises which have a direct investment enterprise that is a subsidiary, associate or branch – operating in a country other than the country or countries of residence of the direct investor or investors. Host Economy – is the country that receives FDI or FPI from the foreign investor(s). Home Economy – is the country of origin/residence of the company that invests in the foreign economy/host economy. Subsidiary – is an incorporated enterprise in the host country in which the foreign investor owns more than 50 per cent of the shareholder’s voting power or has the right to appoint or remove a majority of the members of this enterprise’s administrative, management or supervisory body. Equity capital – comprises of equity in branches and ordinary shares in subsidiaries and associates. Reinvested earnings – consist of the direct investor’s share of earnings not distributed as dividends by subsidiaries or associates and earnings of branches not remitted to the direct investor.
Other capital – covers inter-company debt (including short-term loans such as trade credits) between direct investors and subsidiaries, branches and associates. WTO – World Trade Organisation. Correlation coefficient - measures the degree of co-movement between two variables, simple measure of statistical association. Coefficient of Determination (R2) - ranges from 0 - 1, is always part of the standard regression output, the most important measure of goodness of fit. R2 = correlation coefficient (r) squared, since the range of r is from -1 to +1, squaring r forces R2 to fall between 0 and 1.
CHAPTER 3 OVERVIEW OF CHAPTER SCHEME CHAPTER 1 – Theoretical Background This chapter deals with the theoretical background of the study throwing light on the introduction, forms of Foreign Investment, Differences between Portfolio and Direct Investment, factors influencing Foreign Investment decisions and a Survey of Literature. CHAPTER 2 – Design of the Study This chapter states the problem of the study; the objectives of the study, the scope, methodology, tools for collecting data, a plan of analysis, hypothesis and the limitations of the study. The chapter also includes the operational definitions of the terms commonly used in the study, along with which the chapter scheme is included. CHAPTER 3 –Overview of Chapter Scheme CHAPTER 4- Industry Profile This chapter gives information on the Foreign Investment flows in India, Foreign portfolio flows in India, Milestones of FII in India, Acts and Rules relating to FII, a brief profile of SEBI, RBI, BSE and NSE. CHAPTER 5 – Analysis and Interpretation of Data This chapter deals with analysis and interpretation of the data collected. The purpose of this chapter is to draw inferences, based on the calculations and statistics. Graphs are also included to give a clear view of the data analysed. CHAPTER 6 – Findings, Recommendations and Conclusion.
This chapter is the concluding chapter dealing with findings, recommendations and conclusion which are drawn after the study on Influence of FIIs in Equity Stock Market.
CHAPTER 4 INDUSTRY PROFILE
INVESTMENT IN INDIAN MARKET India is believed to be a good investment despite political uncertainty, bureaucratic hassles, shortages of power and infrastructure deficiencies. India presents a vast potential for overseas investment and is actively encouraging the entrance of foreign players into the market. No company, of any size, aspiring to be a global player can, for long ignore this country, which is expected to become one of the top three emerging economies. Success in India Success in India will depend on the correct estimation of the country's potential; underestimation of its complexity or overestimation of its possibilities can lead to failure. While calculating, due consideration should be given to the factor of the inherent difficulties and uncertainties of functioning in the Indian system. Entering India's marketplace requires a well-designed plan backed by serious thought and careful research. For those who take the time and look to India as an opportunity for long-term growth, not short-term profit- the trip will be well worth the effort. Market potential India is the fifth largest economy in the world (ranking above France, Italy, the United Kingdom, and Russia) and has the third largest GDP in the entire continent of Asia. It is also the second largest among emerging nations. (These indicators are based on purchasing power parity). India is also one of the few markets in the world, which offers high prospects for growth and earning potential in practically all areas of business. Despite the practically unlimited possibilities in India for overseas
businesses, the world's most populous democracy has, until fairly recently, failed to get the kind of enthusiastic attention generated by other emerging economies such as China.
Lack of enthusiasm among investors The reason being, after independence from Britain 50 years ago, India developed a highly protected, semi-socialist autarkic economy. Structural and bureaucratic impediments were vigorously fostered, along with a distrust of foreign business. Even as today the climate in India has seen a sea change, smashing barriers and actively seeking foreign investment, many companies still see it as a difficult market. India is rightfully quoted to be an incomparable country and is both frustrating and challenging at the same time. Foreign investors should be prepared to take India as it is with all of its difficulties, contradictions and challenges. Developing a basic understanding or potential of the Indian market Envisaging and developing a Market Entry Strategy and implementing these strategies when actually entering the market are three basic steps to make a successful entry into India. The Indian middle class is large and growing; wages are low; many workers are well educated and speak English; investors are optimistic and local stocks are up; despite political turmoil, the country presses on with economic reforms. But there is still cause for worries- Infrastructure hassles. The rapid economic growth of the last few years has put heavy stress on India's infrastructure facilities. The projections of further expansion in key areas could snap the already strained lines of transportation unless massive programs of expansion and modernization are put in place. Problems include power demand shortfall, port traffic capacity mismatch, poor road conditions (only half of the country's roads are surfaced) and low telephone penetration. Indian Bureaucracy
Although the Indian government is well aware of the need for reform and is pushing ahead in this area, business still has to deal with an inefficient and sometimes still slow-moving bureaucracy. Diverse Market The Indian market is widely diverse. The country has 17 official languages, 6 major religions, and ethnic diversity as wide as all of Europe. Thus, tastes and preferences differ greatly among sections of consumers. Therefore, it is advisable to develop a good understanding of the Indian market and overall economy before taking the plunge.
