(IMPACT OF FORTIGN INSTITUTIONAL INVESTORS ON INDIAN MARKET

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PREFACE
The Indian capital markets may appear mysterious and puzzling to many foreign investors and even to domestic Indian investor. To my knowledge, however, there is no current information material that comprehensively addresses invertors’ concerns about this rapidly growing market. I have no power to solve its inherent problems; but what I have tried to do is shed some light on practices and rules in the Indian market, including problematic ones, so that foreign as well as Indian investors can look at the market more rationally for their portfolio investments in Indian securities. The Indian financial system is a vast universe. This universe is regulated and supervised by two government agencies under the Ministry of Finance. (i). The Reserve bank of India, India’s Central Bank, and (ii). The Securities Exchange Board of India, the country’s capital market regulator. All parts of the system are interconnected with one another, and the jurisdictions of the central bank and the capital market regulator overlap in some fields of Indian financial activities. This research focuses on the FII (foreign institutional investor) flows to Indian capital market, its portfolio investment and determinants of investing in Indian market and deciding the portfolio preferences. This research also gives the suggestions on the investment avenues available for the FII in Indian with the help of Gap analysis. The Indian capital market changes amazingly quickly. Some part of this research may be out-of-date by the time of completion. Therefore, please do not assume that the information in this research continues to be correct or remains unchanged. This research is originally focused on foreign investor and its role and impact on Indian capital market.

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but reduce exposure to the Indian financial system to speculative capital flows An FII means an entity established or incorporated outside India. which encourage foreign institution investors (FIIs). foreign individuals. It covers the investment trend of FII and the various issues related to the FII investment in the domestic market. In this paper I’m particularly covering the relationship between FII and stock market. funds or portfolios established or incorporated outside India on whose behalf investments are proposed to be made in India by an FII 4 . BACKGROUND: The national common minimum programmed of the present UPA government envisages policies. while an FII sub-account includes those foreign corporate.Foreign institutional investors and Indian capital market (its determinants and avenues of investment). institutions. OBJECTIVE OF THE RESEARCH: . CHAPTER 1: INTRODUCTION Since the beginning of the liberalization of investment policies. which proposes to undertake investment in India. Paper covers the flow of FII in India and their relationship with other economic variables.To study the role and impact foreign institutional investor on Indian capital market and find out the factors that determines the flow of FIIs.SYNOPSIS TITLE OF THE PROJECT: . Flows FIIs in India steadily grown in importance.

he can only report what has happened or what is happening.The research will be covering whole capital market and investment made by FIIs. The main aim of research is to find out the truth which is hidden and which has not been discovered as yet. Journals and websites.The main characteristic of this method is that the researcher has no control over the variables. preferences of people. diligent and systematic process of inquiry aimed at discovering.CHAPTER II: RESEARCH METHODOLOGY Research is often described as active. frequency of shopping. In it we study the various steps that are generally adopted by a researcher in studying his research problem along with the logic behind them. Research methodology is a way to systematically solve the research problem. This research is helpful for investors who made the large investment in the market and too much bothered about the volatility because of FII. Most ex post facto research projects are used for descriptive studies in which researcher seeks to measure such items as. it is the key differentiator among strong brands and weak brands. Especially in the sectors like retailing. The major purpose of exploratory research is to explore the facts which are existing but new for everyone. OBJECTIVE: -The main objective of the research is to show that Supply Chain Management is the key tool in the brand building of any company. FMCG. DATA SOURCE: . It is also called as ex post facto research. interpreting and revising facts. consumer durables etc. for example. or similar data. the purpose of research is to discover answers to the questions through the application of scientific procedures. It may be understood as a science of studying how research is done scientifically.To carry out the project work I have consulted the various secondary sources of data such as Magazines. This intellectual investigation produces a greater understanding of events. Exploratory research includes surveys and fact-finding enquiries of different kinds. SCOPE OF THE STUDY: . 5 . behaviors or theories and makes practical application through laws and theories. To carry out my project I have used the exploratory research. In other words we can say.

Determinants of flow of FII. Regulatory information about FII. which will be covered as a part of the study can be given in the following points:      Flow of FII in India. 6 . I have implemented some statistical tools. CHAPTER III: DATA ANALYSIS AND INTERPRETATION To analyze the data that are collected from the various secondary sources. Liberalization of foreign investment policy.CHAPTER IV: DESCRIPTIVE WORK The subtopics. I am using two model. Flow of FII: its nature and causes. one is for analyzing the determinants of FII flow and second is for analyzing the avenues of investment for FII through Cap and Gap analysis. CHAPTER V: SUGGESTIONS AND CONCLUSION This section of the report will show all the conclusions and suggestions that I will be drawing from the above analysis.

2 ACKNOWLEDGEMENT …………………………………….………………………..18 i) ii) Research Process Scope of the study CHAPTER III: DESCRIPTIVE WORK ……. FII flow to India: nature and causes.3 PREFACE ……………………………………………………….26 i) ii) iii) iv) v) Regulatory information...CONTENTS i) ii) iii) iv) CERTIFICATE………………………………………………….4 SYNOPSIS ………………………………………………………5 CONTENT………………………………………………………..9 CHAPTER II: RESEARCH METHODOLOGY .. Determinants of foreign institutional investor.……………………………...8 Background Research Review V) i) ii) CHAPTER 1: INTRODUCTION ………………………………………………. CHAPTER IV: DATA ANALYSIS AND INTERPRETATION ……78 Conceptual model for analysis i) ii) Gap analysis for investment avenues Findings CHAPTER V: SUGGESTIONS AND CONCLUSION …………….98 ANNEXURE..………………………………………………………….94 BIBLIOGRAPHY……………………………………………………….100 7 . Foreign institutional investment in India. Liberalization of foreign institutional investor in India.

CHAPTER – 1 INTRODUCTION OF THE TOPIC 8 .

It can come in two forms: foreign direct investment (FDI) and foreign institutional investment (FII). and foreign exchange markets. impact and relationship of FII’s and Indian capital market. can have bidirectional causation with the returns of other domestic financial markets such as money markets. understanding the determinants of FII is very important for any emerging economy as FII exerts a larger impact on the domestic financial markets in the short run and a real impact in the long run.S. so that we can frame our policies to influence the variables that attract foreign 9 . however. India is in the process of liberalizing its capital account. The present study examines the role. mostly in the financial markets. Hence. has taken many measures to attract foreign investment since the beginning of reforms in 1991. Up to the end of January 2003. and this has a significant impact on foreign investment and particularly on FII. After the opening up of the borders for capital movement. India. varies from country to country. Foreign investment provides a channel through which developing countries can gain access to foreign capital. and also determinants of foreign institutional investment in India. being a capital scarce country. there is a need to determine the push and pull factors behind any change in the FII. a country that opened its economy to foreign capital following a foreign exchange crisis. these investments have grown in leaps and bounds. But foreign institutional investment is a short-term investment. The effect of foreign investment. given its short-term nature.S.INTRODUCTION Foreign investment refers to investments made by the residents of a country in the financial assets and production processes of another country. not only to increase the productivity of labor but also because foreign capital helps to build up the foreign exchange reserves needed to meet trade deficits.$48 billion out of which U. It can affect the factor productivity of the recipient country and can also affect the balance of payments. India succeeded in attracting a total foreign investment of around U.to long-term nature. Foreign direct investment involves in direct production activities and is also of a medium. which affects short-term stability in the financial markets. In developing countries there has been a great need for foreign capital. stock markets.$12 billion was in the form of FII. These figures show the importance of FII in the overall foreign investment program. Hence. FII.

investment. The present study aims to examine the role. ADR (American Depositary Receipts). we discuss the theoretical model. The database and methodology adopted in this study are explained in Section V. risk. 10 . In the next section we will briefly consider the existing studies of this topic. impact. as it is held to be responsible for having intensified the currency crises of the 1990s in East Asia and elsewhere in the world. We attempt to analyze the effect of return. FII has been the subject of intense discussion. and inflation. Section IV briefly assesses the trends in FII in India. In Section III. we discuss the estimated results of the study. we consider only FII in this study. Foreign portfolio investments include FII and other components like GDR (Global Depositary Receipts). and appropriate conclusions are drawn in the last section. In Section VI. whereas inflation and risk in the foreign country and return in the domestic country have a favorable effect on the flow of FII. There is another concept called “foreign portfolio investments” (FPI). Also. determinants and avenues of investment for FII in the Indian context. As the components in FPI other than FII are not dependent on market forces and they are not volatile. and offshore funds and others. The proposed relationship among the factors (discussed in detail later) is that inflation and risk in the domestic country and return in the foreign country adversely affect the FII flowing to the domestic country. which in the research are considered to be the major determinants of FII. which is a broader one compared to FII.

foreign individuals. to 275. the share of capital flows in the form of portfolio investments quadrupled to reach 37. In this process multilateral bodies led by the International Finance Corporation (IFC) played a major role. funds or portfolios established or incorporated outside India on whose behalf investments are proposed to be made in India by an FII The national common minimum programmed of the present UPA government envisages policies. All the main components of the private account capital transfers. the Official Development Assistance (ODA). but reduce exposure to the Indian financial system to speculative capital flows.THE BACKGROUND An FII means an entity established or incorporated outside India. By the time the East Asian financial crisis surfaced. The character of global capital flows to developing countries underwent significant changes on many counts during the 'nineties. (b) foreign direct investments (FDI).55 per cent. by 1996. Portfolio flows increased at a faster rate than direct investments on private account. In relative terms the percentage of private account capital flows increased from 43. (a) commercial loans.22 per cent in 1996 reflecting the enhanced emphasis on private capital flows with portfolio investments forming the second important constituent of the flows during the 'nineties. Following the East Asian financial crisis. Decline in FDI was also delayed. namely. while an FII sub-account includes those foreign corporate.9 billion during the same period. initially there was a slow down followed. It stood at US$ 100.55 to 89. the overall size of the flows more than tripled. by a decline in private capital flows. starting with a low level of 11. But the fall in FDI was quite small compared to the 11 .8 bn. in 1990 and rose to US$ 308. As a result. which proposes to undertake investment in India. which encourage foreign institution investors (FIIs).9 bn. loans from commercial banks dropped a year later in 1998. declined both in relative and absolute terms. institutions. Simultaneously.16 per cent.1 bn. While bonds and portfolio equity flows reacted quickly and declined in 1997 itself. and (c) foreign portfolio investments (equity and bonds) (FPI) recorded significant increases. The increase was entirely due to the sharp rise in the flows under private account that rose from US$ 43.

The declining importance of official development finance is attributed to budgetary constraints in donor countries and the optimism of private investors in the viability of the developing countries. the industrialised world preferred to encourage private capital transfers through direct investments instead of official assistance. Portfolio investments spread risk for foreign investors. starting with the resolve by the developed countries to provide one per cent of their GNP as developmental aid. 12 . following the crisis.other three major forms of private capital flows. While flows on official account increased. which are expected to grow faster. and provide an opportunity to share the fruits of growth of developing countries. Thus. they continue to constitute only a small portion of the total flows.

Host countries seeking foreign portfolio investments are obliged to improve their trading and delivery systems. FPI. multilateral bodies. provides critical risk capital for new projects. For developing countries. To retain confidence of portfolio investors’ host countries are expected to follow consistent and business friendly liberal policies. as foreign portfolio investors are believed to invest on the basis of well-researched strategies and a realistic stock valuation. which would also benefit the local investors. This could hurt 13 .Investing in emerging markets is expected to provide a better return on investments for pension funds and private investors of the developed countries. portfolio investments would influence the exchange rate and could lead to artificial appreciation of local currency. it is expected. To enable FPI flows which prefer easy liquidity. and helps expand host country markets and foreign trade. are welcomed by developing countries since these are non-debt creating. Portfolio investments have some macroeconomic implications. Portfolio investments supplement foreign exchange availability and domestic savings but are most often not project specific. foreign portfolio investors can influence developing country capital markets in a significant manner especially in the absence of large domestic investors. have been encouraging establishment and strengthening of stock markets in developing countries as a medium that will enable flow of savings from developed countries to developing countries. led by the International Finance Corporation (IFC). foreign portfolio equity investment has different characteristics and implications compared to FDI. While contributing to build-up of foreign exchange reserves. it does not directly contribute to creation of new production capabilities. introduce new management and marketing skills. increase price-earning (PE) ratios and consequently reduce cost of capital for investment. FPI. if involved in primary issues. data and experience of operating in widely differing economic and political environments. could help achieve a higher degree of liquidity at stock markets. FPI. FDI is expected to facilitate transfer of technology. FPI is also expected to lead to improvement in the functioning of the stock market. The portfolio investors are known to have highly competent analysts and access to a host of information. Besides supplementing domestic savings. Having access to large funds. Since FPI takes the form of investment in the secondary stock market.

the Mexican and East Asian crises brought into focus the higher risk involved in portfolio investments.competitiveness. to assess the importance of different types of foreign portfolio investments in capital flows to India. Such an exercise. The present paper has two objectives. The volatility of FPI is considerably influenced by global opportunities and flows from one country to another. And two. it is hoped. One. RESEARCH REVIEW 14 . Though it is sometime argued that FDI and FPI are both equally volatile. would explain the relationship between foreign institutional investments and trading pattern in the Indian stock market better than aggregate level analysis. Portfolio investments are amenable to sudden withdrawals and therefore these have the potential for destabilizing an economy. to understand the investment behaviour of foreign portfolio investors through an analysis of the portfolios of US-based India specific funds.

