CHAPTER –I

Introduction to Foreign Institutional Investment

Post liberalization period of India had witnessed

rapid expansion & enrichment of various industrial
activities. After the independence India followed
socialist-inspired approach for most of its independent
history, with strict government control over private sector
participation, foreign trade, & foreign direct investment.
However, since the early 1990s, India had gradually
opened up its markets through economic reforms by
reducing government controls onto foreign trade &
investment. The privatization of publicly owned
industries & the opening up of certain sectors to private
& foreign interests had proceeded slowly amid political
debate.

Foreign Investment refers to investments made by

residents of country into financial assets & production
process of another country. After the opening up of the
borders for capital movement these investments had grown
into leaps & bounds. But it had varied effects across the
countries. Into developing countries there was great need
of foreign capital, not only to increase their productivity of
labor but also helps to build the foreign exchange reserves
to meet the trade deficit. Foreign investment provides
channel through which these countries can had access to
foreign capital. It can come into two forms: foreign direct
investment (FDI) & foreign portfolio investment (FPI).
Foreign direct investment involves into the direct production
activity & also of medium to long-term nature. But the
foreign portfolio investment was short-term investment
mostly into the financial markets & it consists of Foreign
Institutional Investment (FII). The present study examines
the determinants of foreign portfolio investment into the
Indian context as the country after experiencing the foreign
exchange crisis opened up the economy for foreign capital.
India, being capital scarce country, had taken lot of
measures to attract foreign investment since the beginning
of reforms into 1991. Till the end of January 2003 it could
attract total foreign investment of around US$ 48 billion out
of which US$ 23 billion was into the form of FPI. FII consists
of around US$ 12 billion into the total foreign investments.
This shows the importance of FII into the overall foreign
investment programmed. As India was into the process of
liberalizing the capital account, it would had significant
impact onto the foreign investments & particularly onto the
FII, as this would affect short-term stability into the financial
markets. Hence, there was need to determine the push &
pull factors behind any change into the FII, so that we can
frame our policies to influence the variables which drive-in
foreign investment. Also FII had been subject of intense
discussion, as it was held responsible for intensifying
currency crisis into 1990’s elsewhere. The present study
would examine the determinants of FII into Indian context.
Here we make attempt to analyze the effect of return, risk
& inflation, which were treated to be major determinants into
the literature, onto FII. The proposed relation (discussed
into detail later) was that inflation & risk into domestic
country & return into foreign country would adversely affect
the FII flowing to domestic country, whereas inflation & risk
into foreign country & return into domestic country would
had favorable affect onto the same. Into the next section we
would briefly discuss the existing studies. Into section 3, we
discuss the theoretical model.
There was strong growth into Foreign Direct
Investment (FDI) flows with three quarters of such flows into
the form of equity. As per the economic survey, the growth
rate was 27.4 per cent into 2008-09, which was followed by
98.4 per cent into April-September 2006. At US$ 4.2 billion
during the first six months of this fiscal, FDI was almost
twice its level into April-September, 2005. Capital flows into
India remained strong onto overall basis even after gross
outflows under FDI with domestic corporate entities seeking
global presence to harness scale, technology & market
access advantages through acquisitions overseas.

Total FDI inflows for April-December 2006 stood at

US$ 9.3 billion, as compared to US$ 3.5 billion into the
corresponding period last fiscal. According to certain
estimates, India was likely to receive US$ 12 billion of FDI
during the current financial year as compared to US$ 5.5
billion into the previous fiscal.
 In the past two years, FDI had jumped 100 per cent,
from US$ 3.75 billion into 2004-05 to US$ 7.231 billion till
November 2006. However, these figures may be
underestimation, say Finance Ministry officials, since these
numbers do not include the amount that was reinvested by
foreign companies operating into the country. The figure for
2009-2010 was likely to be close to US$ 10 billion if one
takes into account profits reinvested by foreign players into
Indian operations.

The number of foreign institutional investors (FIIs)

registered with the Securities & Exchange Board of India
(Sebi) had now increased to 1,030. Into the beginning of
calendar year 2006, the figure was 813. As many as 217
new FIIs opened their offices into India during 2006. This
was the highest number of registrations by FIIs into year till
date. The previous highest was 209 into 2005. The net
investments made by the institutions during 2006 was US$
9,185.90 million against US$ 9,521.80 million into 2005.