INTERNATIONAL PORTFOLIO FLOWS: International portfolio flows, as opposed to foreign direct investment (FDI) flows, refer to capital flows made by individuals or investors seeking to create an internationally diversified portfolio rather than to acquire management control over foreign companies. Diversifying internationally has long been known as a way to reduce the overall portfolio risk and even earn higher returns. Investors in developed countries can effectively enhance their portfolio performance by adding foreign stocks particularly those from emerging market countries where stock markets have relatively low correlations with those in developed countries. International portfolio flows are largely determined by the performance of the stock markets of the host countries relative to world markets. With the opening of stock markets in various emerging economies to foreign investors, investors in industrial countries have increasingly sought to realize the potential for portfolio diversification that these markets present. It is likely that for quite a few years to come, FII flows would increase with global integration. The main question is whether capital flew in to these countries primarily as a result of changes in global (largely US) factors or in response to events and indicators in the recipient countries like its credit rating and domestic stock market return. The answer is mixed – both global and country-specific factors seem to matter,
with the latter being particularly important in the case of Asian countries and for debt flows rather than equity flows.
FOREIGN INVESTMENT FLOWS IN INDIA: One of the most important distinctions between Portfolio and Direct investment to have emerged from this young era of globalisation is that portfolio investment can be much more volatile.
TABLE: Foreign Investment Flows in India
Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 A. Direct Investment B. Portfolio Investment (US $ million) (US $ million) 97 6 129 4 315 244 586 3567 1314 3824 2144 2748 2821 3312 3557 1828 2462 61 2155 3026 4029 2760 6131 2021 4660 979 4675 11377 Total (A + B) (US $ million) 103 133 559 4153 5138 4892 6133 5385 2523 5181 6789 8152 5639 16052
From a net foreign investment inflow of US $ 5.3 billion in 1997-98, such inflows declined to US $ 2.4 billion in 1998-99. This is because of the lower portfolio inflows, as a result of which the net investment has dropped. The changes in the investment conditions in a country or region can lead to dramatic swings in portfolio investment. For a country on the rise, in other words for developing countries, FPI can bring about rapid development, helping an emerging economy move quickly to take advantage of economic opportunity, creating many new jobs and significant wealth. However, when a country's economic situation takes a downturn, sometimes just by failing to meet the expectations of international investors, the large flow of money into a country can turn into a stampede away from it.
CHART: FOREIGN INVESTMENT FLOWS
0 1 990-91 1 -92 991 FPI FDI 1 99293 1 993- 1 994-95 1 995-96 1 996-97 1 997-98 94 Y EA R 1 99899 1 99900 200001 2001 02 200203 200304
FOREIGN PORTFOLIO FLOWS TO INDIA Foreign portfolio investments have been allowed in India on the basis of the recommendations of the Narasimham committee which stated: The committee would also suggest that the capital markets should be gradually opened up to foreign portfolio investments and simultaneously efforts should be initiated to improve the depth of the market by facilitating the issue of new types of equities and innovative debt instruments.’ (Narasimham committee report) Prior to 1992, only non-resident Indians (NRIs) and Overseas corporate bodies (OCBs) were allowed to undertake portfolio investment in India. Only on September 14, 1992 the Government of India issued guidelines on FII investments in India which was followed by a notification by Securities and Exchange Board of India (SEBI) three years later in November 1995.
FOREIGN INSTITUTIONAL INVESTMENT IN INDIA: MILESTONES
India embarked on a programme of economic reforms in the early 1990s to tie
over its balance of payment crisis and also as a step towards globalisation.
An important milestone in the history of Indian economic reforms happened on
September 14, 1992, when the FIIs (Foreign Institutional Investors) were allowed to invest in all the securities traded on the primary and secondary markets, including shares, debentures and warrants issued by companies which were listed or were to be listed the stock exchanges in India and in the schemes floated by domestic mutual funds.
Initially, the holding of a single FII and of all FIIs, NRIs (Non-Resident Indians)
and OCBs (Overseas Corporate Bodies) in any company were subject to a limit of 5% and 24% of the company's total issued capital respectively.
In order to broad base the FII investment and to ensure that such an investment
would not become a camouflage for individual investment in the nature of FDI (Foreign Direct Investment), a condition was laid down that the funds invested by FIIs had to have at least 50 participants with no one holding more than 5%. Ever since this day, the regulations on FII investment have gone through enormous changes and have become more liberal over time.
From November 1996, FIIs were allowed to make 100% investment in debt
securities subject to specific approval from SEBI as a separate category of FIIs or subaccounts as 100% debt funds. Such investments were, of course, subjected to the fund-specific ceiling prescribed by SEBI and had to be within an overall ceiling of US $ 1.5 billion. The investments were, however, restricted to the debt instruments of companies listed or to be listed on the stock exchanges. * In 1997, the aggregate limit on investment by all FIIs was allowed to be raised from 24% to 30% by the Board of Directors of individual companies by passing a resolution in their meeting and by a special resolution to that effect in the company's General Body meeting.
From the year 1998, the FII investments were also allowed in the dated
government securities, treasury bills and money market instruments.
In 2000, the foreign corporates and high net worth individuals were also allowed
to invest as sub-accounts of SEBI-registered FIIs. FIIs were also permitted to seek SEBI registration in respect of sub-accounts. This was made more liberal to include the domestic portfolio managers or domestic asset management companies.
40% became the ceiling on aggregate FII portfolio investment in March 2000. This was subsequently raised to 49% on March 8, 2001 and to the specific sectoral
cap in September 2001.
As a move towards further liberalization a committee was set up on March 13,
2002 to identify the sectors in which FIIs portfolio investments will not be subject to the sectoral limits for FDI.