There have been several attempts to explain FII behavior in India. All the existing studies have found that equity return has a significant and positive impact on FII (Agarwal 1997; Chakrabarti 2001; Trivedi and Nair 2003). But given the huge volume of investments, foreign investors can play the role of market makers and book their profits, that is, they can buy financial assets when the prices are declining, thereby jacking-up the asset prices, and sell when the asset prices are increasing (Gordon and Gupta 2003). Hence, there is a possibility of a bidirectional relationship between FII and equity returns. Following the Asian financial crisis and the bursting of the info-tech bubble internationally in 1998/99, net FII declined by U.S.$61 million. This, however, exerted little effect on equity returns. This negative investment might possibly disturb the longterm relationship between FII and other variables such as equity returns, inflation, and so on. Chakrabarti (2001) has perceived a regime shift in the determinants of FII following the Asian financial crisis and found that in the pre–Asian crisis period, any change in FII had a positive impact on equity returns. But it was found that in the post–Asian crisis period, a reverse relationship has been the case, namely, that change in FII is mainly due to change in equity returns. This is a fact that needs to be taken into account in any empirical investigation of FII. Investments, either domestic or foreign, depend heavily on risk factors. Hence, while studying the behavior of FII, it is important to consider the risk variable. Further, realized risk can be divided into ex-ante and unexpected risk. Ex-ante risk is an observed component and is negatively related to FII. But the relationship between unexpected risk and FII is obscure. Therefore, while examining the impact of risk on FII, one needs to separate the unobserved component from the realized risk. Trivedi and Nair (2003) have used only the realized risk. Another possible determinant of FII is the operation of foreign factors such as returns in the source country’s financial markets and other real factors in the source economy. So far, however, studies have found that both return in the source country stock market and the inflation rate have not exerted any impact on FII. Agarwal (1997) found that world stock market capitalization had a favorable impact on the FII in India. A survey of the literature shows that existing studies do not account for volatility, which can be expected in most of the monthly financial time series data. Yet given the increase

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in financial market integration, both domestically and in foreign financial markets, accounting for volatility is unavoidable. Further, the existing studies either do not incorporate risk in foreign and domestic markets or make use of realized risk, an approach that does not always yield robust results. This is because standard deviation/variance (realized risk variable) increases irrespective of the direction in which stock returns move, while movement of FII is determined by bull/bear phases. It is preferable, therefore, to divide the realized risk into ex-ante risk and unpredictable risk. Since investment in stock markets is sentiment driven, and is affected more or less by everything, the crucial task is to identify a few critical determinants. This research makes a modest attempt to explore the relation between FII and its pivotal determinants, for the particular case of India. More specifically, a few important variables believed to be affecting FII are chosen and then a theoretical model is built and empirically tested for India. The focus of this research is the study of the critical determinants of FII, so as to provide a better understanding of FII behavior that helps while liberalizing the capital account and investment avenues for FII in Indian capital market. We hope that the study will be important from a policy perspective, as FII constitutes an important element for the smooth functioning of domestic financial markets.

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CHAPTER – 2 RESEARCH MATHEDOLOGY

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situation or a group. Research methodology is a way to systematically solve the research problem. 18 . Thus. 3) To determine the frequency with which something occurs or with which it is associated with something else. we may think of research objectives as falling into a number of following broad categories: 1) To gain familiarity with a phenomenon or to achieve new insights into it.RESEARCH MATHEDOLOGY The purpose of research is to discover answers to the questions through the application of scientific procedures. what data have been collected and what particular method has been adopted. Research methodology has many dimensions and research methods do constitute a part of the research methodology. 2) To portray accurately the characteristics of a particular individual. why particular technique of analyzing data has been used and a host of similar other question are usually answered when we talk of research methodology concerning a research problem or study. In it we study the various steps that are generally adopted by a researcher in studying his research problem along with the logic behind them. when we talk of research methodology we not only talk of the research methods but also consider the logic behind the methods we use in the context of our research study and explain why we are using a particular method or technique and why we are not using others so that research results are capable of being evaluated either by the researcher himself or by others. It may be understood as a science of studying how research is done scientifically. The scope of research methodology is wider than that of research methods. Why a research study has been undertaken. 4) To test a hypothesis of a casual relationship between variables. The main aim of research is to find out the truth which is hidden and which has not been discovered as yet. Though each research study has its own specific purpose.

that is he must decide the general area of interest or aspect of a subject matter that he would like to inquire into. i. In this research the problem that I have formulated is ‘role and impact of foreign institutional investor on Indian capital market.’ 19 . if any. each formulation more specific than the preceding one. Initially the problem may be stated in a broad general way and then the ambiguities. Then the feasibility of a particular solution has to be considered before a working formulation of the problem can be set up. In fact. each one phrased in more analytical terms. Review the Literature Review concepts & theories Review previous research & findings Feed forward Define research problem Formulate hypotheses Design research Collect data Analyze data Feed back Interpret and report A brief description of the above steps is stated below: 1) Formulating the research problem At the very outset the researcher must single out the problem he wants to study.Research Process Research process consists of series of actions or steps necessary to effectively carry out research and the desired sequencing of these steps. and each more realistic in terms of the available data and resources. formulation of the problem often follows a sequential pattern where a number of formulations are set up. relating to the problem be resolved.e.

2) Extensive literature survey Once the problem is formulated. he will have to state the conceptual structure within which research would be conducted. They also affect the manner in which tests must be conducted in the analysis of the data and indirectly the quality of data. Working hypothesis is tentative assumption made in order to draw out and test its logical or empirical consequences. 20 . which are similar to the study in hand have been carefully studied. involves usually the consideration of the following: a) b) c) The means of obtaining the information: The availability and skills of the researcher and his staff. The preparation of the research design. which is required for the analysis. At this juncture I have undertaken extensive literature survey connected with the problem. The manner in which research hypothesis are developed is particularly important since they provide the focal point for research. Explanation of the way in which selected means of obtaining information will be organized and the reasoning leading to the selection. 3) Development of the working hypothesis After extensive literature survey.e. time and money. The earlier studies. the researcher will be required to prepare a research design i. In other words the function of research design is to provide for the collection of relevant evidence with minimal expenditure of effort. 4) Preparing the research design The research problem having been formulated in clear-cut terms. a brief summary of it should be written down. researcher should state in clear terms the working hypothesis or hypotheses.

but in case of survey. The items so selected constitute what is technically called a sample. Through telephone interview. and The cost factor relating to research. objective and scope of the inquiry. Primary data can be collected either through experiment or through survey. By mailing of questionnaires. 21 . a sample design is a definite plan determined before any data are actually collected for obtaining a sample from a given population 6) Collecting the data In dealing with any real life problem it becomes necessary to collect data that are appropriate. 5) Determining sample design All the items under consideration in any field of inquiry constitute a ‘universe’ or ‘population’. Through schedules. The researcher should select one of these methods of collecting the data taking into consideration the nature of investigation.d) e) The time available for research. Through personal interview. There are several ways of collecting the appropriate data. Quite often we select only a few items from the universe for our study purposes. In other words. data can be collected by any one of the following ways: a) b) c) d) e) By observation. The researcher must decide the way of selecting a sample or what is popularly known as the sample design.

Analysis work after tabulation is generally based on the computation of various percentages. 22 . the application of these categories to raw data through coding.e. to build a theory. As a matter of fact. the real value of research lies in its ability to arrive at certain generalization.the analysis of data requires a number of closely related operations such as establishment of categories. he had formulated earlier. if any. etc. 8) Analysis of the data After the data have been collected. The researcher should see that the project is executed in a systematic manner and in time. in brief the researcher can analyse the collected data with the help of various statistical tools. 9) Hypothesis-testing After analyzing the data. 10) Generalisations and interpretation If a hypothesis is tested and upheld several times. A careful watch should be kept for unanticipated factors in order to keep the survey as much realistic as possible.7) Execution of the project Execution of the project is a very important step in the research process. which should be answered while testing the hypothesis. it may be possible for the researcher to arrive at generalization. Do the facts support the hypothesis or they happen to be contrary? This is the usual question.. tabulation and then drawing statistical inferences. coefficients. the researcher turns to the task of analyzing them. i. the researcher is in a position to test the hypothesis.

Writing of report must be done with great care keeping in view the following: 1) In its preliminary pages the report should carry the title and data followed by acknowledgements and foreword. 23 . Charts and illustrations in the main report should be used only if they present the information more clearly and forcibly.11) Preparation of the report Finally the researcher has to prepare the report of what has been done by him. 2) 3) Report should be written in a concise and objective style.

24 . but their influence on the domestic markets is also growing. have the additional advantage of being project specific and thus can contribute directly to productive investments. In the absence of any other substantial form of capital inflows. Particularly. the initial expectations have not been realised. Results of this study show that not only the FIIs are the major players in the domestic stock market in India.SCOPE OF THE STUDY A number of studies in the past have observed that investments by FIIs and the movements of Sensex are quite closely correlated in India and FIIs wield significant influence on the movement of sensex. FII investments. From the point of attracting foreign capital. 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. GDR issues. seem to have influenced the Indian stock market to a considerable extent. There is little doubt that FII inflows have significantly grown in importance over the last few years. Moreover. in the companies that constitute the Bombay Stock Market Sensitivity Index (Sensex). Data on shareholding pattern show that the FIIs are currently the most dominant non-promoter shareholder in most of the Sensex companies and they also control more tradable shares of Sensex companies than any other investor groups. 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. their level of control is very high. unlike FII investments. Investment by FIIs directly in the Indian stock market did not bring significantly large amount compared to the GDR issues. the potential ill effects of a reduction in the FII flows into the Indian economy can be severe.

CHAPTR – 3 DESCRIPTIVE WORK ON SUBTOPICS 25 .

1999. FII investment (in shares and debentures) started in January 1993. Over the years. the Securities and Exchange Board of India (SEBI) 6 enforced the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations. (c) raising the caps for FII investment in different sectors and companies. The SEBI FII Regulations and RBI policies are amended and modified from time to time in response to the gradual maturing of the Indian financial market and changes taking place in the global economic scenario. as India has to compete with other Asian nations and other emerging markets of the world for global capital inflows. 1995 (henceforth. the SEBI acts as the nodal authority and once SEBI registration has been obtained. lowering fees. (d) easing the norms for FII registration. an FII does not require any further permission for trading securities or for transferring funds into or out of India. In India. needless to mention. operating foreign currency and rupee bank accounts and remitting and repatriating funds. reducing procedural delays. and (e) mandating stricter 26 .. coverage and quality of FII investment. FII regulations by the SEBI were first introduced on November 14. etc. is required to be done to ensure quantitative as well as qualitative improvements in the portfolio flows through the FII route. At present. through a variety of measures. The SEBI regulations require FIIs to register with the SEBI and also obtain approval from the Reserve Bank of India (RBI) under the FEMA for securities trading. are trying to improve the scope.REGULATORY INFORMATION FII flows to India formally began in September 1992 under the foreign portfolio investment (FPI) scheme. referred to as SEBI FII Regulations) to regulate matters relating to FII investment flows. (b) expanding the list of the types of funds that can be registered as FIIs in India and the entities on behalf of whom they can invest. 1995 in the form of the SEBI FII Regulations. In November 1995. investment by FIIs is jointly regulated by this and Regulation 5(2) of the Foreign Exchange Management Act (FEMA). the SEBI and the RBI together. These measures include (a) widening the array of instruments in which FIIs are allowed to trade. Such modification. In the entire process of FII registration and regulation. when the Government of India issued the Guidelines for Foreign Institutional Investment.

disclosure norms. etc. The hypothesis underlying the present empirical analysis is essentially that both strengthening of the regulatory infrastructure by the SEBI and the RBI on the one hand and further liberalisation and easing of regulatory curbs for FIIs at various time points in history on the other have had a positive impact on the flows to the national stock markets. 27 . A summary of the major regulatory changes relating to FIIs along with their reference dates is presented in Table 1.

