PROJECT REPORT

ON

“IMPACT OF FII’S AND FDI’S ON

INDIAN STOCK MARKET”

A Dissertation report submitted in partial fulfillment of the

requirement for the MBA degree course of Bangalore
University

By
NITHYASHREE .T.
Reg. No. 03VWCM6067
(2003-2005)

Under the guidance and support of

Prof. R.Narayanaswamy
Faculty
Alliance Business Academy

ALLIANCE BUSINESS ACADEMY

BANGALORE – 560 076
2003-05
 DECLARATION

I, NITHYASHREE.T. of MBA IV Semester, studying at Alliance Business

Academy, Bangalore, hereby declare that this project titled “Foreign Institutional
Investments and Influence of Foreign Institutional Investments on the Equity
Stock Market of India ” has been prepared by me in partial fulfillment of the
requirements of the Bangalore University MBA programme during 2003-2005.

I further declare that this project has not been submitted earlier in any other
university or institution for the award of any degree or diploma.

DATE:

PLACE: BANGALORE NITHYASHREE.T.

 GUIDE CERTIFICATION

This is to certify that NITHYASHREE T. student of MBA IV

semester of our Institute has completed her DISSERTATION on
the topic “FII investments and its influence on Indian Stock
Market”, under my guidance, and that no part of this report has
been submitted for the award of any other Degree or Diploma to
any other Board or University by any one else.

Date:
Place: Bangalore

Prof.R.Narayanaswamy
Faculty
Alliance Business Academy
 ACKNOWLEDGEMENT

The satiation and euphonies that accompany the success completion of a task would be
incomplete without a mention of people who made it possible. So, with immense gratitude, I
acknowledge all those, whose guidance and encouragement served as a beacon light and crowned
my effort with success.

I thank Mr. R.Narayanaswamy, Faculty of Alliance Business Academy and my project

guide for his valuable guidance and suggestions, which were vital inputs towards the
completion of the project.

I am indebted to Dr. Mihir Das, Faculty of Alliance Business Academy for his help in
analysing, interpreting the data and for the stimulating discussion which has greatly
added to the study.

Lastly, I would like to thank all those who have directly or indirectly helped me complete
the project successfully.

NITHYASHREE.T.
 RESEARCH ABSTRACT

Since the beginning of liberalization FII flows to India have steadily grown in
importance. In this paper we analyze these flows and their relationship with Indian equity
market. Foreign capital flows have come to be acknowledged as one of
the important sources of funds for economies that would like to grow
at a rate higher than what their domestic savings can support. Foreign
capital flows have particularly become prominent after the advent of
globalization that has led to widespread implementation of
liberalization
programmes and financial reforms in various countries across the
globe in 1990s. This resulted in the integration of global financial
markets. As a result, capital started flowing freely across national
borders seeking out the highest rate of return.

Foreign portfolio inflows through FIIs, in India, are important from the policy
perspective, especially when the country has emerged as one of the most attractive
investment destinations in Asia. This paper reveals if the FIIs influence the Indian Equity
Market.
 CHAPTER 1

THEORETICAL BACKGROUND

Introduction

When people think about globalization, they often first think of the increasing volume
of trade in goods and services. Trade flows are indeed one of the most visible aspects
of globalization. But many analysts argue that international investment is a much
more powerful force in propelling the world toward closer economic integration.
Investment, often alters entire methods of production through transfers of know-how,
technology and management techniques, and thereby initiates much more significant
change than the simple trading of goods.

Over the past ten years, foreign investment has grown at a significantly more rapid
pace than either international trade or world economic production generally. From
1980 to 1998, international capital flows, a key indication of investment across
borders, grew by almost 25% annually, compared to the 5% growth rate of
international trade. This investment has been a powerful catalyst for economic
growth.

But as with many of the other aspects of globalisation, foreign investment is raising
many new questions about economic, cultural and political relationships around the
world. Flows of investment and the rules that govern or fail to govern it can have
profound impacts upon such diverse issues as economic development, environmental
protection, labour standards and economic stability.

Forms of Foreign Investment

International investment or capital flows fall into four principal categories:

Commercial loans: These primarily take the form of loans by banks to foreign
businesses or governments.

Official flows: This category refers generally to the forms of development assistance
given by developed countries to developing ones.
Foreign Direct Investment (FDI): This category refers to international investment in
which the investor obtains a lasting interest in an enterprise in another country. FDI is
calculated to include all kinds of capital contributions, such as the purchases of
stocks, as well as the reinvestment of earnings by a wholly owned company
incorporated abroad (subsidiary), and the lending of funds to a foreign subsidiary or
branch. The reinvestment of earnings and transfer of assets between a parent company
and its subsidiary often constitutes a significant part of FDI calculations. An investor's
earnings on FDI take the form of profits such as dividends, retained earnings,
management fees and royalty payments.

Foreign Portfolio Investment (FPI): FPI is a category of investment instruments

that are more easily traded, may be less permanent, and do not represent a controlling
stake in an enterprise. These include investments via equity instruments (stocks) or
debt (bonds) of a foreign enterprise which does not necessarily represent a long-term
interest. The returns that an investor acquires on FPI usually take the form of interest
payments or non-voting dividends. Investments in FPI that are made for less than one
year are distinguished as short-term portfolio flows.

Until the 1980s, commercial loans from banks were the largest source of foreign
investment in developing countries. However, since that time, the levels of lending
through commercial loans have remained relatively constant, while the levels of
global FDI and FPI have increased dramatically. Over the period 1991 - 1998, FDI
and FPI comprised 90% of the total capital flows to developing countries.

Similarly, when viewed against the tremendous and growing volume of FDI and FPI,
the funds provided in the past by governments through official development
assistance, or lending by commercial banks the World Bank or IMF, are diminishing
in importance with each passing year. When one talks about the recent phenomenon
of globalization therefore, one is referring in large part to the effects of FDI and FPI,
and these two instruments will therefore be the primary focus of this issue brief.
Calculating Investment:

Calculations of FDI and FPI are typically measured as either a "flow," referring to the
amount of investment made in one year, or as "stock," measuring the total
accumulated investment at the end of that year.

Differences Between Portfolio and Direct Investment

One of the most important distinctions between Portfolio and Direct investment to
have emerged from this young era of globalisation is that portfolio investment can be
much more volatile. Changes in the investment conditions in a country or region can
lead to dramatic swings in portfolio investment. For a country on the rise, FPI can
bring about rapid development, helping an emerging economy move quickly to take
advantage of economic opportunity, creating many new jobs and significant wealth.
However, when a country's economic situation takes a downturn, sometimes just by
failing to meet the expectations of international investors, the large flow of money
into a country can turn into a stampede away from it.

By contrast, because FDI implies a controlling stake in a business, and often connotes
ownership of physical assets such as a equipment, buildings and real estate, FDI is
more difficult to pull out or sell off. Consequently, direct investors may be more
committed to managing their international investments, and less likely to pull out at
the first sign of trouble.

This volatility has effects beyond the specific industries in which foreign investments
have been made. Because capital flows can also affect the exchange rate of a nation's
currency, a quick withdrawal of investment can lead to rapid decline in the purchasing
power of a currency, rapidly rising prices (inflation) and then panic buying to avoid
still higher prices. In short, such quick withdrawals can produce widespread economic
crisis. This was partly the case in the Asian Economic Crisis that began in 1997.
Although the economic turmoil began as a result of some broader shifts in
international economic policy and some serious problems within the banking and
financial sectors of the affected East Asian nations, the capital flight which ensued --
some compared it to the great financial panics which took place in the United States
during the 19th century -- significantly exacerbated the crisis.
Why Do Companies Invest Overseas?

Companies choose to invest in foreign markets for a number of reasons, often the
same reasons for expanding their operations within their home country. The
economist John Dunning has identified four primary reasons for corporate foreign
investments:

Market seeking - Firms may go overseas to find new buyers for goods and services.
Market-seeking may happen when producers have saturated sales in their home
market, or when they believe investments overseas will bring higher returns than
additional investments at home. This is often the case with high technology goods.

Resource seeking - Put simply, a company may find it cheaper to produce its product
in a foreign subsidiary- for the purpose of selling it either at home or in foreign
markets. The foreign facility may be able to obtain superior or less costly access to the
inputs of production (land, labor, capital and natural resources) than at home.

Strategic asset seeking - Firms may seek to invest in other companies abroad to help
build strategic assets, such as distribution networks or new technology. This may
involve the establishment of partnerships with other existing foreign firms that
specialize in certain aspects of production.

Efficiency seeking - Multinational companies may also seek to reorganize their

overseas holdings in response to broader economic changes. Fluctuations in exchange
rates may also change the profit calculations of a firm, leading the firm to shift the
allocation of its resources.

Foreign Investment Increased so Dramatically in recent Decades?