Later, on December 27, 2002 the committee was reconstituted and came out with
recommendations in June 2004. The committee had proposed that, 'In general, FII investment ceilings, if any, may be reckoned over and above prescribed FDI sectoral caps. The 24 per cent limit on FII investment imposed in 1992 when allowing FII inflows was exclusive of the FDI limit. The suggested measure will be in conformity with this original stipulation.' The committee also has recommended that the special procedure for raising FII investments beyond 24 per cent up to the FDI limit in a company may be dispensed with by amending the relevant regulations.
Meanwhile, the increase in investment ceiling for FIIs in debt funds from US $ 1
billion to US $ 1.75 billion has been notified in 2004. The SEBI also has reduced the turnaround time for processing of FII applications for registrations from 13 working days to 7 working days except in the case of banks and subsidiaries. All these are indications for the country's continuous efforts to mobilize more foreign investment through portfolio investment by FIIs. The FII portfolio flows have also been on the rise since September 1992. Their investments have always been net positive, but for 1998-99, when their sales were more than their purchase
ACTS AND RULES FII registration and investment are mainly governed by SEBI (FII) Regulations, 1995. ELIGIBILITY FOR REGISTRATION AS FII: Following entities / funds are eligible to get registered as FII: 1. Pension Funds 2. Mutual Funds 3. Insurance Companies 4. Investment Trusts 5. Banks 6. University Fund s 7. Endowments 8. Foundations 9. Charitable Trusts / Charitable Societies Further, following entities proposing to invest on behalf of broad based funds(a fund established or incorporated outside India, which has at least twenty investors with no single individual investor holding more than 10% shares or units of the fund) , are also eligible to be registered as FIIs: 1. Asset Management Companies 2. Institutional Portfolio Managers 3. Trustees 4. Power of Attorney Holders INVESTMENT OPPORTUNITIES FOR FIIs The following financial instruments are available for FII investments
a) Securities in primary and secondary markets including shares, debentures and warrants of companies, unlisted, listed or to be listed on a recognized stock exchange in India; b) Units of mutual funds; c) Dated Government Securities; d) Derivatives traded on a recognized stock exchange ; e) Commercial papers. Investment limits on equity investments a) FII, on its own behalf, shall not invest in equity more than 10% of total issued capital of an Indian company. b) Investment on behalf of each sub-account shall not exceed 10% of total issued capital of an India company. c) For the sub-account registered under Foreign Companies/Individual category, the investment limit is fixed at 5% of issued capital. These limits are within overall limit of 24% / 49 % / or the sectoral caps a prescribed by Government of India / Reserve Bank of India. Investment limits on debt investments The FII investments in debt securities are governed by the policy if the Government of India. Currently following limits are in effect: • For FII investments in Government debt, currently following limits are applicable:
For corporate debt the investment limit is fixed at US $ 500 million.
TAXATION The taxation norms available to a FII is shown in the table below. Nature of Income Long-term capital gains Short-term capital gains Dividend Income Tax Rate 10% 30% Nil
Interest Income than one year.
Long term capital gain: Capital gain on sale of securities held for a period of more Short term capital gain: Capital gain on sale of securities held for a period of less than one year.
BRIEF PROFILE OF IMPORTANT INSTITUTIONS: A brief profile of important institutions included in the study is given below. RESERVE BANK OF INDIA India's Central Bank - the RBI - was established on 1 April 1935 and was nationalized on 1 January 1949. Some of its main objectives are regulating the issue of bank notes, managing India's foreign exchange reserves, operating India's currency and credit system with a view to securing monetary stability and developing India's financial structure in line with national socio-economic objectives and policies. The RBI acts as a banker to Central/State governments, commercial banks, state cooperative banks and some financial institutions. It formulates and administers monetary policy with a view to promoting stability of prices while encouraging higher production through appropriate deployment of credit. The RBI plays an important role in maintaining the exchange value of the Rupee and acts as an agent of the government in respect of India's membership of IMF. The RBI also performs a variety of developmental and promotional functions. The first concern of a central bank is the maintenance of a soundly based commercial banking structure. While this concern has grown to comprehend the operations of all financial institutions, including the several groups of non-bank financial intermediaries, the commercial banks remain the core of the banking system. A central bank must also cooperate closely with the national government. Indeed, most governments and central banks have become intimately associated in the formulation of policy.
They are often responsible for formulating and implementing monetary and credit policies, usually in cooperation with the government. they have been established specifically to lead or regulate the banking system. SECURITUIES AND EXCHANGE BOARD OF INDIA In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government of India through an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government Control, a statutory and autonomous regulatory board with defined responsibilities, to cover both development & regulation of the market, and independent powers have been set up. The basic objectives of the Board were identified as:
• • • •
to protect the interests of investors in securities; to promote the development of Securities Market; to regulate the securities market and for matters connected therewith or incidental thereto.
Since its inception SEBI has been working targetting the securities and is attending to the fulfillment of its objectives with commendable zeal and dexterity. The improvements in the securities markets like capitalization requirements, margining, establishment of clearing corporations etc. reduced the risk of credit and also reduced the market. SEBI has introduced the comprehensive regulatory measures, prescribed registration norms, the eligibility criteria, the code of obligations and the code of conduct for different intermediaries like, bankers to issue, merchant bankers, brokers and subbrokers, registrars, portfolio managers, credit rating agencies, underwriters and others. It has framed bye-laws, risk identification and risk management systems for Clearing houses of stock exchanges, surveillance system etc. which has made dealing in securities both safe and transparent to the end investor.
Another significant event is the approval of trading in stock indices (like S&P CNX Nifty & Sensex) in 2000. A market Index is a convenient and effective product because of the following reasons:
• • • •
It acts as a barometer for market behavior; It is used to benchmark portfolio performance; It is used in derivative instruments like index futures and index options; It can be used for passive fund management as in case of Index Funds.