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THE PRE. formally set forth in detail: • Conditions and procedures for grant or renewal of certificates to FIIs (and their subaccounts) permitting them to operate directly in the Indian stock market. which include appointment of a domestic custodian. 31 . maintenance of proper books of accounts. records. • The fees and taxes to be paid.) • Conditions for and restrictions on investment. verification of whether it is legally permissible for the applicant to invest in securities outside the country of its incorporation. • Provisions for appeal in case of any grievances. appointment of a branch of a bank approved by the RBI for opening of foreign currency denominated accounts and special non-resident rupee accounts. etc.AND POST-FII REGULATION PERIODS The SEBI FII Regulations. and the applicable caps or ceilings in respect of different types of instruments (or sectors). etc. • General obligations and responsibilities. and whether any legal proceeding has been initiated by any statutory authority against the applicant. which include the type of instruments an FII is allowed to invest in. (This includes the eligibility criteria for being permitted to be registered as an FII in India. • Procedure for action in case of default and suspension/cancellation of certificate. whether the applicant has been registered with any statutory authority in that country. introduced in mid-November 1995.

we regress the monthly net equity flows (FIINM) (for the 54-month preceding the Asian crisis) on returns on the BSE Sensex (BSER). 32 . Comparing the monthly inflows prior to the introduction of the SEBI Regulations with the corresponding post regulation (pre-Asian crisis) period inflows. in the post-regulation period.regulation flows. To carry out this test. causing a major gap between the pre. with the post-regulation period having a much higher average (and median) inflow.and post. we compare our pre-regulation period with the post-regulation period up to the beginning of the Asian crisis (which is taken to be up to June 1997). We use the monthly data series of FII net equity inflows (FIINM) to study this impact. However. The result of the Chow test strongly suggests existence of a structural break in the time series data on FII flows under consideration at the time point of the introduction of the SEBI Regulations in November 1995. it is easy to see that the average (and median) monthly inflows during these two sub-periods were quite different. the Asian currency crisis had a very strong negative effect on global capital flows. thus confirming that the introduction of a comprehensive set of laws to govern FII flows had definitely helped to attract more foreign portfolio investment flows into the country until the onset of the Asian financial crisis. particularly to emerging Asian economies. which helps us detect any significant shift in the flows immediately after the introduction of the SEBI FII Regulations.It is obviously of interest to see whether the introduction of the SEBI FII Regulations had any immediate repercussions on FII equity investments. Next we consider the result of a Chow break point test. In order to filter out this effect. A research confirms that the difference between the means (and medians) of the two sub-periods are indeed statistically significant with the postregulation period experiencing much higher flows on an average.

Diversifying internationally has long been known as a way to reduce the overall portfolio risk and even earn higher returns. 2600 crores in 1993 to over Rs. The corresponding figures in the previous year were 59% and 64% respectively. or in the absence of a pre-specified risk level. an investor holding an all-US portfolio could improve her returns by over 25% by holding the MSCI world index instead and at the same time. 33 . to reach the optimum portfolio. reduce her risk by about 2%. The Indian situation has been no different. A significant part of these portfolio flows to India comes in the form of Foreign Institutional Investors’ (FIIs’) investments. For instance. 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. In the year 2000-01 portfolio investments in India accounted for over 37% of total foreign investment in the country and 47% of the current account deficit. between 1985 and 1990. which lies at the heart of the portfolio flows. The International Portfolio Investor’s decision-making problem International portfolio flows. mostly in equities. is briefly described bellow.000 crores in the first half of 2001 alone.FII FLOWS TO INDIA: NATURE AND CAUSES Portfolio investment flows from industrial countries have become increasingly important for developing countries in recent years. as opposed to foreign direct investment (FDI) flows. Their share in total portfolio flows to India grew from 47% in 1993-94 to over 70% in 1999-20001. FII investments have steadily grown from about Rs. that which has the highest Sharpe ratio. The nature of the foreign investor’s decision-making process. Ever since the opening of the Indian equity markets to foreigners.11. The portfolio investor’s problem may be thought of as deciding upon appropriate country weights in the portfolio so as to maximize portfolio returns subject to a risk constraint. according to Morgan Stanley Capital International’s estimates. 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. S where the Sharpe ratio is the ratio of expected excess return (excess over the risk-free rate) to the dispersion (standard deviation) of the return.

International capital flows and capital controls have emerged as an important policy issues in the Indian context as well. Next we study the relationship between FII flows and the stock market returns in India with a close look at the issue of causality. had no significant benefits for the economy at large. for these reasons. 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. In all of these investigations we make a distinction between the pre-Asian crisis period and the post-Asian crisis period to check if there was a regime shift in the relationships owing to the Asian crisis. in fact.While it is generally held that portfolio flows benefit the economies of recipient countries. The broad objective of the present paper is to gain a better understanding of the nature and determinants of FII flows. comparatively less attention has been paid so far to analyzing the FII flows data and understanding their key features. expressed doubts about the wisdom of the IMF view of promoting free capital mobility among countries. 34 . Towards this end we first take a look at the FII investment flow data to bring out the key features of these flows. Portfolio flows – often referred to as “hot money” – are notoriously volatile compared to other forms of capital flows. is essential for a meaningful debate about their effects as well as predicting the chances of their sudden reversals. In the wake of the Asian crisis. 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. Finally we study the impact of other factors identified in the portfolio flows literature on the FII flows to India. this paper undertakes an empirical analysis of FII investment flows to India. Some authors have argued that FII flows have. A proper understanding of the nature and determinants of these flows. While these concerns are all well-placed. policy-makers worldwide have been more than a little uneasy about such investments. In an attempt to address this lacuna. They have also been held responsible for spreading financial crises – causing ‘contagion’ in international financial markets. however. prominent economists have. The danger of Mexico-style ‘abrupt and sudden outflows’ inherent with FII flows and their destabilizing effects on equity and foreign exchange markets have been stressed.

reducing their diversification benefits. however. several researchers5 have found evidence of persistent ‘home bias’ in the portfolios of investors in industrial countries in the 90’s. therefore. They are usually undertaken by institutional investors like pension funds and mutual funds. This ‘home bias’ – 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. investors in developed countries will have a greater opportunity to hold foreign assets. It is important to note that global financial integration. liquid in nature and are motivated by international portfolio diversification benefits for individual and institutional investors in industrial countries. as opposed to foreign direct investment. The next section sketches a brief review of the recent literature in the area. investors in industrial countries have increasingly sought to realize the potential for portfolio diversification that these markets present. The third section provides an overview of the nature and sources of portfolio flows in India pointing out their main characteristics. Such flows are. the subsequent ‘Tequila effect’. can have two distinct and in some ways conflicting effects on this ‘home bias’. Which of these two effects will dominate is. The fourth section probes into the possible determinants of FII flows to India. and the widespread ‘Asian crisis’ have had temporary dampening effects on international portfolio flows. largely determined by the performance of the stock markets of the host countries relative to world markets. The fifth and final section concludes with a summary of the major findings and their policy implications. along with greater trade flows will tend to cause different national markets to increasingly become parts of a more unified ‘global’ market. However. While the Mexican crisis of 1994. As more and more countries – particularly the emerging markets – open up their markets for foreign investment. these flows themselves. With the opening of stock markets in various emerging economies to foreign investors. International Portfolio Flows International portfolio flows are.The paper is arranged as follows. of 35 . Indeed. they have failed to counter the long-term momentum of these flows.

FII flows would increase with global integration. For the present purposes. the patterns of foreign equity investment were far from what an international portfolio diversification model would recommend. The share of investments going to emerging markets has been roughly proportional to the share of these markets in global market capitalization but the volatility of US transactions were even higher in emerging markets than in other OECD countries. The question is particularly important for policy makers in order to get a better understanding of the reliability and stability of such flows. high turnover in foreign market investments and that. 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. In recent years. While papers in the finance tradition have focused on the nature and determinants of portfolio flows from the perspective of the diversifying investors. those from the international macroeconomics perspective have focused on the recipient country’s situation and appropriate policy response to such flows. The findings include the well-documented ‘home bias’ in OECD investments. As for the motivation of US equity investment in foreign markets.course. with the latter being particularly important in the case of Asian countries and for debt flows rather than equity flows. an empirical issue. we shall focus only on papers that address the issue of portfolio flows exclusively. international portfolio flows to developing countries have received the attention of scholars in the areas of finance and international economics alike. in general. The Mexican and Asian crises and the widespread outcry against international portfolio investors in both cases have prompted analyses of short-term movements in international 36 . In the 90’s several papers have explored the causes and effects of cross-border Portfolio investment. Previous research has also attempted to identify the factors behind these capital flows. The answer is mixed – both global and countryspecific factors seem to matter. Furthermore there was no relation between the volume of US transactions in these markets and their stock market volatility. recent research8 suggest that US portfolio managers investing abroad seem to be chasing returns in foreign markets rather than simply diversifying to reduce overall portfolio risk. but given the extent of the ‘home bias’ it is likely that for quite a few years to come.

Also the flows are more persistent than returns in the domestic markets. It is commonly argued that local investors possess greater knowledge about a country’s financial markets than foreign investors and that this asymmetry lies at the heart of the observed ‘home bias’ among investors in industrialized countries. only the recipient country’s returns should affect these flows. portfolio flows to a country would be related to returns in both recipient and source countries. More recent studies find that the effect of ‘regional factors’ as determinants of portfolio flows have been increasing in importance over time. If a gain in equity values tends to bring in more portfolio inflows. In the period leading to the Asian crisis. however. Between 1989 and 1996 unexpected equity flows from abroad raised stock prices in Mexico with at the rate of 13 percentage points for every 1% rise in the flows. While FII flows to the Asian Crisis countries dropped sharply in 1997 and 1998 from their precrisis levels. In other words portfolio flows to different countries in a region tend to be highly correlated. Korea witnessed positive feedback trading and significant ‘herding’ among foreign investors. This refers to investors’ reaction to recent changes in equity prices. these tendencies actually diminished markedly in the crisis period and there has been no evidence of any ‘destabilizing role’ of foreign equity investors in the Korean crisis. on the other hand. In the absence of such asymmetry. contrary to the belief in some segments. There has been. 37 . it is an instance of ‘positive feedback trading’ while a decline in flows following a rise in equity values is termed ‘negative feedback trading’.portfolio investment flows. The flows appear to affect contemporaneous and future stock returns positively. no evidence of ‘feedback trading’ among foreign investors in Mexico. Feedback trading or return-chasing behavior is also more pronounced. Nevertheless. particularly in the case of emerging markets. Finally stock prices seem to behave on the assumption of persistent portfolio inflows. A key implication of recent theoretical work in this area is that in the presence of such information asymmetry. it is generally held that the flows reacted to the crisis (possibly exacerbating it) rather than causing it. The question of ‘feedback trading’ has received For the related literature on international capital flows in general (comprising both FDI and portfolio flows) considerable attention.

foreign corporations need to register with the SEBI as Foreign Institutional Investors (FII). as well as asset management companies and other money managers operating on their behalf. SEBI’s definition of FIIs presently includes foreign pension funds. In order to trade in Indian equity markets. mutual funds. since 1993.FOREIGN INSTITUTIONAL INVESTMENT IN INDIA: AN OVERVIEW India opened its stock markets to foreign investors in September 1992 and has. received considerable amount of portfolio investment from foreigners in the form of Foreign Institutional Investor’s (FII) investment in equities. charitable/endowment/university funds etc. 38 . This has become one of the main channels of international portfolio investment in India for foreigners.

1900 crores during the first six months of 2001.000 crores during this time (see Fig. By June 2001. In terms of market capitalization too. 39 .The trickle of FII flows to India that began in January 1993 has gradually expanded to an average monthly inflow of close to Rs. The total amount of FII investment in India had accumulated to a formidable sum of over Rs. 50. over 500 FIIs were registered with SEBI. in turn. 1). the share of FIIs has steadily climbed to about 9% of the total market capitalization of BSE (which. accounts for over 90% of the total market capitalization in India).

It is also possible for foreigners to trade in Indian securities without registering as an FII but such cases require approval from the RBI or the Foreign Investment Promotion Board. US-based institutions accounted for slightly over 41%. the regional breakdown of the FIIs does provide an idea of the relative importance of different regions of the world in the FII flows.The sources of these FII flows are varied. or even those based at Singapore or Hong Kong are likely to be investing funds largely on behalf of residents in other countries. instructive to bear in mind The closedend country fund. It is. however. Foreign Currency Convertible Bonds and Foreign Currency Bonds issued by Indian companies and traded in foreign exchanges provide other routes for portfolio investment in India by foreign investors. American Depository Receipts. “The India Fund” launched in June 1986 provided a channel for portfolio investment in India before the stock market liberalization in 1992. those from the UK constitute about 20% with other Western European countries hosting another 17% of the FIIs (Fig. national affiliations are very rough indicators of the ‘home’ of the FII investments. Cayman Islands or Channel Islands. 40 . that these national affiliations do not necessarily mean that the actual investor funds come from these particular countries. 2). In particular institutions operating from Luxembourg. Global Depository Receipts. Given the significant financial flows among the industrial countries. The FIIs registered with SEBI come from as many as 28 countries (including money management companies operating in India on behalf of foreign investors). Nevertheless.

The correlation coefficients between different measures of FII flows and market returns on the Bombay Stock Exchange during different sample periods are shown in the different panels of Table 1. FII flows and stock returns – determining the cause and the effect FII flows and contemporaneous stock returns are strongly correlated in India. While the correlations are quite high throughout the sample period. particularly stock returns in the Indian market.FACTORS AFFECTING FII FLOWS In this section we shall study the relationship between FII flows and possible economic factors affecting it. 41 . they exhibit a significant rise since the beginning of the Asian crisis.