As stated earlier in this brief, international investment levels have exploded in recent
decades. These increases in the flows of foreign investment have themselves marked a
new and distinct phenomenon in the era of globalisation. Several factors have helped
drive this growth:
1) Technology. Telecommunications and transportation advances have simply made
it easier to do business across large distances. As former President Clinton once
pointed out, in the 1960s, transatlantic telephone lines could only accommodate 80
simultaneous calls between Europe and the United States. Today, satellites and other
telecommunications infrastructure can handle one million calls at one time.
Fax machines, email and the drop in the cost of air travel have also contributed
significantly to the growth of FDI. As you can imagine, a business owner might think
twice about trying to run an affiliate in a foreign country if communication with that
office were not both easy and cheap. Changes in practices tend to be driven by
changes in capabilities, and these new methods to communicate have unquestionably
helped drive much of the subsequent desire to promote economic integration.

2) The lure of higher profits. Many countries in East Asia had built their
phenomenal growth on a foundation based on greater integration into the international
economy, particularly emphasizing export-led growth. Investors from around the
world realized that access to East Asian markets and their trading partners might help
them attain much higher returns on their investments than they could obtain at home.

3) Financial liberalization. Prior many countries imposed strict limits on the rights
of companies and individuals to invest overseas, to purchase foreign securities, or
even to hold foreign currencies. Many of these restrictions were put in place following
the Great Depression of the 1930's, which had produced volatile movements of
capital, triggering financial panics in some cases. Financial liberalization has been the
most direct, and probably the single biggest, factor accounting for the growth of
international investment flows over the past several decades.

Factors Influencing Foreign Investment Decisions

Now that you understand the basic economic reasons why companies choose to invest
in foreign markets, and what forms that investment may take, it is important to
understand the other factors that influence where and why companies decide to invest
overseas. These other factors relate not only to the overall economic outlook for a
country, but also to economic policy decisions taken by foreign governments, aspects
that can be very political and controversial.
The policy frameworks relating to FDI and FPI are relatively similar, although there
are a few differences.

The determinants of FPI are somewhat complex because portfolio investment

earnings are more likely to be tied to the broader macroeconomic indicators of a
country, such as overall market capitalization of an economy, they can be more
sensitive to factors such as:

• high national economic growth rates

• exchange rate stability
• general macroeconomic stability
• levels of foreign exchange reserves held by the central bank
• general health of the foreign banking system
• liquidity of the stock and bond market
• interest rates

In addition to these general economic indicators, portfolio investors also look at the
economic policy environment as well, and especially at factors such as:

• the ease of repatriating dividends and capital

• taxes on capital gains
• regulation of the stock and bond markets
• the quality of domestic accounting and disclosure systems
• the speed and reliability of dispute settlement systems
• the degree of protection of investor's rights

SURVEY OF LITERATURE:
Balance of Payments is a statistical record of ALL of a country's int'l transactions
with the rest of the world, over a certain time period (quarter or year), using double-
entry bookkeeping. (private transactions and government transactions).

Examples of International Transactions in BALANCE OF PAYMENT:

1. Imports (M) and Exports (X) of a) goods/merchandise and b) services

2. Cross-border Financial flows (investments in foreign stocks and bonds, real
estate, interest/DIV income, business investment, FDI, etc.)
3. Foreign Aid

BALANCE OF PAYMENT ACCOUNTS

1. CURRENT ACCOUNT
Exports (X) / Imports (M) of: a) Merchandise, b) Services, c) Factor income and d)
Unilateral (one way) government transfers.
Balance on Current Account (CA) = X + M + Net Transfer

2. CAPITAL ACCOUNT
Record of the Sales of Indian Assets (Stocks, bonds, real estate, businesses) to
foreigners, X of assets, resulting in a capital inflow, or a Credit (cash inflow); and the
Purchases of Foreign assets by Indians, M of assets, capital outflow, Debit (cash
outflow).
Specifically:

a. Foreign Direct Investment (FDI)

Refers to international investment in which the investor obtains a lasting interest in an
enterprise in another country. Most concretely, it may take the form of buying or
constructing a factory in a foreign country or adding improvements to such a facility,
in the form of property, plants or equipment.

b. Portfolio Investment:
 Purchases/sales of stocks, bonds, notes, mutual funds, money market securities,
options, etc., in foreign capital markets not involving controlling interest.
International portfolio investments have increased significantly recently due to a)
relaxation/deregulation of capital controls (increased capital mobility) and b) a desire
for International portfolio diversification (most security returns have a low correlation
among countries, resulting in risk reduction).

3. OTHER ACCOUNTS

HOME BIAS IN PORTFOLIO HOLDINGS

Despite significant and obvious gains from International portfolio diversification,
investors demonstrate a "home bias" and allocate a disproportionate share of funds to
domestic securities.
Excessive transactions costs:
1. Information costs, language barriers
2. Possible unfavorable tax treatment
3. Legal barriers to foreign investment
4. Currency, inflation risk

FII flows and contemporaneous stock returns are strongly correlated in India. The
correlation coefficients between different measures of FII flows and market returns on
the Bombay Stock Exchange during different sample periods.

Positive correlations have often been held as evidence of FII actions determining
Indian equity market returns. However, correlation itself does not imply causality.
A positive relationship between portfolio inflows and stock returns is consistent with
at least four distinct theories:
1) the “omitted variables” hypothesis;
2) the “downward sloping demand curve” view;
3) the “base-broadening” theory; and
4) the “positive feedback strategy” view.
The “omitted variables” view is the classic case of spurious correlation – that the
correlated variables, in fact, have no causal relationship between them but are both
affected by one or more other variables missed out in the analysis.

The “downward sloping demand curve” view contends that foreign investment creates
a buying pressure for stocks in the emerging market in question and causes stock
prices to rise much in the same way as suddenly higher demand for a commodity
would cause its price to rise.

The ‘base-broadening’ argument contends that once foreigners begin to invest in a

country, the financial markets in that country are now no longer moved by national
economic factors alone but rather begin to be affected by foreign market movements
as well. As the market itself is now affected by more factors than before, its exposure
to domestic shocks decline. Consequently the ‘risk’ of the market itself falls, people
demand a lower risk premium to buy stocks, and stock prices rise to higher levels.

Finally the ‘positive feedback view’ asserts that if investors ‘chase’ returns in the
immediate past (like the previous day or week) then aggregating their fund flows over
the month can lead to a positive relationship in the contemporaneous monthly data.
In the present context, both directions of causation are equally plausible.

The positive relationship between market return and FII flows, however, serves only
as a first-pass in understanding the nature of such flows and their implications for the
Indian markets. Since the FII flows essentially serve to diversify the portfolio of
foreign investors, it is only normal to expect that several factors – both domestic as
well as external to India – are likely to affect them along with the expected stock
returns in India. The declining world interest rates have been among the important
“push” factors for international portfolio flows in the early 90’s. The “usual suspects”
in the literature include:
US and world equity returns, changes in interest rates, stock market volatility, some
measure of the country risk and the exchange rate. Other factors that may affect FII
flows Country risk measures, that incorporate political and other risks in addition to
the usual economic and financial variables, may be expected to have an impact on
portfolio flows to India though they are likely to matter more in the case of FDI flows.
 CHAPTER 2
DESIGN OF THE STUDY

TITLE OF THE STUDY

“FOREIGN INSTUTIONAL INVESTMENTS AND THE INFLUENCE OF
FOREIGN INSTITUTIONAL INVESTMENTS ON EQUITY STOCK MARKET IN
INDIA”.

STATEMENT OF THE PROBLEM

In this research an effort has been made to develop an understanding of the influence
of the FIIs in the Indian equity market. The Foreign Institutional Investors (FIIs) have
emerged as important players in the Indian equity market in the recent past. This
paper makes an attempt to understand whether there exists a relationship between FII
and Equity Market returns in India.

OBJECTIVES OF THE STUDY

 Analyse the trends of Foreign Investment flows and Foreign Institutional Inflows.
 Analyse the Yearly trends of FII purchases, FII sales and Net Investment.
 Analyse the reason for the major decline of Net Investment in the year 1998-99.
 Examine whether FIIs have any influence on Equity Stock Market.

SCOPE OF THE STUDY

The report examines The Influence of Foreign Institutional Investments on Equity
Stock Market in India. The scope of the research comprises of information derived
from secondary data from various websites. The various information and statistics
were derived from the websites of BSE, NSE, Money Control, RBI and SEBI. Sensex
and Nifty was a natural choice for inclusion in the study, as it is the most popular
market indicies and widely used by market participants for benchmarking.

REFERENCE PERIOD
The study period covered under this is for the financial year : 1st April 2004 to 31st
March 2005.
RESEARCH DESIGN:
TYPE OF RESEARCH:

SOURCES OF DATA
The main source of obtaining necessary data for the study was Secondary Data. This
study is empirical in nature and hence secondary data is used to conduct the research.
The data was collected from the Internet by exploring the Secondary sources available
on websites.
Secondary Data: The secondary data constitutes of daily FII flows data which was
collected from Money Control and Equity Master, the daily returns of SENSEX and
NIFTY from BSE and NSE websites respectively. The trends in FII flows from the
RBI website and information on FII from SEBI.