Two broad approaches of SEBI is to integrate the securities market at the national level, and also to diversify the trading products, so that there is an increase in number of traders including banks, financial institutions, insurance companies, mutual funds, primary dealers etc. to transact through the Exchanges. In this context the introduction of derivatives trading through Indian Stock Exchanges permitted by SEBI in 2000 AD is a real landmark. BOMBAY STOCK EXCHANGE: Of the 22 stock exchanges in the country, Mumbai's (earlier known as Bombay), Bombay Stock Exchange is the largest, with over 6,000 stocks listed. The BSE accounts for over two thirds of the total trading volume in the country. Established in 1875, the exchange is also the oldest in Asia. Among the twenty-two Stock Exchanges recognised by the Government of India under the Securities Contracts (Regulation) Act, 1956, it was the first one to be recognised and it is the only one that had the privilege of getting permanent recognition ab-initio. Approximately 70,000 deals are executed on a daily basis, giving it one of the highest per hour rates of trading in the world. There are around 3,500 companies in the country which are listed and have a serious trading volume. The market capitalization of the BSE is Rs.5 trillion. The BSE `Sensex' is a widely used market index for the BSE. The main aims and objectives of the BSE is to provide a market place for the purchase and sale of security evidencing the ownership of business property or of a public or
business debt. It aims to promote, develop and maintain a well-regulated market for dealing in securities and to safeguard the interest of members and the investing public having dealings on the Exchange. It helps industrial development of the country through efficient resource mobilization. To establish and promote honourable and just practices in securities transactions BSE Sensex The BSE Sensex is a value-weighted index composed of 30 companies with the base April 1979 = 100. It has grown by more than four times from January 1990 till date. The set of companies in the index is essentially fixed. These companies account for around one-fifth of the market capitalization of the BSE.
NATIONAL STOCK EXCHANGE OF INDIA The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions (FIs) to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a taxpaying company unlike other stock exchanges in the country. On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000. S&P CNX Nifty S&P CNX Nifty is a well-diversified 50 stock index accounting for 23 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds.
S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is India's first specialised company focused upon the index as a core product. IISL have a consulting and licensing agreement with Standard & Poor's (S&P), who are world leaders in index services.
The average total traded value for the last six months of all Nifty stocks is approximately 58% of the traded value of all stocks on the NSE Nifty stocks represent about 60% of the total market capitalization as on March 31, 2005. Impact cost of the S&P CNX Nifty for a portfolio size of Rs.5 million is 0.07% S&P CNX Nifty is professionally maintained and is ideal for derivatives trading
CHAPTER 4 ANALYSIS AND INTERPRETATION Portfolio flows – often referred to as “hot money” – are notoriously volatile compared to other forms of capital flows. Investors are known to pull back portfolio investments at the slightest hint of trouble in the host country often leading to disastrous consequences to its economy. They have been blamed for exacerbating small economic problems in a country by making large and concerted withdrawals at the first sign of economic weakness. TRENDS IN FII INVESTMENT IN INDIA TABLE : Trends in FII investment
Year FII PURCHASE FII SALES in crores in crores FII NET in crores FII NET CUM FII NET US$ million US$ million
1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04
5593 7631 9694 15554 18695 16115 56856 74051 49920 47060 144858
466 2835 2752 6979 12737 17699 46734 64116 41165 44371 99094
5126 4796 6942 8575 5958 -1584 10122 9934 8755 2689 45765
1634 1528 2036 2432 1649 -386 2339 2160 1846 562 9949
1638 3167 5202 7634 9284 8898 11237 13396 15242 15804 25754
Source: Reserve Bank of India Annual Report 2004 INFERENCE: The investments by FIIs have been registering a steady growth since the opening of the Indian capital markets in September 1992. Their investments have always been net positive, but for 1998-99, when their sales were more than their purchases. It can be observed from the above table that the portfolio investment inflows have always been on the increase. But the years 2001-02 and 2002-03 saw some reversal in the trend. From a net inflow of US $ 2.1 billion in 2000-01, such inflows declined to US $ 1.8 billion in 2001-02, and further dropped to US $ 0.562 billion in 2002-03. The decline is because of the lower portfolio inflows, as a result of which the net investment has dropped in these years. However, this decline witnessed a sharp reversal in the year 2003-04. FIIs have made a net investment of Rs. 45,764 crores during this year registering a growth of 1602% over the previous year, creating a record in the history of FII investment in India. Gross purchases in this year amounted to Rs.144,857 crores, a growth rate of 208% compared to the year before. This trend continued in April 2004, only to suffer reversal again during May and June 2004, when the net investment became negative. Fortunately, the year from July 2004 has been seeing a net positive portfolio flows by FIIs. As of September 2004, the net FII portfolio investment stands at US $ 27,637 million. If it is so, then increasing the FII investment cap per se will not be helpful. The country has to work on specific measures to encourage more FII investments. The analysis of data indicates that there has been substantial divestment by the FIIs during the year 1998-99. The maximum outflow was during the months of May and June 1998 (almost US$430 millions).
CHART : Sources of FII in India
Source: Sebi website INFERENCE: The sources of these FII flows are varied. The FIIs registered with SEBI come from as many as 28 countries. US-based institutions accounted for slightly over 41%, those from the UK constitute about 20% with other Western European countries hosting another 17% of the FIIs). It is, however, instructive to bear in mind that these national affiliations do not necessarily mean that the actual investor funds come from these particular countries. Given the significant financial flows among the industrial countries, national affiliations are very rough indicators of the ‘home’ of the FII investments. In particular institutions operating from Luxembourg, Cayman Islands or Channel Islands, or even those based at Singapore or Hong Kong are likely to be investing funds largely on behalf of residents in other countries. Nevertheless, the regional breakdown of the FIIs does provide an idea of the relative importance of different regions of the world in the FII flows.