The ‘base-broadening’ argument contends that once foreigners begin to invest in a country. The positive relationship between market return and FII flows. correlation itself does not imply causality. During and after the crisis. the returns explained about 40% of the total variation in FII flows. however. in fact. 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. it is only normal to expect that several factors – both domestic as well 42 . that the Asian crisis marked a regime shift in the relationship between FII flows and Indian stock market return. As the market itself is now affected by more factors than before. and 4) the “positive feedback strategy” view. and stock prices rise to higher levels. Consequently the ‘risk’ of the market itself falls. 2) the “downward sloping demand curve” view. have no causal relationship between them but are both affected by one or more other variables missed out in the analysis. however. Since the FII flows essentially serve to diversify the portfolio of foreign investors. 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. both directions of causation are equally plausible. A positive relationship between portfolio inflows and stock returns is consistent with at least four distinct theories: 1) the “omitted variables” hypothesis. 3) the “base-broadening” theory. serves only as a first-pass in understanding the nature of such flows and their implications for the Indian markets. However. 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. Further returns on the BSE Index explain close to a third of the total variation in FII flows during the entire period. its exposure to domestic shocks decline. The “omitted variables” view is the classic case of spurious correlation – that the correlated variables.These positive correlations have often been held as evidence of FII actions determining Indian equity market returns. people demand a lower risk premium to buy stocks. They also indicate. In the present context.

These raw ratings were then divided by the world average rating to obtain normalized ratings.15. Thus we can conclude that broadly speaking there is no evidence of India’ credit rating affecting FII flows. If India’s credit rating improves but that of other countries improve even more. The relation between the normalized country rating and the average monthly FII flows (as a proportion of the preceding month’s BSE capitalization) is shown in Figure 5. Past research suggests that the declining world interest rates have been among the important “push” factors for international portfolio flows in the early 90’s. In order to check the impact of such country risk on FII flows. an important country-rating agency. The correlation between the two variables is –0. then India may not improve its relative attractiveness as a destination of investment flows. stock market volatility. however these factors do not appear to have had a prominent role in motivating FII flows. In the Indian case. Other factors that may affect FII flows Country risk measures. 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. some measure of the country risk and the exchange rate. changes in interest rates. that incorporate political and other risks in addition to the usual economic and financial variables. semi-annual country risk scores for India were taken from the Institutional Investor magazine.as external to India – are likely to affect them along with the expected stock returns in India. Finally it also appears that there has been no significant informational disadvantage for FIIs vis-à-vis the local investors in the Indian market. The “usual suspects” in the literature include US and world equity returns. No relationship is evident from the figure itself and statistical testing confirms this view. The intuition behind this normalization is as follows. 43 .

It is also conceivable that the extent to which the Indian market moves out of step with the world market is a factor in determining its attractiveness to foreign investors. the greater the protection that investment in India provides to investors against world market shocks. The lower the co-movement. 44 .

the Committee had 5 meetings. B Recommendations in para A above would apply. The suggested measure will be in conformity with this original stipulation. the existing limit of 10per cent by a FII in a single company may continue. FII investment ceilings. examines the pros and cons of FII investment. d. The Committee was reconstituted twice. The report gives an evolution of FII policy in India. FII investments are currently not permitted in print media. especially in an era with no balance of payment pressures. b. Telecom services. Defence production c. if any. 24. Public sector banks. 45 . in general. (i) In general. After the second reconstitution. and also provides a perspective on FII investment restrictions in peer countries in Asia. sectors which are not yet opened for private investment and in gambling. Insurance companies. Specific recommendations are being made for the following sectors with overall composite caps : a.LIBERALISATION OF FOREIGN INSTITUTIONAL INVESTMENT Following the announcement by the Government in the Budget 2002-03 that suggested those foreign institutional investors’ (FII) portfolio investments would not be subject to the sectoral limits for foreign direct investment except in specified sectors. the last being held on June. The Committee recommends the same may continue. The 24 per cent limit on FII investment imposed in 1992 when allowing FII inflows was exclusive of the FDI limit. a Committee was constituted with representation from the Department of Economic Affairs as well as the Department of Industrial Policy and Promotion. to all sectors. may be reckoned over and above prescribed FDI sectoral caps. betting. (ii) Special procedure for raising FII investments beyond 24per cent upto the FDI limit in a company may be dispensed with by amending the relevant SEBI (FII) Regulations. The recommendations are as follows: A. (iii) In order to provide dispersed investments and prevent concentration. 2004. lottery.

Furthermore. 1992. a committee was set up on March 13. Evolution of FII Investment Policy India embarked on a gradual shift towards capital account convertibility with the launch of the reforms in the early 1990s. Ever since September 14. 46 . including shares. however. 2002. debentures and warrants issued by companies which were listed or were to be listed on the Stock Exchanges in India and in the schemes floated by domestic mutual funds. with the approval of Finance Minister. when FIIs were first allowed to invest in all the securities traded on the primary and secondary markets. Although foreign natural persons – except NRIs – are prohibited from investing in financial assets. respectively. the holding of a single FII and of all FIIs. FII investments. except in print media companies. such investments were permitted by FIIs and Overseas Corporate Bodies (OCBs) with suitable restrictions.FDI investment in retail trading is prohibited. 2002 to identify the sectors in which FIIs’ portfolio investments will not be subject to the sectoral limits for Foreign Direct Investment (FDI). In his Budget Speech on February 28.” 2. funds invested by FIIs had to have at least 50 participants with no one holding more than 5 per cent to ensure a broad base and preventing such investment acting as a camouflage for individual investment in the nature of FDI and requiring Government approval. The Committee recommends the same may continue as this would help in developing supply chains in a wide range of products including that of agriculture. Guidelines in this regard will be issued separately. I propose that now FII portfolio investments will not be subject to the sectoral limits for foreign direct investment except in specified sectors. are permitted up to 24 per cent in all listed companies. the Finance Minister announced that: “Foreign Institutional Investors (FIIs) can invest in a company under the portfolio investment route beyond 24 per cent of the paid-up capital of the company with the approval of the general body of the shareholders by a special resolution. Non-resident Indians (NRIs) and OCBs in any company were subject to the limit of 5 per cent and 24 per cent of the company’s total issued capital. Following this announcement.

SEBI has indicated that the existing non-eligible PNs. or a proprietary fund. FIIs were also permitted to seek SEBI registration in respect of sub-accounts for their clients under the regulations. 2001. leaving out individual foreign investors and foreign companies. investment in to a sub account is to be made either by FIIs. SEBI stipulated that PNs are not to be issued to any non-regulated entity. or a broad-based fund. OCB investments through the portfolio route have been banned since November. diversified funds. In view of the recent concerns of some unregulated entities taking positions in the stock market through the mechanism of Participatory Notes (PNs) issued by FIIs. 47 . or a fund. the domestic portfolio managers or domestic asset management companies were also allowed to manage the funds of such sub-accounts and also to make application on behalf of such sub-accounts. Besides. the issue was examined by the Ministry of Finance in consultation with the Reserve Bank of India (RBI) and SEBI. Such sub-accounts could be an institution. or within a period of 5 years. and not by itself directly. Following this consultation. 2000. reporting requirement on a regular basis has been imposed on all the FIIs. the FII regulations were amended to permit foreign corporates and high net worth individuals to also invest as sub-accounts of Securities and Exchange Board of India (SEBI)-registered FIIs. Foreign corporates and high net worth individuals fall outside the category of diversified investors. in January 2004.Initially the idea of allowing FIIs was that they were broad-based. and the principle of "know your clients” may be strictly adhered to. whichever is earlier. and of their lack of expertise in market matters and relatively short-term perspective. or by domestic portfolio manager or asset Management Company. or a portfolio established or incorporated outside India. which could be registered as both FIIs and sub-accounts. will be permitted to expire or to be wound-down on maturity. The only exceptions were the NRI and OCB portfolio investments through the secondary market. In February. or even a foreign corporate or individual. So. in practice there are common categories of entities.” Individuals were left out because of the difficulties in checking on their antecedents. While initially FIIs were permitted to manage the sub-account of clients. which were subject to individual ceilings of 5 per cent to prevent a possible “take over. However.

This recommendation has since been implemented. inter alia. (i) Power of Attorney holders. (c)vestment Trusts. 1998 was also 48 . (b) 100 per cent debt-fund FIIs – those who are permitted to invest only in debt instruments. 1998 was permitted. 2003 by the Government. The following entities are entitled to be registered as sub-accounts: i) an institution or fund or portfolio established or incorporated outside India. recommended streamlining of SEBI registration procedure. (f) Banks. (g) Institutional Portfolio Managers. endowments. Forward cover in respect of equity funds for outstanding investments of FIIs over and above such investments on June 11. ii) a foreign corporate or a foreign individual. FIIs registered with SEBI fall under the following categories: (a) Regular FIIs – those who are required to invest not less than 70 per cent of their investment in equity-related instruments and up to 30 per cent in non-equity instruments. (e) Nominee Companies. forward cover up to a maximum of 15 per cent of the outstanding position on June 11. established or incorporated abroad. (j) University funds. Subsequently. are eligible to be registered as FIIs: (a)Pension Funds. (d) Asset Management Companies. foundations or charitable trusts or charitable societies. A Working Group for Streamlining of the Procedures relating to FIIs constituted in April. The FIIs can also invest on behalf of sub-accounts. (h) Trustees.The following entities. and suggested that dual approval process of SEBI and RBI be changed to a single approval process of SEBI. Besides the above. a domestic portfolio manager or domestic asset management company is now also eligible to be registered as an FII to manage the funds of subaccounts. (b)Mutual Funds.

Such investments by 100 per cent debt funds were.5 billion. FII investments were also allowed in dated Government securities. 1997. The basic presumption is that FIIs are not interested in management control. While permitting foreign corporates/high net worth individuals in February. Investments were free from maturity limitations. investments were allowed only in debt securities of companies listed or to be listed in stock exchanges. the restrictions on FII investment have been progressively liberalized. it was noted that adequate safety nets were in force. (iii) provisions of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations. it was noted that there was a clear distinction between portfolio investment and FDI. 1997 (iv) monitoring of sectoral caps by RBI on a daily basis. From November 1996. for example. was allowed to be increased up to 30 per cent by the Indian company concerned by passing a resolution by its Board of Directors followed by a special resolution to that effect by its General Body. subject to fund-specific ceilings specified by SEBI and an overall debt cap of US$ 1-1. however. were encouraged to deepen the debt market. From April 1998. Moreover. This 15 per cent limit was liberalized to 100 per cent of portfolio value as on March 31. Such investments. 1998. (ii) every transaction is settled through a custodian who is under obligation to report to SEBI and RBI for all transactions on a daily basis. To allay fears of management control being exercised by portfolio investors.permitted. 2000 to invest through SEBI registered FII/domestic fund managers. 49 . which was 24 per cent. any registered FII willing to make 100 per cent investment in debt securities were permitted to do so subject to specific approval from SEBI as a separate category of FIIs or sub-accounts as 100 per cent debt funds. 1999 in January 2003. but were subsequently included from May. Like in other countries. Treasury bills being money market instruments were originally outside the ambit of such investments. which are external debt of the Government denominated in rupees. (i) transaction of business in securities on the stock exchanges are only through stock brokers who have been granted a certificate by SEBI. the aggregate limit for all FIIs. From April.

FDI plus portfolio investments by FIIs and NRIs are capped at 20 per cent and 26 per cent under the above statutes. 2001.In 1998. Accordingly. The enhanced ceiling was made applicable only under a special procedure that required approval by the Board of Directors and a Special Resolution by the General Body of the relevant company. 50 . Sectoral Caps Quite apart from the ceilings on FII investment. Subsequently. the FII ceiling under the special procedure was raised up to the sectoral cap in September. the aggregate portfolio investment limits of NRIs/PIOs/OCBs and FIIs were enhanced from 5 per cent to 10 per cent and the ceilings of FIIs and NRIs/OCBs were declared to be independent of each other. private sector 10 banks) FDI plus portfolio investments by FIIs and NRIs cannot exceed the administrative caps fixed. telecom services. ii) a separate cap on FII. media. Aggregate FII portfolio investment ceiling was enhanced from 30 per cent to 40 per cent of the issued and paid up capital of a company [March 01 2000]. There are also sectors where administrative caps for non-resident investments have been prescribed. In these sectors (viz. and iii) a composite caps on FDI and FII combined together. unified ceilings for nonresident investments. and in some cases. Caps can be of three types: i) a separate cap on FDI. there were and are ceilings on FDI. The FII ceiling under the special procedure was further enhanced [March 08 2001] from 40 per cent to 49 per cent. Currently non-resident investments in public sector banks and insurance sector are capped under Acts at 20 per cent and 26 per cent respectively. There are two types of ceilings on FII investment: statutory and administrative.