PLAN OF ANALYSIS
The data gathered from various sources were primarily studied and necessary data
was sorted out sequentially keeping in mind the procedure of the study. The analysis
has been made by, correlating the FII purchases, sales and net investment with equity
market returns to identify whether a relation exists between them. Findings are
included which transmits the important points, which were gathered from the study.

METHODOLOGY

1. Form a testable hypothesis

2. Collect relevant data to test hypothesis
3. Perform statistical analysis.
4. Interpret the results.

HYPOTHESIS
Null Hypothesis (Ho): There is no influence of FIIs on the Stock indexes.
Alternative Hypothesis (Ha): There is an influence of FIIs on Stock indexes.
If we reject the Ho, then we accept the Ha, setting the significance level to 5% and
1% at Degree of Freedom = n-2.

LIMITATIONS OF THE STUDY

As the time available is limited and the subject is very vast the study is mainly
focused on identifying whether there does exist a relationship between FIIs and Indian
Equity Stock Market.
• The study is general.
• It is mainly based on the data available in various websites;
• The inferences made is purely from the past year’s performance;
• There is no particular format for the study;
• Sufficient time is not available to conduct an in-depth study;
 OPERATIONAL DEFINITIONS

Exchange rate of a nation's currency- Currency like other commodities, rises or

falls in "price" with demand. When investors leave, they sell their holdings in a
country's currency and as demand falls, the "price" of that currency will also fall

Gold standard-When a country is said to be on the Gold Standard, the value of its
currency and the quantity of its currency in circulation is tied the nation's reserve of
gold. Such a system tends to restrict the country's monetary supply.

OECD-The Organization for Economic Cooperation and Development (OECD) is a

descendant of the U.S.-European cooperation required to execute the Marshall Plan
and rebuild Europe after World War II. A tribute to the success of that effort is the
fact that the 30 or so members of the OECD now include Japan and Korea as well, are
thought of as the wealthy nations of the world.

Economies of Scale-Produces are often able to enjoy considerable production cost

savings by buying inputs in bulk, mass-producing or retailing their end product. These
lower costs achieved through expanded production are called Economies of Scale.

Debt/equity ratio-The debt/equity ratio measures the extent to which a firm's capital
is provided by lenders (through debt instruments such as fixed-return bonds) or
owners (through variable-return stocks). A greater reliance on financing through debt
can mean greater profitability for shareholders, but also greater risk in the event things
go sour.

International Monetary Fund-The IMF is an international organization of 183

member countries, established in 1947 to promote international monetary cooperation,
exchange stability, and orderly exchange arrangements; to foster economic growth
and high levels of employment; and to provide temporary financial assistance to
countries to help ease balance of payments adjustment.
Institutional Investor- An organization whose primary purpose is to invest its own
assets or those held in trust by it for others. includes pension funds, investment
companies, insurance companies, universities and banks.

Interest rates-Interest rates have a powerful effect on the volume of a nation's money
supply. By raising interest rates, i.e., making the cost of borrowing money more
expensive, governments or banks can decrease the money supply. A decrease in the
money supply tends to be counter-inflationary, which makes a currency more valuable
compared to other currencies.

Foreign Direct Investment (FDI)-This category refers to international investment in

which the investor obtains a lasting interest in an enterprise in another country. Most
concretely, it may take the form of buying or constructing a factory in a foreign
country or adding improvements to such a facility, in the form of property, plants or
equipment.

Foreign Portfolio Investment (FPI)-FPI is a category of investment instruments that

are more easily traded, may be less permanent, and do not represent a controlling
stake in an enterprise. These include investments via equity instruments (stocks) or
debt (bonds) of a foreign enterprise that does not necessarily represent a long-term
interest.

Most Favored Nation Treatment-The phrase "most favored nation" refers to the
obligation of the country receiving the investment to give that investment the same
treatment as it gives to investments from its "most favored" trading partner.

Balance of payments-The Balance of Payments (BOP) is a statistical statement that

summarizes, for a specific period (typically a year or quarter), the economic
transactions of an economy with the rest of the world. It covers:

• All the goods, services, factor income and current transfers an economy
receives from or provides to the rest of the world
• Capital transfers and changes in an economy's external financial claims and
liabilities
Portfolio investment – covers the acquisition and disposal of equity and debt
securities that cannot be classified under direct investment or reserve asset
transactions. These securities are tradable in organised financial markets.

FDI Flows and Stocks – Through direct investment flows the investors builds up a
direct investment stock (position), making part of the investor’s balance sheet. The
FDI stock (position) normally differs from accumulated flows because of revaluation
(changes in prices or exchange rates) and other adjustments like rescheduling or
cancellation of loans, debt forgiveness or debt-equity swaps with different values.

Multinational Companies (MNCs) – are incorporated or unincorporated enterprises

comprising parent enterprises and their foreign affiliates.

Foreign Direct Investor – A foreign direct investor is an individual, an incorporated

or unincorporated public or private enterprise, a government, a group of related
individuals, or a group of related incorporated and/or unincorporated enterprises
which have a direct investment enterprise that is a subsidiary, associate or branch –
operating in a country other than the country or countries of residence of the direct
investor or investors.

Host Economy – is the country that receives FDI or FPI from the foreign investor(s).

Home Economy – is the country of origin/residence of the company that invests in

the foreign economy/host economy.

Subsidiary – is an incorporated enterprise in the host country in which the foreign

investor owns more than 50 per cent of the shareholder’s voting power or has the right
to appoint or remove a majority of the members of this enterprise’s administrative,
management or supervisory body.

Equity capital – comprises of equity in branches and ordinary shares in subsidiaries

and associates.

Reinvested earnings – consist of the direct investor’s share of earnings not

distributed as dividends by subsidiaries or associates and earnings of branches not
remitted to the direct investor.
Other capital – covers inter-company debt (including short-term loans such as trade
credits) between direct investors and subsidiaries, branches and associates.

WTO – World Trade Organisation.

Correlation coefficient - measures the degree of co-movement between two

variables, simple measure of statistical association.

Coefficient of Determination (R2) - ranges from 0 - 1, is always part of the standard

regression output, the most important measure of goodness of fit. R2 = correlation
coefficient (r) squared, since the range of r is from -1 to +1, squaring r forces R2 to
fall between 0 and 1.
 CHAPTER 3
OVERVIEW OF CHAPTER SCHEME

CHAPTER 1 – Theoretical Background

This chapter deals with the theoretical background of the study throwing light on the
introduction, forms of Foreign Investment, Differences between Portfolio and Direct
Investment, factors influencing Foreign Investment decisions and a Survey of
Literature.

CHAPTER 2 – Design of the Study

This chapter states the problem of the study; the objectives of the study, the scope,
methodology, tools for collecting data, a plan of analysis, hypothesis and the
limitations of the study. The chapter also includes the operational definitions of the
terms commonly used in the study, along with which the chapter scheme is included.

CHAPTER 3 –Overview of Chapter Scheme

CHAPTER 4- Industry Profile

This chapter gives information on the Foreign Investment flows in India, Foreign
portfolio flows in India, Milestones of FII in India, Acts and Rules relating to FII, a
brief profile of SEBI, RBI, BSE and NSE.

CHAPTER 5 – Analysis and Interpretation of Data

This chapter deals with analysis and interpretation of the data collected. The purpose
of this chapter is to draw inferences, based on the calculations and statistics. Graphs
are also included to give a clear view of the data analysed.

CHAPTER 6 – Findings, Recommendations and Conclusion.

This chapter is the concluding chapter dealing with findings, recommendations and
conclusion which are drawn after the study on Influence of FIIs in Equity Stock
Market.

CHAPTER 4

INDUSTRY PROFILE

INVESTMENT IN INDIAN MARKET

India is believed to be a good investment despite political uncertainty, bureaucratic
hassles, shortages of power and infrastructure deficiencies. India presents a vast
potential for overseas investment and is actively encouraging the entrance of foreign
players into the market. No company, of any size, aspiring to be a global player can,
for long ignore this country, which is expected to become one of the top three
emerging economies.

Success in India
Success in India will depend on the correct estimation of the country's potential;
underestimation of its complexity or overestimation of its possibilities can lead to
failure. While calculating, due consideration should be given to the factor of the
inherent difficulties and uncertainties of functioning in the Indian system. Entering
India's marketplace requires a well-designed plan backed by serious thought and
careful research. For those who take the time and look to India as an opportunity for
long-term growth, not short-term profit- the trip will be well worth the effort.

Market potential
India is the fifth largest economy in the world (ranking above France, Italy, the United
Kingdom, and Russia) and has the third largest GDP in the entire continent of Asia. It
is also the second largest among emerging nations. (These indicators are based on
purchasing power parity). India is also one of the few markets in the world, which
offers high prospects for growth and earning potential in practically all areas of
business. Despite the practically unlimited possibilities in India for overseas
businesses, the world's most populous democracy has, until fairly recently, failed to
get the kind of enthusiastic attention generated by other emerging economies such as
China.

