Foreign Institutional Investments (FIIs) & India

International Economics Project

MET PGDM SEMESTER III - FINANCE

SUBMITTED BY Nishant Shah (PG12053) Dashang Ashar (PG12064) Karishma Vora (PG12072) Pratik Mehta (PG12077) Monil Dagli (PG12091)

SUBMITTED TO Prof. P.A. Johnson

ACKNOWLEDGEMENT
We take this opportunity to express our profound gratitude and deep regards to our guide Prof. P.A. Johnson for his exemplary guidance, monitoring and constant encouragement throughout the course of this thesis. The help and guidance given by him time to time shall carry us a long way in the journey of life on which we are about to embark. We would also like to thank MET Management Centre for their constant support and encouragement to undertake this project. And finally, doing this project has indeed been a very enriching and a great learning experience for us and will definitely help us in our future endeavours.

INDEX
S. NO. 1 2 3 4 5 6 7 PARTICULARS PAGE NO.

FOREIGN INSTITUTIONAL INVESTMENTS (FIIS) A BRIEF OVERVIEW

The economic landscape of India underwent a paradigm change when the economy was liberalized in 1991. It also laid the foundation for a strong regulatory network. India witnessed stellar economic performance through the period 2003-09 .This was manifested through an average 8.5 9 percent GDP growth rates, rising domestic savings and investment levels and the amount of foreign capital flowing into the country. Foreign investments can be any of the three forms: Portfolio investments in Indian companies Foreign Institutional Investor (FII) route essentially entailing transactions executed on stock exchanges in India; Direct investment into Indian companies Foreign Direct Investment (FDI) route; Private Equity investments Foreign Venture Capital Investor (FVCI) route. Foreign Institutional Investors (FIIs) are entities who are established or incorporated outside India & invest in India. They invest mostly in secondary markets & government securities. There has been a consistent upsurge in foreign institutional investment since 2002 2003. These FIIs have started playing a significant role in the Indian capital market & India has become an attractive destination for FIIs, as it has immense potentiality for overseas investment. The inflow of foreign capital, in search of a better risk return tradeoff, helps the home country to share risks with foreign investors. Institutional investors have grown in importance in the mature economies in recent years & come to supplant banks as the primary custodians of peoples savings. Flows of private capital through FIIs have in recent years augmented forex reserves in emerging markets. In India, over the past decade, FIIs have displaced domestic mutual funds in importance in the equity market. There shareholding in the Sensex companies is large enough for them to be able to move the market. The volatility in portfolio inflows to India has been modest, compared to other emerging markets. As domestic funds grow in size & pension funds enter the equity market, which would provide a measure of self insurance against volatility occasioned by FII flows. The real problem caused by variations in FII inflows from year to year is not stock market volatility, but the difficulties posed in management of money supply & exchange rate.

The FII inflows from capital surplus countries to capital scarce countries contributed to the enhancement of productivity & efficiency of capital at global level. A critical analysis of portfolio investment patterns in Indian companies highlights this trend. Good foreign institutional investments have resulted in contemporary changes in the corporate governance structures on the agency costs of the publicly traded companies & it was found that FIIs are effective monitors in reducing the agency costs. Agency cost is the sum of bonding costs, monitoring costs & residual loss. Though developments in the wake of economic reforms signalled new opportunities for foreign investments in several sectors of Indian economy, these are subject to significant restrictions, norms, regulation in terms of percentage caps on foreign equity ownership & other factors. In this globalised age significant amount of capital is invested into developing economies from developed world. Significant amount of these investment are bought to developing economies by the way of portfolio investments by foreign institutional investors (FII). Foreign institutional investors have gained a significant role in Indian capital markets. Availability of foreign capital depends on many firm specific factors other than economic development of the country. 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.

SIGNIFICANCE OF FIIS / DIFFERENCE BETWEEN FDI & FII

SIGNIFICANCE OF FIIS A) MEANING FII (Foreign Institutional Investors) is used to denote an investor; it is mostly of the form of an institution or entity which invests money in the financial markets of a country. The term FII is most commonly used in India to refer to companies that are established or incorporated outside India, and is investing in the financial markets of India. These investors must register with the Securities & Exchange Board of India (SEBI) to take part in the market. Foreign institutional investment is liquid nature investment, which is motivated by international portfolio diversification benefits for individuals and institutional investors in industrial country. Currently, the following entities are eligible to invest under FII route: 1) As FIIs o Overseas pension funds, o Mutual funds, o Investment trusts, o Asset management companies, o Nominee companies, o Banks, o Institutional portfolio managers, o University funds, o Endowments foundations, o Charitable trusts, o Charitable societies, o Trustee or o Power of attorney holders

Asset Management Companies, Institutional Portfolio Managers, Trustees and Power of Attorney Holders proposing to invest on behalf of broad-based funds too are eligible to register as FII.