On culture and media. culture and media. 2004 are given in Table 1 (at annex1). In August. The Steering Group observed that while all governments prefer vital defence industries to be controlled by their own resident nationals..1 In this report.g. submitted its report.Terrestrial broadcasting FM. and transition costs. the Steering Group on Foreign Direct Investment headed by Shri N. whether portfolio or FDI. monopoly power.g.g. there was not much justification for restrictions on the production of civilian goods used by the defence forces. II) non-zero separate caps on both FDI and FII ([e. were discussed in some detail. natural monopolies. cable network and Direct-to-home. lottery business. no distinction is made either between different categories of sub-sectors of FM radio broadcasting and satellite uplinking.g. insurance. print media). editorial control must vest with 51 . The sectoral equity caps as of May 13. in turn. retail trading). For example. DTH-broadcasting]). [DTH has composite ceiling with a sub-ceiling for FDI at 20 per cent] III) a composite non-zero cap on FDI and FII (banking. and production of those goods that are either imported or are banned for exports from developed countries for strategic reasons. telecom) IV) ban on FDI with a non-zero cap on FII (e. and V) ban on FII with a non-zero cap on FDI (e. can be of five types: I) ban on both FDI and FII (e. six reasons given for imposing caps and bans on FDI national security. Similarly. the Steering Group observed that there was a need for true cultural globalization – not a one-way process of only India having access to the culture of the rest of the world but a two-way street – and in the field of current affairs and news programmes. for private sector banks falling within the purview of the RBI’s regulatory jurisdiction. gambling and betting).K. natural resources. 2002..Singh.Separate caps on FDI and FII. Member. Planning Commission. no distinction is made either between different categories of nonresident investors or the nature of foreign investment.

With ownership of natural resources.Indian nationals and eventually could be replaced by limits on aggregate market share (25 – 49 per cent) that can accrue to foreign controlled news/current affairs companies taken together.” On abuse of monopoly power. 52 . As regards natural monopolies. the Steering Group argued that foreign investment can in fact enhance domestic competition and any potential problem arising from a foreign producer with very high global share tying up with an existing domestic producer should be addressed under the Competition Law. “It can be argued that when such expertise does not exist in the regulatory system it may be better for monopoly profits to accrue to resident nationals than to foreigners. is effectively designed to maximize such resource rent to Government through appropriate tax and auction systems there would be no need to discriminate between foreign and domestic investments. the electro-magnetic spectrum and sites for dams and harbours vesting with the people and their Government. because of their more intimate knowledge of and association with domestic political processes. Any such restrictions therefore must be temporary with continuous efforts made to improve regulatory structures and skills. the Steering Group noted that if extraction of the resource rent. Though this argument has some validity in the short term it is a defeatist approach in the long term. such as. Considerable difficulties were encountered in the monitoring of the sectorspecific composite ceilings on foreign investment because of the problems in identifying the sector of investment merely by the name of the company and the existence of companies with diversified activities. Domestic monopolies are more likely to succeed in distorting the regulatory process in their favour (‘regulatory capture’) than foreign monopolies. which arises from the difference between the market price and efficient costs of exploitation of the particular resource. the Steering Group observed that in the absence of a proper regulatory system with the requisite expertise.

and growing wealth. It can be expected that with rapid progress in disclosure norms. shareholder rights. People’s Republic of China. 2001 – from the beginning of 2001. better corporate governance. and 15 per cent and 30 per cent until January 1. for example. FII investments in some companies are already at their ceiling level. FIIs have a natural advantage in processing information. opened itself up to FII investment in 2003. FII investments are going to accelerate in India. One of the problems noted for such investment in emerging markets consists in the lower amount of reliable and quality information available in such countries relative to developed ones. accounting standards. Now that there is no apparent balance of payments problem. 53 .Supply and Demand Various supply and demand factors have made investing via institutions a rapidly growing sector in many developed countries. there is likely to be a large and growing demand for Indian stocks by FIIs. for example. without a balance of payments problem. Given this background. removed all restrictions – previously 10 per cent individually and 25 per cent collectively until March 1998. liquidity. Institutions are also able to give better services and attractive returns because of ease of diversification. in the aftermath of the 1991 crisis and around the 1997 East Asian crisis. and corporate governance in general. legal framework. It is of some importance to note that the bouts of liberalization of the FII regime has coincided with pressure on the foreign exchange and balance of payments fronts. the critical question is whether there are any reasons for liberalizing the FII regime. funded pension systems.2 There is enhanced supply of funds from investors to institutions because of the aging of population. and the ceiling is much below the stakes that FIIs have acquired in some of the top Korean chaebols. Countries that have liberalized their FII regimes did not do it out of balance of payments compulsions. deregulation and fiscal incentives. Taiwan.

54 . Enhanced flows of equity capital FIIs are well known for a greater appetite for equity than debt in their asset structure. For example. pension funds in the United Kingdom and United States had 68 per cent and 64 per cent. FII inflows can also contribute in bridging the investment gap so that sustained high GDP growth rate of around 8 per cent targeted under the 10th Five Year Plan can materialize. 2003. A. because of their interest in hedging risks.6 per cent. given the existing savings-investment gap of around 1. Pros of FII Investment The advantages of having FII investments can be broadly classified under the following categories.Swiss Bank UBS. Managing uncertainty and controlling risks Institutional investors promote financial innovation and development of hedging instruments. Institutions. not only enhance competition in financial markets. Sinotrans Air. by buying into four of China’s A-share stocks – Baoshan Iron and Steel. for example. because of this preference for equities over bonds. are known to have contributed to the development of zero-coupon bonds and index futures. but also improve the alignment of asset prices to fundamentals. Furthermore. of their portfolios in equity in 1998. Thus. respectively. FIIs can help in compressing the yield-differential between equity and bonds and improve corporate capital structures. as professional bodies of asset managers and financial analysts. Further. FIIs. and ZTE Corp – became the first FII to enter the Chinese market on Wednesday. Shanghai Port Container. B. July 9. opening up the economy to FIIs is in line with the accepted preference for non-debt creating foreign inflows over foreign debt.

but shareholding beyond say 5 per cent can also lead to exploitation of minority shareholders. for example. With boards often captured by managers or passive. Bad corporate governance makes equity finance a costly option. Information asymmetries and incomplete contracts between share-holders and management are at the root of the agency costs. Improving capital markets FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. the FIIs can help in the process of economic development. 55 . they should be as stable as the fundamentals themselves. Improved corporate governance Good corporate governance is essential to overcome the principal-agent problem between share-holders and management. a variety of FIIs with a variety of risk-return preferences also help in dampening volatility. is discretionary. C. if prices are aligned to fundamentals. What is needed is large shareholders with leverage to complement their legal rights and overcome the free-rider problem. and increasing firms’ incentives to supply more information about themselves. they stabilize markets. Fundamentals are known to be sluggish in their movements. ensuring the rights of shareholders is a problem that needs to be addressed efficiently in any economy. D.3 By increasing the availability of riskier long term capital for projects. Furthermore. Dividend payment. By aligning asset prices closer to fundamentals. Thus.Institutions in general and FIIs in particular are known to have good information and low transaction costs. Equity market development aids economic development. Incentives for shareholders to monitor firms and enforce their legal rights are limited and individuals with small share-holdings often do not address the issue since others can freeride on their endeavour.

Cons: Management Control and Risk of Hot Money Flows The two common apprehensions about FII inflows are the fear of management takeovers and potential capital outflows. has institutional investors at its core. Management control FIIs act as agents on behalf of their principals – as financial investors maximizing returns. US law prevents mutual funds from owning more than 5 per cent of a company’s stock. and enhances productivity growth. direct control via equity. There are domestic laws that effectively prohibit institutional investors from taking management control. leveraged control or market control via debt. There is some evidence that institutionalization increases dividend payouts. and remove under performing managers. A. The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the investor in the management of the enterprise. 56 . Among the four models of corporate control – takeover or market control via equity. FDI is that category of international investment that reflects the objective of obtaining a lasting interest by a resident entity in one economy in an enterprise resident in another economy. In this third model. According to EU law. foreign investment is labeled direct investment when the investor buys more than 10 per cent of the investment target. by contributing to better understanding of firms’ operations. and portfolio investment when the acquired stake is less than 10 per cent. board representation is supplemented by direct contacts by institutional investors. who.FIIs constitute professional bodies of asset managers and financial analysts. For example. According to the International Monetary Fund’s Balance of Payments Manual 5. and direct control via debt or relationship banking – the third model. Institutions are known for challenging excessive executive compensation. improve corporate governance. which is known as corporate governance movement.

and performance judged on the basis of how other funds are doing.000 with $500 billion of assets under control in 1998.4 With performance-related fees for fund managers. Movements in the weightage attached to a country by indices such as Morgan Stanley Country Index (MSCI) or International Finance Corporation ( IFC) also leads to en masse shift in FII portfolios. Another source of concern are hedge funds. because of the herding behaviour and potential for large capital outflows. life insurance companies and mutual funds. Herding behaviour. and sub-accounts of FIIs are deemed to be “persons acting in concert” with other persons in the same category unless the contrary is established. reporting requirement have been imposed on FIIs and currently Participatory Notes cannot be issued to un-regulated entities abroad. 1997. and maturity of claims. All take-overs are governed by SEBI (Substantial Acquisition of Shares and Takeovers) Regulations. engage in short-term trading. B. rather than taking the risk of being wrong when some others are right. with all the FIIs trying to either only buy or only sell at the same time. there is great incentive to suffer the consequences of being wrong when everyone is wrong. take short positions and borrow more aggressively. as observed in Russia and Long Term Capital Management 1998 (LTCM) crisis. Extrapolative expectations or trend chasing rather than focusing on fundamentals can lead to destabilization. Potential capital outflows FII inflows are popularly described as “hot money”. 57 . In addition. particularly at times of market stress. unlike pension funds.Institutional investors on the other hand are specialized financial intermediaries managing savings collectively on behalf of investors. Value at Risk models followed by FIIs may destabilize markets by leading to simultaneous sale by various FIIs. The incentive structure highlights the danger of a contrarian bet going wrong and makes it much more severe than performing badly along with most others in the market. especially small investors. who. can be rational. returns. It not only leads to reliance on the same information as others but also reduces the planning horizon to a relatively short one. towards specific objectives in terms of risk. and numbered about 6.

(ii) if management control is what is to be protected. and exploration of natural resources.Some of these issues have been relevant right from 1992. telecom. The restrictions on foreign ownership of companies in emerging markets have been summarised in Annex-III. and (iii) whether the limit of 24 per cent on FII investment will be over and above the 51 per cent limit on FDI. There are some other issues such as whether the existing ceiling on the ratio between equities and debentures in an FII portfolio of 70:30 should continue or not. banks. further across the board relaxation by India in all sectors except a few very specific sectors to be excluded. when FII investments were allowed in. but this is beyond the terms of reference of the Committee. finance companies. retail trading medicine. is there a reason to put a restriction on the maximum amount of shares that can be held by a foreign investor rather than the maximum that can be held by all foreigners put together. media. 58 . which continue to be relevant even today. may considerably enhance the attractiveness of India as a destination for foreign portfolio flows. The issues. It is felt that with adequate institutional safeguards now in place the special procedure mechanism for raising FII investments beyond 24 per cent may be dispensed with. are: (i) benchmarking with the best practices in other developing countries that compete with India for similar investments. It may be noted that all emerging peer markets have some restrictions either in terms of quantitative limits across the board or in specified sectors. such as. Against this background.

59 .

60 .

61 .

610 28.$120. university funds.070 (49. The total amount of foreign institutional investment in India has accumulated to the formidable sum of over U. foreign corporations need to register with the Securities and Exchange Board of India (SEBI) as foreign institutional investors. 12 Jan.331 99.2007 Fri.520 17. In order to trade in the Indian equity market.FOREIGN INSTITUTIONAL INVESTMENT IN INDIA India opened its stock market to foreign investors in September 1992 and since then has received portfolio investment from foreigners in the form of foreign institutional investment in equities.2007 Tue.2007 Total PURCHASES (Rs m) 13.068) 1.603 26. 9 Jan. charitable interests and charitable societies that have a track record of five years and which are registered with a statutory authority in their own country of incorporation or settlement.2007 Thu.2007 Wed. endowments.230) 62 .588 28.243 million as of January 2007. 10 Jan.068) (11. It is possible for foreigners to trade in Indian securities without registering as an FII but such cases require approval from the Reserve Bank of India (RBI) or the Foreign Investment Promotion Board (FIPB).010 24. 11 Jan. asset management companies.853 17.261 149. foundations.757) (11.827 SALES (Rs m) 44. 8 Jan. India allows only authorized foreign investors to invest in pension funds.S.593 2. This has become one of the main channels of FII in India.057 NET INV (Rs m) (30. Daily FII Activity DATE Mon. Foreign institutional investors generally concentrate on the secondary market.588 23. investment trusts.520 24.