Lack of enthusiasm among investors

The reason being, after independence from Britain 50 years ago, India developed a
highly protected, semi-socialist autarkic economy. Structural and bureaucratic
impediments were vigorously fostered, along with a distrust of foreign business. Even
as today the climate in India has seen a sea change, smashing barriers and actively
seeking foreign investment, many companies still see it as a difficult market. India is
rightfully quoted to be an incomparable country and is both frustrating and
challenging at the same time. Foreign investors should be prepared to take India as it
is with all of its difficulties, contradictions and challenges.

Developing a basic understanding or potential of the Indian market

Envisaging and developing a Market Entry Strategy and implementing these strategies
when actually entering the market are three basic steps to make a successful entry into
India. The Indian middle class is large and growing; wages are low; many workers are
well educated and speak English; investors are optimistic and local stocks are up;
despite political turmoil, the country presses on with economic reforms. But there is
still cause for worries- Infrastructure hassles.

The rapid economic growth of the last few years has put heavy stress on India's
infrastructure facilities. The projections of further expansion in key areas could snap
the already strained lines of transportation unless massive programs of expansion and
modernization are put in place. Problems include power demand shortfall, port traffic
capacity mismatch, poor road conditions (only half of the country's roads are
surfaced) and low telephone penetration.

Indian Bureaucracy
Although the Indian government is well aware of the need for reform and is pushing
ahead in this area, business still has to deal with an inefficient and sometimes still
slow-moving bureaucracy.

Diverse Market
The Indian market is widely diverse. The country has 17 official languages, 6 major
religions, and ethnic diversity as wide as all of Europe. Thus, tastes and preferences
differ greatly among sections of consumers. Therefore, it is advisable to develop a
good understanding of the Indian market and overall economy before taking the
plunge.

INTERNATIONAL PORTFOLIO FLOWS:

International portfolio flows, as opposed to foreign direct investment (FDI) flows,
refer to capital flows made by individuals or investors seeking to create an
internationally diversified portfolio rather than to acquire management control over
foreign companies. Diversifying internationally has long been known as a way to
reduce the overall portfolio risk and even earn higher returns. Investors in developed
countries can effectively enhance their portfolio performance by adding foreign stocks
particularly those from emerging market countries where stock markets have
relatively low correlations with those in developed countries.

International portfolio flows are largely determined by the performance of the stock
markets of the host countries relative to world markets. With the opening of stock
markets in various emerging economies to foreign investors, investors in industrial
countries have increasingly sought to realize the potential for portfolio diversification
that these markets present.

It is likely that for quite a few years to come, FII flows would increase with global
integration. The main question is whether capital flew in to these countries primarily
as a result of changes in global (largely US) factors or in response to events and
indicators in the recipient countries like its credit rating and domestic stock market
return. The answer is mixed – both global and country-specific factors seem to matter,
with the latter being particularly important in the case of Asian countries and for debt
flows rather than equity flows.

FOREIGN INVESTMENT FLOWS IN INDIA:

One of the most important distinctions between Portfolio and Direct investment to
have emerged from this young era of globalisation is that portfolio investment can be
much more volatile.

TABLE: Foreign Investment Flows in India

Year A. Direct Investment B. Portfolio Investment Total (A + B)
(US $ million) (US $ million) (US $ million)
1990-91 97 6 103
1991-92 129 4 133
1992-93 315 244 559
1993-94 586 3567 4153
1994-95 1314 3824 5138
1995-96 2144 2748 4892
1996-97 2821 3312 6133
1997-98 3557 1828 5385
1998-99 2462 61 2523
1999-00 2155 3026 5181
2000-01 4029 2760 6789
2001-02 6131 2021 8152
2002-03 4660 979 5639
2003-04 4675 11377 16052

From a net foreign investment inflow of US $ 5.3 billion in 1997-98, such inflows
declined to US $ 2.4 billion in 1998-99. This is because of the lower portfolio
inflows, as a result of which the net investment has dropped. The changes in the
investment conditions in a country or region can lead to dramatic swings in portfolio
investment. For a country on the rise, in other words for developing countries, FPI can
bring about rapid development, helping an emerging economy move quickly to take
advantage of economic opportunity, creating many new jobs and significant wealth.
However, when a country's economic situation takes a downturn, sometimes just by
failing to meet the expectations of international investors, the large flow of money
into a country can turn into a stampede away from it.
 CHART: FOREIGN INVESTMENT FLOWS

12000

10000

8000

6000

4000

2000

0
1990-91 1991-92 1992- 1993- 1994-95 1995-96 1996-97 1997-98 1998- 1999- 2000- 2001- 2002- 2003-
93 94 99 00 01 02 03 04
FPI FDI Y EA R

FOREIGN PORTFOLIO FLOWS TO INDIA

Foreign portfolio investments have been allowed in India on the basis of the
recommendations of the Narasimham committee which stated:

The committee would also suggest that the capital markets should be gradually
opened up to foreign portfolio investments and simultaneously efforts should be
initiated to improve the depth of the market by facilitating the issue of new types of
equities and innovative debt instruments.’ (Narasimham committee report)

Prior to 1992, only non-resident Indians (NRIs) and Overseas corporate bodies
(OCBs) were allowed to undertake portfolio investment in India. Only on September
14, 1992 the Government of India issued guidelines on FII investments in India which
was followed by a notification by Securities and Exchange Board of India (SEBI)
three years later in November 1995.
FOREIGN INSTITUTIONAL INVESTMENT IN INDIA: MILESTONES

 India embarked on a programme of economic reforms in the early 1990s to tie

over its balance of payment crisis and also as a step towards globalisation.
 An important milestone in the history of Indian economic reforms happened on
September 14, 1992, when the FIIs (Foreign Institutional Investors) were allowed 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 the stock exchanges in India and in the schemes floated by domestic mutual
funds.
 Initially, the holding of a single FII and of all FIIs, NRIs (Non-Resident Indians)
and OCBs (Overseas Corporate Bodies) in any company were subject to a limit of 5%
and 24% of the company's total issued capital respectively.
 In order to broad base the FII investment and to ensure that such an investment
would not become a camouflage for individual investment in the nature of FDI
(Foreign Direct Investment), a condition was laid down that the funds invested by FIIs
had to have at least 50 participants with no one holding more than 5%. Ever since this
day, the regulations on FII investment have gone through enormous changes and have
become more liberal over time.
 From November 1996, FIIs were allowed to make 100% investment in debt
securities subject to specific approval from SEBI as a separate category of FIIs or sub-
accounts as 100% debt funds. Such investments were, of course, subjected to the
fund-specific ceiling prescribed by SEBI and had to be within an overall ceiling of US
$ 1.5 billion. The investments were, however, restricted to the debt instruments of
companies listed or to be listed on the stock exchanges.
* In 1997, the aggregate limit on investment by all FIIs was allowed to be raised from
24% to 30% by the Board of Directors of individual companies by passing a
resolution in their meeting and by a special resolution to that effect in the company's
General Body meeting.
 From the year 1998, the FII investments were also allowed in the dated
government securities, treasury bills and money market instruments.
 In 2000, the foreign corporates and high net worth individuals were also allowed
to invest as sub-accounts of SEBI-registered FIIs. FIIs were also permitted to seek
SEBI registration in respect of sub-accounts. This was made more liberal to include
the domestic portfolio managers or domestic asset management companies.
 40% became the ceiling on aggregate FII portfolio investment in March 2000.
 This was subsequently raised to 49% on March 8, 2001 and to the specific sectoral
cap in September 2001.
 As a move towards further liberalization a committee was set up on March 13,
2002 to identify the sectors in which FIIs portfolio investments will not be subject to
the sectoral limits for FDI.
 Later, on December 27, 2002 the committee was reconstituted and came out with
recommendations in June 2004. The committee had proposed that, 'In general, FII
investment ceilings, if any, may be reckoned over and above prescribed FDI sectoral
caps. The 24 per cent limit on FII investment imposed in 1992 when allowing FII
inflows was exclusive of the FDI limit. The suggested measure will be in conformity
with this original stipulation.' The committee also has recommended that the special
procedure for raising FII investments beyond 24 per cent up to the FDI limit in a
company may be dispensed with by amending the relevant regulations.
 Meanwhile, the increase in investment ceiling for FIIs in debt funds from US $ 1
billion to US $ 1.75 billion has been notified in 2004. The SEBI also has reduced the
turnaround time for processing of FII applications for registrations from 13 working
days to 7 working days except in the case of banks and subsidiaries.

All these are indications for the country's continuous efforts to mobilize more foreign
investment through portfolio investment by FIIs. The FII portfolio flows have also
been on the rise since September 1992. Their investments have always been net
positive, but for 1998-99, when their sales were more than their purchase
ACTS AND RULES

FII registration and investment are mainly governed by SEBI (FII) Regulations,
1995.

