Author Name:   rashmiperumal

In recent years particularly in developing countries including India, there has been increased liberalization of domestic financial and capital markets and an opening up of the market to foreign institutional investors. The main emerging feature of India’s equity market is its gradual integration with the global market and its consequent problems due to the hot money movement by Foreign Institutional investors. This article gives a critical analysis on the need and impact of FIIs on Indian Economy...

Liberalization Of The Law Relating To Foreign Institutional Investment And Its Impact On Economic Development

In recent years particularly in developing countries including India, there has been increased liberalization of domestic financial and capital markets and an opening up of the market to foreign institutional investors. The main emerging feature of India’s equity market is its gradual integration with the global market and its consequent problems due to the hot money movement by Foreign Institutional investors.

The concept of globalization in the sense in which it is used now can be traced to the phenomenon of nation states. In the distant past there were just human communities. For much of human history, most people remained confined to their communities, villages or local areas. With developments in communication and economic activity, it became progressively easier to move from the local to the regional, and then from the regional to the national level and finally across nations. While developments in technology enabled and accelerated the movement of goods, people and services; the policies of many nations tended to impose restrictions.

Most of the countries of the world which embarked on the path to economic development had to depend on foreign capital on some extent. The degree of dependence however varied with the extent to which domestic resources could be mobilised, the state of domestic economy in respect of technical progress and the attitude of respective governments.

The need for foreign arises on account of the following reasons:
· Domestic capital is inadequate for purposes of economic growth and it is necessary to invite foreign capital.
· For want of experience, domestic capital and entrepreneurship may not flow into certain lines of production. Foreign capital can show the way for domestic capital.
· There may be potential savings in a developing economy like India but this may come forward only at a higher level of economic activity. It is, therefore, necessary that foreign capital should help in speeding up economic activity in the initial phase of development.
· It may be difficult to mobilise domestic savings for the financing of projects that are badly needed for economic development. In the early stages of development, the capital market is itself underdeveloped. During the period in which the capital market is in the process of development, foreign capital is essential as a temporary measure.
· Foreign capital brings with it other scarce productive factors, such as technical knowhow, business experience and knowledge which are equally essential for economic development.

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.

A HISTORICAL SKETCH OF FOREIGN INVESTMENT IN INDIA
The history of Indian economy can roughly be categorized into three main different eras of life in Indian society beginning with the pre-colonial period lasting up to the 17th century. The advent of British colonization of the Indian sub-continent started the colonial period in the 17th century, which ended with the Indian independence in 1947. The third period is the post-independence period after 1947.

Assessment of India’s pre-colonial economy is mostly qualitative, owing to the lack of quantitative information. However the statistics of 1872 census has revealed that 99.3% of the population of the region constituting present day India resided in villages whose economies were largely isolated and self-sustaining, with agriculture the pre-dominant occupation. The Company rule in India brought a major change in the taxation environment from revenue taxes to property taxes, resulting in mass impoverishment and destitution of majority of farmers and led to numerous famines. The effects of the vast gains made by Industrial revolution in Europe were deprived to Colonial India. Exploitation was rampant and the implementation of bad economic policies took the status of Indian economy to an all time low. An estimate by Cambridge University historian Angus Maddison reveals that "India's share of the world income fell from 22.6% in 1700, comparable to Europe's share of 23.3%, to a low of 3.8% in 1952". At the end of colonial rule, India inherited an economy that was one of the poorest in the developing world, with industrial development stalled, agriculture unable to feed a rapidly growing population, India had one of the world's lowest life expectancies, and low rates for literacy.

The year 1947 regarded as a historic year for the growth and prosperity of Indian economy. As Independence Day dawned on us, the people of India took a vow to protect its sovereignty and integrity at all costs and never to subject them to tyranny of a foreign rule again. Thus, the Indian economic policy after independence was influenced by the colonial experience which was seen by Indian leaders as exploitative in nature. Policy tended towards protectionism, with a strong emphasis in import substitution, industrialization, state intervention in labour and financial markets, a large public sector, business regulation and central planning. Capitalism and private sector did not exist before 1991. Elaborate licences, regulations and the accompanying red tape, commonly referred to as Licence Raj, were required to set up business in India between 1947 and 1990.

But these measures restricted the Indian economy stalling its growth. The collapse of the Soviet Union, which was India’s major trading partner, and the first Gulf War, which caused a spike in oil prices, caused a major balance-of-payments crisis for India, which found itself facing the prospect of defaulting on its loans. In the context of the balance of payments crisis of 1991, a comprehensive structured and financial sector reform process was initiated in India as recommended by committee on the financial system (Chairman M. Narasimham, 1991) which became the starting point for gradual deregulation of financial sector and development and integration of various segments of financial markets.

