A PROJECT REPORT ON “ROLE AND IMPACT OF FII‟s ON INDIAN CAPITAL MARKET” SPECIALISATION : FINANCE

Submitted in partial fulfillment of the requirement for the award of Post Graduate Diploma in Business Management under Bharati Vidyapeeth’s Institute of Management & Information Technology Submitted by ROHAN. R. SHIRODKAR ROLL NO:34 BATCH: 2010-2012 Under the guidance of PROF. VEENA CHAVAN

Bharati Vidyapeeth‘s Institute of Management & Information Technology Sector 8, CBD-Belapur, Navi Mumbai –400614

ACKNOWLEDGEMENT I take this opportunity to thank my institute director Dr.D Y Patil for providing me with an excellent infrastructure and conducive atmosphere for developing this project. I express my deepest thanks to my mentor, Prof. Veena Chavan for her precious advice that helped in selecting my study site in the initial but the most crucial stage of my project. Her constructive comments and feedback have been very useful towards the completion of my project. I am greatly indebted to for her invaluable advices on the quantitative research part of my project. I would like to thank her for bearing with me very patiently in the process. I also express my thanks to my friends and colleagues for their continuous help and support. Finally, I thank my parents and all my close relatives who encouraged and supported my decision to work on this project and dedicate this to them without their support and encouragement this could have never been realized.

(ROHAN RAMDAS SHIRODKAR)

(i)

Certificate

This is to certify Mr. Rohan R Shirodkar student of Post Graduation Diploma in Business Management (Finance) batch of Bharati Vidyapeeth’s Institute Of Management & Information Technology, Navi Mumbai has satisfactorily completed final project on “Role And Impact Of Fii‘s On Indian Capital Market” Under my supervision & guidance as partial fulfillment of requirement of PGDBM 2010-2012.

(PROF. VEENA CHAVAN) PROJECT GUIDE (ii)

(DR.D.Y.PATIL) DIRECTOR

EXECUTIVE SUMMARY

Since the beginning of liberalization FII flows to India have steadily grown in importance. As a part of its initiative to liberalize its financial markets, India opened her doors to Foreign Institutional Investors in September 1992. This event represents a landmark event since it resulted in effectively globalizing its financial services industry. The foreign institutional investors (FIIs) have emerged as important players in the Indian equity market in the recent past. This study makes an attempt to develop an understanding of the dynamics of the trading behavior of FIIs. Along with this the purpose of study is to find out the impact of FII inflows on Indian stock market, do we need FII inflows? Do FII play an important role in Indian equity market? And at last should we encourage FII inflows? For this monthly, yearly data of FII inflow is taken into consideration. First, the introduction about the Indian economy and FIIs is given followed by the conceptual framework, guidelines, investing limits in Indian companies is observed. Second, trends in FII flows and FII activities up to March 2012 are considered. This is followed by the role of FIIs in the Indian stock market. As per the study done it is found out that the trading behavior of FII do not have a destabilizing impact on the equity market. It can be said that we can encourage FII inflows into India through appropriate regulation of PNs and sub-accounts and invent a series of check and balances system so as to protect the economy and look over the fact that the economy works best with such kind of filters system. Thus, it can be said that FII do play an important role in Indian equity market.

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Table of Contents PARTICULARS Acknowledgement Certificates Executive Summary Table of Contents Chapter 1: Introduction of the Project 1.1: Objective of the Study 1.2: Type of Research 1.3: Scope and Limitations 1.4: Literature Review Chapter 2: Introduction to Topic 2.1: Indian Capital Market : An overview 2.2: Foreign Institutional Investments(FIIs) 2.3: Foreign Institutional Investors 2.4: Background of FIIs 2.5: Introduction of FIIs in India 2.6: Investment Limits 2.7: Eligibility criteria for entering as an FII in India 2.8: FIIs and their impact on Indian stock exchanges 2.9: FIIs and their impact on Indian economy (Positive and Negative effects) 2.10: FII activity in India from 1992-2006 2.11: FII activity in India from 2006-2010 2.12: FII activity in India 2010-2011(present scenario) 27 32 37 4 5 7 8 9 12 15 22 23 1 1 1 2 PAGE NO: (i) (ii) (iii) (v)

2.13: FII activity in 2012 in India Chapter 3: Research Methodology 3.1: Research Design 3.2: Data Collection Techniques and Tools 3.3: Sample Design 3.4: Research Analysis Tools 3.5 :Analysis and Interpretation Chapter 4: Future Prospects 4.1: Reasons why FII will keep pumping in Indian Market 4.2: U.S ratings downgraded Chapter 5: Conclusions and Suggestions Bibliography

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51 51 52 52 54

56 64 65 67

CHAPTER 1 : INRODUCTION TO THE PROJECT

Objective:  FII inflow and outflow trends in Indian Capital Markets during the post liberalization period that is 1991 to 2012 Influence of FII inflow and outflow trends on Indian Capital Markets To study the importance of FII on Indian economy as a whole

 

Type of Research Exploratory Research method applied for the study. As an exploratory study is conducted with an objective to gain familiarity with the phenomenon or to achieve new insight into it, this study aims to find the new insights in terms of finding the relationship between FII'S and Indian Stock Markets. Rationale and Scope of the Study and Limitations Foreign Institutional Investors are said to be the driver of the market. Those are the one cause behind the rise and fall of Sensex and Nifty. FII investment trends tell us about many effects that the Indian market is experiencing. The companies in which they invest are getting overvalued. Whenever FII find any trouble they withdraw their investments. Scope of the study is very broader and covers Capital Market Indices and its comparison with foreign institutional investments. But, study is only going to cover foreign investments in form of equity. The time period is from liberalization year 1992 to March 2012 as it will give exact impact in both the bullish and bearish trend. The study will provide a very clear picture of the impact of foreign institutional investors on Indian stock indices. It will also describe the market trends due to FIIs inflow and outflow. The study would be helpful for further descriptive studies and moreover, it would be beneficial to gain knowledge regarding foreign institutional investments, their process of registration and their impact on Indian stock market. The data on daily basis can give more positive results.In the study only FII equity investment and sales were considered. Other economic variables of macro and micro environment such as foreign exchange rate, speculative trading, interest rate prevailing in the market, political factors, government policies related to specific sectors etc. which can affect the performance of Indian capital market and FII inflow to the Indian capital market were not considered. Inclusion of these factors can provide more accurate insight to the findings of the present study

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Literature Review

According to India Report, Astaire Research “A Balance of Payments crisis in 1991 pushed the country to near bankruptcy. In return for an IMF bailout, gold was transferred to London as collateral, the rupee devalued and economic reforms were forced upon India. That low point was the catalyst required to transform the economy through badly needed reforms to unshackle the economy. Controls started to be dismantled, tariffs, duties and taxes progressively lowered, state monopolies broken, the economy was opened to trade and investment, private sector enterprise and competition were encouraged and globalization was slowly embraced. The reforms process continues today and is accepted by all political parties, but the speed is often held hostage by coalition politics and vested interests.” As a part of the reforms process, the Government under its New Industrial Policy revamped its foreign investment policy recognizing the growing importance of foreign direct investment as an instrument of technology transfer, augmentation of foreign exchange reserves and globalization of the Indian economy. Simultaneously, the Government, for the first time, permitted portfolio investments from abroad by foreign institutional investors in the Indian capital market. The entry of FIIs seems to be a follow up of the recommendation of the Narsimhan Committee Report on Financial System. While recommending their entry, the Committee, however did not elaborate on the objectives of the suggested policy. The committee only suggested that the capital market should be gradually opened up to foreign portfolio investments. In India, the purchase of domestic securities by FIIs was first allowed in September 1992 as part of the liberalization process that followed the balance of payment crisis in 1990-91. From September 14, 1992 with suitable restrictions, FIIs were permitted to invest in all the securities traded on the primary and secondary markets, including shares, debentures and warrants issued by companies which were listed or were to be listed on the Stock Exchanges in India. The Indian market was integrated with the world economy and international investors were invited to participate in India. Consequently, the committee on ―the reforms of the financial system‖ under the chairmanship of Mr M. Narsimham Rao was made which sought for reforms in the financial sector. Now days, a significant portion of Indian corporate sector's securities are held by Foreign Institutional Investors, such as pension funds, mutual funds and insurance companies. These investors are often viewed as sophisticated investors as these institutional investors are better informed and better equipped to process information than individual investors

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The impact study of FIIs flows on domestic stock market is important from government as well as investor point of view, for example, does the opening up of the market for FII increase speculation in the market and thus make the market more volatile and more vulnerable to foreign shocks The Impact of FII in equity investment behavior in stock Market is studied in this project and it‘s relative performance of Indian stock market. In this project the researcher has studied about the idea, that financial liberalization increases the efficiency of financial market and permission of FIIs equity investment are an important example of financial liberalization. Apart from net investment of FII's the purchase and sale behavior of FIIs were also analyzed in the study. The researcher has studied and analysed FII flows and examined if the overall experience has been stabilizing or destabilizing for the Indian capital market.

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CHAPTER 2: INTRODUCTION TO THE TOPIC 2.1 Indian Capital Markets: An Overview

It all started in India, when twenty-two agents started the Bombay Stock Exchange (BSE). That was way back in 1875. From then on, Indian markets have evolved continuously. Transparency is a buzzword in the Indian business finance scene. Characterized by operational excellence, and conformity to rules and regulations, the Indian financial market is a beacon of the economy. The Indian stock market is probably the oldest in Asia. In 1994, the National Stock Exchange (NSE) was commenced. NSE‘s objectives are to provide for speedy transactions. It also encouraged small investors. The Company Act of 1956 governs the securities market in India. Having the powers to regulate companies, the central government and the company law board abide by the companies act of 1956. Powers such as auditing of accounting information, reviewing the business finance model and looking into the other affairs of the company are given to the government. Investigators from the directorate of investigation do the audits. The Securities Contracts (Regulation) Act of 1956 and the Securities and Exchange Board of India (SEBI) Act of 1992.are the other body of rules that govern the Indian capital markets. Control of stocks, listings, contracts and a variety of other things are dealt by the former act. SEBI is concerned with the growth of the securities and business finance market in India. It looks into various other things like eligibility criteria for registration, developing the code of conduct, and so on. One of SEBI‘s main activities is to protect the business finance interests of investors, by providing the facilities to safeguard their wealth. In many ways, SEBI is instrumental in attracting investments, due to the safe nature in the Indian business finance scene. At a broad level, the Indian security market can be grouped into the savers and the spenders. The savers are normal households, and the spenders are companies and the government. If the money of the savers is put in financial securities, then spenders get money to operate, and in turn the savers get interest or dividend to enjoy. Hence the security market is where the companies meet the savers.

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The changes in economic scenario(after the liberalization) and the economic growth have raised the interest of Indian as well as Foreign Institutional Investors(FII‘s) in the Indian capital market. The recent massive structural reforms on the economic and industry front in the form of de-licensing rupee convertibility, tapping of foreign funds, allowing foreign investors to come to India, have resulted, on one hand, in the quantum leap in activities/volume in the Indian capital market, and on the other hand and more importantly, that the Indian capital market has undergone a metamorphosis in terms of institutions, instruments, etc. The capital market in India is rightly termed as an emerging and promising capital market. During last 20 years or so, the Indian capital market has witnessed growth in volume of funds raised as well as of. The buoyancy in the capital market has appeared as a result of increasing industrialisation, growing awareness globalisation of the capital market, etc. Several financial institutions, financial instruments and financial services have emerged as a result of economic liberalisation policy of the Government of India. The capital market has two interdependent segments : the primary market and the secondary market. The primary market is the channel for creation of new securities. These securities are issued by public limited companies or by government agencies‘ In the primary market, the resources are mobilized either through the public issue or through private placement route. It is a public issue if anybody and everybody can subscribe for it, whereas if the issue is made available to a selected group of persons it is termed as private placement. There are two major types of issuers of securities, the corporate entities who issue mainly debt and equity instruments and the Government (Central as well as State) who issue debt securities. These new securities issued in the primary market are traded in the secondary market. The secondary market enables participants who hold securities to adjust their holdings in response to changes in their assessment of risks and returns. 2.2 Foreign Institutional Investments (FIIs) In present era of globalization no country or economy has been left untouched from international trade and commerce. More access to international capital markets and foreign investments has helped developing countries surmount their less developed capital markets. During the past few years, a flow of capital has been seen from the developed part of the world to the less developed economies which has led to decrease in the vulnerability of developing countries to financial crisis by reduction in their external debt burden from 39% of gross national income in 1995 to 26% in 2006 and increase in foreign exchange reserves to 92% of long term debt and 423% of more volatile short term debt in 2006. Over the years same scenario has been witnessed in the Indian economy also. And thus, today most of the market entities are interested in attracting foreign capital as it not only helps in creating liquidity for the firms stock and the stock market but also leads to lowering of the cost of the capital for the firms and allows them to compete more effectively in the global market place.
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Foreign Investment It has been defined as ―a transfer of funds or materials from one country (called capital exporting country) to another country (called host country) in return for a direct or indirect participation in the earnings of that enterprise.‖ Foreign investments provide a channel through which one can have access to foreign capital and after the opening up of the Indian economy; these have grown in leaps and bounds. Basically foreign investment can be made through following routes:
  

Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI). Private Equity investments-Foreign venture capital investor(FVCI)

Firstly, foreign direct investment pertains to international investment in which the investor obtains a lasting interest in an enterprise in another country. Mostly it takes the form of buying or constructing a factory in a foreign country or adding improvements to such a facility in form of property, plants or equipments and thus is generally long term in nature. On the other hand, a private equity investment is one made by foreign investors in Indian Venture Capital Undertakings (VCU) and Venture Capital Funds (VCF). Thirdly, a foreign portfolio investment is a short-term to medium- term investment mostly in the financial markets and is commonly made through foreign Institutional Investors (FIIs), non resident Indian (NRI) and persons of Indian origin (PIO).
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2.3 FOREIGN INSTITUTIONAL INVESTORS The term ‗FII‘ is used to denote an investor, mostly in the form of an institution or entity which invests money in the financial markets of a country different from the one where in the institution or the entity is originally incorporated. According to Securities and Exchange Board of India (SEBI) it is ―an institution that is a legal entity established or incorporated outside India proposing to make investments in India only in securities‖. These can invest their own funds or invest funds on behalf of their overseas clients registered with SEBI. The client accounts are known as ‗sub-accounts‘. A domestic portfolio manager can also register as FII to manage the funds of the sub-accounts. From the early 1990s, India has developed a framework through which foreign investors participate in the Indian capital market. A foreign investor can either come into India as a FII or as a sub-account. As on March 31, 2011, there were 1,722 FIIs registered with SEBI and 5,686 sub-accounts registered with SEBI as on March 31, 2011 Basically FIIs have a huge financial strength and invest for the purpose of income and capital appreciation. They are no interested in taking control of a company. Some of the big American mutual funds are fidelity, vanguard, Merrill lynch, capital research etc. They are permitted to trade in securities in primary as well as secondary markets and can trade also in dated government securities, listed equity shares, listed non convertible debentures/bonds issued by Indian company and schemes of mutual funds but the sale should be only through recognized stock exchange. These also include domestic asset management companies or domestic portfolio managers who manage funds raised or collected or bought from outside India for the purpose of making investment in India on behalf of foreign corporate or foreign individuals. In the Indian context, foreign institutional investors (FIIs) and their sub-accounts mostly use these instruments for facilitating the participation of their overseas clients, who are not interested in participating directly in the Indian stock market. FIIs contribute to the foreign exchange inflow as the funds from multilateral finance institutions and FDI are insufficient.
   