CHART : GROWTH OF FII INVESTMENTS IN INDIA
INFERENCE: The trickle of FII flows to India that began in January 1993 has gradually expanded to an average monthly inflow of close to Rs. 1900 crores during the first six months of 2001. By June 2001, over 500 FIIs were registered with SEBI. The total amount of FII investment in India had accumulated to a formidable sum of over Rs.50,000 crores during this time. In terms of market capitalization too, the share of FIIs has steadily climbed to about 9% of the total market capitalization of BSE (which, in turn, accounts for over 90% of the total market capitalization in India).
CHART: TRENDS IN YEARLY GROSS PURCHASES
GROSS PURCHASE (in Rs crores)
160000 140000 120000 100000 80000 60000 40000 20000 0 5593 7631 9694 15554 18695 16115 56856 74051 49920 47060
1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 YEAR
INFERENCE: On observation of the above chart of trends in yearly Gross Purchases, the Gross Purchases of FIIs in India registered a record of Rs.144,857 crores in the year 2003-04, a growth rate of 208% compared to the previous year 2002-03. This trend continued in April 2004, only to suffer reversal again during May and June 2004, when the net investment became negative.
CHART: TRENDS IN YEARLY GROSS SALES
120000 100000 GROSS SALES (in Rs. crores) 80000 64116 60000 40000 20000 466 0 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2835 2752 12737 17699 46734 44371 99094
INFERENCE In the above chart we can see that during the year 2003-04 FIIs Gross Sales amounted an increase Rs.99094 crores when compared to Rs. 44371 crores. The FIIs Gross Sales shows an upward trend with reference to the base year of 1993-94 when the Gross Sales where only Rs. 466 crores.
CHART: TRENDS IN YEARLY NET INVESTMENT
NET INVESTMENT US$ million) (in
10000 8000 6000 4000 2000 0 -2000 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04
INFERENCE: From a net inflow of US $ 2.1 billion in 2000-01, such inflows declined to US $ 1.8 billion in 2001-02, and further dropped to US $ 0.562 billion in 2002-03. The decline is because of the lower portfolio inflows, as a result of which the net investment has dropped in these years. However, this decline witnessed a sharp reversal in the year 2003-04. The country has to work on specific measures to encourage more FII investments. If one looks at the trend of portfolio equity investment in the Indian stock market since 2002-03, it shows that there has been a very sharp increase in the net FII investment in India since April 2003. For the financial year 2003-04, FIIs have invested more than Rs 44,000 crore of portfolio capital in the Indian stock market. To put this figure into perspective, for the period 1992-93 to 2002-03, the maximum annual net investment by FIIs in India was in the year 1999-2000 and for that year, total net FII investment in India was Rs 9,765 crores. This rising trend of portfolio investment continued in 2004 also. In fact, in March 2004, a record Rs 8.800 crores of net foreign portfolio investment came into the Indian equity market. This trend continued till the end of April and more than Rs 4,200 crores of portfolio investment was made in the Indian stock market in that month. However, for the month of May, FIIs turned net sellers in the Indian equity markets. Between 30th April 2004 and 31st May 2004, net FII investment was negative. During this period, FIIs withdrew more than Rs 3,500 crores from the Indian equity market. In June, net FII investment turned
positive, however, net FII investment for the month of June was only Rs 516 crores which is much lower than the average The analysis of data indicates that there has been substantial divestment by the FIIs during the year 1998-99. The maximum outflow was during the months of May and June 1998 (almost US$430 millions).
TABLE : Monthly Trends of FIIs for the Year 1998-99 Month Apr-98 May-98 Jun-98 Jul-98 Aug-98 Sep-98 Oct-98 Nov-98 Dec-98 Jan-99 Feb-99 Mar-99 Purchases (Rs mn) 11422 8253 8023 13098 7932 14381 10737 10391 11089 16355 16477 25207 Sales (Rs mn) 11756 13284 16072 12154 11783 12458 16470 9845 8789 11894 13084 23973 Net (Rs mn) -335 -5031 -8049 944 -3851 1923 -5733 546 2300 4462 3393 1233 Net (US$ mn) -8.4 -124.3 -190.5 22.2 -90.1 45.2 -135.4 12.9 104.8 104.8 79.8 29
A major factor which led to continuous outflow of funds during the middle and end of the year 1998 was the worsening outlook on the emerging markets. Credit worthiness of almost all the South-east Asian nations was severely damaged by the crises which started in July 1997. As a result, the FIIs were facing heavy redemption pressures from the Emerging Markets Funds. The stock markets in all these countries fell continuously from March 1998 till about September 1998. The integration of the
Indian capital markets with the international markets thus spilled over to Indian markets as well. However, the net outflow from the Indian markets was much lower than the other Asian countries. A further indication of the integration of the Indian markets can be seen from the upsurge in the valuations and funds inflows during the first quarter of 1999, when all the other Asian countries have also seen rising trend in stocks indices. The sluggishness in investment in the emerging markets was exacerbated by the fact that throughout 1998-99, US and European markets showed historically high valuations, and the expectations of further rise because of the strong economic indicators there which led to reduced allocations elsewhere.
INFLUENCE OF FII ON THE EQUITY INDEXES OF INDIA We are interested in testing a hypothesis about the influence of FII in Equity Stock Market by correlating Gross Purchases, Gross Sales and Net Investment with Nifty and Sensex. T-test is conducted at 1% and 5% significance. Statistical significance is way to measure the likelihood that chance explains the results. FORMULATING A HYPOTHESIS: Null Hypothesis (Ho): there is no influence of FIIs on the Stock indexes. Alternative Hypothesis (Ha): there is an influence of FIIs on Stock indexes. If we reject the Ho, then we accept the Ha. Setting the significance level to 5% and 1%, the null hypothesis would be rejected only when the maximum number of months show positive correlation. T-Statistic: Using T-test is calculated using the following formula:
(1 − r )
When, -the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level. -if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated Conclusion: At the 1% level of stat sig we find that there is an influence of FIIs on Stock Market Indexes of India.