ELIGIBILITY FOR REGISTRATION AS FII: Following entities / funds are

eligible to get registered as FII:
1. Pension Funds
2. Mutual Funds
3. Insurance Companies
4. Investment Trusts
5. Banks
6. University Fund s
7. Endowments
8. Foundations
9. Charitable Trusts / Charitable Societies
Further, following entities proposing to invest on behalf of broad based funds(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) , are
also eligible to be registered as FIIs:
1. Asset Management Companies
2. Institutional Portfolio Managers
3. Trustees
4. Power of Attorney Holders

INVESTMENT OPPORTUNITIES FOR FIIs

The following financial instruments are available for FII investments
a) Securities in primary and secondary markets including shares, debentures and
warrants of companies, unlisted, listed or to be listed on a recognized stock exchange
in India;
b) Units of mutual funds;
c) Dated Government Securities;
d) Derivatives traded on a recognized stock exchange ;
e) Commercial papers.
Investment limits on equity investments
a) FII, on its own behalf, shall not invest in equity more than 10% of total issued
capital of an Indian company.
b) Investment on behalf of each sub-account shall not exceed 10% of total issued
capital of an India company.
c) For the sub-account registered under Foreign Companies/Individual category, the
investment limit is fixed at 5% of issued capital.
These limits are within overall limit of 24% / 49 % / or the sectoral caps a prescribed
by Government of India / Reserve Bank of India.

Investment limits on debt investments

The FII investments in debt securities are governed by the policy if the Government
of India. Currently following limits are in effect:
• For FII investments in Government debt, currently following limits are
applicable:

• For corporate debt the investment limit is fixed at US $ 500 million.

TAXATION
The taxation norms available to a FII is shown in the table below.
Nature of Income Tax Rate
Long-term capital gains 10%
Short-term capital gains 30%
Dividend Income Nil
Interest Income 20%
Long term capital gain: Capital gain on sale of securities held for a period of more
than one year.
Short term capital gain: Capital gain on sale of securities held for a period of less than
one year.

BRIEF PROFILE OF IMPORTANT INSTITUTIONS:

A brief profile of important institutions included in the study is given below.

RESERVE BANK OF INDIA

India's Central Bank - the RBI - was established on 1 April 1935 and was nationalized
on 1 January 1949. Some of its main objectives are regulating the issue of bank notes,
managing India's foreign exchange reserves, operating India's currency and credit
system with a view to securing monetary stability and developing India's financial
structure in line with national socio-economic objectives and policies.

The RBI acts as a banker to Central/State governments, commercial banks, state

cooperative banks and some financial institutions. It formulates and administers
monetary policy with a view to promoting stability of prices while encouraging higher
production through appropriate deployment of credit. The RBI plays an important role
in maintaining the exchange value of the Rupee and acts as an agent of the
government in respect of India's membership of IMF. The RBI also performs a variety
of developmental and promotional functions.

The first concern of a central bank is the maintenance of a soundly based commercial
banking structure. While this concern has grown to comprehend the operations of all
financial institutions, including the several groups of non-bank financial
intermediaries, the commercial banks remain the core of the banking system. A
central bank must also cooperate closely with the national government. Indeed, most
governments and central banks have become intimately associated in the formulation
of policy.
They are often responsible for formulating and implementing monetary and credit
policies, usually in cooperation with the government. they have been established
specifically to lead or regulate the banking system.

SECURITUIES AND EXCHANGE BOARD OF INDIA

In 1988 the Securities and Exchange Board of India (SEBI) was established by the
Government of India through an executive resolution, and was subsequently upgraded
as a fully autonomous body (a statutory Board) in the year 1992 with the passing of
the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In
place of Government Control, a statutory and autonomous regulatory board with
defined responsibilities, to cover both development & regulation of the market, and
independent powers have been set up.

The basic objectives of the Board were identified as:

• to protect the interests of investors in securities;

• to promote the development of Securities Market;
• to regulate the securities market and
• for matters connected therewith or incidental thereto.

Since its inception SEBI has been working targetting the securities and is attending to
the fulfillment of its objectives with commendable zeal and dexterity. The
improvements in the securities markets like capitalization requirements, margining,
establishment of clearing corporations etc. reduced the risk of credit and also reduced
the market.

SEBI has introduced the comprehensive regulatory measures, prescribed registration

norms, the eligibility criteria, the code of obligations and the code of conduct for
different intermediaries like, bankers to issue, merchant bankers, brokers and sub-
brokers, registrars, portfolio managers, credit rating agencies, underwriters and others.
It has framed bye-laws, risk identification and risk management systems for Clearing
houses of stock exchanges, surveillance system etc. which has made dealing in
securities both safe and transparent to the end investor.
Another significant event is the approval of trading in stock indices (like S&P CNX
Nifty & Sensex) in 2000. A market Index is a convenient and effective product
because of the following reasons:

• It acts as a barometer for market behavior;

• It is used to benchmark portfolio performance;
• It is used in derivative instruments like index futures and index options;
• It can be used for passive fund management as in case of Index Funds.

Two broad approaches of SEBI is to integrate the securities market at the national
level, and also to diversify the trading products, so that there is an increase in number
of traders including banks, financial institutions, insurance companies, mutual funds,
primary dealers etc. to transact through the Exchanges. In this context the introduction
of derivatives trading through Indian Stock Exchanges permitted by SEBI in 2000 AD
is a real landmark.

BOMBAY STOCK EXCHANGE:

Of the 22 stock exchanges in the country, Mumbai's (earlier known as Bombay),

Bombay Stock Exchange is the largest, with over 6,000 stocks listed. The BSE
accounts for over two thirds of the total trading volume in the country. Established in
1875, the exchange is also the oldest in Asia. Among the twenty-two Stock
Exchanges recognised by the Government of India under the Securities Contracts
(Regulation) Act, 1956, it was the first one to be recognised and it is the only one that
had the privilege of getting permanent recognition ab-initio.

Approximately 70,000 deals are executed on a daily basis, giving it one of the highest
per hour rates of trading in the world. There are around 3,500 companies in the
country which are listed and have a serious trading volume. The market capitalization
of the BSE is Rs.5 trillion. The BSE `Sensex' is a widely used market index for the
BSE.

The main aims and objectives of the BSE is to provide a market place for the purchase
and sale of security evidencing the ownership of business property or of a public or
business debt. It aims to promote, develop and maintain a well-regulated market for
dealing in securities and to safeguard the interest of members and the investing public
having dealings on the Exchange. It helps industrial development of the country
through efficient resource mobilization. To establish and promote honourable and just
practices in securities transactions

BSE Sensex
The BSE Sensex is a value-weighted index composed of 30 companies with the base
April 1979 = 100. It has grown by more than four times from January 1990 till date.
The set of companies in the index is essentially fixed. These companies account for
around one-fifth of the market capitalization of the BSE.

NATIONAL STOCK EXCHANGE OF INDIA

The National Stock Exchange of India Limited has genesis in the report of the High
Powered Study Group on Establishment of New Stock Exchanges, which
recommended promotion of a National Stock Exchange by financial institutions (FIs)
to provide access to investors from all across the country on an equal footing. Based
on the recommendations, NSE was promoted by leading Financial Institutions at the
behest of the Government of India and was incorporated in November 1992 as a tax-
paying company unlike other stock exchanges in the country.

On its recognition as a stock exchange under the Securities Contracts (Regulation)

Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market
(WDM) segment in June 1994. The Capital Market (Equities) segment commenced
operations in November 1994 and operations in Derivatives segment commenced in
June 2000.

S&P CNX Nifty

S&P CNX Nifty is a well-diversified 50 stock index accounting for 23 sectors of the
economy. It is used for a variety of purposes such as benchmarking fund portfolios,
index based derivatives and index funds.
S&P CNX Nifty is owned and managed by India Index Services and Products Ltd.
(IISL), which is a joint venture between NSE and CRISIL. IISL is India's first
specialised company focused upon the index as a core product. IISL have a consulting
and licensing agreement with Standard & Poor's (S&P), who are world leaders in
index services.

• The average total traded value for the last six months of all Nifty stocks is
approximately 58% of the traded value of all stocks on the NSE
• Nifty stocks represent about 60% of the total market capitalization as on
March 31, 2005.
• Impact cost of the S&P CNX Nifty for a portfolio size of Rs.5 million is
0.07%
• S&P CNX Nifty is professionally maintained and is ideal for derivatives
trading
 CHAPTER 4
ANALYSIS AND INTERPRETATION

Portfolio flows – often referred to as “hot money” – are notoriously volatile compared
to other forms of capital flows. Investors are known to pull back portfolio investments
at the slightest hint of trouble in the host country often leading to disastrous
consequences to its economy. They have been blamed for exacerbating small
economic problems in a country by making large and concerted withdrawals at the
first sign of economic weakness.