It lowers cost of capital, access to cheap global credit. It supplements domestic savings and investments. It leads to higher asset prices in the Indian market. And has also led to considerable amount of reforms in capital market and financial sector.

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2.4 BACKGROUND In the late 1980s India suffered an acute financial crunch. At that time Indian foreign exchange stood at mere US $1.2 bn which could barely finance 3 weeks‘ worth of imports. And India had to pledge its gold reserve with IMF to secure a loan of just US $457 mn. The gross fiscal deficit of the government rose from 9.0% of GDP in 1980-81 to 10.4 percent in 1985-86 and to 12.7% in 1990-91. Since these deficits had to be met by borrowings, the internal debt of the government accumulated rapidly, rising from 35% of GDP at the end of 1980-81 to 53% of GDP at the end of 1990-91. According to India Report, Astaire Research “A Balance of Payments crisis in 1991 pushed the country to near bankruptcy. In return for an IMF bailout, gold was transferred to London as collateral, the rupee devalued and economic reforms were forced upon India. That low point was the catalyst required to transform the economy through badly needed reforms to unshackle the economy. Controls started to be dismantled, tariffs, duties and taxes progressively lowered, state monopolies broken, the economy was opened to trade and investment, private sector enterprise and competition were encouraged and globalization was slowly embraced. The reforms process continues today and is accepted by all political parties, but the speed is often held hostage by coalition politics and vested interests.”

Thus it was decided to open up the economy, the economic policies were liberalized and private sector was given the freedom to participate in the Indian economy more effectively. The Indian market was integrated with the world economy and international investors were invited to participate in India. Consequently, the committee on ―the reforms of the financial system‖ under the chairmanship of Mr M. Narsimham Rao was made which sought for reforms in the financial sector. One of its recommendation included developing an active government securities market and strengthening the open market operations as an instrument of monetary policy. And thus this reform paved way for foreign investments which were at that time the need of the hour. As a result of this, Indian stock market witnessed metamorphic changes and a transition-from a ―dull‖ to a highly ―buoyant‖ stock market. Improved market surveillance system, trading mechanism and introduction of new financial instruments made it a center of attraction for the international investors. Until the 1980s, India‘s development strategy was focused on self-reliance and Importsubstitution. Current account deficits were financed largely through debt flows and official development assistance. There was a general disinclination towards foreign investment or private
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commercial flows. Since the initiation of the reform process in the early 1990s, however, India‘s policy stance has changed substantially, with a focus on harnessing the growing global foreign direct investment (FDI) and portfolio flows. The broad approach to reform in the external sector after the Gulf crisis was delineated in the Report of the High Level Committee on Balance of Payments (Chairman: C. Rangarajan). It recommended:      a compositional shift in capital flows away from debt to non-debt creating flows; strict regulation of external commercial borrowings, especially short-term debt; discouraging volatile elements of flows from non-resident Indians (NRIs); gradual liberalisation of outflows; disintermediation of Government in the flow of external assistance.

2.5 Introduction to FII
Since 1990-91, the Government of India embarked on liberalization and economic reforms with a view of bringing about rapid and substantial economic growth and move towards globalization of the economy. As a part of the reforms process, the Government under its New Industrial Policy revamped its foreign investment policy recognizing the growing importance of foreign direct investment as an instrument of technology transfer, augmentation of foreign exchange reserves and globalization of the Indian economy. Simultaneously, the Government, for the first time, permitted portfolio investments from abroad by foreign institutional investors in the Indian capital market. The entry of FIIs seems to be a follow up of the recommendation of the Narsimhan Committee Report on Financial System. While recommending their entry, the Committee, however did not elaborate on the objectives of the suggested policy. The committee only suggested that the capital market should be gradually opened up to foreign portfolio investments. From September 14, 1992 with suitable restrictions, FIIs were permitted to invest in all the securities traded on the primary and secondary markets, including shares, debentures and warrants issued by companies which were listed or were to be listed on the Stock Exchanges in India. While presenting the Budget for 1992-93, the then Finance Minister Dr. Manmohan Singh had announced a proposal to allow reputed foreign investors, such as Pension Funds etc., to invest in Indian capital market. To operationalise this policy announcement, it had become necessary to evolve guidelines for such investments by Foreign Institutional Investors (FIIs). A major development in our country post 1991 has been liberalization of the financial sector, especially that of capital markets. Our country today has one of the most prominent and followed stock exchanges in the world. Further, India has also been consistently gaining prominence in various international forums, though we still have a long way to go.

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EVOLUTION OF FII POLICIES IN INDIA

After the launch of the reforms in the early 1990s, there was a gradual shift towards capital account convertibility. From September 14, 1992, with suitable restrictions, FIIs and Overseas Corporate Bodies (OCBs) were permitted to invest in financial instruments. The policy framework for permitting FII investment was provided under the Government of India guidelines, which enjoined upon FIIs to obtain an initial registration with SEBI and also RBI‘s general permission under FERA. The Government guidelines of 1992 also provided for eligibility conditions for registration, such as track record, professional competence, financial soundness and other relevant criteria, including registration with a regulatory organisation in the home country. The guidelines were suitably incorporated under the SEBI (FIIs) Regulations, 1995.With coming into force of the Foreign Exchange Management Act, (FEMA), 1999 foreign exchange related transactions of FIIs were permitted by RBI. Right from 1992, FIIs have been allowed to invest in all securities traded on the primary and secondary markets, including shares, debentures and warrants issued by companies which were listed or were to be listed on the Stock Exchanges in India and in schemes floated by domestic mutual funds. The holding of a single FII, and of all FIIs, NRIs and OCBs together in any company were initially subject to the limit of 5 per cent and 24 per cent of the company‘s total issued capital, respectively. Furthermore, to ensure a broad base and prevent such investment acting as a camouflage for individual investment in the nature of FDI and requiring Government approval, funds invested by FIIs have to have at least 50 participants (changed to 20 investors in August, 1999) with no single participant holding more than 5 per cent (revised to 10 per cent in February, 2000). However, this was allowed to be increased subject to passing of resolution by the Board of Directors of the company followed by passing of a special resolution by the General Body of the company. The ceiling limit under special procedure was enhanced in stages as follows:  to 30 per cent from April 4, 1997  to 40 per cent from March 1, 2000,  to 49 per cent from March 8, 2001,and  to sectoral cap/statutory ceiling from September 20,2001. The Government guidelines for FII of 1992 allowed, inter-alia, entities such as asset management companies, nominee companies and incorporated/institutional portfolio managers or their power of attorney holders (providing discretionary and non discretionary portfolio management services) to be registered as FIIs. While the guidelines did not have a specific provision regarding clients, in the application form the details of clients on whose behalf investments were being made were sought. While granting registration to the FII, permission was also granted for making investments in the names of such clients. Asset management companies/portfolio managers are basically in the business of managing funds and investing them on behalf of their funds/clients. Hence, the intention of the guidelines was to allow these
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categories of investors to invest funds in India on behalf of their ‗clients‘. These ‗clients' later came to be known as sub-accounts. The broad strategy consisted of having a wide variety of clients, including individuals, intermediated through institutional investors, who would be registered as FIIs in India. A Working Group for Streamlining of the Procedures relating to FIIs, constituted in April, 2003, inter alia, recommended streamlining of SEBI registration procedure, and suggested that dual approval process of SEBI and RBI be changed to a single approval process of SEBI. This recommendation was implemented in December 2003. Under eligibility conditions, the definition of broad based funds was relaxed in August, 1999 and in February, 2000 and newer entities, such as foreign firms were allowed to invest as subaccounts. In order to have a level playing field in intermediation, domestic portfolio managers were allowed in February, 2000 to manage the funds of sub-accounts, so as to give endcustomers a greater choice about the identity of their fund manager in India. FIIs were initially allowed to only invest in listed securities of companies. Gradually, they were allowed to invest in unlisted securities, rated government securities, commercial paper and derivatives traded on a recognised stock exchange. From November 1996, 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 In order to increase transparency, SEBI issued a circular on October 31, 2001 to all FIIs and their custodians advising the FIIs to report as and when any derivative instruments with Indian underlying securities are issued/renewed/redeemed by them, either on their own account or on behalf of subaccounts registered under them. In 2003 this circular was further revised to include disclosure of more details about terms, nature and contracting parties. The overall cap on investments in Government securities, both through the normal route and the 100 per cent debt fund route, was revised from US$1 billion to US$1.75 billion in November, 2004. Moreover, investments were allowed only in debt securities of companies listed or to be listed in stock exchanges. Investments were free from maturity limitations. From April 1998, FII investments were also allowed in dated Government securities. Treasury bills, being money market instruments, were originally outside the ambit of such investments, but were included subsequently from May, 1998.In April 2006 there was a rise in the cumulative debt investment limits from US $1.75 billion to US $2 billion and US $0.5 billion to US $1.5 billion for FII/Sub Account investments in Government securities and Corporate Debt, respectively.

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2.6 Investments by FIIs
A FII may invest through 2 routes:

Equity Investment 100% investments could be in equity related instruments or upto 30% could be invested in debt instruments i.e.70 (Equity Instruments): 30 (Debt Instruments) 100% Debt 100% investment has to be made in debt securities only

Equity Investment route: In case of Equity route the FIIs can invest in the following instruments: A. Securities in the primary and secondary market including shares which are unlisted, listed or to be listed on a recognized stock exchange in India. B. Units of schemes floated by the Unit Trust of India and other domestic mutual funds, whether listed or not. C. Warrants 100% Debt route: In case of Debt Route the FIIs can invest in the following instruments: A. B. C. D. E. Debentures (Non Convertible Debentures, Partly Convertible Debentures etc.) Bonds Dated government securities Treasury Bills Other Debt Market Instruments

It should be noted that foreign companies and individuals are not be eligible to invest through the 100% debt route.

The evolution of FII policy in India has displayed a steady and cautious approach to liberalisation of a system of quantitative restrictions (QRs). The policy liberalization has taken the form of, (i) relaxation of investment limits for FIIs; (ii) relaxation of eligibility conditions; (iii) liberalisation of investment instruments accessible for FIIs

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Market design in India for foreign institutional investors Foreign Institutional Investors means an institution established or incorporated outside India which proposes to make investment in India in securities. A Working Group for Streamlining of the Procedures relating to Foriegn Institutional Investors, constituted in April, 2003, inter alia, recommended streamlining of SEBI registration procedure, and suggested that dual approval process of SEBI and RBI be changed to a single approval process of SEBI. This recommendation was implemented in December 2003. Currently, entities eligible to invest under the FII route are as follows:

As FII: Overseas pension funds, mutual funds, investment trust, asset management company, nominee company, bank, institutional portfolio manager, university funds, endowments, foundations, charitable trusts, charitable societies, a trustee or power of attorney holder incorporated or established outside India proposing to make proprietary investments or with no single investor holding more than 10 per cent of the shares or units of the fund. As Sub-accounts: The sub account is generally the underlying fund on whose behalf the FII invests. The following entities are eligible to be registered as sub-accounts, viz. partnership firms, private company, public company, pension fund, investment trust, and individuals.

FIIs registered with SEBI fall under the following categories:
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Regular FIIs- those who are required to invest not less than 70 % of their investment in equity-related instruments and 30 % in non-equity instruments. 100 % debt-fund FIIs- those who are permitted to invest only in debt instruments.

The Government guidelines for FII of 1992 allowed, inter-alia, entities such as asset management companies, nominee companies and incorporated/institutional portfolio managers or their power of attorney holders (providing discretionary and non-discretionary portfolio management services) to be registered as Foreign Institutional Investors. While the guidelines did not have a specific provision regarding clients, in the application form the details of clients on whose behalf investments were being made were sought. While granting registration to the FII, permission was also granted for making investments in the names of such clients. Asset management companies/portfolio managers are basically in the business of managing funds and investing them on behalf of their funds/clients. Hence, the intention of the guidelines was to allow these categories of investors to invest funds in India on
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behalf of their ‗clients‘. These ‗clients‘ later came to be known as sub-accounts. The broad strategy consisted of having a wide variety of clients, including individuals, intermediated through institutional investors, who would be registered as FIIs in India. FIIs are eligible to purchase shares and convertible debentures issued by Indian companies under the Portfolio Investment Scheme. Prohibitions on Investments: Foreign Institutional Investors are not permitted to invest in equity issued by an Asset Reconstruction Company. They are also not allowed to invest in any company which is engaged or proposes to engage in the following activities:
   

Business of chit fund Nidhi Company Agricultural or plantation activities Real estate business or construction of farm houses (real estate business does not include development of townships, construction of residential/commercial premises, roads or bridges). Trading in Transferable Development Rights (TDRs).