TABLE: CORRELATION OF FII WITH NIFTY MONTH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH GROSS PURCHASES -0.308891015 -0.203839618 0.40719847 0.231397721 -0.296292834 0.631541276 -0.107835133 0.103856902 -0.689594568 -0.02034654 0.124176605 0.419911809 GROSS SALES NET INVESTMENT -0.486299015 -0.122510317 -0.226174846 0.127555673 0.013881057 0.556762421 -0.008199745 0.352195939 -0.009987101 -0.288696993 0.478957403 0.377141924 -0.303940405 0.118451125 0.232269601 -0.020576251 -0.692805116 -0.496878284 -0.57330261 0.64885866 -0.056354197 0.233709555 -0.255570154 0.483718703
FII flows and contemporaneous stock returns are strongly correlated in India. The correlation coefficients between different measures of FII flows and market returns on the Bombay Stock Exchange during different sample periods are shown in Table above. While the correlations are quite high throughout the sample period, they exhibit a significant rise since the beginning of the 1999-00. The calculations show that there exists a relationship between FIIs and Nifty since 6 out of 12 months show positive correlation in the case of Gross Purchass and 8 out of 12 months indicate a positive correlation in the case of Net FII Investment and Nifty.
TABLE : CORRELATION OF FII WITH SENSEX MONTH GROSS PURCHASES GROSS SALES NET INVESTMENT APRIL -0.267580403 -0.509025858 -0.076211493 MAY -0.184653959 -0.224809346 0.1484205 JUNE 0.405635894 -0.004710378 0.575995013 JULY 0.291205286 0.045396684 0.353391901 AUGUST -0.315900375 -0.033391574 -0.301709231 SEPTEMBER 0.661834837 0.506184274 0.389776394 OCTOBER -0.067640059 -0.311421901 0.18995454 NOVEMBER 0.083505749 0.244942636 -0.057919794 DECEMBER -0.666663184 -0.688620778 -0.46494095 JANUARY 0.02201209 -0.551509386 0.679227006 FEBRUARY 0.00689661 -0.170243004 0.149373722 MARCH 0.417854257 -0.250893125 0.479619465 The behaviour of the foreign portfolio investors matched the behaviour of Sensex during this period. Net FII investment in the Indian capital markets started fluctuating sharply during April and it turned negative. Net FII investment in the Indian stock market was positive from May to July. During this period, the Sensex and net FII investment showed very high degree of correlation. For the month of June showed a correlation as high as 0.60. The months of September, October, November and December shows a declining trend, the FII investment reversed from that day. On the whole, there exists a relationship between FIIs and Sensex since 7 out of 12 months show positive correlation in the case of Gross Purchases and 8 out of 12 months indicate a positive correlation in the case of Net FII Investment and Sensex.
TABLE : COEFFECIENT OF DETERMINATION OF FII WITH NIFTY MONTH GROSS PURCHASES GROSS SALES NET INVESTMENT APRIL 0.095413659 0.236486732 0.015009 MAY 0.04155059 0.051155061 0.01627 JUNE 0.165810594 0.000192684 0.309984 JULY 0.053544905 6.72358E-05 0.124042 AUGUST 0.087789444 9.97422E-05 0.083346 SEPTEMBER 0.398844383 0.229400194 0.142236 OCTOBER 0.011628416 0.09237977 0.014031 NOVEMBER 0.010786256 0.053949168 0.000423 DECEMBER 0.475540669 0.479978929 0.246888 JANUARY 0.000413982 0.328675883 0.421018
Coefficient of Determination (R2), ranges from 0 - 1, is always part of the standard regression output, the important measure of goodness of fit. R2 = correlation coefficient (r) squared, since the range of r is from -1 to +1, squaring r forces R2 to fall between 0 and 1. R2 in the above table gives the percentage (%) of the total variation in Nifty that is explained by the regression equation, or explained by FIIs. During the month of January the total variation in Nifty explained by FII amounted to 42% and the remaining 58% is explained by other factors which influence Nifty.
TABLE : COEFFECIENT OF DETERMINATION OF FII WITH SENSEX MONTH GROSS PURCHASES GROSS SALES NET INVESTMENT APRIL 0.071599272 0.259107325 0.005808 MAY 0.034097085 0.050539242 0.022029 JUNE 0.164540479 2.21877E-05 0.33177 JULY 0.084800519 0.002060859 0.124886 AUGUST 0.099793047 0.001114997 0.091028 SEPTEMBER 0.438025352 0.256222519 0.151926 OCTOBER 0.004575178 0.0969836 0.036083 NOVEMBER 0.00697321 0.059996895 0.003355 DECEMBER 0.444439801 0.474198576 0.21617 JANUARY 0.000484532 0.304162603 0.461349 FEBRUARY 4.75632E-05 0.028982681 0.022313 MARCH 0.17460218 0.06294736 0.230035 Similarly, in the case of FII and Sensex we have R2 = .46, indicating that variation in FII explains about 46% of the variation in Sensex. 54% of the variation in Sensex is unexplained by FII, explainable by other factors, omitted variables, random variation, etc. We shouldn't put too much emphasis on R2, t-stat are more important. However, R2, or some other measure of goodness of fit is expected in reported empirical results.