Some investment highlights of FII

Billionaire investor George Soros-owned fund Dacecroft &

New York-based investment firm Blue Ridge were picking
21 per cent equity stake into Anil Dhirubhai Ambani Group's
Reliance Asset Reconstruction Company (Reliance ARC).
Role of Government initiatives

The Government was looking at reviewing regulation

involving foreign investments into the country. Aimed at
simplifying the investment process, the revised policy will
treat foreign direct investment (FDI) & investment from
foreign institutional investors (FII) into the same light.

At present, investments by GE Capital, for instance, were

termed as FII, while funds from GE were bracketed as FDI.
This, despite the fact that GE Capital could be subsidiary of
GE. & into sectors which had cap onto investments, matters
were even more complicated. Into such situation, treating
all foreign investments, irrespective of FDI or FII, as the
same into terms of investment limits & conditions, can be
more workable solution. Once the changes were into place,
the policy will be more into tune with investments into
developed countries where the distinctions between FDI &
FII were fast disappearing.

The sectors that will be affected by the revision include

asset reconstruction companies, direct-to-home distribution
of broadcast signals & real estate, where separate sub-
ceilings or conditions apply at present for FDI, leaving FII
investments outside their ambit.
In move to bolster investments into the aviation sector, the
Reserve Bank of India had said that FIIs can pick up stake
into domestic airlines beyond the sectorial FDI cap of 49 per
cent through secondary market purchases.

Meanwhile, FDI into India was onto the verge of surpassing

FII for the first time, the Prime Minister's Economic Advisory
Council (EAC) had said. According to the EAC, net FDI for
2009-2010 would be around US$ 9 billion, up from US$ 4.7
billion last year while FII or portfolio inflows were likely to be
US$ 7 billion.

Advantages of FII

The advantages of having FII investments can be broadly

classified under the following categories.
A. Enhanced flows of equity capital
FIIs were well known for greater appetite for equity than
debt into their asset structure. For example, pension funds
into the United Kingdom & United States had 68 percent &
64 per cent, respectively, of their portfolios into equity into
1998. Thus, opening up the economy to FIIs was into line
with the accepted preference for non-debt creating foreign
inflows over foreign debt. Furthermore, because of this
preference for equities over bonds, FIIs can help into
compressing the yield-differential between equity & bonds
& improve corporate capital structures.
B. Managing uncertainty & controlling risks
Institutional investors promote financial innovation &
development of hedging instruments. Institutions, for
example, because of their interest into hedging risks, were
known to have contributed to the development of zero-
coupon bonds & index futures. FIIs, as professional bodies
of asset managers & financial analysts, not only enhance
competition into financial markets, but also improve the
alignment of asset prices to fundamentals. 39. Institutions
into general & FIIs into particular were known to have good
information & low transaction costs. By aligning asset prices
closer to fundamentals, they stabilize markets.
Fundamentals were known to be sluggish into their
movements. Thus, if prices were aligned to fundamentals,
they should be as stable as the fundamentals themselves.
Furthermore, variety of FIIs with variety of risk-return
preferences also help into dampening volatility.
C. Improving capital markets
. FIIs as professional bodies of asset managers & financial
analysts enhance competition & efficiency of financial
markets. Equity market development aids economic
development. By increasing the availability of riskier long
term capital for projects, & increasing firms’ incentives to
supply more information about themselves, the FIIs can
help into the process of economic development.

D. Improved corporate governance Good corporate

governance was essential to overcome the principal-agent
problem between share-holders & management.
Information asymmetries & incomplete contracts between
share-holders & management were at the root of the
agency costs. Dividend payment, for example, was
discretionary. Bad corporate governance makes equity
finance costly option. With boards often captured by
managers or passive, ensuring the rights of shareholders
was problem that needs to be addressed efficiently into any
economy.