Trends of Foreign Institutional Investments in India. Portfolio investments in India include investments in American Depository Receipts (ADRs)/ Global Depository Receipts (GDRs), Foreign Institutional Investments and investments in offshore funds. Before 1992, only Non-Resident Indians (NRIs) and Overseas Corporate Bodies were allowed to undertake portfolio investments in India. Thereafter, the Indian stock markets were opened up for direct participation by FIIs. They were allowed to invest in all the securities traded on the primary and the secondary market including the equity and other securities/instruments of companies listed/to be listed on stock exchanges in India. Procedure for Registration: The Procedure for registration of FII has been given by SEBI regulations. It states- ―no person shall buy, sell or otherwise deal in securities as a Foreign Institutional Investor unless he holds a certificate granted by the Board under these regulations‖. An application for grant of registration has to be made in Form A, the format of which is provided in the SEBI (FII) Regulations, 1995.

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2.7 Entities which can register as FII‟s in India- Eligibility Entities who propose to invest their proprietary funds or on behalf of ―broad based‖ funds (fund having more than twenty investors with no single investor holding more than 10 per cent of the shares or units of the fund) or of foreign corporate and individuals and belong to any of the under given categories can be registered for Foreign Institutional Investors (FII‘s)
                

Pension Funds Mutual Funds Investment Trust Insurance or reinsurance companies Endowment Funds University Funds Foundations or Charitable Trusts or Charitable Societies who propose to invest on their own behalf Asset Management Companies Nominee Companies Institutional Portfolio Managers Trustees Power of Attorney Holders Banks Foreign Government Agency Foreign Central Bank International or Multilateral Organization or an Agency thereof

Some of the above mentioned types are described below: Pension funds: A pension fund is a pool of assets that form an independent legal entity that are bought with the contributions to a pension plan for the exclusive purpose of financing pension plan benefits. It manages pension and health benefits for employees, retirees, and their families. FII activity in India gathered momentum mainly after the entry of CalPERS (California Public Employees‘ Retirement System), a large US-based pension fund in 2004. Mutual funds: A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, or other such securities. The mutual fund will have a fund manager that trades the pooled money on a regular basis. The net proceeds or losses are then distributed to the investors. Investment trust: An Investment trust is a form of collective investment .Investment trusts are closed-end funds and are constituted as public limited companies. A collective investment
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scheme is a way of investing money with others to participate in a wider range of investments than feasible for most individual investors, and to share the costs and benefits of doing so Investment banks: An investment bank is a financial institution that raises capital, trades in securities and manages corporate mergers and acquisitions. Investment banks profit from companies and governments by raising money through issuing and selling securities in capital markets (both equity, debt) and insuring bonds (e.g. selling credit default swaps), as well as providing advice on transactions such as mergers and acquisitions. Hedge funds: A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of investment and trading activities than other investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and the methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of investments including shares, debt and commodities. Many hedge funds investments in India were facilitated by global investors borrowing at near zero interest rates in Japan and investing the proceeds in High interest markets like India. University Fund: The purpose of investments of these funds is to establish an asset mix for each of the University funds according to the individual fund‘s spending obligations, objectives, and liquidity requirements. It consists of the University‘s endowed trust funds or other funds of a permanent or long-term nature. In addition, external funds may be invested including funds of affiliated organizations and funds where the University is a beneficiary. Endowment fund: It is a transfer of money or property donated to an institution, usually with the stipulation that it be invested, and the principal remain intact in perpetuity or for a defined time period. This allows for the donation to have an impact over a longer period of time than if it were spent all at once. Insurance Funds: An insurance company‘s contract may offer a choice of unit-linked funds to invest in. All types of life assurance and insurers pension plans, both single premium and regular premium policies offer these funds. They facilitate access to wide range and types of assets for different types of investors. Asset Management Company: An asset management company is an investment management firm that invests the pooled funds of retail investors in securities in line with the stated investment objectives. For a fee, the investment company provides more diversification, liquidity, and professional management consulting service than is normally available to individual investors. The diversification of portfolio is done by investing in such securities which are inversely correlated to each other. They collect money from investors by way of floating various mutual fund schemes.
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Nominee Company: Company formed by a bank or other fiduciary organization to hold and administer securities or other assets as a custodian (registered owner) on behalf of an actual owner (beneficial owner) under a custodial agreement. Charitable Trusts or Charitable Societies: A trust created for advancement of education, promotion of public health and comfort, relief of poverty, furtherance of religion, or any other purpose regarded as charitable in law. Benevolent and philanthropic purposes are not necessarily charitable unless they are solely and exclusively for the benefit of public or a class or section of it. Charitable trusts (unlike private or non-charitable trust) can have perpetual existence and are not subject to laws against perpetuity. They are wholly or partially exempt from almost all taxes. An application for registration has to be made in Form A, the format of which is provided in the SEBI(FII) Regulations, 1995 and submitted with under mentioned documents in duplicate addressed to SEBI as well as to Reserve Bank of India (RBI) and sent to the following address within 10 to 12 days of receipt of application. Address for application The Division Chief FII Division Securities and Exchange Board of India, 224, Mittal Court, 'B' Wing, 1st Floor, Nariman Point, Mumbai - 400 021. INDIA. Supporting documents required are
   

  

Application in Form A duly signed by the authorised signatory of the applicant. Certified copy of the relevant clauses or articles of the Memorandum and Articles of Association or the agreement authorizing the applicant to invest on behalf of its clients Audited financial statements and annual reports for the last one year , provided that the period covered shall not be less than twelve months. A declaration by the applicant with registration number and other particulars in support of its registration or regulation by a Securities Commission or Self Regulatory Organisation or any other appropriate regulatory authority with whom the applicant is registered in its home country. A declaration by the applicant that it has entered into a custodian agreement with a domestic custodian together with particulatrs of the domestic custodian. A signed declaration statement that appears at the end of the Form. Declaration regarding fit & proper entity.

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The eligibility criteria for applicant seeking FII registration As per Regulation 6 of SEBI (FII) Regulations,1995, Foreign Institutional Investors are required to fulfill the following conditions to qualify for grant of registration:
 

    

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

SUB-ACCOUNT REGISTRATION a) Institution or funds or portfolios established outside India, whether incorporated or not. b) Proprietary fund of FII. c) Foreign Corporates d) Foreign Individuals. The FII should apply on the behalf of the Sub-account. Both the FII and the Sub-account are required to sign the Sub-account application form. "Annexure B" to "Form A" (FII application form) needs to be filled when applying for subaccount registration. No document is needed to be sent with annexure B. The fee for sub-account registration is US$ 1,000. The fee is to be submitted at the time of submitting the application. The mode of payment is Demand Draft in the name of "Securities and Exchange Board of India" payable at New York. SEBI generally takes three working days in granting FII registration. However, in cases where the information furnished by the applicants is incomplete, three days shall be counted from the days when all necessary information sought, reaches SEBI. The validity of sub-account registration is co-terminus with the FII registration under which it is registered. The process of renewal of sub-account is same as initial registration. Renewal fee in this case is US $ 1,000. OCBs / NRIs are not permitted to get registered as FII/sub-account.

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FII Regulations: Investment by FIIs is regulated under SEBI (FII) Regulations, 1995. Following are some of important regulations by SEBI and RBI: 1. A Foreign Institutional Investor may invest only in the instruments mentioned earlier. 2. The total investments in equity and equity related instruments (including fully convertible debentures, convertible portion of partially convertible debentures and tradable warrants) made by a FII in India, whether on his own account or on account of his sub- accounts, should be at least 70% of the aggregate of all the investments of the FII in India, made on his own account and through his sub-accounts. 3. The cumulative debt investment limit for FII investments in Corporate Debt is US $15 billion. The amount was increased from US $6 billion to USD 15 billion in March 2009. 4. US $8 billion will be allocated to the FIIs and Sub-Accounts through an open bidding platform while the remaining amount is allocated on a ‗first come first served‘ basis subject to a ceiling of Rs.249 cr. per registered entity. 5. The debt investment limit for FIIs in government debt is currently capped at $5 billion and cumulative investments under 2% of the outstanding stock and no single entity can be allocated more than Rs. 1000 crores of the government debt limits. Further, in 2008 amendments were made to attract more foreign investors to register with SEBI, these amendments are: 1. The definition of ―broad based fund‖ under the regulations was substantially widened allowing several more sub accounts and FIIs to register with SEBI. 2. Several new categories of registration viz. sovereign wealth funds, foreign individual, foreign corporate etc. were introduced, 3. Registration once granted to foreign investors was made permanent without a need to apply for renewal from time to time thereby substantially reducing the administrative burden, 4. Also the application fee for foreign investors applying for registration has recently been reduced by 50% for FIIs and sub accounts 5. Also, institutional investors including FIIs and their sub-accounts have been allowed to undertake short-selling, lending and borrowing of Indian securities from February 1, 2008.

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6. Also the rigid criteria of requiring FIIs and sub-account to register as a 70:30 FII/ sub-account or 100% debt FII/sub-account has recently been done away with(as has been discussed above in the essay).

With regard to investments in the secondary market, SEBI states that:
 

    

The Foreign Institutional Investor is allowed to transact business only on the basis of taking and giving deliveries of securities bought and sold. Short selling in securities is not allowed. However, in December 2007, abroad regulatory framework enabling short selling by FIIs was put in place. Which stipulated that naked short selling was not permitted and settlement of securities sold short would be through a mechanism for borrowing of securities. FIIs are not permitted to short sell equity shares which are in the caution list of RBI. Equity shares can be borrowed by FIIs only for the purpose of delivery into short sale. No transactions on the stock exchange can be carried forward. Transaction of business in securities can be carried out only through stock brokers who has been granted a certificate by the Board. A Foreign institutional Investor or a sub-account having an aggregate of securities worth rupees ten crore or more, as on the latest balance sheet date, can settle their only through dematerialised securities. Securities have to be registered in the name of the Foreign Institutional Investor, if he is making investments on his own behalf or in his name on account of his sub-account, or in the name of the sub-account, in case he is investing on behalf of the sub-account. The purchase of equity shares of each company by a Foreign Institutional Investor investing on his own account cannot exceed ten percent of the total issued capital of that company. Investment by individual FIIs cannot exceed 10% of paid up capital. Investment by foreign registered as sub accounts of FII cannot exceed 5% of paid up capital. All FIIs and their subaccounts taken together cannot acquire more than 24% of the paid up capital of an Indian Company. An Indian Company can raise the 24% ceiling to the Sectoral Cap / Statutory Ceiling by passing a resolution by its Board of Directors followed by passing a Special Resolution to that effect by their General Body. For FIIs investing in the equity shares of a company on behalf of his sub-accounts, the investment on behalf of each such sub-account cannot exceed ten percent of the total issued capital of that company.

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The FII position limits in a derivative contracts (Individual Stocks)
  

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

FII Position limits in Index options contracts FII position limit in all index options contracts on a particular underlying index is Rs. 250 Crore or 15 % of the total open interest of the market in index options, whichever is higher, per exchange. This limit is applicable on open positions in all option contracts on any underlying index.

FII Position limits in Index futures contracts FII position limit in all index futures contracts on a particular underlying index is Rs. 250 Crore or 15 % of the total open interest of the market in index futures, whichever is higher, per exchange. This limit is applicable on open positions in all futures contracts on a particular underlying index. In addition to the above, FIIs can take exposure in equity index derivatives subject to the conditions that :
 

Short positions in index derivatives (short futures, short calls and long puts) cannot exceed (in notional value) the FII‘s holding of stocks. Long positions in index derivatives (long futures, long calls and short puts) can not exceed (in notional value) the FII‘s holding of cash, government securities, TBills and similar instruments.

FII Position Limits in Interest rate derivative contracts

At the level of the FII – The notional value of gross open position of a FII in exchange traded interest rate derivative contracts is US $ 100 million.

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In addition to the above, FIIs can take exposure in exchange traded in interest rate derivative contracts to the extent of the book value of their cash market exposure in Government Securities. At the level of the sub-account – The position limits for a Sub-account in near month exchange traded interest rate derivative contracts is the higher of: Rs. 100 Cr Or 15% of total open interest in the market in exchange traded interest rate derivative contracts.

2.8 FIIs and their impact on Indian Stock market It is influence of the FIIs which changed the face of the Indian stock markets. Screen based trading and depository are realities today largely because of FIIs. Equity research was something unheard of in the Indian market a decade ago. It was FII which based the pressure on the rupee from the balance of payments position and lowered the cost of capital to Indian business. It is due to the FIIs that a concept like corporate governance is being increasingly adopted by Indian companies; this is benefiting domestic investors also. FIIs are the trendsetters in any market. They were the first ones to identify the potential of Indian technology stocks. When the rest of the investors invested in these scrips, they exited the scrips and booked profits. Before the arrival of FIIs, the activity in stocks used to be evenly attributed with little differences between volumes in specified and cash groups. However since FIIs concentrate on the top 200 companies against the 6,000 listed companies on BSE, the stock trading activity has concentrated to these liquid scrips making them less liquid scrips totally illiquid. Thus, FIIs have become the driving force behind the movements of the stock indices on the Indian stock markets. Rolling settlement was introduced at the insistence of FIIs as they were uncomfortable with the badla system. The major beneficiaries of the rolling settlement system are FIIs as short settlement cycles offer them quick exit from the market. With their massive financial muscle FIIs have almost replaced conventional market of the Indian bourse. Today financial institutions and mutual funds including UTI can do little to help the stock markets at a time of crisis. Even UTI, which used to be counter force for FIIs has ceased to play that role in the Indian stock markets. It is expected that with the adoption of international practices such as rolling settlement and derivatives FII participation will increase and more money will flow into the Indian capital market.

