foreign institutional investor (fii) their impact on indian stock market

CHAPTER 1

CAPITAL MARKET- AN OVERVIEW

1.1 Introduction to Capital Market:

A capital market can be defined as “The market for long-term funds where securities

such as common stock, preferred stock, and bonds are traded”. Both the primary

market for new issues and the secondary market for existing securities are part of the

capital market. The capital market is an important part of financial system. Capital

market can be defined as “A market for long term funds both equity and debt and

funds raised within and outside the country.” In other words capital market is wide

term used to comprise all operations in the new issues and stock market. New issues

made by companies constitute the primary market, while trading in existing securities

comprise secondary market. In simple words capital market encompasses all the

activities of F.I.s, Banks, NBFCs, etc, at a long term perspective or for a period more

than one year. The capital market aids economic growth by mobilizing savings of the

economic sectors and directing the same towards channels of productive use. This is

facilitated through the following measures.

iIssue of ‘primary securities’ in the ‘primary market’, i.e., directing cash flow from

the surplus sector to the deficit sectors such as the government and the corporate

sector.

iiIssue of ‘secondary securities’ in the ‘primary market’ i.e., directing cash flow

from the surplus sector to financial intermediaries such as banking as non-banking

financial institutions.

iiiSecondary market transactions in outstanding securities which facilitated liquidity.

The liquidity of the stock market is an important factor affecting growth. Many

profitable projects require long term financial investment which was locking up funds

for a long period. Investors do not like to relinquish control over their savings for such

a long time.

Hence they are reluctant to invest in long gestation projects. It is the presences of the

liquid secondary market that attracts investors because it ensures a quick exit without

heavy losses or costs.

Hence, the development of an efficient capital market is necessary for creating a

climate conductive to investment and economic growth.

1.1.1 Major Players in the Market:

The players in the capital market can be divided into following two broad areas.

I. Players in Primary Market:

1) Merchant Banker: The functions and working of merchant bankers are very

crucial in the primary market. They act as issue managers, lead managers, co-

managers and are responsible to the company and SEBI.

They take all policy decisions for and behalf of company regarding the new issue and

coordinate the various agencies and give “Due Diligence” certificate to the SEBI

regarding the true disclosures as required by law and SEBI guidelines.

2) Registrars: The functions of registrars in next important is merchant bankers.

They collect applications for new issues, their cheques, stock invests etc., classify and

Computerize them. They also make allotments in consultation with the regional stock

exchanges regarding norms in the event of over subscription and before a public

representative. They have to dispatch the litters of allotments, refund orders and share

certificates within the time schedules stipulated under the companies act and observe

the guidelines of SEBI, the Governments and RBI. Besides they have also to satisfy

the listing requirements and get them listed one or more stock exchanges.

3) Collecting and Co-coordinating bankers: The collecting and co-coordinating

banks may be same or different. While the former collects subscripting in cash,

cheques, stock invests etc., the later collates the information on subscriptions and co-

ordinates the collection work and monitors the same to the registrars and merchant

bankers, who in turn keep the company informed.

4) Underwriters and Brokers: Underwriters may be financial institutions, banks,

mutual funds, brokers etc, and undertake to mobilize the subscriptions up to some

limits; failing to secure subscriptions as agreed to, they have to make good the

shortfalls by their own subscriptions. Brokers along with their network of sub-brokers

market the new issues by their own circulars, sending the applications from and

follow up recommendations.

5) Printers, advertising and mailing agencies: They are other organizations

involved in the new issue market operations.

II. Secondary Market Intermediaries: The major players in the secondary market

are issuers of securities, companies, intermediaries like brokers, sub-brokers etc., and

the investors who bring in their savings and funds into the market.

The stock brokers are of various categories, namely:

iClient Brokers: These are players doing simple broking between buyers and sellers

and earning only brokerage for their services from the clients.

iiFloor Brokers: Floor brokers are authorised clerks and sub brokers who enter the

trading floor and execute orders for the clients or for members, and also called trading

brokers.

iiiJobbers: These are those members who are ready to buy & sell simultaneously in

selected scrips, offering bid and offer rates for the brokers and sub-brokers on the

trading floor &earning profit through the margin between buying and selling rates.