The changes in economic scenario after the liberalization and economic growth have raised the interest of Indian as well as Foreign Institutional Investors(FII’s) in the Indian capital market. As a result of this, Indian stock market has 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 have made it a center of attraction for the international investors.

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

What is Capital market?
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. Capital market is the market for long term funds, just as the money market is the market for short term funds. It refers to all the facilities and the institutional arrangements for borrowing and lending term funds (medium-term and long-term funds).it does not deal in capital goods but is concerned with the raising of money capital for purposes of investment.

The demand for long-term memory capital comes predominantly from private sector manufacturing industries and agriculture and from the government largely for the purpose of economic development. As the central and state governments are investing not only on economic overheads like transport, irrigation and power development but also on basic industries and sometimes even in consumer goods industries, they require substantial sums from the capital market.

Foreign Institutional Investment
Foreign Institutional Investment or FIIs as it is more popularly known. In layman terms it may be used to refer to the companies that are established or incorporated outside India and are investing in the financial markets of India by registering themselves with the Securities & Exchange Board of India (SEBI).
However, a formal definition of the term has been given under SEBI regulations as “an institution that is a legal entity established or incorporated outside India proposing to make investments in India only in securities”. 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.

FIIs are governed by the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995. Potential investors also have to get approval from the Reserve Bank of India to operate foreign currency accounts to bring in and take out funds and rupee bank accounts to pay for transactions. The Reserve Bank of India also regulates the activities of FIIs, through exchange control regulations.

The following categories of FIIs are registered with SEBI:
a) 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.
b) 100 % debt-fund FIIs- those who are permitted to invest only in debt instruments.

FIIs include:
1) overseas pension funds,
2) mutual funds,
3) investment trusts,
4) asset management companies,
5) nominee companies,
6) banks,
7) institutional portfolio managers,
8) university funds,
9) endowments, foundations, charitable trusts, charitable societies,
10) a trustee or power of attorney holder incorporated or established outside India proposing to make proprietary investments on behalf of a broad-based fund (i.e., fund having more than 20 investors with no single investor holding more than 10% of the shares or units of the fund).

Pension fund
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 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

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.

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.

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.

Procedure for Registration
The Procedure for registration of Foreign Institution Investor has been given SEBI regulations. It has been stated- “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.

The Eligibility criteria for applicant seeking FII registration is as follows:
· Good track record, professional competence and financial soundness.
· Regulated by appropriate foreign regulatory authority in the same capacity/category where registration is sought from SEBI.
· permission under the provisions of the Foreign Exchange Management Act, 1999 from the Reserve Bank of India.
· legally permitted to invest in securities outside the country or its incorporation/establishment.
· The applicant must be a ‘fit and proper’ person.
· Local custodian and designated bank to route its transactions.

Sub- Account
A ‘Sub-account’ is the underlying fund on whose behalf the FII invests. Sub- Accounts can include those foreign corporate, foreign individuals, and institutions, funds or portfolios established or incorporated outside India on whose behalf investments are proposed to be made in India by a FII. It is possible for a registered sub-account to transfer from one FII to another. In such a case, the FII to whom it is proposed to be transferred has to request SEBI with the following documentation:

· A declaration that it is authorized to invest on behalf of the sub-account.
· A no-objection letter for the transfer of the sub-account from the transferor FII.

Eligible Securities
A FII can make investments only in the following types of securities:
o Securities in the primary and secondary markets including shares, debentures and warrants of unlisted, to- be-listed companies or companies listed on a recognized stock exchange
o Units of schemes floated by domestic mutual funds including Unit Trust of India, whether listed on a recognized stock exchange or not, and units of scheme floated by a Collective Investment Scheme.
o Government Securities
o Derivatives traded on a recognized stock exchange – like futures and options. FIIs can now invest in interest rate futures that were launched at the National Stock Exchange (NSE) on 31st August, 2009.
o Commercial paper
o Security receipts
Foreign Institutional Investors (FIIs) are allowed to invest in the primary and secondary capital markets in India through the Portfolio Investment Scheme (PIS) administered by the Reserve Bank of India (RBI). Under this scheme, FIIs can acquire shares/debentures of Indian companies through the stock exchanges in India. The ceiling for overall investment by FIIs is 24 per cent of the paid up capital of the Indian company (20 per cent in the case of public sector banks, including the State Bank of India). The ceiling of 24 per cent for FII investment can be raised subject to:
Ø approval by the company’s board and the passing of a special shareholder resolution to that effect,
Ø certain sector caps imposed by RBI and the Government of India.