Of these 40% originate from 20% and US from UK.10% of the total market turnover. Of the new issuances in FY 2006 -Domestic IPOs aggregated $5. 11% of the total market and approx.Contribution by FIIs The diversity of FIIs has been increasing over 30 countries registered with SEBI as at march 31st.4 billion -Overseas issuance by the way of ADRs and GDRs were $5billion -Foreign currency convertible bonds (FCCBs) were for $6 billions FIIs contributed over 75% of the new equity and equity linked issuances The · · · FII High Efficient inflows economic into India and of have been on account of and of: Strong fundamentals quality attractive corporate for valuations companies clearing governance market mechanisms settlement · Product diversification and availability of active derivatives market. 63 . Recently FIIs from Japan and continental Europe are increasing their India exposure. FIIs contributed approx. 2006.

85 4. BANKS TOTAL OUSTANDING SHARES FII SHAREHOLDING AS A PERCENT OF TOTAL 13.Portfolio of FIIs Shareholding pattern of COMPANIES FII CEMENT AUTO IT POWER PHARMA REFINERIES ENGG METALS CONSUMER GOODS TEXTILE TELECOMUNICATION PETROLEUM FMGC FIIs.12 SHAREHOLDING NIFTY NON-NIFTY TOTAL 3227 1508 4735 23285 35060 58345 FIIs registered with SEBI 64 .3 8.

FINANCIAL YEAR DURING THE YEAR TOTAL REGISTEREDATAT THE END OF THE YEAR 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2001-03 2003-04 2004-05 2005-06 0 3 153 197 99 59 59 56 84 48 51 83 145 131 0 3 156 353 439 496 450 506 528 490 502 540 685 803 EFFECT OF FII ON STOCK MARKET The FIIs are major institutional investors in Indian capital market. Although there are 4700 companies listed with stock exchange. who tend to follow the FIIs when making their investment decision. trading on whose shares are seen as indicative f market activity. increase in investment by FIIs cause sharp price increase. Movement in the sensex has clearly been driven by the behavior of foreign institution investors. It would provide additional incentives for FII investment and this encourages further investment so that there is a tendency for any correction of price unwaeeabted by price earnings ratios to be 65 .the BSE sensex incorporates only 30 companies. This shallowness also means that the FIIs can also affect the behavior of other retail investors. their role in determining the share price movements must be considerable. The presence of foreign institution investor in the sensex companies and their active trading behaviours. These features of Indian stock markets induce a high degree of instability for four reasons First. Indian stock markets are known to be known narrow and shallow in the sence that there are few companies whose shares are actively traded.

as and when FIIs are attracted to the market by expectations of a price increase that tend to be automatically realized. the investments turn even more attractive triggering an investment twisting that would imply a sharper fall when any correction begins. when rupee assets are sold and the revenue converted into dollars. This increases the return earned in foreign exchange. This implicit manipulation of the market if resorted to often enough would obviously imply a substantial increase in volatility. encourages speculative investment aimed at pushing the market up and choosing an appropriate moment to exit. As a result. in volatile markets. Third. Finally. Second. And when the correction begins it would have to lead by an FII pullout and can take the form of extremely sharp decline in the share prices. domestic speculators too attempt to manipulate markets in periods of unusually high prices. the inflow of foreign capital can result in an appreciation of the rupee. the growing realization by the FIIs of the power they wield in what are shallow markets.delayed. 66 .

it is important to see what percentage of free-floats shares are controlled by FIIs. promoters 36% banks.shareholding pattern of sensex companies private Corp. 67 .insurance cos promoters private Corporate bodies NRIs/OCBs mutual funds and UTI FIIs indian public Others Above fig masks the fact that FIIs hold a much higher percentage of shares that are normally available for trading in the market therefore to judge the real influence of the FIIs on the share prices of sensex companies.it shows that average equity holding by FIIs is more than 20% in the sensex companies. FI Is 22 % mut.Fis... indian public 13% NRIs/OCBs 3% Others 8% banks.it also shows that an investor group. .. FIIs are the biggest non-promoter shareholders of the sensex companies...

9 27.495 46.703 173. we can also see that there is a continuous increase in the BSE sesex from 9.744 11.39 44.473) 9.2006 Mar . 2006.995 93.9 18.2006 May -2006 Jun .1 30.570 96.280 12.2006 Nov .56 46.2006 Jul .787 excepted may.481 213.936) 44.142 (35.771 (82.62 44.422 (111.27 9.609 10.795 382.700 57.5 25.2006 Apr .) 41.484) 12.) MONTH END Rs / US$ MONTH END INDEX CURRENT VALUE (Rs mn) CUMM.2006 Dec .764 47.983 113.0 37.043 10.03 44.6 16.4 25. Rs.983 75.252 130.1 24.920 to 13. (Rs mn. Or net investment by the FII and at the end of December the total flow was 382.778 39.8 22.97 46.2006 Sep .2006 37.720 59.04 46. INV.658 325.2006 Aug .370 11. This just because of heavy withdrawn by the FII and lesser investment in the month of June.1 23.94 45.MONTHLY FII INVESTMENTS MONTH ENDED NET INV.617 13.739 59.3 Jan .873 152.987 mn.640) 37.642 74.787 53.1 26.54 45.653 418.2 27. 68 .779 139.361 66.454 12.8 30. So we can say that there is a direct relationship between the index and FII flow.9 25.699 12. (Rs mn.962 13.69 44.37 46.2006 Feb .) 42.rs.920 10.) % GAIN (Rs Mn.1 24.637 200.050 16.2 32.8 19.2006 Oct .07 44.5 % GAIN (US $ mn.2 20.859 As per the data available for the current month and presented in the above table shows the monthly flow of the FII during January 2006 to dec. in the year 2006 the flow was 37.9 16.152 (36.2 17.094 12.399 10.912 71.7 37.823 102.282 65.859mn.376 259.6 33.

Net Investment 15000 Net Investment 10000 5000 0 -5000 Sensex 14000 12000 10000 8000 6000 4000 2000 0 The economic literature is prosperous with research pointing towards the close correlation of the BSE Sensex and FII fund flows. as the ceiling for FII investments were relaxed. 2001” observes that FIIs have a disproportionately high level of influence on the sentiments and price trends in the Indian equity market as other market participants perceive the FIIs to be infallible in their assessment of the market and tend to follow decisions taken by FIIs. Interestingly.Monthly FII inflows and BSE sensex. Over the years. a note by National Stock Exchange “Indian Securities Markets: A review Vol IV. there has also been a progressive increase in the share of FII holdings in leading Indian companies (and also in the Sensex companies). Such ‘herd mentality’ displayed by market participants amplifies the role of the FIIs in the Indian stock market. A big role of the FIIs in determining the Sensex level is therefore not out of place. Jan-99 Apr-99 Jul-99 OctJan-00 Apr-00 Jul-00 OctJan-01 Apr-01 Jul-01 OctJan-02 Apr-02 Jul-02 OctJan-03 Apr-03 Jul-03 OctJan-04 Apr-04 Jul-04 OctJan-05 Apr-05 Jul-05 OctJan-06 Apr-06 -10000 Time 69 Sensex .

70 . But despite the general upward trajectory of the BSE sensex there have been some months of correction and such corrections occurred in months with negative FII flows. Little doubts therefore that the BSE Sensex fell by around 14% in May 2006 compared to April 2006 after FIIs turned net seller to the extent of USD 1. It is evident that the equity markets were more or less in a steady state till around April 2003 when FII inflows per month tended to follow a normal historical trajectory. The upswings in the FII inflows from around May 2003 have also led to quantum jumps in the BSE Sensex.6 bn in that month.That the BSE Sensex is closely correlated with the trend of FII inflows is clearly brought out from the above fig.

Studies indicate a positive relationship between portfolio flows and the growth performance of an economy. also a reason why Indian policy makers sought to liberalize such flows in the wake of the BoP crisis in 1990-91. FII inflows help supplement domestic savings and smoothen inter-temporal consumption. 71 . net flow of investment by FIIs in India FII investments are non-debt creating flows. though such specific studies for India were not found. FII investments bring in global liquidity into the equity markets and raise the priceearning ratio and thereby reduce the cost of capital domestically. Theoretically.Importance of FII flow in India net investment 60000 50000 40000 30000 20000 10000 0 -10000 19 92 -9 19 3 93 -9 19 4 94 -9 19 5 95 -9 19 6 96 -9 19 7 97 -9 19 8 98 -9 19 9 99 -0 20 0 00 -0 20 1 01 -0 20 2 02 -0 20 3 03 -0 20 4 04 -0 20 5 05 -0 6 fig.

India.Rising shares of FII investment in FX reserves and total foreign investment. Exhibit 3 also indicates that FII inflows had significantly contributed to the sharp increase in the foreign exchange reserves of the economy. While in the last three years the average share of FII in the total foreign investments was above 70%. Our analysis indicates that FII inflows as a percentage of the BOP surplus was at around 35% in the most recent last three years while the average from FY95 to FY03 had been only around 4. in the recent past few years seems to have received a disproportionately large part of its foreign investment flows via the FII investments in the equity markets. The large build-up of foreign exchange reserves through FII inflows poses a potential threat of destabilization of the economy. Portfolio flows are most often referred to as “hot money” that can be notoriously volatile when compared to other forms of capital flows.fig . FII inflows have significantly contributed to the Balance of Payments surplus in the last three years.5%. this is almost double the average share of around 36% of FII investments in the three years of FY01 to FY03. 72 . More so.

Equity development aids economic development by the viability of riskier long term capital for projects and increasing firms’ incentives to supply more information about themselves. FIIs as professional bodies of asset managers and financial analysts. Improving capital markets FIIs enhance competition and efficiency in the markets.thus. respectively. Because of this preference for equities over bonds. but also improve the alignment of asset prices to fundamentals. In pension funds in the UK and USA had 68% and 64%. opening up the economy to FIIs in the line with accepted preferences for non-debt creating foreign inflows over foreign debt. Improved corporate governance Bad corporate governance makes equity finance a costly option . FIIs can help in compressing the yield differential between equity and bonds and improve corporate capital structure. of their portfolio in equity in 1998. the FIIs can help in the process of economic development.Advantages of FII investment Enhance flow of equity capital FIIs are well known for a greater appetite for equity than debt in their asset structure. not only enhance competition in the financial markets.incentives for shareholders to monitor firms and enforce their legal rights are limited and individuals with small-holdings often do not address the issue since others can free-ride on their 73 . Managing uncertainty and controlling risks FIIs promote financial innovation and development of hedging instruments.

without interest in control. promote innovation. 74 . development of sophisticated products such as financial derivatives. and this lack of sound information may generate herding and positive feedback trading (buying after positive return and selling after negative returns these kind of behaviour can exacerbate volatility. portfolio investor can occasionally behave like FDI investors. Complexities of monetary management The problem showed up in terms of very large foreign exchange reserve inflows requiring considerable sterilization operations by RBI to maintain stability. and seek control of companies. and pushes price away from fair values Possibilities of taking over companies While FIIs arne seen as pure portfolio investors. What is needed is large shareholders with leverage to complaint their legal rights and overcome the free-rider problem. Costs Herding and positive feedback trading There are concern that foreign investors are chronically ill-informed about India.endeavor. and enhance competition in financial intermediation. Knowledge flows The activities of FIIs help strengthen Indian finance .FIIs advocate modern ideas in market design.

they can buy financial assets when the prices are declining. namely. But given the huge volume of investments. Investments.DETERMINANTS OF FII INVESTMENT There have been several attempts to explain FII behavior in India. Therefore. it is important to consider the risk variable. realized risk can be divided into ex-ante and unexpected risk. inflation. any change in FII had a positive impact on equity returns. that is. and so on. This negative investment might possibly disturb the longterm relationship between FII and other variables such as equity returns. Another possible determinant of FII is the operation of foreign factors such as returns in the source country’s financial markets and other real factors in the source economy. So far. All the existing studies have found that equity return has a significant and positive impact on FII. one needs to separate the unobserved component from the realized risk. that change in FII is mainly due to change in equity returns. and sell when the asset prices are increasing (Gordon and Gupta 2003). exerted little effect on equity returns.S. either domestic or foreign. there is a possibility of a bidirectional relationship between FII and equity returns . Hence. foreign investors can play the role of market makers and book their profits. Further. while examining the impact of risk on FII. depend heavily on risk factors. Chakrabarti (2001) has perceived a regime shift in the determinants of FII following the Asian financial crisis and found that in the pre–Asian crisis period. This. This is a fact that needs to be taken into account in any empirical investigation of FII. Hence. studies have found that both return in the source country stock market and 75 . however. net FII declined by U. Following the Asian financial crisis and the bursting of the info-tech bubble internationally in 1998/99.$61 million. however. But it was found that in the post–Asian crisis period. Trivedi and Nair (2003) have used only the realized risk. thereby jacking-up the asset prices. Ex-ante risk is an observed component and is negatively related to FII. while studying the behavior of FII. a reverse relationship has been the case. But the relationship between unexpected risk and FII is obscure.