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2.9 EFFECTS ON INDIAN ECONOMY The various reforms introduced by Indian government to encourage FIIs to invest in Indian market have been effective to such an extent that in November 2010 FIIs stood at 5426 whereas it stood at 1713 in early 1990s. The changes have led to increase in liquidity, reduce risk, improve disclosure and thus FIIs have become the corner stone in the phenomenal rise of the Indian stock market. From the table below it becomes apparent that from just Rs 4 crores of net investment in 1992-93, the investment rose to Rs 5445 the next financial year when the economic changes were introduced and further today in 2010-11 it stands at Rs 133,049. YEAR 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-2010 2010-2011 Net Investments by FIIs (rs cr.) 4 5445 4777 6721 7386 5908 -729 9765 9682 8273 2669 44000 41416 47,602 36,396.60 71,952 -53,796 84,269 133,049

In 1993 the first and only FII to invest in India was Pictet Umbrella Trust Emerging Markets‘ Fund, an institutional investor from Switzerland but today Indian growth story has attracted global majors like CLSA, HSBC, Citigroup, Merrill Lynch, Crown Capital, Fidelity, Goldman Sachs and Morgan Stanley, among others to enter the Indian financial market. Goldman Sachs and Macquarie have acquired a 20% stake each in PTC India Financial services Ltd. Temasek Holdings, Investment Corporation of Dubai, Goldman Sachs, Macquarie, AIF Capital, Citigroup and India Equity Partners (IEP) have picked a combined stake of 10% in Bharti Infratel. Also an

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entity of Merrill Lynch has picked up 49% stake in seven residential projects of real estate major, DLF. This boost, though good for Indian economy has led to a number of negative consequences. Let us study the positive and the negative side of this rise of investments by FIIs one by one. Positive impact: It has been emphasized upon the fact that the capital market reforms like improved market transparency, automation, dematerialization and regulations on reporting and disclosure standards were initiated because of the presence of the FIIs. But FII flows can be considered both as the cause and the effect of the capital market reforms. The market reforms were initiated because of the presence of them and this in turn has led to increased flows. A. 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, respectively, of their portfolios in equity in 1998. Not only it can help in supplementing the domestic savings for the purpose of development projects like building economic and social infrastructure but can also help in growth of rate of investment, it boosts the production, employment and income of the host country. B. Managing uncertainty and controlling risks: FIIs promote financial innovation and development of hedging instruments. These because of their interest in hedging risks, are known to have contributed to the development of zero-coupon bonds and index futures. FIIs not only enhance competition in financial markets, but also improve the alignment of asset prices to fundamentals. FIIs in particular are known to have good information and low transaction costs. By aligning asset prices closer to fundamentals, they stabilize markets. In addition, a variety of FIIs with a variety of risk-return preferences also help in dampening volatility. C. Improving capital markets: FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. By increasing the availability of riskier long term capital for projects, and increasing firms‘ incentives to supply more information about them, the FIIs can help in the process of economic development. D. Improved corporate governance: Good corporate governance is essential to overcome the principal-agent problem between share-holders and management. Information asymmetries and incomplete contracts between share-holders and management are at the root of the agency costs. Bad corporate governance makes equity finance a costly option. With boards often captured by managers or passive, ensuring the rights of shareholders is a problem that needs to be addressed efficiently in any economy. 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 free-ride on their endeavor. FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms‘ operations, improve
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corporate governance. Among the four models of corporate control - takeover or market control via equity, leveraged control or market control via debt, direct control via equity, and direct control via debt or relationship banking-the third model, which is known as corporate governance movement, has institutional investors at its core. In this third model, board representation is supplemented by direct contacts by institutional investors. Negative impact: If we see the market trends of past few recent years it is quite evident that Indian equity markets have become slaves of FIIs inflow and are dancing to their tune. And this dependence has to a great extent caused a lot of trouble for the Indian economy. Some of the factors are: A. Potential capital outflows: ―Hot money‖ refers to funds that are controlled by investors who actively seek short-term returns. These investors scan the market for short-term, high interest rate investment opportunities. ―Hot money‖ can have economic and financial repercussions on countries and banks. When money is injected into a country, the exchange rate for the country gaining the money strengthens, while the exchange rate for the country losing the money weakens. If money is withdrawn on short notice, the banking institution will experience a shortage of funds. B. Inflation: Huge amounts of FII fund inflow into the country creates a lot of demand for rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created. This situation leads to excess liquidity thereby leading to inflation where too much money chases too few goods. C. Problem to small investors: The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high then they can bring in huge amounts of funds in the country‘s stock markets and thus have great influence on the way the stock markets behaves, going up or down. The FII buying pushes the stocks up and their selling shows the stock market the downward path. This creates problems for the small retail investor, whose fortunes get driven by the actions of the large FIIs. D. Adverse impact on Exports: FII flows leading to appreciation of the currency may lead to the exports industry becoming uncompetitive due to the appreciation of the rupee. E. Issue related to participatory notes: When Indian-based brokerages buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors. Any entity investing in participatory notes is not required to register with SEBI (Securities and Exchange Board of India), whereas all FIIs have to compulsorily get registered. Trading through participatory notes is easy because participatory notes are like contract notes transferable by endorsement and delivery. Secondly, some of the entities route their investment through participatory notes to take
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advantage of the tax laws of certain preferred countries. Thirdly, participatory notes are popular because they provide a high degree of anonymity, which enables large hedge funds to carry out their operations without disclosing their identity. The hedge funds borrow money cheaply from western markets and invest these funds into stocks in emerging economies. It is also feared that the hedge funds, acting through participatory notes, will cause economic volatility in Indian exchange and generally these are blamed for the sudden fall in indices. These unlike FIIs are not directly registered under SEBI, but they operate through sub accounts with FIIs and according to a number of studies it has been found that more than 50% of the funds are flowing through this anonymous route, which can lead to a great loss to the Indian economy. Further, FIIs have contributed a lot in making Indian economy one of the fastest growing economy in the world today. Foreign institutional investment can play a useful role in development by adding to the savings of low and middle income developing countries. And India among the world inventors is believed to be a good investment destination inspite of all the political uncertainty and infrastructural inefficiencies. After the liberalization of financial policies India has been able to attract a lot of FII from rest of the world and which in turn has played its part very well by helping in development of Indian economy from what it was in early 1990s to a would be super power that it is today. But still the harsh consequences of FIIs should not be ignored by the government and further reforms should be introduced in the economic sector to counter the tendency of the FIIs to destabilize the emerging equity market. And also attempts should be made to encourage small domestic investors to participate in the equity market.

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2.10 FII activity in India from 1992-2006
The Indian financial market was opened to the foreign institutional investors in 1992 to widen and broaden the Indian capital market. Since then, the net investment by FIIs in India has been positive every year except in 1998-99. During the last few years, there has been a phenomenal increase in the portfolio investment by FIIs in the Indian market. (Table 1 & Chart 1). The gross purchases of debt and equity together by FIIs increased by 59.9 per cent to Rs.3,46,978 crore in 2005-06 from Rs.2,16,953 crore in 2004-05. The gross sales by FIIs also rose by 78.6 per cent to Rs.3,05,512 crore from Rs. 1,71,072 crore during the same period. However, the net investment by FIIs in 2005-06 declined by 9.6 per cent to Rs.41,467 crore in 2005-06 from Rs.45,881 crore in 2004-05 mainly due to large net outflows from the debt segment. The cumulative net investment by FIIs at acquisition cost, which was US$15.8 billion at the end of March 2003, rose to US$ 45.3 billion at the end of March 2006. (Chart 2) The provisional net investment figure as of March 2007 was US $ 3225 million as per RBI Table1:InvestmentsbyFIIs

Source : SEBI Annual Report 2005-06

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Chart 1 : FII Investments in India

Source : SEBI Annual Report 2005-06 Chart 2: Trends in FII Investment

The FII investment in equity increased significantly since 2003-04. During 2005-06, FIIs increased their net investment in equities, but reduced their commitments in debt Securities (Table 2). The net FII investment in equity during 2005-06 was Rs.48,801 crore, the highest ever in a single year. Buoyancy in the markets was sustained in 2005-06 on account of surge in net investment by the institutional investors with FIIs playing a major role. Month-wise, FII investment was negative in the months of April, May and October 2005. However, during the remaining months of the financial year, there was large net equity investment by FIIs,
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particularly in the second half of 2005-06, which drove the benchmark indices to surpass the earlier record highs on several occasions. The net FII investment in December 2005 was the highest for 2005-06, followed by July 2005 and February 2006. However, month-wise, the FII investment in the debt segment was negative in all the months in 2005-06. The total net investment in the debt segment in 2005-06 declined by Rs.7,334 crore mainly due to firming up of the yield rate of G-sec across the entire maturity spectrum. Table 2: Investments by MFs & FIIs

Source : SEBI Annual Report 2005-06 Several factors are responsible for increasing confidence of FIIs on the Indian stock market which include, inter alia, strong macro-economic fundamentals of the economy, transparent regulatory system, abolition of long-term capital gains tax and encouraging corporate results. Reflecting the congenial investment climate, the total number of FIIs registered with
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SEBI increased to 882 as on March 31, 2006 compared to 685 a year ago, an increase of 197 over the year ( Table 3). The diversity of FIIs has been increasing with the number of registered FIIs in India steadily rising over the years.

Table 3: FIIs Registered in India FINANCIAL YEAR DURING THE YEAR TOTAL REGISTERED AT THE END OF THE YEAR 0 3 156 353 439 496 450 506 528 490 502 540 685 882

1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

0 3 153 197 99 59 59 56 84 48 51 83 145 210

Source : Expert Group Report, GOI 2005

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SOURCES OF FIIS As on March 31, 2006, SEBI had registered FIIs from 37 countries. The highest number of FIIs, as on March 31, 2006, was from the USA (342), followed by the UK (148). About 90 per cent FIIs come from the top 13 countries. There has been increase in the number of FII registrations from non-traditional countries like Malaysia, Australia, Saudi Arabia, Trinidad and Tobago, Denmark, Italy, Belgium, Canada, Sweden, Ireland etc. (chart 3). These developments have helped improve the diversity of the set of FIIs operating in India. Chart 3: Country-wise FIIs Registered with SEBI as on 31st March 2006

Several factors were responsible for increasing confidence of FIIs on the Indian stock market which include:   Strong economic fundamentals and attractive valuations of companies. Improved regulatory standards, high quality of disclosure and corporate governance requirement, accounting standards, shortening of settlement cycles, efficiency of clearing and settlement systems and risk management mechanisms. Product diversification and introduction of derivatives.

Strengthening of the rupee dollar exchange rate and low interest rates in the US.

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2.11 FII ACTIVITY FOM 2006-2010
2008 FII sell-off the largest ever The Indian equity market kept on sliding in September 2008 with the S&P CNX NIFTY, showing the second sharpest fall since January 2008, with a decline of around 10%. With all courtesy to the US financial markets and its crisis bug, an estimated amount of Rs 2.3 trillion of shareholders' wealth were eroded in the Indian stock markets. We hear a lot about sales and purchases made by foreign institutional investors (FIIs) in Indian equity markets, with these numbers often making headlines. Why are we so obsessed with FIIs? The answer, is "Indian markets are primarily driven by FII fund flows." The market slide can be attributed to lower FII inflows in 2011. A look at stock indices since 2006 shows that the markets peak when FII inflows are the highest and fall when FIIs are missing in action. For instance, in 2008, the BSE Sensex fell almost 50% due to the global financial meltdown, wiping out the gains of 2007. The year 2008 has seen the biggest ever FIIs sell-off for the Indian markets. FIIs were allowed to invest since 1991 when the economy opened up. FIIs sell-off of USD 13.16 billion or Rs 53,000 crores has accounted for a 20% sell-off of the total FII's equity investment since 1991. FIIs have invested USD 53.16 billion or Rs 2.3 lakh crores. The number of registered FIIs have increased from 1,219 in 2007 to 1,595 in 2008, while the number of registered sub-accounts have increased from 3644 in 2007 to 4872 in 2008. In 2008, there were negative FIIs' flows seen for 10 months, and the longest selling streak was seen from May to November. Since 1999, there have been 32 months of negative FIIs flows as against 88 months of positive flows. Since 2003, there have been 19 months of negative FIIs' flows as against 53 months of positive flows. October and January were two carnage months, where USD 3.8 billion and UDS 3.2 billion, respectively, were sold. The depreciation by 23% in rupee and the 51% sell-off in the markets has resulted in the Defty falling 61%, making India one of the worst emerging market performers for 2008. The biggest sell-off was seen in March, when the FIIs sold Rs 1,881 crore. In January, a correction bought the most at Rs 7,702 crore follwed by Rs 3,179 crore in June. "What hurt in 2008 was not the performance of companies but rapid outflow of $13 billion (Rs 55,000 crore) as investors fled risky assets," says Nick Paulson-Ellis, India head, Espirito Santo Securities.The markets were flat during the first three months of 2009 as FIIs stayed away. After that, governments across the globe implemented plans to boost their economies. India, helped by robust economic growth, became a preferred destination for investors.
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85% was the surge in the Sensex in 2009 with FIIs investing a net Rs 84,000 cr, crossing the 2007 level. With FIIs investing a net $19 billion (Rs 93,100 crore) in 2009, crossing the 2007 level, the Sensex surged 85%. In 2010, the trend continued and FIIs pumped in $30 billion(Rs 1.3 lakh crore) into Indian equities, helping the Sensex gain 25%. Between December 2006 and July 2011, the number of FIIs registered in India rose from 1,024 to 1,730. Table 1: Net FIIs Investment in Equity (2007-10) MONTH JAN FEB MARCH APRIL MAY JUNE JULY AUG SEPT OCT NOV DEC 2007 94.45 6065 1403.30 5431.80 4574.50 7939.60 18132.80 -7526.80 18948.50 15577.60 -4597.40 4896.70 2008 -17326.30 5419.90 124.40 979.00 -4917.30 -10577.70 -1012.90 -2065.80 -7937.00 -14248.60 -2820.30 1330.90 2009 -3009.50 -2690.50 269 7384.20 20606.90 3224.90 11625.30 4028.70 19939.50 8304.10 5317.80 10367.20 2010 5902.40 2113.50 18833.60 9764.50 -8629.90 10244.60 17120.60 11185.30 29195.80 24770.80 18519.90 1476.10

Table shows the position of FIIs investment in equity from 2006-10. It is clear from the above table that during 2007, apart from August 2007, FII‟s showed keen interest in purchasing the equity in the Indian market. But so far as the month of August was concerned, FII‟s turned towards net selling in equity for profit booking and seeing the massive sell out of shares in global markets including India especially on August 16 & 17 when there was massive equity selling. Consequently the SENSEX broke down to even 4 to 5% of its previous levels. Moreover, the bears took command of the market and some brokers also started off-loading their positions anticipating a further fall and stop loss button was pressed by many investors. So far as the month of October was concerned, the impact of supportive level was pulling the FII‟s money in India. As a result positive impact in the net position was seen. Again a bearing trend could be noticed during November due to the fact that new norms about PNs were announced which ordered the winding up of PNs within next 18 months.