This category includes market for some scrips.

ivArbitrageurs: The brokers, who do inter market deals for a profit through

differences in prices as between markets, say buy in BSE & sell in NSE and vice-

versa.

1.1.2 FUNCTIONS OF CAPITAL MARKET:

The functions of efficient stock markets are as follows.

1)Mobilise long-term savings to finance long-term investments.

2)Provide risk capital in form of equity or quasi-equity to entrepreneurs.

3)Encourage broader ownership of productive assets.

4)Provide liquidity with a mechanism enabling the investors to sell financial assets.

5) Lower the cost of transaction and information.

6) Improve the efficiency of capital allocation through competitive pricing

mechanism.

1.1.3 Types of Capital Market:

The capital market can be broadly classified into following three types-

iPrimary Market

iiSecondary Market and

iiiDebt Market.

The various types of capital market can be explained later on in this chapter.

1.2 The Primary Market:

1.2.1 Introduction:

The primary market is market for new issues. It is also the new issues market. It is a

market for fresh capital. Funds are mobilised in the primary market through

prospectus, right issues, & private placement. Bonus issue is also one way to raise

capital but it does not bring in any fresh capital.

Some companies distribute profit of existing shareholders by the way of fully paid

bonus share instead of paying them dividend. Bonus share are issued in the ratio of

the existing share held. The shareholders do not have to pay for bonus share but the

rational earnings are converted into capital.

Thus, bonus share enable the company to restructure its capital. Bonus is the

capitalisation of free reserves. Higher the free reserves, higher are the chances of a

bonus issue forthcoming from a corporate. Bonus issue creates excitement in the

market as the shareholders do not have to pay for them and in addition, they add to

their wealth.

Companies issue bonus share for various reasons are:

i To boost liquidity to their stock:

A bonus issue results in expansion of equity base, increasing the number of absolute

share available for trading.

iiTo bring down the stock price:

A high price often acts as a deterrent far a retail investor to buy a stock. The price of a

stock falls on becoming ex-bonus because an investor buying share ex-bonus is not

entitled to bonus share. For instance, scrip trading at`600 cum bonus with a 1:1bonus

begins trading at 300 ex-bonuses.

iiiTo restructure their capital:

Companies with high resources prefer to bonus share as the issue not only restructure

their capital but since they are perceived to be likely candidates for bonus issue by

investors. They fulfill the expectations of the investors.

1.2.2 Type of Issues in Primary Market:

Types issues in Indian Primary Market

Primarily, issues can be classified as a Public, Rights or Preferential issues (also

known as private placements). While public and rights issues involve a detailed

procedure, private placements or preferential issues are relatively simpler. The

classification of issues is illustrated below:

Initial Public Offering (IPO) is when an unlisted company makes either a fresh issue

of securities or an offer for sale of its existing securities or both for the first time to

the public. This paves way for listing and trading of the issuer’s securities.

A follow on public offering (Further Issue) is when an already listed company makes

either afresh issue of securities to the public or an offer for sale to the public, through

an offer document.

Rights Issue is when a listed company which proposes to issue fresh securities to its

existing shareholders as on a record date. The rights are normally offered in a

particular ratio to the number of securities held prior to the issue. This route is best

suited for companies who would like to raise capital without diluting stake of its

existing shareholders.

A Preferential issue is an issue of shares or of convertible securities by listed

companies to a select group of persons under Section 81 of the Companies Act, 1956

which is neither a rights issue nor a public issue. This is a faster way for a company to

raise equity capital. The issuer company has to comply with the Companies Act and

the requirements contained in the Chapter pertaining to preferential allotment in SEBI

guidelines which inter-alia include pricing, disclosures in notice etc.

1.2.3 Offer Documents for the Primary Market:

According to SEBI “draft offer document” means the prospectus in case of a public

issue and letter of offer in case of right issue has to be filed with registrar of

companies (ROC) and notified to stock exchanges. This offer document contains

exclusive information about the companies & its activities. The offer document used

in ease of book built public issue is also called draft red hearing prospectus and

contains information that justify the pricing of the issue. This helps the investors to

rationalize their investment in the issue offered by the company. Basically, the draft

offer document implies the offer document in draft stage.