The focus of this paper is the study of the critical determinants of FII. a few important variables believed to be affecting FII are chosen and then a theoretical model is built and empirically tested for India. as FII constitutes an important element for the smooth functioning of domestic financial markets. It is preferable. which can be expected in most of the monthly financial time series data. Agarwal (1997) found that world stock market capitalization had a favorable impact on the FII in India. while movement of FII is determined by bull/bear phases. This paper makes a modest attempt to explore the relation between FII and its pivotal determinants. 76 . Further. to divide the realized risk into ex-ante risk and unpredictable risk.the inflation rate have not exerted any impact on FII. More specifically. The research shows that existing studies do not account for volatility. This is because standard deviation/variance (realized risk variable) increases irrespective of the direction in which stock returns move. for the particular case of India. and is affected more or less by everything. so as to provide a better understanding of FII behavior that helps while liberalizing the capital account. an approach that does not always yield robust results. Since investment in stock markets is sentiment driven. both domestically and in foreign financial markets. accounting for volatility is unavoidable. the crucial task is to identify a few critical determinants. therefore. the existing studies either do not incorporate risk in foreign and domestic markets or make use of realized risk. We hope that the study will be important from a policy perspective. Yet given the increase in financial market integration.

CHAPTR – 4 DATA ANALYSIS AND INTERPRATATION 77 .

The FII net investment series starts from January 1993 and the BSE market capitalization series starts in April 1993. short-term interest rate in India. once again. The daily FII flows data come from the SEBI website while the daily returns data are.Description of the Data The data used in this paper comes from several sources. we restrict our sample to the end of 1999 for carrying out empirical analyses. In order to check if the Asian crisis marked a structural break in the relationships studied here. Other financial data like the exchange rate. we sub-divide the sample period into two sub-samples. The series of FII flows as a proportion of preceding month’s BSE market capitalization therefore begins in May 1993. Since the net monthly FII flows and the returns in the Indian equity markets constitute two key variables in this study. the net FII flows. We use monthly net FII investment figures obtained from the websites of the RBI and SEBI. The BSE National Index immediately reveals the massive and short-lived ‘bubble’ during 2000. Market capitalization data are obtained from the BSE web site. In order to study the causal linkage between FII flows and contemporaneous stock returns in greater detail. in the three panels of Figure 1. we present. Country credit rating data are obtained from several issues of the Institutional Investor magazine. returns on the MSCI world index. S&P 500 as well as the BSE national index are obtained from Data stream. the pre-Asian Crisis sub-sample runs from May 1993 to June 1997 (50 months) and the Asian crisis sub-sample runs from July 1997 to December 1999 (30 months). the BSE National Index and net FII flows as a proportion of the preceding month’s BSE market capitalization from May 1993 to June 2001. obtained from Datastream. In order to avoid misleading results from this potentially ‘tainted’ period. a phenomenon that is likely to have caused temporary but marked deviations from the long-term relationship between FII flows and Indian market returns. 78 . Dating the Asian crisis to begin in July 1997. we also use daily FII flows data and daily returns on the BSE National Index for the year 1999.

To bring the model closer to reality.THEORETICAL MODEL FOR FOREIGN INSTITUTIONAL INVESTMENT To build the theoretical model. expressed in a common currency. By investing in the domestic market the foreign investor makes two investments. Uncovered interest parity dictates that the expected rate of depreciation of the rupee-dollar exchange rate is equal to the interest rate differential between Indian and U. Let the rate of return to foreign investor by investing in domestic stock market be id and return in the same market if. When there is both perfect capital mobility and equal risk of both home and foreign bonds. This equation represents the uncovered interest parity condition. one being in the Indian stock market and the other in the Indian rupee. Accordingly. Now we incorporate the PPP condition. dollar. according to which the real exchange rate that is defined as the ratio of the two countries’ price level. e.S. the overall return to the investor can be divided into a return on the stock and a return on the investment in the rupee. stocks. then home and foreign bonds are said to be perfect substitutes. 79 . If we consider the nominal exchange rate as rupees per U. initially only expectations can be formed with regard to the exchange rate movement.S. the assumption of equal riskiness in domestic and foreign assets (made under UIP) is relaxed. Perfect substitutability of domestic and foreign bonds implies that the uncovered interest parity condition will hold on a continuous basis. hence If = id − E(˙e / e). the return on the foreign currency would be ic and this can be presented as if =id+ ic . If the foreign investor subsequently sells the rupee at the end of the period. well-known “uncovered interest parity” (UIP) and “purchasing power parity” (PPP) conditions have been combined. where E(˙e / e) is the expected rate of change in value of the rupee against the dollar.

(1) where π is the inflation rate in respective countries.should be equated to unity for all pairs of countries and at all times. In other words. PPP theory also asserts that Q can be taken as exogenously determined (Q = Q¯ ). Now. to be more realistic. Hence. we get ˙e / e =p˙d / pd −p˙f / pf. we have id =I f + π d − π f. e = Q¯ Pd / Pf implying that over a period of time the exchange rate moves in proportion to movements in the ratio of price level. pd / pf. Pd is the domestic price level. the changes in the exchange rate and E(˙e / e) would depend on the inflation rate differentials. Risk averse investors expect higher returns for investing in relatively riskier assets and therefore the risk premium represents compensation to the investor for assuming risk. and Pf is the foreign price level. Putting this result in the uncovered interest parity condition. we relax the assumption of equal risk for domestic and foreign assets under UIP. where e is the nominal exchange rate. This can be expressed as e = QPd / Pf . Hence. Taking log and differentiating with respect to time. a large interest rate differential implies a market expectation of large exchange rate depreciation or currency risk. Q is the real exchange rate. 80 . where P is risk premium. By dropping this assumption we have id −if = E(˙e / e) + P.

hence investors will withdraw from the domestic market. Since FII follows higher returns. σ d. Similarly. Investors are considered to be risk averse. the purchasing power of funds invested in the foreign country declines.S.σ f). the purchasing power of the funds invested declines. π f. π d. When inflation in the domestic country increases.) market increases. (foreign) market. FII flows to the domestic market. This can be represented as id −if = π d − π f + σ d − σ f. Hence. causing institutional investors to withdraw from the foreign (U. Considering investors as risk averse. hence when the return in the domestic market increases.S.) market and invest in the Indian (domestic) market. if. the return differentials depend on the inflation rate differentials and the risk premium. an increase in the return in the U.) market and make investment in the domestic (Indian) market.S.The above equation is modeled as id −if = E(˙e / e) + σ d −σ f.S. (foreign) market will induce investors to withdraw from the Indian (domestic) stock market to invest in the U. where σ is a measure of dispersion (standard deviation) representing risk in respective countries. In a functional form.  where we have drawn three domestic and three foreign variables affecting FII. 81 . when inflation in the foreign country increases. (2) Briefly the signs for the coefficients of each variable and the rational for it are as follows: Investors are believed to follow a higher return.S. investors will withdraw from the foreign (U. hence when risk in the domestic market increases they will withdraw from the domestic market. when risk in the foreign (U. it can be represented as FII =f(id.

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. the regulations on FII investment have gone through enormous changes and have become more liberal over time. Initially. 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).5 billion. restricted to the debt instruments of companies listed or to be listed on the stock exchanges. Such investments were. Ever since this day. subjected to the fund-specific ceiling prescribed by SEBI and had to be within an overall ceiling of US $ 1. From November 1996. 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. when the FIIs (Foreign Institutional Investors) were allowed to invest in all the securities traded on the primary and secondary markets. An important milestone in the history of Indian economic reforms happened on September 14. however. 1992. In 2000. From the year 1998. of course. FIIs were allowed to make 100% investment in debt securities subject to specific approval from SEBI as a separate category of FIIs or sub-accounts as 100% debt funds. treasury bills and money market instruments. FIIs were also permitted to seek SEBI registration in respect of sub-accounts. the FII investments were also allowed in the dated government securities. In 1997. including shares. the holding of a single FII and of all FIIs. the foreign corporates and high net worth individuals were also allowed to invest as subaccounts of SEBI-registered FIIs.A GAP ANALYSIS OF FIIS INVESTMENTS – AN ESTIMATION OF FIIS INVESTMENTS AVENUES IN INDIAN EQUITY MARKET 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 globalization. This was made more liberal to include the domestic portfolio 82 . The investments were. 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%. debentures and warrants issued by companies which were listed or were to be listed on the stock exchanges in India and in the schemes floated by domestic mutual funds.

“Foreign Institutional Investors (FIIs) can invest in a company under the portfolio investment route beyond 24 per cent of the paid up capital of the company with the approval of the general body of the shareholders by a special resolution. the Finance Minister announced in his budget speech on February 28. This was subsequently raised to 49% on March 8.75 billion has been notified in 2004. FII investment ceilings. the increase in investment ceiling for FIIs in debt funds from US $ 1 billion to US $ 1. 83 . ‘In general. Guidelines in this regard will be issued separately. 2002 to identify the sectors in which FIIs portfolio investments will not be subject to the sectoral limits for FDI. As a move towards further liberalization. if any.’ 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. may be reckoned over and above prescribed FDI sectoral caps. Meanwhile. 40% became the ceiling on aggregate FII portfolio investment in March 2000. 2002 that. 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. The FII portfolio flows have also been on the rise since September 1992. The committee has proposed that. All these are indications for the country’s continuous efforts to mobilize more foreign investment through portfolio investment by FIIs. 2001 and to the specific sectoral cap in September 2001.” Accordingly.managers or domestic asset management companies. Their investments have always been net positive. The 24 per cent limit on FII investment imposed in 1992 when allowing FII inflows was exclusive of the FDI limit. I propose that now FII portfolio investments will not be subject to the sectoral limits for foreign direct investment except in specified sectors. The suggested measure will be in conformity with this original stipulation. a committee was set up on March 13. but for 1998-99. when their sales were more than their purchases.

and further dropped to US $ 0. As of September 2004.637 million. such inflows declined to US $ 1.764 crores during this year registering a growth of 1602% over the previous year. the net FII portfolio investment stands at US $ 27. But the years 2001-02 and 2002-03 saw some reversal in the trend.144. when the net investment became negative. a growth rate of 208% compared to the year before.8 billion in 2001-02. FIIs have made a net investment of Rs. However. 45. creating a record in the history of FII investment in India. only to suffer reversal again during May and June 2004. This study is undertaken 84 . Gross purchases in this year amounted to Rs. This trend continued in April 2004.1 billion in 2000-01.TABLE 1 TRENDS IN FII INVESTMENT the increase. this year from July 2004 has been seeing a net positive portfolio flows by FIIs. this decline witnessed a sharp reversal in the year 2003-04. as a result of which the net investment has dropped in these years.857 crores.562 billion in 2002-03. Fortunately. From a net inflow of US $ 2. The decline is because of the lower portfolio inflows.

to assess what is the net FII investment in specific companies’ vis-à-vis the FII investment cap in them. This is done to bring to light that though the FII investment, if studied over time in India, shows a positive trend of increase in general, they are still insufficient and very much below the level envisaged and permitted by the regulations. If it is so, then increasing the FII investment cap per se will not just be helpful The country has to work on specific measures to encourage more FII investments. The Study The study has undertaken an analysis of the FII investment gap in the companies included in the S & P CNX 500 index of National Stock Exchange, by comparing the FII investment in each of these companies as of September 30, 2004 with the FII investment cap. The FII investment gap, the difference between the investment allowed under the FII investment cap provision for the company and the actual investment, is estimated in terms of the market value prevailing as on the estimate date of September 30, 2004. Information on the shareholding pattern of these companies as of September 30, 2004, the closing market price of these shares is downloaded from the NSE site, www.nseindia.com. Since information is not available for 31 companies they are excluded from the study. In all the findings of this study relates to 469 companies included in the S & P CNX 500 index of National Stock Exchange as of September 30, 2004. The information on the FII investment cap for each of these companies is assessed from the Reserve Bank of India site, www.rbi.org.in The reason for choosing the companies included in this index is because this index is fairly comprehensive and includes companies from different sectors in the same proportion of how they are in the population of all the listed companies. Sample Profile The FIIs hold 8.12 per cent of the total outstanding shares of the 469 companies studied as of September 2004, emerging as the biggest institutional investor, ahead of the mutual funds, domestic financial institutions and the private corporate bodies. In an overall ranking they occupy the third position after the promoters and the Indian public holding higher levels of investment than FIIs.

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However, when the companies are grouped into those included in the S & P CNX NIFTY index(referred to as NIFTY companies from now onwards) and those which are not included, a specific concentration of FIIs investment in NIFTY companies. The FIIs shareholding is around 13.85 per cent in NIFTY companies as against 4.30 per cent in the Non-NIFTY companies.