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The analysis of the above table depicts a negative view of the FII‟s investment in India during 2008. The main reason could be tremendous selling at the beginning of the year. The next three months i.e. February, March & April showed a consistent pattern in the trading activities. But from the month of May to November, FII‟s again showed the exit mode from the stock market. This was due to the fact that impact of international recession had started affecting Indian markets also. Further the famous subprime crisis of USA e.g. the crash of Banks and investment firms like Lehman Brother had also started impacting global economy. Market analysts feel that the foreign fund managers were trying to play safe and therefore rushed towards risk aversion and taking off their money. Due to this reason a negative impact of FII‟s was reflected showing immense selling and taking back their money from the Indian stock market. During the year 2009, FII‟s investment in equity showed an initial sell off in the first two months, may be the impact of 2008 was still continuing. This year market sentiments seemed to improve from March onwards as the foreign investors starting returning with their investments. India emerged out as one of the better performing markets since October crash and the growth potential was seen. The trend turned positive with the sign of revival of economies. The trend of FII‟s inflows witnessed during quarter from April to June continued further and FII‟s proved to be the prime investors in the month of September. The reasons for such huge investments by FII‟s in this month could be attributed to number of positive news about Indian economy. During the year 2010, the same trend of revival of economic activity could be observed. As a result, FIIs went on to purchase more equity during this year with the exception of the month of May. This showed positive view of FIIs about Indian market. FII‟s started pumping funds into emerging markets like India because of its growth potential and stability of Indian Stock Market. Table No: 2 FII Inflows in Equity (2006-10) YEARS NET PURCHASE/ SALES RS. (IN CRORES) 2006 2007 2008 2009 2010

TREND %

32254.08 100.00 70940.05 226.978 -530517.70 -169.743 85367.2 264.494 140497.2 436.949 It is evident from this table that apart from the year 2008, in all other years, there has been a positive trend in FII inflows in India. The year 2008, as we all know, was the year of worldwide recession. The value of the trend is higher during last two years of this study i.e. 2009 and 2010 because of the fact that Indian economy could recover well from the shocks of worldwide recession due to its strong fundamentals and rules and regulations.

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Table 3: FII Investments in Debt (2006-10) YEARS NET PURCHASE/ TREND (%) SALES RS. (IN CRORES) DEBT 2006 3629.18 100.00 2007 8356.13 230.248 2008 12340.40 147.68 2009 3458.40 28.025 2010 54442.80 1574.219 The analysis of the above table depicts the positive trend of FII‟s investment in debt market. The sharp rise in the FII inflows into the debt market came after a sharp rise in the interest rates over the past couple of years which attracted the foreign investors towards the Indian market. Besides that market observers believed that the huge inflow into the Indian equity market also led to FIIs parking a portion of their capital into the debt market as a hedge against any potential downslide in the stocks. The sharp rally in rupee against the US dollar also led to an increase in the FII interest in the debt market. Table 4: Comparison between FII inflows & Industrial Growth Rate YEARS NET FII INFLOWS INDUSTRIAL GROWTH RATE (%) 2006 32254.08 7.4 2007 70940.05 7.6 2008 -530517.70 9.8 2009 85367.2 6.3 2010 140497.2 5.8 The analysis of above table shows that there is a Low Degree of Correlation between FII inflows & Industrial Growth Rate. It means that during the period under study, with the increase of FII inflows, the industrial growth of India also rose up. Industrial growth plays a pivotal role in increasing the GDP. In the year 2008, in spite of major outflows, the industrial growth rate still increased. During the next two years, a fall in industrial growth can be observed. Thus it can be safely said that industrial growth rate has not been much influenced by the FII inflows. Table 5: Relationship between FII Inflows & SENSEX YEAR SENSEX FII INFLOWS 2006 13786 31254.08 2007 20826 70940.05 2008 9647 -53051.70 2009 17464 85367.20 2010 20509 140497.20

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Table 5 shows the impact of FII‟s on SENSEX. In 2006 the foreign institutional investors (FII) inflows were a bit slow, but they once again proved that they were the drivers of the Indian equity market. Interestingly, the dependence of the Indian equity markets on the foreign investors was further proved by the fact that in the period between May 10, 2006 to June 14, 2006, when the SENSEX moved from a high of 12,612.38 to a low of 8,928.44. In the year 2007 when FIIs were pumping money in stock market and were Net Buyers of Equity worth Rs. 70940.05 Crores; the SENSEX was moving upwards on the weekly basis. It took nearly two months for the SENSEX to move from the level of 15000 to 17000. But from 17000 to 20000 it moved in a span of few weeks i.e. from 26th September 2007 to 29th October 2007. As the Indian markets move from one peak to another this year, foreign institutional investors (FIIs) have pumped top dollar into stocks. Investments during 2007 by foreign funds were the most influential group of investors in the market. In September, FIIs injected $2.7 billion into the markets, sending the benchmark indices to record peaks. The bulk of this amount came in after the US Fed cut interest rates on September 18 which ultimately led to increasing liquidity in global markets. In January 2008 the SENSEX touched the new height of 21000. This rally of 1000 points of SENSEX infused Rs. 2403 Crores during a period of just 49 trading days. But in the later part of 2008 the SENSEX crashed affecting large number of investors. The major cause of this crash was attributed to the recession in the global economies, especially with the US dollar losing its strength to the Indian rupee. A large amount of equity in the form of shares was floated in the Indian economy as an impact of Foreign Institutional Investors (FII‟s) withdrawing their money from the Indian markets. This has disturbed the demand and supply ratio to a great extent resulting in easy availability of shares of well-performing companies, thus leading to a dip in the selling price of these shares. However, in 2009 with the sign of revival of economies, the trend turned positive and overseas investors started betting big on the domestic bourses as the liquidity conditions started improving. In 2010 most of the stocks which have shown an increase in prices were driven by huge FII buying. India continued to be a favored destination for FIIs and would continue to be so because of its strong fundamentals. This could well be reflected in the FII inflows towards the country, which had already reached all-time highs. Thus it can be observed that there is a positive correlation between FII inflows and SENSEX. PROPPING UP STOCKS Investing in stocks with high FII interest can give good returns. For instance, the FII holding in HDFC has been 58-60% since 2008. Similarly, the FII holding in ICICI Bank has been 38-40% for years. Between March 2008 and 29 September 2011, HDFC Bank and ICICI Bank have risen 35% and 20%, respectively.

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2.12 PRESENT SCENARIO (2010-2011) Recent Trends in Foreign Institutional Investment Foreign Institutional Investors play an important role in Indian securities markets.Since 1992-93, when FIIs were allowed entry into Indian financial markets, foreign institutional investment has increased over the years except in 2008-09. In tandem with the boom in stock markets and a better global scenario, investments by FIIs into India were quite high in last few years, particularly since 2003-04. FIIs made a record investment in the Indian equity market in 2010-11, surpassing the 2009-10 inflows.

Chart: Trends in Foreign Institutional Investment The gross purchases of debt and equity by FIIs increased by 17.3 percent to 9,92,599 crore in 2010-11 from 8,46,438 crore in 2009-10 (Table 2.50). The combined gross sales by FIIs also increased by 20.2 percent to 8,46,161 crore from ` 7,03,780 crore during the same period in previous year. The total net investment of FII was 1,46,438 crore as compared to of 1,42,658 crore in 2009-10. This was the highest net FII investments into Indian securities market in any financial year so far.

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Table : Investment by Foreign Institutional lnvestors

Cumulative investment by FIIs at acquisition cost, which was US$ 89,335 million at the end of March, 2010, increased to US$ 1,21,561 million at the end of March, 2011. During 2010-11, FIIs invested 1,10,121 crore in equity and 36,317 crore in debt as compared to an investment of 1,10,220 crore in equity and 32,438 crore in debt during 2009-10 respectively (Table 2.51 and Chart 2.12). Month-wise, the net FII investment was the highest in equity segment in October, 2010 (28,563 crore) followed by September,2010 ( 24,979 crore) and November,2010 (18,293 crore). In debt segment, FII investment was the highest in January, 2011 (10,177 crore) followed by July, 2010 (8,107 crore) and September, 2010(7,690 crore).
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The FIIs have been permitted to trade in the derivatives market since February, 2002. The cumulative FIIs trading in derivatives was 5,34,748 crore as on March 31, 2011 as compared to 3,88,310 crore as on March 31,2010. Open interest position of FIIs in index options was the highest at 11,33,838 crore by end-March 2011, followed by stock futures( 6,22,875 crore), index futures (2,83,890 crore) and stock options ( 22,547 crore) (Table 2.52).

Table 2.51: Investments by Mutual Funds and Foreign Institutional lnvestors

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Chart: Net Institutional Investment (crore) and Monthly Average Nifty Registration of Foreign Institutional Investors and Custodians of Securities There was a small increase in the number of Foreign Institutional Investors (FIIs) registered with SEBI. As on March 31, 2011, there were 1,722 FIIs registered with SEBI as compared to 1,713 a year ago, showing an increase of 0.53 percent during the year. There were 5,686 sub-accounts registered with SEBI as on March 31, 2011 as compared to 5,378 as on March 31, 2010, an increase of 5.73 percent The number of custodians registered with SEBI under the SEBI (Custodian of Securities) Regulations, 1996 was 19, as on March 31, 2011, as compared to 17 a year ago. Status of registration of FIIs, sub-accounts and custodians during 2010-11 is provided in below Table Table : Number of Registered FIIs, Subaccounts and Custodians

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The Indian economy has successfully proved its mettle time and again in terms of financial stability and economic sustainability as it has resiliently weathered global financial turmoil. Where majority of emerging economies are experiencing huge capital outflows by foreign institutional investors (FIIs), Indian markets have managed to hold their confidence as well as investments during such times. A report titled 'Doing Business in India' by Ernst & Young (E&Y) further supports the fact by highlighting India as the second most preferred destination for foreign investors, next only to China. Overseas entities are among the important drivers for Indian stock markets. FII flows account for about 45 per cent of the market free-float. The overview further discusses recent developments, investments, facts & figures and Government initiatives pertaining to foreign investments in India. FII – Recent Developments

 

According to the data released by Securities and Exchange Board of India (SEBI), FIIs purchased stocks worth Rs 600,000 crore (US$ 113.81 billion) during 2011. FIIs were also seen attracted to the debt market in 2011 wherein they infused Rs 42,067 crore (US$ 7.98 billion). This intense interest in debt markets helped India get a net FII inflow of Rs 39,353 crore (US$ 7.46 billion) for the year (taking both- debt and stocks- into account). Global rating agency Moody's has uplifted Indian bond market by upgrading credit rating of the Indian government's bonds from the speculative to investment grade. The move is expected to attract higher investments from FIIs and help companies raise funds at competitive rates abroad. India's foreign exchange reserves stood at US$ 297 billion as on December 30, 2011. According to the data available with the Bombay Stock Exchange (BSE), FIIs have consolidated their holdings in 11 out of the 30-Sensex firms during the July-September quarter of 2011. They majorly enhanced their holdings in auto stocks such as Mahindra & Mahindra, Maruti Suzuki, Hero MotorCorp and Bajaj Auto. The number of FIIs registered with SEBI stood at 1,749 as of October 2011, while the number of FII sub-accounts was 6,058 during the month. The statistics revealed that there were 1,743 FII accounts and 6, 028 sub-accounts at the end of September 2011

FII- Key Investments

FIIs have bought stakes in BSE and National Stock Exchange of India (NSE) recently. Argonaut Ventures (a US-based private equity firm) increased its stake in BSE from 2.54 per cent at the end of May 2010 to 4.75 per cent at the end of June 2011, while couple of SEBI-registered FIIs and sub-accounts bought stakes in NSE.

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India-based micro-lender SKS Microfinance has raised investment limit for foreign institutional investors in the company to 74 per cent from 24 per cent and the company plans to raise funds of up to Rs 5 billion (US$ 94.84 million) through a share sale to institutional investors by March 2012. World Bank's private equity arm IFC has made its single-largest country exposure to India at 8.8 per cent of total committed portfolio in fiscal 2011. Also, India is expected to take the lead during the fund allocation for the current fiscal (year ending June 2012), when IFC's approved funding is estimated at US$ 10 billion. According to market insiders, IFC plans to scale up equity investments over debt funding in private firms in India. According to data released by auditing and consultancy firm KPMG, first three quarters of 2011 witnessed a 31 per cent increment in private-equity (PE) investment to US$ 7.89 billion. Private equity firms like Blackstone India and Kohlberg Kravis Roberts & Co (KKR & Co) are betting high on Indian markets. The Blackstone India chief was reported to have said that he intends to close 5-6 deals a year in India whose financial valuations would revolve around roughly US$ 100 million to US$ 120 million each. As on October 31, 2011, FIIs injected Rs 41,253 crore (US$ 7.82 billion) in Government securities (G-secs) and Rs 68,289 crore (US$ 12.95 billion) in corporate bonds.