Management Control & Risk of Hot Money Flows

The two common apprehensions about FII inflows were the
fear of management takeovers & potential capital outflows.
A. Management control
FII fact as agents onto behalf of their principals – as
financial investors maximizing returns. There were
domestic laws that effectively prohibit institutional investors
from taking management control. For example, US law
prevents mutual funds from owning more than 5 per cent
of company’s stock. According to the International
Monetary Fund’s Balance of Payments Manual 5, FDI was
that category of international investment that reflects the
objective of obtaining lasting interest by resident entity into
one economy into enterprise resident into another
economy. The lasting interest implies the existence of long-
term relationship between the direct investor & the
enterprise & significant degree of influence by the investor
into the management of the enterprise. According to EU
law, foreign investment was labeled direct investment when
the investor buys more than 10 per cent of the investment
target, & portfolio investment when the acquired stake was
less than 10 percent. Institutional investors onto the other
hand were specialized financial intermediaries managing
savings collectively onto behalf of investors, especially
small investors, towards specific objectives into terms of
risk, returns, & maturity of claims. All take-overs were
governed by SEBI (Substantial Acquisition of Shares &
Takeovers) Regulations, 1997, & sub-accounts of FIIs were
deemed to be “persons acting into concert” with other
persons into the same category unless the contrary was
established.
B. Potential capital outflows FII inflows were popularly
described as “hot money”, because of the herding behavior
& potential for large capital outflows. Herding behavior, with
all the FIIs trying to either only buy or only sell at the same
time, particularly at times of market stress, can be rational.
With performance-related fees for fund managers, &
performance judged onto the basis of how other funds were
doing, there was great incentive to suffer the
consequences of being wrong when everyone was wrong,
rather than taking the risk of being wrong when some
others were right. The incentive structure highlights the
danger of contrarian bet going wrong & makes it much more
severe than performing badly along with most others into
the market. It not only leads to reliance onto the same
information as others but also reduces the planning horizon
to relatively short one. Value at Risk models followed by
FIIs may destabilize markets by leading to See
Bikhchandani, S & S. Sharma (2000): “Herd Behavior into
Financial Markets”, Working Paper No. WP/00/48,
International Monetary Fund, Washington DC, 2000. 15
simultaneous sale by various FIIs, as observed into Russia
& Long Term Capital Management 1998 (LTCM) crisis.
Extrapolative expectations or trend chasing rather than
focusing onto fundamentals can lead to destabilization.
Movements into the weightage attached to country by
indices such as Morgan Stanley Country Index (MSCI) or
International Finance Corporation (W) (IFC) also leads to
en masse shift into FII portfolios.
. Another source of concern were hedge funds, who, unlike
pension funds, life insurance companies & mutual funds,
engage into short-term trading, take short positions &
borrow more aggressively, & numbered about 6,000 with
$500 billion of assets under control into 1998. 50. Some
of these issues had been relevant right from 1992, when FII
investments were allowed in. The issues, which continue
to be relevant even today, are: (i) benchmarking with the
best practices into other developing countries that compete
with India for similar investments; (ii) if management
control was what was to be protected, was there reason to
put restriction onto the maximum amount of shares that can
be held by foreign investor rather than the maximum that
can be held by all foreigners put together; & (iii) whether
the limit of 24 per cent onto FII investment will be over &
above the 51 per cent limit onto FDI. There were some
other issues such as whether the existing ceiling onto the
ratio between equities & debentures into FII portfolio of
70:30 should continue or not, but this was beyond the
terms of reference of the Committee
To conclude Foreign Institutional Investment refers to
investments made by residents of country into financial
assets & production process of another country. After the
opening up of the borders for capital movement these
investments had grown into leaps & bounds. But it had
varied effects across the countries. It can affect the factor
productivity of the recipient country & can also affect the
balance of payments. Into developing countries there was
great need of foreign capital, not only to increase their
productivity of labor but also helps to build the foreign
exchange reserves to meet the trade deficit. Foreign
investment provides channel through which these
countries can had access to foreign capital. It can come
into two forms: foreign direct investment (FDI) & foreign
portfolio investment (FPI). Foreign direct investment
involves into the direct production activity & also of
medium to long-term nature. But the foreign portfolio
investment was short-term investment mostly into the
financial markets & it consists of Foreign Institutional
Investment (FII). The FII, given its short-term nature, might
had bi-directional causation with the returns of other
domestic financial markets like money market, stock
market, foreign exchange market, etc. Hence, unde