The RBI monitors the ceilings on FII investments in Indian companies on a daily basis and publishes a list of companies allowed to attract investments from FIIs with their respective ceilings.

FII Regulations
Investment by FIIs is regulated under SEBI (FII) Regulations, 1995. Following are some of important regulations by SEBI and RBI:
Ø A Foreign Institutional Investor may invest only in the instruments mentioned earlier.
Ø The total investments in equity and equity related instruments (including fully convertible debentures, convertible portion of partially convertible debentures and tradeable warrants) made by a Foreign Institutional Investor in India, whether on his own account or on account of his sub- accounts, should be at least seventy per cent of the aggregate of all the investments of the Foreign Institutional Investor in India, made on his own account and through his sub-accounts.
Ø The cumulative debt investment limit for FII investments in Corporate Debt is USD 15 billion. The amount was increased from USD 6 billion to USD 15 billion in March 2009.
Ø USD 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.
Ø The debt investment limit for FIIs in government debt in G-secs currently capped at $5 billion and cumulative investments under 2% of the outstanding stock of G-secs and no single entity can be allocated more than Rs. 1000 cr of the government debt limits.

PARTICIPATORY NOTES
Participatory notes (PNs / P-Notes) are instruments used by investors or hedge funds that are not registered with the SEBI (Securities & Exchange Board of India) to invest in Indian securities. Participatory notes are instruments that derive their value from an underlying financial instrument such as an equity share and, hence, the word, 'derivative instruments'. SEBI permitted FIIs to register and participate in the Indian stock market in 1992.

Indian based brokerages buy Indian-based securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors. Participatory notes are instruments used for making investments in the stock markets. However, they are not used within the country. They are used outside India for making investments in shares listed in that country. That is why they are also called offshore derivative instruments.

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. For example, 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 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.

Advantages and Disadvantages of FIIs
In 1993, when investments in FIIs were introduced, Pictet Umbrella Trust Emerging Markets’ Fund, an institutional investor from Switzerland, was the only FII to enter the Indian market. Data sourced from SEBI shows that the number of registered FIIs stood at 1713 and number of registered sub-accounts rose to 5,426 as of June 30, 2010.

FII flows into a country are associated with several advantages and disadvantages.
The advantages of FII flows into the country include:
Enhanced flows of equity capital
FIIs have a greater appetite for equity than debt in their asset structure. The opening up of the economy to FIIs has been in line with the accepted preference for non-debt creating foreign inflows over foreign debt. Enhanced flow of equity capital helps improve capital structures and contributes towards building the investment gap.

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

Improving capital markets
FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets.

Equity market development aids economic development
By increasing the availability of riskier long term capital for projects, and increasing firms’ incentives to provide more information about their operations, FIIs can help in the process of economic development.

Improved corporate governance
FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms’ operations, improve corporate governance. Bad corporate governance makes equity finance a costly option. Also institutionalization increases dividend payouts and enhances productivity growth.

Disadvantages
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
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 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.
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.
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.

Trends of FIIs- Impact on Indian economy
Given the presence of foreign institutional investors in Sensex companies and their active trading behaviours, their role in determining share price movements must be considerable. Indian stock markets are known to be narrow and shallow in the sense that there are few companies whose shares are actively traded. This shallowness would also mean that the effects of FII activity would be exaggerated by the influence their behaviour has on other retail investors, who, in herd-like fashion tend to follow the FIIs when making their investment decisions.

These features of Indian stock markets induce a high degree of volatility for four reasons. Inasmuch as an increase in investment by FIIs triggers a sharp price increase, it would provide additional incentives for FII investment and in the first instance encourage further purchases, so that there is a tendency for any correction of price increases unwarranted by price earnings ratios to be delayed. And when the correction begins it would have to be led by an FII pullout and can take the form of an extremely sharp decline in prices.

Second, as and when FIIs are attracted to the market by expectations of a price increase that tend to be automatically realised, the inflow of foreign capital can result in an appreciation of the rupee vis-à-vis the dollar. This increases the return earned in foreign exchange, when rupee assets are sold and the revenue converted into dollars. As a result, the investments turn even more attractive triggering an investment spiral that would imply a sharper fall when any correction begins.

Third, the growing realisation by the FIIs of the power they wield in what are shallow markets, encourages speculative investment aimed at pushing the market up and choosing an appropriate moment to exit. This implicit manipulation of the market if resorted to often enough would obviously imply a substantial increase in volatility.