Government Initiatives Government of India keeps taking different initiatives in order to attract FII investments. For instance, investment limit in infrastructure bonds was raised from US$ 5 billion to US$ 25 billion in March 2011. Similarly, in November 2011, the Ministry of Finance enhanced investment limit for FIIs in G-secs and corporate bonds by US$ 5 billion each, increasing the cap to US$ 15 billion and US$ 20 billion respectively. The Government intends to increase capital flows in Indian markets through such measures that would eventually increase the availability of resources for Indian corporate. Also, along with the debt instruments issued by infrastructure companies, FIIs can now also invest in debt instruments issued by non-banking financial companies (NBFCs) categorised as 'Infrastructure Finance Companies' by the Reserve Bank of India (RBI). In a bid to attract more FII funds into the Indian infrastructure sector, the Government is considering a trim on the lock-in-period in the corresponding bonds to one year from three years. The Government's top priority seems to be the enhancement of investor base for the Indian markets. That is why the Ministry of Finance started 2012 with a happy announcement by allowing foreign nationals, trusts and pension funds to invest directly in the country's listed companies from mid-January 2012.
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EPISODES OF VULNERABILITY IN INDIA There have been some episodes of vulnerability in India, which are negative shocks affecting the economy, and influencing the behavior of investors. These are: the East Asian crisis in 1997, the Pokhran Nuclear explosion (May 1998) and the attendant sanctions, the stock market scam of early 2001, and the Black Monday of May 17, 2004. The investment behavior of the FIIs vis-àvis the movements of the stock market indices during these episodes FII investment behavior during these four specific events indicates that these events did affect the behaviour of the foreign portfolio investors. But, these events did affect domestic investors‘ behaviour as well. The critical question to ask is: whether there was any perceptible difference, particularly with a bias towards destabilization, in the behaviour of the FIIs vis-à-vis that of domestic investors? Table 7: India: FII Behaviour During East Asian Crisis

Table 8: India : FII Behaviour in the aftermath of Pokhran Nuclear Explosion

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Table 9: India : FII Behaviour during the Stock Market Scam 2001

Table 10: India: FII Behaviour around Black Monday, May 17, 2004

These experiences show that FII outflow of as much as a billion dollars in a month which corresponds to an average of $40 million or Rs.170 crore per day – has never been observed. These values – Rs.170 crore per day – are small when compared with equity turnover in India. In calendar 2004, gross turnover on the equity market of Rs.88 lakh crore contained Rs.5 lakh crore of gross turnover by FIIs. This suggests that as yet, FIIs are a small part of the Indian equity market. Transactions by FIIs of Rs.5 lakh crore in a year might have been large in 1993, but the success of a radical new market design in the Indian equity market have led to enormous growth of liquidity and market efficiency on the equity market. Through this, India‘s ability to absorb substantial transactions on the equity market appears to be in place.

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RECENT DEVELOPMENTS FII investment limit in government securities, bonds hiked The finance ministry on Nov 18, 2011 decided to increase investment limit of Foreign Institutional Investor (FIIs) in government securities and corporate bonds by $5 billion as the current limit for this year has almost been exhausted. Now, an FII can invest up to $15 billion in government securities , and for the corporate bonds the cap has been enhanced to $20 billion. The changes will be effective in the next few days after the Securities and Exchange Board of India issues a circular and notifies it. FII investment in India has reached its current limit for both government papers and corporate bonds, reflecting confidence of foreign investors in Indian economy. As on October 31, 2011, FIIs have invested more than Rs 41,000 crore in government papers and Rs 68,000 crore in corporate bonds. The present ceiling for government securities is Rs 43,650 crore and for the corporate bonds it is 74,000 crore. The changes are likely to enhance capital flows and investments at lower cost. Indian corporates also have enough room to borrow through the External Commercial Borrowing route where the cap is $30 billion, of which, so far, this year's borrowings have touched $21 billion. In September, the government had relaxed norms for FIIs investment in long-term infrastructure bonds, reducing the residual maturity period to one year for investments of up to $5 billion. Though the government had raised investment limit of FIIs in long-term infrastructure bonds from $5 billion to $25 billion in the 2011-12 Budget, investments under this scheme had a minimum residual maturity of five years and were subject to a minimum lock-in period of three years. From the table below, we can see that as on October 31, 2011, FIIs have nearly exhausted the investment limit in government securities and corporate bonds. This move will further give an investment opportunity of approximately Rs 25000 cr in each, government security and corporate bond (assuming a conversion rate of Rs 50). However, the investment in long term infrastructure bonds is merely Rs 2837 cr (in the first 7 months of FY12 ) versus the limit of Rs 112095cr

Since infrastructure is a key area where India is still lacking, the government should bring in reforms and attract investments in infrastructure, which can further boost the country's economic growth. The move will help in cooling the 10-year government bond yields, and will reduce the borrowing cost for the government. Further, this will also help in developing our bond market.
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We further feel that this move will attract a lot of FIIs, as the interest rate cycle in India is almost at its peak. Going forward, there could be a rise in the prices of the bonds, leading to better capital gains. It will also ease some pressure from the government with respect to the rupee, which has depreciated in the past couple of quarters. Overall, the move has multiple purposes. such as moving a step ahead for developing the bond market, helping the rupee stabilise, a cool off in the 10-year bond yield to some extent and attracting foreign investment in the country.

Particulars

New Cap for Investment (In USD bn)

Old Cap for Investment (In USD bn)

Investment limit according to old cap (Converted into INR Cr)

Investment made by FII according to old cap (Converted into INR Cr)

Government Securities Corporate Debt Corporate Debt - Long Term Infra

15 20 25

10 15 25

43650 74416 112095

Additional Investment could be made (Assuming Conversion rate of Rs 50) in INR Cr 41253 25000 68289 2837 25000

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2.13 FII activity in 2012 The investment by overseas investors into Indian stock market since the beginning of 2012 has crossed $7 billion level, out of which more than $5 billion were pumped in the month of February. Foreign Institutional Investors (FIIs) purchased equities and debt securities worth a gross amount of Rs 76,548 crore in January 2012, while their gross sales for the month were worth Rs 50,219 crore, translating into a net inflow of Rs 26,329 crore, as per data compiled by the market regulator Sebi. Overseas investors poured in over Rs 26,000 crore ($5.08 billion) in Indian markets in January 2012, the highest one-month net inflow in 16 months, as sentiments got a boost from easing inflation concerns and attractive valuations. The Foreign Institutional Investors (FIIs) infused a net amount of $ 5.12 billion (about Rs 25,212 crore) during February, taking the total for 2012 so far to $7.16 billion for the Indian stocks. Market analysts attributed strong FII inflows to signs of a reversal in RBI‘s monetary policy and the subsequent impact of improved liquidity position. They expect the positive trend to continue further, given that the liquidity conditions remain strong.Market analysts attributed strong FII inflows to signs of a reversal in RBI's monetary policy and the subsequent impact of improved liquidity position. During February, FIIs were gross buyers of shares worth Rs 79,898.6 crore, while they sold equities amounting to Rs 54,686.6 crore, translating into a net investment of Rs 25,212 crore ($ 5.12 billion), as per data available with market regulator Sebi. This is the highest monthly net investment by FIIs in equities since October 2010, where they had infused Rs 28,563 crore. The foreign fund houses also infused Rs 1,0016 crore ($2.03 billion) in the debt market last month. This takes the overall net investments by FIIs into debt markets to Rs 25,987 crore ($5.08 billion) so far this year. ―FIIs have been infusing money into the Indian market due to change in RBI‘s monetary policy that have added liquidity to the system. This liquidity will help in growth of the country,‖ Wellindia Executive Director Hemant Mamtani said. ―Indian market will continue to witness inflows in the whole year, if the liquidity conditions remain strong,‖ he added. Strong surge in FII inflows in 2012 so far has helped boost the equity markets, as also the rupee. The stock market barometer Sensex has gained 15 per cent in 2012, despite a fall of about 3.25 percent last month. The index finished at 17,752.68 on February 29. FIIs had mostly stayed away

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from Indian equities in 2011. They flocked towards the debt market last year with a net investment of Rs 20,293 crore, while pulling out Rs 2,812 crore from equities. In the year 2011, FIIs purchased stocks and bonds worth Rs 8 lakh crore, but sold securities worth Rs 7.9 lakh crore, resulting in a net investment of Rs 17,480 crore during the year. Strong surge in FII inflow in 2012 has helped boost the equity markets as well as helped the Indian rupee to strengthen. The foreign fund houses have also infused Rs 17,281 crore in the debt market so far this year. Strong surge in FII inflow in 2012 has helped boost the equity markets as well as helped the Indian rupee to strengthen. It is not only India which has witnessed an upsurge in investment, equity funds focused on all emerging markets put together have seen an inflow of over $24 billion in 2012. "FIIs investments in debt market are rising because of higher yields on local bonds," Bandyopadhyay said. In terms of equity investment, foreign funds have poured in maximum money in infrastructure and pharma stocks, he added. This is the highest net investment by FIIs in stocks and bonds since September 2010. ―In 2012, FIIs infused money into the Indian market mainly on account of easing inflation, a relaxing of foreign investor restrictions and the RBI‘s policy moves,‖ CNI Research Head Kishor Ostwal said. Stock market inflows in the first 17 days of February, at Rs 13,867 crore, were higher than that for the entire month of January 2012, which stood at Rs 10,358 crore.

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Secret of the Sensex: Biggest FII turn-on since 2000
The Sensex crossed the 18,000 mark and closed at a six-month high. India, which was among the worst performing markets by December 2011, is one of the best performing ones today. Fundamentally, nothing seems to have changed, either in India or in the world. In fact, after the December quarter corporate numbers, the outlook is even more bleak. So what is the secret behind this sudden rally? The answer is the largest foreign inflows since the turn of the decade.

The main reason for the sharp 18 percent rise in indices is the Rs 22,000 crore FII money that has entered the country, the highest ever, since Sebi started disclosing the data in 2000. Inflows in the first 15 days of February, at Rs 11,681.7 crore, were higher than that for the entire month of January 2012, which stood at Rs 10,907 crore. This means around $4 billion of money has already flown into the country in the first 45 days of this year. It has resulted in Sensex moving from a low of 15,358 0n 2 January 2012 to 18,231 on 15 February. While emerging markets trade at a valuation of 12 times their reported profits, developed markets are trading at 14 times their reported profits. Reuters The MSCI (Morgan Stanley Capital International) Emerging Markets Index has already gained 15 percent in 2012, the best start to a year since 1991. It has outperformed the MSCI World Index by 6 percentage point. According to a report in Bloomberg, Jonathan Garner, the chief Asia and emerging markets strategist at Morgan Stanley, said the surge in optimism is a contrarian indicator that may signal the rally has gone too far, too fast. Michael Hartnett, chief global equity strategist at Bank of America Investor, says holdings in emerging markets have climbed to a level that historically foreshadowed short-term underperformance.

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From the chart below, it‘s clear that the banking sector has been the favourite among sector investments. The banking sector retained its top position for eight of the the nine quarters analysed by the investment research firm. FIIs had an 11 percent exposure to this sector in the December quarter. Power and metal companies also received allocations of 6.6-7.9 percent, although their shares have declined slightly from the September quarter. At the moment, it‘s difficult to tell whether foreigners will continue to invest robustly in India‘s capital markets. Some experts believe the results could inhibit the government from taking any bold reform measures and lower the prospects of the economy, which could dampen the appetite of foreign investors. Indeed, the Sensex reported volatility as it closed lower at 17,173 points on Tuesday, 500 points lower from its intra-day high on the elections results, as investors sensed more economic policy-making delays ahead. The rupee also plunged below 50 against the dollar.

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CHAPTER 3: Research Methodology
The study carried out is analytical and empirical in nature in which it explores the relationship between the Inflows of FII and their impact on Indian Capital Market. The study focuses on Bombay Stock Exchange. In this research the sale and gross purchases data was used to find therelation with sensex

Framing Of Hypothesis:Following hypotheses were developed for the study and tested at 5% level of significance. Hypothesis 1  Hypothesis (H1) There is significant relationship between Sensex and FII equity investment  Null Hypothesis (Ho): There is no significant relationship between Sensex and FII equity investment Hypothesis 2  Hypothesis (H2) Sensex is significantly correlated with FII equity purchases  Null Hypothesis (Ho): There is no significant relationship between Sensex and FII equity purchases Hypothesis 3  Hypothesis (H3) Sensex is significantly correlated with FII equity sale  Null Hypothesis (Ho): There is no significant relationship between Sensex and FII equity sale

3.1 Research Design Exploratory Research method applied for the study. As an exploratory study is conducted with an objective to gain familiarity with the phenomenon or to achieve new insight into it, this study aims to find the new insights in terms of finding the relationship between FII'S and Indian Stock Markets.

3.2 Data Collection Data for the study collected primarily from Secondary sources. For this various literatures, books, journals, magazines, web links were used. Monthly closing data of sensex (1992-2012), Monthly data of FII flow in equity (1992-2012), Yearly data of FII flow in equity (19922012),Yearly data of sensex (1992-2012)
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3.3 Sampling Method Convenient Sampling method used for the Study. Convenience sampling is a non-probability sampling technique where subjects are selected because of their convenient accessibility and proximity .

