Role of FIIs in present context

Post 1991, our country has succeeded in striking the right chord with foreign investors,
though the pace of such development was slow. FII money flowing into the Indian stock
markets is definitely not a new phenomenon, and much is written about this issue in the
media and academia.

FIIs are more than just money. They represent something unquantifiable known as
investors' sentiment. I guess thats why we get a bit anxious when there are sudden FII
outflows, since such behavior MAY reflect a change in investor sentiment.

Macro-economic importance of FII flows for India

A survey of literature on portfolio investments revealed the importance of such

investments for a developing economy like India’s. Foremost, FII investments are non-
debt creating flows, also a reason why Indian policy makers sought to liberalize such
flows in the wake of the BOP crisis in 1990-91. Theoretically, FII investments bring in
global liquidity into the equity markets and raise the price-earning ratio and thereby
reduce the cost of capital domestically. FII inflows help supplement domestic savings
and smoothen inter-temporal consumption. Studies indicate a positive relationship
between portfolio flows and the growth performance of an economy, though such
specific studies for India were not found.

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. While
in the last three years the average share of FII in the total foreign investments was
above 70%, this is almost double the average share of around 36% of FII investments in
the three years of FY01 to FY03. More so, FII inflows have significantly contributed to
the Balance of Payments surplus in the last three years. Our analysis indicates that FII
inflows as a percentage of the BOP surplus was at around 35% in the most recent last
three years while the average from FY95 to FY03 had been only around 4.5%. Exhibit 3
also indicates that FII inflows had significantly contributed to the sharp increase in the
foreign exchange reserves of the economy.

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. Indeed, the recent soft trends in FII
inflows in May had led the Indian currency to depreciate against the US dollar The risk
of a large depreciation is even more as we are in a situation where the higher
international price of crude oil has led to a significant weakening of the current account
deficit. In other words, in the event of a significant tapering off of FII inflows, $/Re could
depreciate sharply in consonance to a widening current account deficit, as the other
forms of capital inflows into the economy are not significant enough.

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,
while I do not indicate that FII inflows are per-se bad, there is possibly 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.