TABLE: T-statistics- FII and Nifty
MONTH April May Purchases Sales Net FII t(0.01) t(0.05) -1.339074452 -2.29467 -0.50896 2.567 1.74 -0.907571397 -1.0121 0.560581 2.539 1.729
June July August September October November December January February March
1.993833093 1.063712023 -1.38735818 3.642698972 -0.460189184 0.443023275 -4.363626504 -0.083908304 0.53094617 2.069166259
0.062084 -0.03667 -0.04467 2.440043 -1.35354 1.013144 -4.40261 -2.88498 -0.23947 -1.1822
2.997474 1.682898 -1.34851 1.821109 0.506109 -0.08732 -2.62379 3.515943 1.019787 2.471661
2.528 2.528 2.528 2.528 2.552 2.552 2.518 2.567 2.552 2.528
1.725 1.725 1.725 1.725 1.734 1.734 1.721 1.74 1.734 1.725
Comparing the t-stat to the critical value at the 1% level (one-tailed test) at degree of Freedom, D.F. = N –2; -the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level. -if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated We accept the Null Hypothesis since the maximum number of months show that FII and Nifty are uncorrelated.
TABLE: T-statistics- FII and Sensex
MONTH April May June July August September October November December January February March
Purchases Sales Net FII t(0.01) t(0.05) -1.145014609 -2.4383 -0.31514 2.567 1.74 -0.818971306 -1.00566 0.654196 2.539 1.729 1.984671667 -0.02107 3.151163 2.528 1.725 1.361307913 0.20323 1.689426 2.528 1.725 -1.488997461 -0.14941 -1.41523 2.528 1.725 3.948264684 2.624836 1.892839 2.528 1.725 -0.287631201 -1.39039 0.820854 2.552 1.734 0.355526636 1.071855 -0.24615 2.552 1.734 -4.098741766 -4.3519 -2.40656 2.518 1.721 0.09078017 -2.72599 3.815802 2.567 1.74 0.029260533 -0.73298 0.64093 2.552 1.734 2.056876281 -1.1591 2.444422 2.528 1.725
Comparing the t-stat to the critical value at the 1% level (one-tailed test) at degree of Freedom, D.F. = N –2; -the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level. -if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated
We accept the Null Hypothesis since the maximum number of months show that FII -Nifty and FII-Sensex are uncorrelated.
F-STATISTIC: Testing the Hypothesis Null Hypothesis (Ho): There is no influence of FIIs on the Stock indexes. Alternative Hypothesis (Ha): There is an influence of FIIs on Stock indexes. If we reject the Ho, then we accept the Ha. Setting the significance level to 1%, the null hypothesis would be rejected only when the entire year of 2004-05 shows positive correlation. Formula For F Test
( n − 2) r 2
(1 − r )
Formula For T Test
TABLE: YEARLY CORRELATION AND F-TEST AT 1% SIGNIFICANCE
PARTICULARS Pearson Correlation Sig. (1-tailed) N Pearson Correlation Sig. (1-tailed) N Pearson Correlation Sig. (1-tailed) N
NIFTY 0.440552215 1.04808E-13 252 0.260429215 1.41899E-05 252 0.309072081 2.79231E-07 252
SENSEX 0.440403204 1.07029E-13 252 0.263882768 1.0996E-05 252 0.306581522 3.4768E-07 252
FII flows and contemporaneous stock returns are strongly correlated in India. The correlation coefficients between different measures of FII flows and market returns on the Bombay Stock Exchange during the year 2004-05 are shown in the Table. While the correlations are high being 0.44 between FII purchases and Nifty, 0.44 between FII Purchases and Sensex, 0.26 between FII Sales and Nifty, 0.26 between Gross Sales and Sensex, 0.31 between Net FII and Nifty, 0.31 between Net FII and Sensex. At the 1% significance level the null hypothesis is rejected with a view that FIIs flows and market Purchases of have a high correlation. Hence the FIIs have significant influence on Equity Indexes Nifty and Sensex.
The positive relationship between market return and FII flows, however, serves only as a first-pass in understanding the nature of such flows and their implications for the Indian markets. Since the FII flows essentially serve to diversify the portfolio of foreign investors, it is only normal to expect that several factors – both domestic as well as external to India – are likely to affect them along with the expected stock returns in India.
CHAPTER 5 SUMMARY OF FINDINGS, RECOMMENDATIONS AND CONCLUSION FINDINGS: It is an accepted fact now that FIIs have significant influence on the movements of the stock market indexes in India. If one looks at the total FII trade in equity in India and its relationship with the stock market major indexes like Sensex and Nifty, it shows a steadily growing influence of FIIs in the domestic stock market. FIIs and the movements of Sensex are quite closely correlated in India and FIIs wield significant influence on the movement of Sensex. NSE also observes that in the Indian stock markets FIIs have a disproportionately high level of influence on the market sentiments and price trends. This is so because other market participants perceive the FIIs to be infallible in their assessment of the market and tend to follow the decisions taken by FIIs. This ‘herd instinct’ displayed by other market participants amplifies the importance of FIIs in the domestic stock market in India. Results of this study show that not only the FIIs are the major players in the domestic stock market in India, but their influence on the domestic markets is also growing. Data on trading activity of FIIs and domestic stock market turnover suggest that FII’s are becoming more important at the margin as an increasingly higher share of stock market turnover is accounted for by FII trading. Moreover,
the findings of this study also indicate that Foreign Institutional Investors have emerged as the most dominant investor group in the domestic stock market in India. Particularly, in the companies that constitute the Bombay Stock Market Sensitivity Index (Sensex) and NSE Nifty, their level of control is very high. Dominant position of FIIs in the Sensex companies, it is not surprising that FIIs are in a position to influence the movement of Sensex and Nifty in a significant way.