TRENDS IN FII INVESTMENT IN INDIA

TABLE : Trends in FII investment

Year FII PURCHASE FII SALES FII NET FII NET CUM FII NET
in crores in crores in crores US$ million US$ million
1993-94 5593 466 5126 1634 1638
1994-95 7631 2835 4796 1528 3167
1995-96 9694 2752 6942 2036 5202
1996-97 15554 6979 8575 2432 7634
1997-98 18695 12737 5958 1649 9284
1998-99 16115 17699 -1584 -386 8898
1999-00 56856 46734 10122 2339 11237
2000-01 74051 64116 9934 2160 13396
2001-02 49920 41165 8755 1846 15242
2002-03 47060 44371 2689 562 15804
2003-04 144858 99094 45765 9949 25754
Source: Reserve Bank of India Annual Report 2004

INFERENCE: The investments by FIIs have been registering a steady growth since
the opening of the Indian capital markets in September 1992. Their investments have
always been net positive, but for 1998-99, when their sales were more than their
purchases.
It can be observed from the above table that the portfolio investment inflows have
always been on the increase. But the years 2001-02 and 2002-03 saw some reversal in
the trend. From a net inflow of US $ 2.1 billion in 2000-01, such inflows declined to
US $ 1.8 billion in 2001-02, and further dropped to US $ 0.562 billion in 2002-03.
The decline is because of the lower portfolio inflows, as a result of which the net
investment has dropped in these years. However, this decline witnessed a sharp
reversal in the year 2003-04. FIIs have made a net investment of Rs. 45,764 crores
during this year registering a growth of 1602% over the previous year, creating a
record in the history of FII investment in India. Gross purchases in this year amounted
to Rs.144,857 crores, a growth rate of 208% compared to the year before. This trend
continued in April 2004, only to suffer reversal again during May and June 2004,
when the net investment became negative. Fortunately, the year from July 2004 has
been seeing a net positive portfolio flows by FIIs. As of September 2004, the net FII
portfolio investment stands at US $ 27,637 million. If it is so, then increasing the FII
investment cap per se will not be helpful. The country has to work on specific
measures to encourage more FII investments. The analysis of data indicates that there
has been substantial divestment by the FIIs during the year 1998-99. The maximum
outflow was during the months of May and June 1998 (almost US$430 millions).

CHART : Sources of FII in India

Source: Sebi website

INFERENCE: The sources of these FII flows are varied. The FIIs registered with
SEBI come from as many as 28 countries. US-based institutions accounted for
slightly over 41%, those from the UK constitute about 20% with other Western
European countries hosting another 17% of the FIIs). It is, however, instructive to
bear in mind that these national affiliations do not necessarily mean that the actual
investor funds come from these particular countries. Given the significant financial
flows among the industrial countries, national affiliations are very rough indicators of
the ‘home’ of the FII investments. In particular institutions operating from
Luxembourg, Cayman Islands or Channel Islands, or even those based at Singapore or
Hong Kong are likely to be investing funds largely on behalf of residents in other
countries. Nevertheless, the regional breakdown of the FIIs does provide an idea of
the relative importance of different regions of the world in the FII flows.

CHART : GROWTH OF FII INVESTMENTS IN INDIA

INFERENCE: The trickle of FII flows to India that began in January 1993 has
gradually expanded to an average monthly inflow of close to Rs. 1900 crores during
the first six months of 2001. By June 2001, over 500 FIIs were registered with SEBI.
The total amount of FII investment in India had accumulated to a formidable sum of
over Rs.50,000 crores during this time. In terms of market capitalization too, the share
of FIIs has steadily climbed to about 9% of the total market capitalization of BSE
(which, in turn, accounts for over 90% of the total market capitalization in India).

CHART: TRENDS IN YEARLY GROSS PURCHASES

160000 144858
GROSS PURCHASE (in Rs crores)

140000
120000
100000
74051
80000
56856
60000 49920 47060
40000
15554 18695 16115
20000 5593 7631 9694

0
1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04

YEAR
INFERENCE: On observation of the above chart of trends in yearly Gross
Purchases, the Gross Purchases of FIIs in India registered a record of Rs.144,857
crores in the year 2003-04, a growth rate of 208% compared to the previous year
2002-03. This trend continued in April 2004, only to suffer reversal again during May
and June 2004, when the net investment became negative.

CHART: TRENDS IN YEARLY GROSS SALES

120000

99094
100000
GROSS SALES (in Rs. crores)

80000
64116
60000
46734 44371
41165
40000

17699
20000 12737
6979
466 2835 2752
0
1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04

YEAR

INFERENCE
In the above chart we can see that during the year 2003-04 FIIs Gross Sales amounted
an increase Rs.99094 crores when compared to Rs. 44371 crores. The FIIs Gross
Sales shows an upward trend with reference to the base year of 1993-94 when the
Gross Sales where only Rs. 466 crores.
 CHART: TRENDS IN YEARLY NET INVESTMENT

12000
(in US$ million)

10000

8000

6000
NET INVESTMENT

4000

2000

0
1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04
-2000

YEAR

INFERENCE: From a net inflow of US $ 2.1 billion in 2000-01, such inflows

declined to US $ 1.8 billion in 2001-02, and further dropped to US $ 0.562 billion in
2002-03. The decline is because of the lower portfolio inflows, as a result of which
the net investment has dropped in these years. However, this decline witnessed a
sharp reversal in the year 2003-04. The country has to work on specific measures to
encourage more FII investments.

If one looks at the trend of portfolio equity investment in the Indian stock market
since 2002-03, it shows that there has been a very sharp increase in the net FII
investment in India since April 2003. For the financial year 2003-04, FIIs have
invested more than Rs 44,000 crore of portfolio capital in the Indian stock market. To
put this figure into perspective, for the period 1992-93 to 2002-03, the maximum
annual net investment by FIIs in India was in the year 1999-2000 and for that year,
total net FII investment in India was Rs 9,765 crores. This rising trend of portfolio
investment continued in 2004 also. In fact, in March 2004, a record Rs 8.800 crores of
net foreign portfolio investment came into the Indian equity market. This trend
continued till the end of April and more than Rs 4,200 crores of portfolio investment
was made in the Indian stock market in that month. However, for the month of May,
FIIs turned net sellers in the Indian equity markets. Between 30th April 2004 and 31st
May 2004, net FII investment was negative. During this period, FIIs withdrew more
than Rs 3,500 crores from the Indian equity market. In June, net FII investment turned
positive, however, net FII investment for the month of June was only Rs 516 crores
which is much lower than the average

The analysis of data indicates that there has been substantial divestment by the FIIs
during the year 1998-99. The maximum outflow was during the months of May and
June 1998 (almost US$430 millions).

TABLE : Monthly Trends of FIIs for the Year 1998-99

Month Purchases Sales Net Net

(Rs mn) (Rs mn) (Rs mn) (US$ mn)
Apr-98 11422 11756 -335 -8.4
May-98 8253 13284 -5031 -124.3
Jun-98 8023 16072 -8049 -190.5
Jul-98 13098 12154 944 22.2
Aug-98 7932 11783 -3851 -90.1
Sep-98 14381 12458 1923 45.2
Oct-98 10737 16470 -5733 -135.4
Nov-98 10391 9845 546 12.9
Dec-98 11089 8789 2300 104.8
Jan-99 16355 11894 4462 104.8
Feb-99 16477 13084 3393 79.8
Mar-99 25207 23973 1233 29

A major factor which led to continuous outflow of funds during the middle and end of
the year 1998 was the worsening outlook on the emerging markets. Credit worthiness
of almost all the South-east Asian nations was severely damaged by the crises which
started in July 1997. As a result, the FIIs were facing heavy redemption pressures
from the Emerging Markets Funds. The stock markets in all these countries fell
continuously from March 1998 till about September 1998. The integration of the
Indian capital markets with the international markets thus spilled over to Indian
markets as well. However, the net outflow from the Indian markets was much lower
than the other Asian countries. A further indication of the integration of the Indian
markets can be seen from the upsurge in the valuations and funds inflows during the
first quarter of 1999, when all the other Asian countries have also seen rising trend in
stocks indices.

The sluggishness in investment in the emerging markets was exacerbated by the fact
that throughout 1998-99, US and European markets showed historically high
valuations, and the expectations of further rise because of the strong economic
indicators there which led to reduced allocations elsewhere.

INFLUENCE OF FII ON THE EQUITY INDEXES OF INDIA

We are interested in testing a hypothesis about the influence of FII in Equity Stock
Market by correlating Gross Purchases, Gross Sales and Net Investment with Nifty
and Sensex. T-test is conducted at 1% and 5% significance. Statistical significance is
way to measure the likelihood that chance explains the results.

FORMULATING A HYPOTHESIS:
Null Hypothesis (Ho): there is no influence of FIIs on the Stock indexes.
Alternative Hypothesis (Ha): there is an influence of FIIs on Stock indexes.