3.4 Research Analysis Tools The data was classified and tabulated using MS EXCEL and SPSS 12.0. Correlation analysis used as statistical tool for data analysis. Correlation analysis measures the relationship between two data sets that are scaled to be independent of the unit of measurement. The population correlation calculation returns the covariance of two data sets divided by the product of their standard deviations. We can use the Correlation tool to determine whether two ranges of data move together - that is, whether large values of one set are associated with large values of the other (positive correlation), whether small values of one set are associated with large values of the other (negative correlation), or whether values in both sets are unrelated (correlation near zero). Data were analyzed with the help of SPSS 12.

Table 1 Correlation among FII & Sensex for entire period from liberalization 1992-2011

Cor relations sens ex sens ex Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N 1 . 20 .770** .000 20 NetFII .770** .000 20 1 . 20

NetFII

**. Correlation is s ignif icant at the 0.01 level (2-tailed).

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Table 2 Correlation among FII & Sensex from Jan 2006- Dec 2011
Cor relations sens ex sens ex Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N 1 . 72 .668** .000 72 .528** .000 72 .334** .004 72 Gros s Purchase Gros sSales NetInvst .668** .528** .334** .000 .000 .004 72 72 72 1 .883** .310** . .000 .008 72 72 72 .883** 1 -.170 .000 . .154 72 72 72 .310** -.170 1 .008 .154 . 72 72 72

Gros sPurchase

Gros sSales

NetInvst

**. Correlation is s ignif icant at the 0.01 level (2-tailed).

Table 3 Correlation among FII & Sensex from Jan 2010- 23 March 2012
Cor relations sens ex sens ex Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N 1 . 27 .605** .001 27 .337 .085 27 .437* .023 27 Gros s Purchase Gros sSales NetInvst .605** .337 .437* .001 .085 .023 27 27 27 1 .614** .723** . .001 .000 27 27 27 .614** 1 -.095 .001 . .638 27 27 27 .723** -.095 1 .000 .638 . 27 27 27

Gros sPurchase

Gros sSales

NetInvst

**. Correlation is s ignif icant at the 0.01 level (2-tailed). *. Correlation is s ignif icant at the 0.05 level (2-tailed).

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3.5 Analysis and Interpretation Table 1 It is revealed from table 1 that performances of indices are positively correlated with FII and the strength of correlation is very strong. It was also revealed that the performances of indices were also highly and positively related. Degree of correlation between Net FII flows and BSE Sensex is 0.770 hence hypothesis H1 is accepted Table 2 Table 2 also indicates that performance of indices is positively correlated with FII and the strength of correlation is very strong. It was also revealed that the performances of indices were also highly and positively related. Degree of correlation between FII purchase and BSE Sensex is 0.668 hence hypothesis H2 is accepted Table 2 also indicates that performance of indices is positively correlated with FII and the strength of correlation is very strong. It was also revealed that the performances of indices were also highly and positively related Degree of correlation between FII sale and sensex is 0.528 hence hypothesis H3 is accepted Table 3 Table 3 also indicates that performance of indices is positively correlated with FII and the strength of correlation is very strong. It was also revealed that the performances of indices were also highly and positively related. Degree of correlation between FII purchase and BSE Sensex is 0.605 hence hypothesis H2 is accepted Table 3 also indicates that performance of indices is positively correlated with FII and the strength of correlation is very strong. It was also revealed that the performances of indices were not affected by the performance of gross sales. Degree of correlation between FII sale and sensex is 0.337 hence hypothesis H3 is rejected Results and Findings So for the study of data from 1992 to March-2012, FII equity investment yearly and monthly and closing of Sensex Indices were considered. Correlation Test has been carried out to find the degree of association between the FII Gross Purchases and Sensex and FII Gross sales and sensex. First of all correlation between sensex and FII gross purchase and FII gross sale and sensex is carried out to verify relation between them Sensex of Bombay Stock Exchange is considered as the barometer of Indian Capital Market. This inference is further supported by high degree of correlation coefficient obtained between two variables in the Table-1, 2 & 3. This high degree of correlation further suggests that there is direct correlation between the Midcap & Smallcap Indices and FIIs investments. FIIs gross purchases have been taken as independent variable to find the impact of FII because net investments involve negative values when there are more sales as compared to purchases FII invest in scripts of these Indices because they provide higher returns as compared to large cap scripts.

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This analysis indicates the impact of FIIs on Indices. An FII driven market can impact the real economy indirectly, when their behavior in the market exerts pressure on policy makers. Secondly, the wealth effect' where capital gains are translated into increased consumption and investment, can act as a more direct link between equity and physical markets. FIIs are always considered to increase the volatility of market. Volatility is often viewed as a negative in that it represents uncertainty and risk. However, volatility can be good in that if one shorts on the peaks, and buys on the lows one can make money, with greater money coming with greater volatility. The possibility for money to be made via volatile markets is how short term market players like day traders hope to make money, and is in contrast to the long term investment view of buy and hold. Foreign institutional investment is certainly volatile in nature and its volatility has certainly posed some threats to the Indian stock market considering its influence on the market. Increase in investment by FIIs cause sharp price increase. It would provide additional incentives for FII investment and this encourages further investment so that there is a tendency for any correction of price 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 Indices because only FIIs are not responsible for the fluctuations instead there are other factors like company specific factors, speculative trading, interest rate prevailing in the market, political factors, government policies related to specific sectors etc. which cause a significant change in the price. Findings of the study can be summarized as: 1. Growth potential of Indian Capital Market has attracted the continuous increase in the number of registered FIIs and the Gross purchases made by them. 2. The movements in Midcap & Smallcap Indices and Sensex are highly correlated with FII equity investment in Indian Capital market. 3. The movement of FIIs gross purchases follows almost significant influence on the movement of Midcap & Smallcap Indices. When there is a downward trend in FIIs due to huge selling, there is decline in Midcap & Smallcap Indices. On the other hand if there is an upward trend in FII due to more gross purchases as compared to selling, Indices rises. 4. The high degree of volatility in Indian stock market is caused by the increase in investment by FIIs which increases stock indices that in turn increases the price and encourages further investments. In this event when any correction takes place the stock prices decline and there will be pull out by the FII in a large number as earning per shares declines. 5. The FIIs manipulate the situation of boom in such a manner that they will wait till the index rises up to a certain height and exit at an appropriate time. This tendency increases the volatility further.

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CHAPTER 4: FUTURE PROSPECTS 4.1 Reasons Why FIIs Will Keep Pumping Money Into Indian Market The Foreign Institutional Investors (FIIs) infused a net amount of $ 5.12 billion (about Rs 25,212 crore) during February, taking the total for 2012 so far to $7.16 billion for the Indian stocks. For some, it may be just another factoid, but when we look at it from the perspective of the Indian equity market the massive inflow has far-reaching consequences. The inflow helped Indian equity market to turn around from the negative return of year 2011 and post one of the best returns in the last two decades . The last time we witnessed return in excess of 75 per cent was in 1991. That was mainly because the then Finance Minister and present Prime Minister Dr Manmohan Singh ushered in new economic policy of liberalization, privatization and globalization and creating euphoria that resulted in historic market returns. So will India be lucky to repeat the inflows of 2007 again in 2012? But before we come to that, we will try to understand the nature of FII investments and their importance in shaping the market direction and returns. India may attract better portfolio flows this year. Various conducive factors are present that can encourage these flows. To begin, there is little risk to the long-term GDP growth in our country. Over the last 30 years, India's real GDP growth has averaged about 6.2 per cent. With little dependence on the western world for its growth, a slowdown elsewhere in the world will have little impact on India. Domestic consumption continues to be key factor driving growth. Good monsoons and higher farm prices should keep the rural economy humming. Those worried about inflation need to remember that, for India, this is not new phenomenon. In the early 1990s, India had grown despite the high interest rates and inflation. However, for FIIs coming into India with an 8-9 per cent GDP growth assumption, a 6.5 per cent growth could be a disappointment. The second factor is that valuations of Indian stocks are attractive and earnings growth is good. If the price-to-earnings multiple of our market is considered, stocks are not as cheap as they were in 2003 or 2008 when valuations were less than 10x. If the euro crisis escalates further, we might see those kinds of valuations; however, at the current levels, given the current earnings growth rates in India, it is still attractive as it is below the long-term average of 17.6x. According to Bloomberg's consensus estimate, earnings is expected to grow 25.6 per cent in FY2012 and 16.8 per cent in 2013. Based on these growth estimates, valuations appear reasonable. While no one prefers the policy freeze in New Delhi, a rate of growth in GDP of 6.5- 7 per cent with more equitable growth is far better than a 9 per cent growth number with massive corruption.

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In the first half of 2012, slowing inflation and lower economic activity would set the stage for the RBI to reverse its monetary policy by cutting interest rates and adding liquidity, thus improving investment sentiment. As things stand today, foreign investors get to buy more Indian assets for the same dollar due to a weaker rupee. On a long-term basis, given the huge deficits in India, we are of the view that the rupee will depreciate. However, the 16 per cent depreciation in the rupee since August seems unwarranted. So there is a case for currency appreciation, which is positive for an FII. Year-todate, the rupee has appreciated 7.6 per cent. Shaky Beginning At the dawn of year 2009 we were staring at uncertainty in the global markets and also facing one of the worst corporate governance issues (Satyam Computers) in India. But as we stand at the dusk of 2012, we find most of the crises have blown away and although certain patches of uncertainty in the global recovery still remain, things are clearer than they were at the start of the year. Undoubtedly, this has helped attract record inflow of FII money into Indian equity market, despite 70 per cent fall in new registrations of FIIs in 2009 (see graph)

. In 2008, when market was down 53 per cent and FIIs pulled out about Rs 53,000 crore (USD 11.3 billion) from Indian market, 375 new FIIs got registered in India as compared to just 111 in 2009. At the end of November 2009, there were 1705 FIIs registered in India. One of the reasons for such low registration numbers might be that many of the hedge funds that were very active during pre-crisis time have either liquidated or significantly cut down their exposure to emerging markets and are still treading with caution. This means that the amount has been pumped by the existing FIIs only, which is also substantiated by the fact that registration of new sub-accounts has declined by 60 per cent. There was a small increase in the number of Foreign Institutional Investors (FIIs) registered with SEBI. As on March 31, 2011, there were 1,722 FIIs registered with SEBI as compared to 1,713 a year ago, showing an increase of 0.53 percent during the year. There were 5,686 sub-accounts registered with SEBI as on March 31, 2011 as compared to 5,378 as on March 31, 2010, an increase of 5.73 percent
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How „Hot‟ is Hot Money? FIIs have fuelled rallies in stock markets across the world, but they have been also accused of fuelling volatility. If the past evidence of FIIs‘ investing pattern in a different country is anything to go by, FIIs seem to be more sensitive to bad news than good news. This means FIIs are more cautious while investing than while withdrawing it. The explanation to this behaviour is that FIIs are riskaverse, which makes them react in a knee-jerk fashion to bad news. Moreover, they view every market as an asset in their global portfolio and, therefore, they tend to restructure and rebalance their portfolio dynamically across countries to minimize and maintain healthy returns on their portfolio. Even among FIIs it is investment through participatory notes (P-Notes), which is considered as prime source of ‗hot money‘ and hence volatility. This is because there is little clarity on who the actual investors are and the source of their money. To keep tabs on this hot money, SEBI banned investment through P-Notes on October 17, 2007, resulting in crash of the benchmark Sensex and suspension of trading for an hour. But the latest SEBI figures suggest that supplies of this hot money are on the decline. In 2007, investment through P-Notes constituted 45.5 per cent of FIIs‘ total assets under management, which has come down to just 16.21 per cent in 2009 (see graph). This is on the backdrop of SEBI lifting the ban on investment through P-Notes. The drop may be attributed to the fear of the regulator imposing the ban again.

FII Inflows & Their Impact One of the reasons for FII money seeking global investment avenues was the fiscal stimulus packages provided by governments across the world as also the lack of demand from the real economy. The FII money found its way to the different financial asset classes, including emerging markets. To understand how important and effective these FII investments are for Indian equity market, we analyzed data for FII inflows (or outflows) and the returns generated by
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BSE Sensex in the corresponding period. It was not surprising to find that Sensex had given positive returns only eight times despite negative flows from FIIs. In almost 70 per cent of the times, Sensex and inflows moved in tandem. Therefore, it is no coincidence that in the history of the Indian equity market the only time when Sensex and Nifty were closed due to upper circuit in May 2009 also happens to be the month when FII inflows were highest at Rs 20,607 crore. Now, let us check where all this money got parked. After the second quarter of FY10, FIIs have raised their stake in more than 200 companies. The sectors where they particularly evinced keen interest were construction, infrastructure and heavy engineering. These are also the sectors where demand has more to do with domestic consumption. These were also the sectors that suffered the worst last year due to credit crisis and got hammered on the bourses. So how do these fare in terms of returns as compared to the broader market and peers? We find that these outperformed, both sector-wise and company-wise. For example, HCC, Sobha Developers whose returns were 227 per cent and 223 per cent, respectively, between April-Sept. 2009 outpaced their respective indices by a wide margin. HCC, which is part of BSE 200 and Sobha Developers, which is part of BSE Realty are up by just 80 per cent and 174 per cent, respectively. Similarly, BSE Realty gave returns of 174 per cent as compared to 73 per cent by Sensex. Of course, FIIs have not increased their stake in all the companies, they have also lowered their holdings in various companies, most of whom belong to media and entertainment. For example, FIIs have reduced their holdings in NDTV from 23.14 per cent to 5 per cent in February 2012. Similarly, they reduced it from 17.99 per cent to 11.37 per cent in TV Eighteen during the same time period. However, when we calculate the returns of these companies in the same period we do not find that they have underperformed the market. For example, NDTV has moved up 88 per cent. Clearly, although FIIs are an important force that moves the stock market, they are not the only ones to influence it. When we analyzed the FII investments in terms of company categorized by market capitalization, we came across a startling revelation that instead of choosing the large caps or Nifty companies, FIIs have instead shown more interest in small and mid cap companies like HDIL, Indiabulls Real Estate, 3i Infotech, etc. and this might be one of the reasons why returns of these indices had outperformed Sensex and Nifty. Having established the fact that FIIs greatly influence the stock market, we will now try to understand the factors that determine the FIIs inflows and why they will invest in the Indian market in 2012.