Broad Based Fund means a fund established or incorporated outside India, which has at least twenty investors with no single individual investor holding more than 10% shares or units of the fund. 2) 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-account o Partnership firms, o Private company, o Public company, o Pension fund, o Investment trust and o Individuals 3) Domestic Entities A domestic portfolio manager or a domestic asset management company shall also be eligible to be registered as FII to manage the funds of sub-accounts. B) AGENCIES REGULATING FIIS IN INDIA

RBI : The apex bank FIPB : Reviews all foreign investment proposals SEBI : Regulates Indias capital market

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

DIFFERENCE BETWEEN FDI & FII

BASIS

FDI Foreign direct investment means funds committed to a Foreign enterprise. The investor may gain partial or total control of the enterprise. That can be done through joint ventures, technical collaborations and by taking part in management of a concern.

FII Foreign Institutional Investment means investment in a foreign stock market by the specialized financial intermediaries managing savings collectively on behalf of investors FIIs presently includes foreign pension funds, mutual funds, charitable/endowment/university funds etc. as well as asset management companies and other money managers operating on their behalf.

Explanation

Investor

Control

The basic motive of FDI is to have control on the enterprise in which they are investing. FDI have lasting interest in their company and stay with it through thick or thin. FDI have the active power to make the interference in the decisions of the enterprise. FDI bring stability in the market because they contribute to fundamental strength in the economy.

FIIs are not interested in managing control.

Termination Period

Interference

Volatility

FIIs are fair weather friends, who come when there is money to be made and leave at the first sign of impending trouble. FIIs are the investors who share the project and business risk without interfering in the critical decisions of the company. FIIs might make market more volatile because they are called fair weather friends.

ENTRY OF FIIS 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, FIIs and overseas corporate bodies (OCBs) were permitted to invest in nancial instruments, with suitable restrictions. The policy framework for permitting FII investment was provided under the Government of Indias guidelines, vide a press note dated September 14, 1992, which enjoined upon FIIs to obtain an initial registration with the SEBI and also the RBIs general permission under the FERA. Both the SEBIs registration and the RBIs general permissions under the FERA were to hold good for 5 years, and were to be renewed after that period. The RBIs general permissions under the FERA would enable the registered FII to buy, sell, and realize capital gains on investments made through an initial corpus remitted to India, to invest on all recognized stock exchanges through a designated bank branch, and to appoint domestic custodians for the investments held. The government guidelines of 1992 also provided the eligibility conditions for registration, such as track record, professional competence, nancial soundness, and other relevant criteria, including registration with a regulatory organization in the home country. The guidelines were suitably incorporated under the SEBI (FIIs) Regulations, 1995. These regulations continue to maintain the link with the government guidelines through a clause that was added to the effect that the investment by FIIs should also be subject to government guidelines. This linkage has allowed the government to indicate various investment limits, including those in specic sectors. With the Foreign Exchange Management Act (FEMA), 1999 coming into force in 2000, the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 were issued to provide the foreign exchange control context where foreign exchange-related transactions of FIIs were permitted by the RBI. A philosophy of preference for institutional funds and the prohibition of portfolio investments by foreign natural persons have been followed, except in the case of non-resident Indians, where direct participation by individuals takes place. 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 that were listed or were to be listed on the stock exchanges in India and in schemes oated by domestic mutual funds.

India opened its stock market to foreign investors in September 1992, and in 1993, received portfolio investment from foreigners in the form of foreign institutional investment in equities. This has become one of the main channels of FII in India for foreigners. Initially, there were terms and conditions which restricted many FIIs to invest in India. But in the course of time, in order to attract more investors, SEBI has simplified many terms such as:o The ceiling for overall investment of FII was increased 24% of the paid up capital of Indian company. o Allowed foreign individuals and hedge funds to directly register as FII. o Investment in government securities was increased to US$5 billion. o Simplified registration norms.