If we reject the Ho, then we accept the Ha. Setting the significance level to 5% and
1%, the null hypothesis would be rejected only when the maximum number of months
show positive correlation.

T-Statistic:
Using T-test is calculated using the following formula:

r
t=
(1 − r ) 2

n−2
When,
-the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level.
-if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated

Conclusion: At the 1% level of stat sig we find that there is an influence of FIIs on
Stock Market Indexes of India.

TABLE: CORRELATION OF FII WITH NIFTY

MONTH GROSS PURCHASES GROSS SALES NET INVESTMENT

APRIL -0.308891015 -0.486299015 -0.122510317
MAY -0.203839618 -0.226174846 0.127555673
JUNE 0.40719847 0.013881057 0.556762421
JULY 0.231397721 -0.008199745 0.352195939
AUGUST -0.296292834 -0.009987101 -0.288696993
SEPTEMBER 0.631541276 0.478957403 0.377141924
OCTOBER -0.107835133 -0.303940405 0.118451125
NOVEMBER 0.103856902 0.232269601 -0.020576251
DECEMBER -0.689594568 -0.692805116 -0.496878284
JANUARY -0.02034654 -0.57330261 0.64885866
FEBRUARY 0.124176605 -0.056354197 0.233709555
MARCH 0.419911809 -0.255570154 0.483718703

FII flows and contemporaneous stock returns are strongly correlated in India. The
correlation coefficients between different measures of FII flows and market returns on
the Bombay Stock Exchange during different sample periods are shown in Table
above. While the correlations are quite high throughout the sample period, they
exhibit a significant rise since the beginning of the 1999-00. The calculations show
that there exists a relationship between FIIs and Nifty since 6 out of 12 months show
positive correlation in the case of Gross Purchass and 8 out of 12 months indicate a
positive correlation in the case of Net FII Investment and Nifty.
 TABLE : CORRELATION OF FII WITH SENSEX

MONTH GROSS PURCHASES GROSS SALES NET INVESTMENT

APRIL -0.267580403 -0.509025858 -0.076211493
MAY -0.184653959 -0.224809346 0.1484205
JUNE 0.405635894 -0.004710378 0.575995013
JULY 0.291205286 0.045396684 0.353391901
AUGUST -0.315900375 -0.033391574 -0.301709231
SEPTEMBER 0.661834837 0.506184274 0.389776394
OCTOBER -0.067640059 -0.311421901 0.18995454
NOVEMBER 0.083505749 0.244942636 -0.057919794
DECEMBER -0.666663184 -0.688620778 -0.46494095
JANUARY 0.02201209 -0.551509386 0.679227006
FEBRUARY 0.00689661 -0.170243004 0.149373722
MARCH 0.417854257 -0.250893125 0.479619465

The behaviour of the foreign portfolio investors matched the behaviour of Sensex
during this period. Net FII investment in the Indian capital markets started fluctuating
sharply during April and it turned negative. Net FII investment in the Indian stock
market was positive from May to July. During this period, the Sensex and net FII
investment showed very high degree of correlation. For the month of June showed a
correlation as high as 0.60. The months of September, October, November and
December shows a declining trend, the FII investment reversed from that day. On the
whole, there exists a relationship between FIIs and Sensex since 7 out of 12 months
show positive correlation in the case of Gross Purchases and 8 out of 12 months
indicate a positive correlation in the case of Net FII Investment and Sensex.

TABLE : COEFFECIENT OF DETERMINATION OF FII WITH NIFTY

MONTH GROSS PURCHASES GROSS SALES NET INVESTMENT

APRIL 0.095413659 0.236486732 0.015009
MAY 0.04155059 0.051155061 0.01627
JUNE 0.165810594 0.000192684 0.309984
JULY 0.053544905 6.72358E-05 0.124042
AUGUST 0.087789444 9.97422E-05 0.083346
SEPTEMBER 0.398844383 0.229400194 0.142236
OCTOBER 0.011628416 0.09237977 0.014031
NOVEMBER 0.010786256 0.053949168 0.000423
DECEMBER 0.475540669 0.479978929 0.246888
JANUARY 0.000413982 0.328675883 0.421018
FEBRUARY 0.015419829 0.003175796 0.05462
MARCH 0.176325927 0.065316104 0.233984

Coefficient of Determination (R2), ranges from 0 - 1, is always part of the standard

regression output, the important measure of goodness of fit. R2 = correlation
coefficient (r) squared, since the range of r is from -1 to +1, squaring r forces R2 to
fall between 0 and 1. R2 in the above table gives the percentage (%) of the total
variation in Nifty that is explained by the regression equation, or explained by FIIs.
During the month of January the total variation in Nifty explained by FII amounted to
42% and the remaining 58% is explained by other factors which influence Nifty.

TABLE : COEFFECIENT OF DETERMINATION OF FII WITH SENSEX

MONTH GROSS PURCHASES GROSS SALES NET INVESTMENT

APRIL 0.071599272 0.259107325 0.005808
MAY 0.034097085 0.050539242 0.022029
JUNE 0.164540479 2.21877E-05 0.33177
JULY 0.084800519 0.002060859 0.124886
AUGUST 0.099793047 0.001114997 0.091028
SEPTEMBER 0.438025352 0.256222519 0.151926
OCTOBER 0.004575178 0.0969836 0.036083
NOVEMBER 0.00697321 0.059996895 0.003355
DECEMBER 0.444439801 0.474198576 0.21617
JANUARY 0.000484532 0.304162603 0.461349
FEBRUARY 4.75632E-05 0.028982681 0.022313
MARCH 0.17460218 0.06294736 0.230035

Similarly, in the case of FII and Sensex we have R2 = .46, indicating that variation in
FII explains about 46% of the variation in Sensex. 54% of the variation in Sensex is
unexplained by FII, explainable by other factors, omitted variables, random variation,
etc. We shouldn't put too much emphasis on R2, t-stat are more important. However,
R2, or some other measure of goodness of fit is expected in reported empirical results.

TABLE: T-statistics- FII and Nifty

MONTH Purchases Sales Net FII t(0.01) t(0.05)
April -1.339074452 -2.29467 -0.50896 2.567 1.74
May -0.907571397 -1.0121 0.560581 2.539 1.729
June 1.993833093 0.062084 2.997474 2.528 1.725
July 1.063712023 -0.03667 1.682898 2.528 1.725
August -1.38735818 -0.04467 -1.34851 2.528 1.725
September 3.642698972 2.440043 1.821109 2.528 1.725
October -0.460189184 -1.35354 0.506109 2.552 1.734
November 0.443023275 1.013144 -0.08732 2.552 1.734
December -4.363626504 -4.40261 -2.62379 2.518 1.721
January -0.083908304 -2.88498 3.515943 2.567 1.74
February 0.53094617 -0.23947 1.019787 2.552 1.734
March 2.069166259 -1.1822 2.471661 2.528 1.725

Comparing the t-stat to the critical value at the 1% level (one-tailed test) at degree of
Freedom, D.F. = N –2;
-the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level.
-if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated
We accept the Null Hypothesis since the maximum number of months show that FII
and Nifty are uncorrelated.

TABLE: T-statistics- FII and Sensex

MONTH Purchases Sales Net FII t(0.01) t(0.05)

April -1.145014609 -2.4383 -0.31514 2.567 1.74
May -0.818971306 -1.00566 0.654196 2.539 1.729
June 1.984671667 -0.02107 3.151163 2.528 1.725
July 1.361307913 0.20323 1.689426 2.528 1.725
August -1.488997461 -0.14941 -1.41523 2.528 1.725
September 3.948264684 2.624836 1.892839 2.528 1.725
October -0.287631201 -1.39039 0.820854 2.552 1.734
November 0.355526636 1.071855 -0.24615 2.552 1.734
December -4.098741766 -4.3519 -2.40656 2.518 1.721
January 0.09078017 -2.72599 3.815802 2.567 1.74
February 0.029260533 -0.73298 0.64093 2.552 1.734
March 2.056876281 -1.1591 2.444422 2.528 1.725

Comparing the t-stat to the critical value at the 1% level (one-tailed test) at degree of
Freedom, D.F. = N –2;
-the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level.
-if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated
We accept the Null Hypothesis since the maximum number of months show that FII
-Nifty and FII-Sensex are uncorrelated.

F-STATISTIC:

Testing the Hypothesis

Null Hypothesis (Ho): There is no influence of FIIs on the Stock indexes.
Alternative Hypothesis (Ha): There is an influence of FIIs on Stock indexes.