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As per belief FII investments in India will be driven by seven major factors that are listed below.  Liquidity ―Liquidity moves the markets, which in turn, attract more liquidity,‖ says Ambareesh Baliga, VP, Karvy Stock Broking and remains the single most important factor which determines the FIIs inflow. We feel that global economy is still flush with liquidity and will remain at this level till second quarter next year. The excess cash in the US banking system has risen by USD 400 billion since March 2009 and has reached 3 trillion euros in Feb 2012 as quantitative easing (QE) exceeded the liquidation of credit facilities. So with quarter ending there is little room for further reduction in various credit facilities, the excess cash in the US banking system should stay close to a trillion euro throughout 2012. Even in euro area, liquidity is expected to remain at higher level till the second half of 2012. The amount of such excess liquidity in the euro area banking system is estimated to be €776.941 billion ($1.034 trillion) ie in European Central Bank (ECB) In contrast to US Federal Reserve & ECB, is set to inject more liquidity into the banking system. This is evident from the recent policies by these governments.Therefore, we believe liquidity will not be sucked out of the global economy in a hurry and part of this liquidity will definitely finds its way into Indian equity market. Indian Growth Story Liquidity and corresponding inflows is like a double-edged sword, and although it helps create wealth by better market returns, ―it also creates bubbles in different asset classes, including art and paints‖ says Mohit Mirchandani, Head of Equity Investments, Taurus Mutual Fund. Therefore, high liquidity creates the problem of absorbing the high inflows with its side effects. But we feel this is not a big concern in case of India. ―If the government goes for PSU divestment as planned, our market will become deeper and will absorb this extra inflows in 2012 and yet avoid much of its pitfalls,‖ says Mirchandani. Apart from this, many fresh issues are lined up, which will take care of extra liquidity. Fresh equity issuance (FPO/IPO/QIP) will continue over the next few quarters and will remain an important source of capital for the private sector till deleveraging is complete and credit growth improves and is incremental. Indian economy is more dependent on domestic consumption, which contributes more than 60 per cent of the GDP. This makes it less vulnerable than those economies, which are more dependent on export sector and commodity cycle. The Indian Government's 2012 economic survey has projected the economic growth at about 7.6% in the next fiscal 2012-13, up from 6.9% estimated in 2011-12 on the back of declining
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inflation and softening interest rate. It expects the economic growth to further improve to 8.6% in 2013-14.. We believe that once the global recovery comes back on track, India‘s GDP will accelerate further, giving more reasons for FIIs to be a part of the Indian growth story.  Diversified Opportunity India offers a much more diversified market than markets such Russia, Brazil or even China. These economies are largely based on commodities like crude and less in terms of primary articles and products. India offers opportunities in IT, banking, services and the range of listed companies available in India is much broader than in Eastern Europe or Russia. However, Chinese market provides a much bigger size in financial and raw materials market, but India still offers more diversified stocks than any other emerging market to an investor. ―India offers diversified exposure across various sectors covering consumers, industries, materials, financials, healthcare, technology, etc. and depending on the evolving economic outlook, one can definitely absorb flows in various pockets,‖ says V. Sriram. Moreover, India is less volatile than many emerging markets and more transparent to international investor community – something that would always give a premium over the long-term. Hence, long-term investors such as pension funds whose investment horizon is much longer (about 10-15 years) are also attracted Opportunity in Indian Companies Although Indian market ranks among the top half of the costliest emerging markets, so certainly we are not cheap when trading. But when we speak of these stretched valuations, it is mainly related to broader market indices like Sensex and Nifty and earning multiples of companies on those indices. ―But if we scratch the surface and look at mid caps and small caps, there are many companies which are available at very cheap price. The year 2012 will be more of stock-picking rather than sector-specific. So, there might be some scrips which might go up to 300 per cent, while the market may stay range-bound,‖ opines Mirchandani. Moreover, till now it was the government spending (either directly through stimulus packages or indirectly through doling out money through 6th Pay Commission) that has been the driving force of recovery but now what will take the market forward is the investment cycle and capacity utilization which is slated to accelerate next year, though it will remain below the pre-crisis level. Nonetheless, it will translate into better growth numbers for India Inc. We believe that there is still scope of upgrading of corporate earnings in certain pockets, which will take care of some of the concerns on higher valuation.

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Carry Trades Other important factor in India‘s favour and which is attracting FII inflows is the relatively higher interest rate. The current near-zero interest rate in the USA and Japan as against the 4-5 per cent in the Indian market gives rise to a strategy called 'carry trade', which involves borrowing in lower yielding (US dollar or Japanese yen) assets and investing in higher yielding assets (rupee) and pocket the difference. Ideally, whatever gain one would have expected from this strategy should be negated by the expected movement in exchange rate, but so far the strategy has worked profitably on an average. Going forward, we do not find any compelling reasons to justify the reverse of dollar carry trade. In addition,in terms of interest rate policy, the US Fed announced no changes. It noted that the Fed funds rate would remain between 0 and 0.25 percent, and reiterated that it was likely to maintain this exceptionally low interest rate stance through late 2014. Other major central banks such European Central Bank and Bank of Japan are expected to follow suit. Till the time differential interest rates remain at these levels and other things remaining equal, we can expect the flow to continue.

US Dollar Index The movement of dollar index, a measure of the performance of the US dollar against a basket of currencies including the yen and euro is one of the most important factors which will shape the future FII inflows. It has been observed that there is inverse relationship between dollar index and Sensex (see graph). Therefore, when Sensex hit its low on March 9th, it was no coincidence that dollar index too hit its high of 89. From there, Sensex started its ascent and touched high of 17,360 on December 24, 2009, whereas dollar index declined to 77.89 after hitting low of 74.26 on November 25, 2009. And now in 2012 when sensex is 17300 dollar index is back on 79.34. Dollar index actually measures risk aversion: when it declines, FIIs look at investing to riskier assets and vice versa.. It is still premature to come to any conclusion about the future course of dollar index and jury is still not out, but it is worth mentioning that despite such ascent of the dollar, Sensex has continued its climb. Therefore, it appears that somehow the two have decoupled as of now. In addition, the US dollar, after loosing ground to most of the major currencies throughout 2009, resurrected after the Dubai crisis. We feel that this was partly due to investors playing safe rather than sorry. This may also be explained by investors‘ tendency of taking away profit from the table as the year draws to a close like what happened in last quarter of 2011

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(The USD Index measures the performance of the US Dollar against a basket of currencies: EUR, JPY, GBP, CAD, CHF and SEK)

Political Stability India being the largest democracy in the world definitely inspires confidence in the Indian economy. This also reduces the risk premium of the country from the FIIs‘ perspective. The FIIs‘ confidence got a further boost after May 2009 general elections, which gave a clear mandate to the Congress party and ushered in the Manmohan Singh government once again. This was cheered by the market and for the first time Sensex and Nifty hit the upper circuit. This led to the return of risk capital into Indian equity market. Recognizing the importance of FIIs to the Indian stock market, the government has played its own role and Finance Minister has constituted a working group to recommend changes in the existing policies so as to attract more portfolio investments. The Finance Minister has also gone on record stating that as of now there is no need to tax capital inflows, which as a policy has been adopted by some of other emerging markets. Last, but not the least, India‘s democratic polity would always enable a premium over the long term. To conclude, the world recognizes that India and China will provide the growth impetus for the global economy, but what differentiates India is its peculiar demographic dividend which will last longer than many emerging economies, its political system and new vigour in India Inc. to take on the challenges of global competition. Therefore, we believe that the FII inflows will remain intact over the long term, although we might see some temporary blips occasionally

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4.2 US Rating Downgraded By S&P The decision by S&P, the global ratings major, to cut US' sovereign rating by a notch to 'AA plus' from 'AAA' is something that has no precedence. So for foreign fund managers as well as institutional dealers in India, this is something they don't understand and hardly anyone has a definite clue how to react to it. As a result, brokers are certain there could be some knee-jerk reaction and selling during 2012 While the US rating downgrade is likely to trigger panic selling in local markets, it may actually make India an attractive investment destination in the long term - provided crude falls and RBI halts monetary tightening. However, most FIIs are expected to be on the 'wait-and-watch' mode for a few months from now, see how things pan out in other parts of the world and then take a decision on their India portfolio, institutional dealers and fund advisors said. Infact, in one of the scenarios that could emerge over a period, fund managers say that FIIs could actually look at India as a preferred investment destination.The silver lining is that such volatility is expected to be short lived.However, they warned that in case if any of the two other ratings majors—Moody's and Fitch—also cut US sovereign ratings, volatility and uncertainty could increase. THREE SCENARIOS :- As things stand now for FIIs, three phases are likely to unfold over the next few months that could be assigned to this unthinkable incident of US ratings downgrade. Some of the hedge funds, registered with Sebi as FIIs, will sell in 2012 like they did in last quarter on 2011. This is because most hedge funds are momentum traders and in times of uncertainty they prefer to be in cash. On the other hand, long-term FII funds, like pension funds and insurance companies, will not sell in a hurry but will wait to have a better understanding of the implications and then take a decision on their India exposure. For the long term players, there are not many alternative markets that offer them good growth and chance of a better return than India, institutional dealers said. Since there are quite a few positives in the Indian market, after this downgrade, money will not go back to the US During the third phase, that is likely to unfold after a few months from now, India could actually start attracting more foreign funds than before. This is because if crude prices fall, that could bring down government's subsidy burden on petro products, pull down the rate of inflation, and also might help RBI's in not raising the rate of interest in the economy. The combined effect, market players believe, could again lure foreign fund managers to invest in the Indian economy. This is something that was witnessed after the dust settled on the Lehman collapse and the recession that followed in September 2008. So far this year, FIIs have pumped in just over $7.5 billion into the Indian market, compared to about $29.4 billion in 2010, Sebi data reveals. Institutional dealers feel 2012 could be a much better year for FII inflows.

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CHAPTER 5: CONCLUSION From all the above discussions and data analysis, we conclude that FIIs have major impact on Indian stock market. Particularly, the decline on October 17, 2007, in which just a speculation about government‘s plan to control P-Notes had caused the biggest fall in Indian stock market, even market had to be closed for one hour without trade. The impact is that even the domestic players and MFs also follow a close look on FIIs. Therefore, if FIIs are confident in Indian markets, there is a general perception that market is on a song. But there is a note of caution too. The source of investment behind these FIIs should be crystal clear. Otherwise this can cause a negative impact on stock market as was the cause of fall on 17th October 2007. Further money launders and even terrorists can use this facility to pump money to Indian market and their sudden withdrawal can cause volatility in markets. Even during the current year also, the major fall in SENSEX has been caused amidst selling of FIIs due to reasons like increased net selling by foreign funds during January or fear of interest Rate hike by RBI or depreciation in the value of Rupee in comparison to dollars. From above discussion it is clear that major falls in stock market were after effects of withdrawal of money by FIIs. So there is a direct relation between the FII's money flow and the movement of SENSEX. The biggest fall in stock markets occurred in 2007 and 2008. This means that the volatility of market was more because during this period there was an increase in registration of FIIs and the investments reached almost Rs. 283468.40 Crores by the end of 2007. Correlation Test has been carried out to find the degree of association between the FII Gross Purchases and Sensex and FII Gross sales and sensex. First of all correlation between sensex and FII gross purchase and FII gross sale and sensex is carried out to verify relation between them Sensex of Bombay Stock Exchange is considered as the barometer of Indian Capital Market. This inference is further supported by high degree of correlation coefficient obtained between two variables in the Table-1, 2 & 3. This high degree of correlation further suggests that there is direct correlation between the Midcap & Smallcap Indices and FIIs investments. So this analysis indicates the impact of FIIs on Indices. An FII driven market can impact the real economy indirectly, when their behavior in the market exerts pressure on policy makers. Secondly, the wealth effect' where capital gains are translated into increased consumption and investment, can act as a more direct link between equity and physical markets. FIIs are always considered to increase the volatility of market. Volatility is often viewed as a negative in that it represents uncertainty and risk. However, volatility can be good in that if one shorts on the peaks, and buys on the lows one can make money, with greater money coming with greater volatility. The possibility for money to be made via volatile markets is how short term
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market players like day traders hope to make money, and is in contrast to the long term investment view of buy and hold. Foreign institutional investment is certainly volatile in nature and its volatility has certainly posed some threats to the Indian stock market considering its influence on the market. Increase in investment by FIIs cause sharp price increase. It would provide additional incentives for FII investment and this encourages further investment so that there is a tendency for any correction of price 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 Indices because only FIIs are not responsible for the fluctuations instead there are other factors like company specific factors, speculative trading, interest rate prevailing in the market, political factors, government policies related to specific sectors etc. which cause a significant change in the price. From all this analysis, we can safely say prime facie that the FIIs influence market.

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Bibliography
http://www.moneycontrol.com/india/stockmarket/foreigninstitutionalinvestors/10/55/activity/FII http://www.bseindia.com/histdata/hindices.asp http://www.nseindia.com/content/equities/eq_fii_nsebse.htm www.finance.indiamart.com www.mydigitalfc.com/news/fii http://www.sebi.gov.in/Index.jsp?contentDisp=Database www.capitalvia.com www.trak.in/Tags/Business/fii/ www.triplecrisis.com www.ftalphaville.ft.com http://www.reuters.com/finance www.indianexpress.com www.scribd.com

Dalal Street Investment Journal (Issue No.17) August 2011 Journal of Business and Economic Issues (Vol.1 Jan 2009) Economic Outlook April 2011

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