Finally, in volatile markets, domestic speculators too attempt to manipulate markets in periods of unusually high prices. Thus, most recently, SEBI is supposed to have issued show-cause notices to four as-yet-unnamed entities, relating to their activities on around Black Monday, May 17, 2004, when the Sensex recorded a steep decline to a low of 4505.

These aspects of the market are of significance because financial liberalisation has meant that developments in equity markets can have major repercussions elsewhere in the system. With banks allowed to play a greater role in equity markets, any slump in those markets can affect the functioning of parts of the banking system. On the other hand, if FII investments constitute a large share of the equity capital of a financial entity, as seems to the case with HDFC, an FII pullout, even if driven by development outside the country, can have significant implications for the financial health of what is an important institution in the financial sector of this country.

Similarly, if any set of developments encourages an unusually high outflow of FII capital from the market, it can impact adversely the value of the rupee and set off speculation in the currency that can, in special circumstances, result in a currency crisis. There are now too many instances of such effects worldwide for them to be dismissed on the ground that India's reserves are adequate to manage the situation.

Thus, the volatility being displayed by India's equity markets warrant returning to a set of questions that have been bypassed in the course of neo-liberal reform in India. The most important of those questions is whether India needs FII investment at all. With the current account of the balance of payments recording a surplus in recent years, thanks to large inflows on account of non-resident remittances and earnings from exports of software and IT-enabled services, we don't need those FII flows to finance foreign exchange expenditures. Neither does such capital help finance new investment, focussed as it is on secondary market trading of pre-existing equity. The poor showing of the markets on the IPO front in most years during the 1990s is adequate confirmation of this. And finally, we do not need to shore up the Sensex, since such indices are inevitably volatile and merely help create and destroy paper wealth and generate, in the process, inexplicable bouts of euphoria and anguish in the financial press.

In the circumstances the best option for the policymaker is to find ways of reducing substantially the net flows of FII investments into India's markets. This would help focus attention on the creation of real wealth as well as remove barriers to the creation of such wealth, such as the constant pressure to provide tax concessions that erode the tax base and the persisting obsession with curtailing fiscal deficits, both of which are driven by dependence on finance capital.

India in the recent past few years seems to have received a disproportionately large part of its foreign investment flows via the FII investments in the equity markets. The large build-up of foreign exchange reserves through FII inflows poses a potential threat of destabilization of the economy. Portfolio flows are most often referred to as “hot money” that can be notoriously volatile when compared to other forms of capital flows. The Mexican crisis and the East Asian crisis are classic examples of the damage that sudden outflows of portfolio money can do to an economy. Without immediately implicating any significant withdrawal of funds out of India of crisis precipitating proportions, it needs to be noted that outflows of FII capital from the market could adversely impact the value of the Indian currency as FII inflows form the most significant part of foreign inflows into the economy.

There are likely to be repercussions on the growth momentum of the Indian economy if FII inflows significantly slow down. This is because a large extent of buoyancy in consumption was possible due to the positive wealth effects of a booming stock market and a decline in the interest rates due to a large overhang of rupee liquidity in the system (also a byproduct of large FII inflows over the last few years). Therefore, if FII inflows were to slow down, it will reduce the wealth generated by the stock market, the Indian currency will depreciate and RBI will have to draw down on the foreign exchange reserves or hike interest rates to prevent wild swings in the exchange rate.

Conclusion
There is little doubt that FII inflows have significantly grown in importance over the last few years. In the absence of any other substantial form of capital inflows, the potential ill effects of a reduction in the FII flows into the Indian economy can be severe. Thus, it cannot be concluded that FII inflows are per-se bad but there is a need to gear up macro-economic policies to target other form of foreign investments into the economy and reduce the over-reliance of the economy on portfolio flows. Therefore, policy measures to ‘develop’ equity market should aim to encourage small domestic investors to participate in it and counter the tendency of the FIIs to destabilize the emerging equity market.

Bibliography
# Handbook of Statistics on Indian Economy, RBI, 2005
# Economic Survey 2004-05 Ministry of Finance, Government of India
# Emerging Equity Market in India: Role of Foreign Institutional Investors Kishore C. Samal Economic and Political Weekly, Vol. 32, No. 42 (Oct. 18-24, 1997), pp. 2729-2732
# http://www.mbaknol.com/financial-management/capital-market-reforms-by-the-sebi/
# http://www.scribd.com/doc/25381962/FII-in-India-Sept-09
# KPM Sundaram Indian Economy Edition 2009

The  author can be reached at: rashmiperumal@legalserviceindia.com

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