GROWTH OF FIIS IN INDIA OVER YEARS

Growth in FII Investments in India

Growth in FII registrations in India

No. of FII's registered with SEBI

2000

1500 1000
500 0

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012 Source - SEBI

PROS & CONS OF FIIS IN INDIA

PROS OF FIIS IN INDIA

1. Reduced Cost of Equity Capital FII inflows augment the sources of funds in the Indian capital markets. In a common sense way, an increase in the supply of funds reduces the required rate of return for equity and enhances stock prices. Simultaneously, it fosters investment by Indian firms in the country. 2. Imparting Stability to Indians Balance of Payment / Increases Forex Reserves For promoting growth in India, there is a need to augment domestic investment, over and beyond domestic savings, through capital flow. The excess of domestic investment over domestic savings result in a current account deficit and this deficit is financed by the capital flow in the balance of payment. Foreign institutional investment as opposed to debt-creating flows is important as safer and more sustainable mechanism for funding the current account deficit. 3. Knowledge Flows The activities of international institutional investors help strengthen financial system. FIIs advocate modern ideas in market design, promote innovation, development of sophisticated products such as financial derivatives, enhance competition in financial intermediation and lead to spill over of human capital by exposing market participants to modern financial techniques and international best practices and systems.

4. Strengthen Corporate Governance Domestic institutional investors and individual investors, who are used to the ongoing practices of domestic corporates, often accept such practices, even when these do not measure up to the international benchmarks of best practices. FIIs with their vast experience with modern corporate governance practices are less tolerant of malpractice by corporate managers and owners (dominant shareholders). FII participation in domestic capital markets often-lead vigorous advocacy of sound corporate governance practices, improved efficiency and better shareholder value.

5. Improve Market Efficiency A significant presence of FIIs can improve market efficiency through two channels. First,

when adverse macroeconomic news, such as bad monsoon, unsettles many domestic investors, it may be easier for a globally diversified portfolio manager to be more dispassionate about a countrys prospects, and engage in stabilizing trades. Second, at the level of individual stocks and industries, FIIs may act as a channel through which knowledge and ideas about valuation of a firm or an industry can more rapidly propagate into market. For example, foreign investors rapidly assess the potential of firms like Infosys, which are primarily export-oriented, by applying valuation principles that prevailed outside India for software services companies.

6. Managing uncertainty & controlling risks FII inflows help in financial innovation and development of hedging instruments which helps to control risks to a greater extent. Also, it not only enhances competition in financial markets, but also improves the alignment of asset prices to fundamentals.

CONS OF FIIS IN INDIA

1. Balance of Payment Vulnerability There are concerns that in an extreme event, there can be a massive flight of foreign capital out of India, triggering difficulties in the balance of payments front. This is the case which Indian economy is facing in the current situation.

2. Complexities of Monetary Management A policy maker trying to design the ideal financial system has three objectives. The policy maker wants to continue national sovereignty in the pursuit of interest rate, inflation and exchange rate objectives; financial markets that are regulated, supervised and cushioned; and the benefits of global capital markets. Unfortunately, these three goals are incompatible. They form the impossible trinity. Indias openness to portfolio flows and FDI has effectively made the countrys capital account convertible for foreign institutions and investors. The problems of monetary management in general and maintaining a tight exchange rate regime, reasonable interest rates and moderate inflation at the same time in particular have come to the fore in

recent times. The problem showed up in terms of very large foreign exchange reserve inflows requiring considerable sterilization operations by the RBI to maintain stable macroeconomic conditions. The government of India had to introduce a Market Stabilization Scheme (MSS) from April 1, 2004.

3. Problems of Inflation Huge amounts of FII fund inflow into the country creates a lot of demand for rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created.

4. Problems for small investor The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high then they can bring in huge amounts of funds in the countrys 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.

5. 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. 6. Problem of Hot Money Hot money refers to funds that are controlled by investors who actively seek short-term returns. These investors scan the market for short-term, high interest rate investment opportunities. Hot money can have economic and financial repercussions on countries and banks. When money is injected into a country, the exchange rate for the country gaining the money strengthens, while the exchange rate for the country losing the money weakens. If money is withdrawn on short notice, the banking institution will experience a shortage of funds.

These are the benefits and harm of the foreign institutional investors. If proper rules are established and implemented by the regulatory body, the harms of the FIIs can be eliminated.