The table above shows that the FIIs investment is certainly more concentrated in the NIFTY companies than in Non-NIFTY companies. But, this analysis is not complete

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because a mere comparison of the number of shares held by FIIs is meaningless as the market price per share varies across companies and it takes different quantum of money to acquire the same number of shares in different companies. Hence, this analysis is further extended to include the monetary value of the FIIs investment as of September 30, 2004 by multiplying the number of shares held by the closing market price per share as of the same day. This will give an understanding of the value of the FIIs investment at market value as of a particulate date. This is done as a proxy as the cost of their investments in each of these companies is not readily available. TABLE 4 VALUE OF FIIS INVESTMENT

Table 4 clearly brings out that when the shareholding of FIIs is analysed in terms of the market value of their investment as of September 30, 2004, about 85 per cent of the total value of their investment is held in NIFTY companies and only about 15 per cent is in Non-NIFTY companies. This shows, once again as mentioned above, that there is a clear concentration of FIIs investments in few chosen companies. A separate analysis of the NIFTY and Non-NIFTY companies bears evidence to this fact. About 25 per cent of the total market value of the FIIs investments is in just two companies namely Infosys and Reliance Industries where the investment is about 14 and 12 per cent respectively. 50 per cent of the total market value of the FIIs investment is only in 6 companies namely Infosys Technologies (13.87%), Reliance Industries (12.44%), ICICI Bank (7.51), HDFC (7.05), ONGC (5.25%) and Satyam (4.88). The total value of the FIIs investment in these

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677. Bank of Baroda. The Analysis The objective of the study is to bring to light the investment gap in the FIIs investments by comparing the current investment levels of FIIs in the chosen sample companies against the cap allowed. Dabur India. It may be noticed from the above table that the percentage of the investment gap in case of NIFTY companies is around 59 and is 84 for the Non-NIFTY companies. When the companies are arranged in a decending order of their FIIs investment. Canara Bank. VSNL. The cap on the individual companies has taken into account the generic cap of 24 per cent prevailing and also the increase of the cap to the sectoral cap by the individual companies by passing of resolution in the Board and General Body.516 million. Tata Chemicals. The total 88 . it is found that 21 of the companies account for around 81.83 per cent of the total market value of the FIIs investments. Colgate-Palmolive and Britannia enjoy less than 0.5 per cent.1 per cent of the FIIs investments in value terms. I-Flex and Asian Paints. In the bottom 13 companies. the FIIs investment is less than 0. As many as 71 companies of the 416 companies in this category have absolutely no FIIs investment in them. In the Non-NIFTY category the top five companies which are the most favoured destinations for FIIs investments are Container Corporation.5 per cent. each one accounting for less than 1.67 per cent and the balance 29 companies share only 18.companies is around Rs.

both in terms of number of shares held by them and the market value of these shares. This is in line with the findings presented in Tables 3 and 4. 89 . Reliance Industries. The top 5 companies where the gap is at the maximum in NIFTY category of companies are Bharti Televentures. This finding presented above is not surprising. in terms of value the difference is not very wide as the average market price per share of the NIFTY category is very much higher than that of the Non-NIFTY category. LIC Housing Finance. ONGC. Though the number of shares available for further investment by FIIs is less in NIFTY companies than Non-NIFTY companies. where it is brought out that the FIIs investments in NIFTY companies is higher than in Non-NIFTY companies. Tata Teleservices(Maharastra) and Himachal Futuristic. Hindustan Lever and Wipro.gap in respect of all the companies works out to 72 per cent. In the NonNIFTY companies the top 5 companies are Mphais BFL. Neyveli Lignite.

In the post Asian crisis period it seems that the returns on the BSE National Index have become the sole driving force behind FII flows. 8. Since the US and world returns are not significant in explaining the FII flows. 3. 4. There appears to be significant differences in the nature of FII flows before and after the Asian crisis.FINDINGS 1. The FIIs investments are highly concentrated in terms of their market value in a very small number of companies. there is no evidence17 of any informational disadvantage of FIIs in comparison with the domestic investors in India. 2. The beta of the Indian market with respect to the S&P 500 index (but not the beta with respect to the MSCI world index) seems to affect the FII flows inversely but the effect disappears in the post-Asian crisis period. 7. 9. There seems to be a clear distinction in the FIIs shareholding in NIFTY and NonNIFTY companies. the causality is likely to be the other way around. This high correlation is not necessarily evidence of FII flows causing ‘price pressure’ – if anything. A collection of domestic and international variables likely to affect both flows and returns fail to diminish the importance of contemporaneous returns in explaining FII flows. Changes in country risk ratings for India do not appear to affect the FII flows. 10. The gap in their investments exist both in NIFTY and Non-NIFTY companies. 11. There is a wide gap between the actual investments by FIIs and the investments allowed as per the cap. FII flows are correlated with contemporaneous returns in the Indian markets. 5. 90 . 6.

This is not an overly surprising result. However. The weakness of the evidence of causality from flows to returns contradicts the view that the FIIs determine market returns in general. This ‘substitution effect’ may well have drowned other long-term relationships. though ‘herding’ effects – particularly with domestic speculators imitating FII moves – may well be present in cases of individual stocks. Besides. it is plausible that the crisis and India’s relative imperviousness to it increased India’s attractiveness to portfolio investors particularly as many other emerging markets began to appear extremely risky. aggravate the occurrence of equity market bubbles though they may not actually start them. In fact the crisis appeared to have altered several of the ‘ground rules’ of international portfolio investing around the world. This is obviously an important concern for policy makers and market regulators. Particularly since the Asian crisis – which seems to have brought about a regime shift in the relationship between FII flows and stock market returns – the direction of causation seems to be running from the returns to the flows. investors may have started paying closer attention to obtaining and processing information in destination countries in the wake of the Asian crisis causing an ‘information effect’ that could have altered the past relationship as well.The stylized facts listed above lead to a better understanding of FII flows to India. Finally behavioral changes among international portfolio investors following the crisis cannot be ruled out either. Another important area is the mild evidence towards the FII flows being affected by returns in the Indian markets in the immediate past. Why exactly the relationships analyzed here demonstrate a structural break at the outbreak of the Asian crisis is a matter of speculation. in fact. FII flows can. The relative stability in the exchange rate of the Indian Rupee in the post-Asian crisis era seems to have outweighed fluctuations in the country’s credit rating among foreign portfolio investors. It is notable that the Asian crisis appears to have acted as a watershed in several of the key relationships affecting the FII flows to India. Such a relationship suggests that given the thinness of the Indian market and its evident susceptibility to manipulations. This paper provides a preliminary analysis of FII flows to India and 91 . Recent research18 has demonstrated that the Asian crisis caused several major changes in the financial relationship among European countries halfway across the globe.

A more detailed study using daily data for a longer period or. 92 . 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. Broader and more long-term issues involving foreign portfolio investment in India and their economy-wide implications have not been addressed in this paper. 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 – indicators that can help us estimate the probability of sudden Mexico-type reversals of these FII flows which now account for a significant part of the capital account balance in our balance of payments.their relationship with several relevant variables especially returns in the Indian stock market. Such issues would invariably require an estimation of the societal costs of the volatility and uncertainty associated with FII flows. 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. better still.

CHAPTER – 5 SUGESTIONS AND CONCLUSION 93 .

Our findings on emerging markets extend the growing literature on the determinants of global investment flows and allocations. Covrig. mutual funds in emerging markets. Prior research focuses on international portfolio flows and examines the relationship between portfolio flows and stock returns. The analysis is based on a unique dataset consisting of 10. A few studies have also examined allocations but they have generally focused only on a specific country.S. Foreigners tend to underweight firms with a dominant owner.SUGGESTIONS • Countries with higher levels of economic development tend to have more developed capital markets and are believed to have greater ability to obtain foreign capital. They find that foreigners have a preference for large firms. our results suggest that the availability of foreign capital also depends on factors other than the country’s economic development and the firm’s financial attributes. firms with better accounting quality and corporate governance attract more foreign capital. index memberships. We extend this analysis and undertake a comprehensive analysis of all emerging markets and provide more detailed analysis of country and firm-level factors that influence investment allocations by U. These studies have analyzed the global. and firms with large cash holdings. However. After controlling for the country effect. Kang and Stulz (1994) report that foreign investment in Japan is concentrated in large firms and in firms that have a larger proportion of export • • • • • • 94 . and stocks with foreign listing. They find that ownership by foreign funds is related to size of foreign sales. Lau. These findings are attributed to information asymmetries between foreign and domestic investors. Similarly. funds. regional and local factors that influence portfolio flows.S. Dahlquist and Robertsson (2001) undertake a detailed analysis of foreign ownership and firm characteristics for the Swedish market. Their empirical analysis shows that domestic investors have informational advantages. The finding on firm size is driven by liquidity and international presence as measured by foreign listings and export sales. and Ng (2002) also conclude that foreign fund managers have less information about domestic stocks than do domestic fund managers. Brennan and Cao (1997) develop a theoretical model that accounts for information asymmetry between domestic and foreign investors. Our results suggest that steps can be taken both at the country and the firm level to create an environment conducive to foreign portfolio investment.688 equity positions of U. firms paying low dividends.

FII inflows can help in augmenting the investible resources in the economy. which are areas of dubious value added and where FDI is prohibited. lottery. the platform for trading the small and mid-cap companies that might bring some focus on these companies and hopefully add some liquidity and volume to their trading. are still far below the permissible limits. FII investments. 95 . • Similarly. and expanding industry by at least 10 per cent per year to integrate not only the surplus labour in agriculture but also the unprecedented number of women and teenagers joining the labour force every year. gambling. are permitted up to 24 per cent in all listed companies. the convergence of the sectoral cap for FIIs and FDI investments alone may not really help bring in more funds unless some specific measures are taken up. This restriction may continue.• sales. betting. which may attract some further investments in them by FIIs. though shown an increasing trend over time. including that of agriculture. as it will help develop supply chains in a wide range of products. FII investments in retail trading cannot exceed 24 per cent as no FDI is permitted. • In retail trading currently FDI is prohibited. there is an urgent need to scale up investment in the economy. • One such measure in this line could be the newly announced INDONEXT. however. may also be kept out of bounds for FII investments. the real answers to the questions on how to attract more FIIs investments lies to some extent on finding the basis of selection of companies for investment by FIIs which the author is pursuing currently. This means. The findings suggest that foreigners invest in firms that they are better informed about. Accordingly. However. except in print media companies. The FIIs investments. • Given the necessity of boosting agricultural growth through development of agro processing.

have the additional advantage of being project specific and thus can contribute directly to productive investments. In the absence of any other substantial form of capital inflows. but their influence on the domestic markets is also growing. From the point of attracting foreign capital. There is little doubt that FII inflows have significantly grown in importance over the last few years. 96 . Data on shareholding pattern show that the FIIs are currently the most dominant non-promoter shareholder in most of the Sensex companies and they also control more tradable shares of Sensex companies than any other investor groups.Investment by FIIs directly in the Indian stock market did not bring significantly large amount compared to the GDR issues. Moreover. Results of this study show that not only the FIIs are the major players in the domestic stock market in India. 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.the initial expectations have not been realised.CONCLUSIONS A number of studies in the past have observed that investments by FIIs and the movements of Sensex are quite closely correlated in India and FIIs wield significant influence on the movement of sensex. GDR issues. seem to have influenced the Indian stock market to a considerable extent. in the companies that constitute the Bombay Stock Market Sensitivity Index (Sensex). Particularly. their level of control is very high. the potential ill effects of a reduction in the FII flows into the Indian economy can be severe.FII investments. 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.unlike FII investments.

com NEWSPAPER AND MAGAZINES  The financial express  The economics times  Business standard  Business today 97 .investopedia.  Portfolio and investment management – FRANK J. FABOZZI JOURNALS REFERRED:     Annual Journal of SEBI Annual Journal of RBI Journal of ISMR Journal of finance WEBSITES VISITED:  www. SHROFF  Marketing Research – HARPER BOYD.equiymaster.PRAVEEN N.nseindia.reservbank.com  www.sebi.bseindia.com  www.com  www.in/finmin/ (Finance Ministry)  www.com (SEBI)  www.BIBLIOGRAPHY BOOKS REFERRED:  Indian securities market – AJAY SHAH AND TADASHI ENDO  The stock market dictionary .nic.com  www.moneycontrol.com  www.

 Outlook business  Outlook money 98 .

03/02. 2001. Runkle.” Journal of Finance 48. held by Indira Gandhi Institute of Development Research. 2003. “Portfolio Flows into India: Do Domestic Fundamentals Matter?” IMF Working Paper no. Rajesh. Lawrence R. 5: 1779–801.” Money and Finance 2.  Perron.” Indian Economic Review 32. no. D. Washington. 99 ..no. “FII Flows to India: Nature and Causes. and Poonam Gupta.” Journal of Econometrics 80: 355–85. 2: 217–29. Pushpa. 1997. 1997. Pierre. “On the Relation between the Expected Value and the Volatility of the Normal Excess Return on Stocks. Mumbai. and Abhilash Nair. “Further Evidence on Breaking Trend Function in Macroeconomic Variables. R.” Paper presented at the Fifth Annual Conference on Money & Finance in the Indian Economy. Ravi Jaganathan. January 30–February 1.C. no.: International Monetary Fund. and David E. 1993. N. James. 2003.  Trivedi. 7.  Glosten.  Gordon. “Foreign Portfolio Investment in Some Developing Countries: A Studyof Determinants and Macroeconomic Impact.REFERENCES  Agarwal.  Chakrabarti. “Determinants of FII Investment Inflow to India.

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ANNEXURE 101 .

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