The draft offer document by the issuer company has to be filed with SEBI, at least 21

days prior to the filing of the document with ROC/ stock exchanges. On submission

SEBI may suggest changes, if any, and the issuer or lead merchant has to make such

changes before filing the documents of the ROC/ stock exchanges. The documents are

put on the website of SEBI for 21 days from filing of the documents, for public

comment. In case of a preference issue, QIB issue or private placement, the filing of

documents with SEBI in not required. Only the merchant banker handing the issue

files the documents to the concerned stock in charge. A company aiming to have an

issue in the primary market have to complete issue in the primary market has to

complete with SEBI disclosure and investors protection (DIP) guidelines before filing

the documents with SEBI.

1.2.4 Types of Investors in Primary Market:

SEBI broadly classifies investors into following categories, SEBI FAQs (March

2008):

I. Retail Investors (RIIs):

Retail investors companies of the individual investors spread across the country.

They apply or bid for maximum security value of Rs.150000.

II. Qualified institutional Buyer (QIB):

QIBs are the financial institution like public financial institution, commercial banks;

FIIs & Provident funds those investors in the securities.

III. Non-Institutional Investors (NIIs):

NIIs are the categories of investors which do not fall in the above categories

In all book building issue SEBI has a fixed maximum limit up to which any of the

above types investors can invest, for example: QIBs portion can be 50% of the entire

amount, Riis can be 35% & NIIs can be 15%.

1.3 The Secondary Market:

1.3.1 Introduction:

The secondary market is a market in which existing securities are resold or traded.

This market is also known as stock market. In India the secondary market consists of

recognised stock exchanges operating under the rules, by laws and regulations duly

approved by the government. These shock exchanges constitute an organized market

where securities issued by central and state governments, public bodies and joint

stock companies are traded.

According to section 2(3) of The Securities Contract (Regulation) Act, 1956 a

stock exchange is defined as a body of individuals whether

Incorporated or not, constitute for the purpose of assisting, regulating and controlling

the business of buying, selling and dealing in securities. The major stock exchanges in

the world are NASDAQ, New York Stock Exchange (NYSE), London Stock

Exchange (LSE), Dow Jones, Tokyo Stock Exchange, etc. The major stock exchanges

in India are BSE, NSE and OTCEI.

1.3.2 Development of Stock Market in India:

The origin of the Indian stock market dates way back in the 18th century when long

term negotiable securities were first issued. The real beginning however, occurred in

the middle of the 19th century after the formation of the Companies Act of 1850,

which introduced feature of limited liability and generated investor’s interest in

corporate securities. The first stock exchange in India was Native Stock Brokers’

Association which is known as the Bombay Stock Exchange. It was formed in the

year 1875. The exchange was started under Banyan Tree with only few brokers. The

development led to reforms throughout India with the development of Ahmadabad

Stock Exchange (1894), Calcutta Stock Exchange (1908), and Madras

(Chennai) Stock Exchange (1937). In order to promote orderly development of stock

exchanges the government introduced a comprehensive legislation called Securities

Contract (Regulation) Act, 1956.

The trade in the secondary market was largely dominated by the Calcutta Stock

Exchange (CSE) till 1960s. Most of the companies registered in India were mainly

listed on two major stock exchanges the CSE and the BSE. In 1961 out of the 1203

companies listed on the Indian stock exchanges 576 were listed on the CSE and 297

were listed on the BSE. The shift of dominance from CSE to BSE started in the late

1960s. Till the early 1990s, the Indian secondary market was plagued with many

limitations such as:

1. Uncertainty of execution price.

2. Uncertainty of delivery and settlement periods.

3. Front running, trading ahead of a client on knowledge of client order.

4. Lack of transparency.

5. High transaction cost.

6. Absence of risk management.

7. Systemic failure of entire market and market closure due to scams.

8. Club mentality of brokers.

9. Kerb trading (off market deals).

In 1991 after the liberalization of the Indian economy, the stock markets entered into

an era of reforms. SEBI was established in the year 1988 but it became a regulatory

body for transaction and issuance of securities, with enation of the SEBI Act, 1992.