If we reject the Ho, then we accept the Ha. Setting the significance level to 1%, the
null hypothesis would be rejected only when the entire year of 2004-05 shows
positive correlation.
Formula For F Test

f =
( n − 2) r 2
(1 − r )
2

Formula For T Test

t= f

TABLE: YEARLY CORRELATION AND F-TEST AT 1% SIGNIFICANCE

PARTICULARS NIFTY SENSEX

PURCHASES Pearson Correlation 0.440552215 0.440403204
Sig. (1-tailed) 1.04808E-13 1.07029E-13
N 252 252
SALES Pearson Correlation 0.260429215 0.263882768
Sig. (1-tailed) 1.41899E-05 1.0996E-05
N 252 252
NET INVESTMENT Pearson Correlation 0.309072081 0.306581522
Sig. (1-tailed) 2.79231E-07 3.4768E-07
N 252 252
FII flows and contemporaneous stock returns are strongly correlated in India. The
correlation coefficients between different measures of FII flows and market returns on
the Bombay Stock Exchange during the year 2004-05 are shown in the Table. While
the correlations are high being 0.44 between FII purchases and Nifty, 0.44 between
FII Purchases and Sensex, 0.26 between FII Sales and Nifty, 0.26 between Gross
Sales and Sensex, 0.31 between Net FII and Nifty, 0.31 between Net FII and Sensex.
At the 1% significance level the null hypothesis is rejected with a view that FIIs flows
and market Purchases of have a high correlation. Hence the FIIs have significant
influence on Equity Indexes Nifty and Sensex.

The positive relationship between market return and FII flows, however, serves only
as a first-pass in understanding the nature of such flows and their implications for the
Indian markets. Since the FII flows essentially serve to diversify the portfolio of
foreign investors, it is only normal to expect that several factors – both domestic as
well as external to India – are likely to affect them along with the expected stock
returns in India.
 CHAPTER 5
SUMMARY OF FINDINGS, RECOMMENDATIONS AND CONCLUSION

FINDINGS:

 It is an accepted fact now that FIIs have significant influence on the movements of
the stock market indexes in India. If one looks at the total FII trade in equity in
India and its relationship with the stock market major indexes like Sensex and
Nifty, it shows a steadily growing influence of FIIs in the domestic stock market.

 FIIs and the movements of Sensex are quite closely correlated in India and FIIs
wield significant influence on the movement of Sensex. NSE also observes that in
the Indian stock markets FIIs have a disproportionately high level of influence on
the market sentiments and price trends. This is so because other market
participants perceive the FIIs to be infallible in their assessment of the market and
tend to follow the decisions taken by FIIs. This ‘herd instinct’ displayed by other
market participants amplifies the importance of FIIs in the domestic stock market
in India.

 Results of this study show that not only the FIIs are the major players in the
domestic stock market in India, but their influence on the domestic markets is also
growing. Data on trading activity of FIIs and domestic stock market turnover
suggest that FII’s are becoming more important at the margin as an increasingly
higher share of stock market turnover is accounted for by FII trading. Moreover,
 the findings of this study also indicate that Foreign Institutional Investors have
emerged as the most dominant investor group in the domestic stock market in
India. Particularly, in the companies that constitute the Bombay Stock Market
Sensitivity Index (Sensex) and NSE Nifty, their level of control is very high.
Dominant position of FIIs in the Sensex companies, it is not surprising that FIIs
are in a position to influence the movement of Sensex and Nifty in a significant
way.

 Since FIIs are dominating the Indian Market, individual investors are forced to
accept the dictates of major FIIs and hence join the group by entering the Mutual
Fund group. Many Mutual Funds floated specific funds for the sectors favoured
by the FIIs. An implication of MFs gaining strength in the Indian stock market
could be that unlike individual investors, whose monies they manage, MFs can
create market trends whereas the small individual investors can only follow the
trends. The situation becomes quite difficult if the funds gain a vested interest in
certain sectors by floating sector specific funds. One can even venture to say that
the behaviour of MFs in India has turned the very logic that mutual funds invest
wisely on the basis of well-researched strategies and individual investors do not
have the time and resources to study and monitor corporate performance, upside
down. Thus, the entry of FIIs has not resulted in greater depth in Indian stock
market; instead it led to focussing on only a few sectors. Ultimately to provide a
level playing field, even the domestic investors had to be offered lower rates of
capital gains tax.

 While it can be expected that foreign affiliated mutual funds would follow the
investment pattern of FIIs, it is important to note that many domestic ones also
followed FIIs. The sectors favoured by FIIs account for a substantial portion of the
net assets under control of many Mutual Funds. The Mutual funds are gaining
prominence in the Indian Stock market and that the share of foreign affiliated MFs
is growing, a number of Indian funds are following the investment strategies of
the foreign ones.

 On the other hand if FII investments constitute a large share of the equity capital
of a financial entity, 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 on the value of the rupee and set
of 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 it
be dismissed on the ground that India's reserves are adequate to manage the
situation.

 FII investments, seem to have influenced the Indian stock market to a

considerable extent. FIIs are interested in the Indian stock market increases its
vulnerability to fluctuations. Analysis suggested a strong influence of FII
investment on the Sensex and Nifty index. This finding takes quite further the
general understanding that net FII investments influences stock prices in India as
it traces the relationship

The ‘home bias’ portfolios of investors in industrial countries – the tendency to hold
disproportionate amounts of stock from the ‘home’ country – suggests substantial
potential for further portfolio flows as global market integration increases over time.
It is important to note that global financial integration, however, can have two distinct
and in some ways conflicting effects on this ‘home bias’. As more and more countries
– particularly the emerging markets – open up their markets for foreign investment,
investors in developed countries will have a greater opportunity to hold foreign assets.
However, these flows themselves, along with greater trade flows will tend to cause
different national markets to increasingly become parts of a more unified ‘global’
market, reducing their diversification benefits. Which of these two effects will
dominate is, of course, an empirical issue, but given the extent of the ‘home bias’ it is
likely that for quite a few years to come, FII flows would increase with global
integration.
RECOMMENDATIONS:

Some of the steps that can be taken to help influence the choices made by foreign
institutional investors include:

 The Government should cut its fiscal deficits, which would result in strengthening
the economy as a whole.

 Creating infrastructure and other facilities to attract foreign investment. As

described earlier, an array of services can help promote foreign institutional
investment in India, ranging from basic services such as the provision of electricity
and clean water, to fair and effective dispute resolution systems.

 The ability of governments to prevent or reduce financial crises also has a great
impact on the growth of capital flows. Steps to address these crises include
strengthening banking supervision, requiring more transparency in international
financial transactions and ensuring adequate supervision and regulation of financial
markets.

 An attempt should be made to bring down the inflation level to attract more
foreign institutional investments into India.

 The Banking system needs to be strengthened which could be achieved by

reducing the number of Non Performing Assets.
 The FIIs investments, though shown an increasing trend over time, are still far
below the permissible limits. One such measure in this line could be the newly
announced INDONEXT, the platform for trading the small and mid-cap companies,
which might bring some focus on these companies and hopefully add some liquidity
and volume to their trading, which may attract some further investments in them by
FIIs.

 The fact is that developing country like India has its own compulsions arising out
of the very state of their social, political and economic development. To attract
portfolio investments and retain their confidence, the host countries have to follow
stable macro-economic policies,

 The provision for clear procedures must be followed in the event of disputes
between investors and host governments, to ensure that rules are adhered to and that
arbitration may be established by mutual consent.

 Countries may impose these kinds of measures like expropriation, domestic

content requirements, restrictions on capital outflows of short term investments, etc
with the intention of protecting domestic industries from international competition
and promoting their economic development, but this usually leads to misallocation of
resources away from the natural economic capabilities of nations.

 There has been a significant shift in the character of global capital flows to the
developing countries in recent years in that the predominance of private account
capital transfer and especially portfolio investments (FPI) increased considerably. In
order to attract portfolio investments which prefer liquidity, it has been advocated to
develop stock markets.
 The general perception about the foreign portfolio investments is that, not only do
they expand the demand base of the stock market, but they can also stabilise the
market through investor diversification.

Obstacles to investment prevent countries from making optimal use of their own and
other countries' resources. Countless billions of dollars of potential wealth - for
investors in the form of profits, for workers in the form of wages, and for consumers
in the form of lower prices - are lost every year due to barriers to trade and
investment. Certain policy decisions of potential target countries of investment
receive close scrutiny from international investors. Consequently, a number of
international agreements have been written to specifically address those concerns.

CONCLUSION

This paper provides a preliminary analysis of FII flows to India and their influence on
the prices of stocks in the Indian stock market. A more detailed study using daily data
of equity returns for a longer period or, better still, disaggregated data showing the
transactions of individual FIIs at the stock level can help address questions regarding
the extent of herding or return-chasing behavior among FIIs which now account for a
significant part of the capital account balance in our balance of payments. The extent
to which FII participation in Indian markets has helped lower cost of capital to Indian
industries is also an important issue to investigate.

Broader and more long-term issues involving foreign portfolio investment in India
and their economy-wide implications have not been addressed in this paper. Such
issues would invariably require an estimation of the societal costs of the volatility and
uncertainty associated with FII flows. A detailed understanding of the nature and
determinants of FII flows to India would help us address such questions in a more
informed manner and allow us to better evaluate the risks and benefits of foreign
portfolio investment in India.