Since FIIs are dominating the Indian Market, individual investors are forced to
accept the dictates of major FIIs and hence join the group by entering the Mutual Fund group. Many Mutual Funds floated specific funds for the sectors favoured by the FIIs. An implication of MFs gaining strength in the Indian stock market could be that unlike individual investors, whose monies they manage, MFs can create market trends whereas the small individual investors can only follow the trends. The situation becomes quite difficult if the funds gain a vested interest in certain sectors by floating sector specific funds. One can even venture to say that the behaviour of MFs in India has turned the very logic that mutual funds invest wisely on the basis of well-researched strategies and individual investors do not have the time and resources to study and monitor corporate performance, upside down. Thus, the entry of FIIs has not resulted in greater depth in Indian stock market; instead it led to focussing on only a few sectors. Ultimately to provide a level playing field, even the domestic investors had to be offered lower rates of capital gains tax.
While it can be expected that foreign affiliated mutual funds would follow the
investment pattern of FIIs, it is important to note that many domestic ones also followed FIIs. The sectors favoured by FIIs account for a substantial portion of the net assets under control of many Mutual Funds. The Mutual funds are gaining prominence in the Indian Stock market and that the share of foreign affiliated MFs is growing, a number of Indian funds are following the investment strategies of the foreign ones. On the other hand if FII investments constitute a large share of the equity capital of a financial entity, an FII pullout, even if driven by development outside the country can have significant implications for the financial health of what is an important institution in the financial sector of this country.
Similarly, if any set of developments encourages an unusually high outflow of FII capital from the market, it can impact adversely on the value of the rupee and set of speculation in the currency that can in special circumstances result in a currency crisis. There are now too many instances of such effects worldwide for it be dismissed on the ground that India's reserves are adequate to manage the situation. FII investments, seem to have influenced the Indian stock market to a considerable extent. FIIs are interested in the Indian stock market increases its vulnerability to fluctuations. Analysis suggested a strong influence of FII investment on the Sensex and Nifty index. This finding takes quite further the general understanding that net FII investments influences stock prices in India as it traces the relationship
The ‘home bias’ portfolios of investors in industrial countries – the tendency to hold disproportionate amounts of stock from the ‘home’ country – suggests substantial potential for further portfolio flows as global market integration increases over time. It is important to note that global financial integration, however, can have two distinct and in some ways conflicting effects on this ‘home bias’. As more and more countries – particularly the emerging markets – open up their markets for foreign investment, investors in developed countries will have a greater opportunity to hold foreign assets. However, these flows themselves, along with greater trade flows will tend to cause different national markets to increasingly become parts of a more unified ‘global’ market, reducing their diversification benefits. Which of these two effects will dominate is, of course, an empirical issue, but given the extent of the ‘home bias’ it is likely that for quite a few years to come, FII flows would increase with global integration.
RECOMMENDATIONS: Some of the steps that can be taken to help influence the choices made by foreign institutional investors include:
The Government should cut its fiscal deficits, which would result in strengthening
the economy as a whole.
Creating infrastructure and other facilities to attract foreign investment. As
described earlier, an array of services can help promote foreign institutional investment in India, ranging from basic services such as the provision of electricity and clean water, to fair and effective dispute resolution systems.
The ability of governments to prevent or reduce financial crises also has a great
impact on the growth of capital flows. Steps to address these crises include strengthening banking supervision, requiring more transparency in international financial transactions and ensuring adequate supervision and regulation of financial markets.
An attempt should be made to bring down the inflation level to attract more
foreign institutional investments into India.
The Banking system needs to be strengthened which could be achieved by
reducing the number of Non Performing Assets.
The FIIs investments, though shown an increasing trend over time, are still far
below the permissible limits. One such measure in this line could be the newly announced INDONEXT, the platform for trading the small and mid-cap companies, which might bring some focus on these companies and hopefully add some liquidity and volume to their trading, which may attract some further investments in them by FIIs.
The fact is that developing country like India has its own compulsions arising out
of the very state of their social, political and economic development. To attract portfolio investments and retain their confidence, the host countries have to follow stable macro-economic policies,
The provision for clear procedures must be followed in the event of disputes
between investors and host governments, to ensure that rules are adhered to and that arbitration may be established by mutual consent.
Countries may impose these kinds of measures like expropriation, domestic
content requirements, restrictions on capital outflows of short term investments, etc with the intention of protecting domestic industries from international competition and promoting their economic development, but this usually leads to misallocation of resources away from the natural economic capabilities of nations.
There has been a significant shift in the character of global capital flows to the
developing countries in recent years in that the predominance of private account capital transfer and especially portfolio investments (FPI) increased considerably. In order to attract portfolio investments which prefer liquidity, it has been advocated to develop stock markets.
The general perception about the foreign portfolio investments is that, not only do
they expand the demand base of the stock market, but they can also stabilise the market through investor diversification. Obstacles to investment prevent countries from making optimal use of their own and other countries' resources. Countless billions of dollars of potential wealth - for investors in the form of profits, for workers in the form of wages, and for consumers in the form of lower prices - are lost every year due to barriers to trade and investment. Certain policy decisions of potential target countries of investment receive close scrutiny from international investors. Consequently, a number of international agreements have been written to specifically address those concerns.
CONCLUSION This paper provides a preliminary analysis of FII flows to India and their influence on the prices of stocks in the Indian stock market. A more detailed study using daily data of equity returns for a longer period or, better still, disaggregated data showing the transactions of individual FIIs at the stock level can help address questions regarding the extent of herding or return-chasing behavior among FIIs which now account for a significant part of the capital account balance in our balance of payments. The extent to which FII participation in Indian markets has helped lower cost of capital to Indian industries is also an important issue to investigate. Broader and more long-term issues involving foreign portfolio investment in India and their economy-wide implications have not been addressed in this paper. Such issues would invariably require an estimation of the societal costs of the volatility and uncertainty associated with FII flows. A detailed understanding of the nature and determinants of FII flows to India would help us address such questions in a more informed manner and allow us to better evaluate the risks and benefits of foreign portfolio investment in India.
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