The Indian stock market then follows a three tier structure form. The structure has:

iRegional stock exchanges.

iiNational Stock Exchange Ltd. (NSE) and

iiiOver The Counter Exchange of India (OTCEI).

NSE was first setup in 1994 as the first automated screen based exchange in India. It

worked on the concept of order matching. The establishment of NSE is marked as a

revolution the Indian stock exchanges. After NSE all major stock exchanges started

electronic trading and dematerialization of securities became necessary for issuers.

Now with e-Revolution in India trader sitting in any part of Country can buy and sell

shares on the market platform during the trading hours. The OTCEI was established in

1992 to enable small and medium enterprises to raise funds and generate capital at

low cost.

Chapter 2:

FOREIGN INVESTMENTS - OVERVIEW

2.1 Introduction to foreign investments

Foreign investment refers to the investments made by the residents of a country in

the financial assets and production process of another country.

The foreign investment is necessary for all developing nation as well as developed

nation but it may differ from country to country. The developing economies are in a

most need of these foreign investments for boosting up the entire development of the

nation in productivity of the labour, machinery etc. The foreign investment or foreign

capital helps to build up the foreign exchange reserves needed to meet trade deficit or

we can say that foreign investment provides a channel through which developing

countries gain access to foreign capital which is needed most for the development of

the nations in the area of industry, telecom, agriculture, IT etc. The foreign investment

also affects on the recipient country like it affects on its factor productivity as well as

affects on balance of payments. Foreign investment can come in two forms: foreign

direct investment and foreign institutional investment.

2.1.1 Foreign direct investment

“Foreign direct investment reflects the objective of obtaining a lasting interest by a

resident entity in one economy (“direct investor”) in an entity resident in an economy

other than that of the investor (“direct investment enterprise”). The lasting interest

implies the existence of a long-term relationship between the direct investor and a

significant degree of influence on the management of the enterprise.”

It has further two types

1) Horizontal FDI

2) Vertical FDI

Horizontal FDI:

Horizontal multinationals are firms that produce the same good or services in multiple

plants in different countries, where each plant serves the local market from the local

production. Two factors are important for the appearance of horizontal FDI: presence

of positive trade costs and firm-level scale economies. The main motivation for

horizontal FDI is to avoid transportation costs or to get access to a foreign market

which can only be served locally. The horizontal models predict that multinational

activities can arise between similar countries.

The intuition behind horizontal FDI is best described in form of an equation with

costs on the one side and benefits on the other side. Establishing a foreign production

instead of serving the market by exports means additional costs of dealing with a new

country. Moreover, there are production costs, both fixed and variable, depending on

factor prices and technology. The plant-level economies of scales will increase the

costs of establishing foreign plants. On the other side of the equation, there are cost

savings by switching from exports to local production. The most obvious are transport

costs and tariffs. Additional benefits arise from the proximity to the market, as shorter

delivery and quicker response to the market becomes easier. Thus, if benefits

outweigh the costs a multinational enterprise will conduct a horizontal FDI.

Vertical FDI

Vertical FDI refers to those multinationals that fragment production process

geographically. It is called “vertical” because MNE separates the production chain

vertically by outsourcing some production stages abroad. The basic idea behind the

analysis of this type of FDI is that a production process consists of multiple stages

with different input requirements. If input prices vary across countries, it becomes

profitable for the firm to split the production chain.

Similar to the intuition of the horizontal models, the decision to conduct vertical FDI

can be described as a trade-off between costs and benefits. The benefits arise from the

lower production costs in the new location. The production chain consists of several

stages, often with different factors required for each stage. A difference in factor

prices makes it then profitable to shift particular stages to the countries, where this

factor is relatively cheaper. This is only profitable as long as the costs of

fragmentation are lower than the cost savings. The costs of splitting the production

process emerge in form of transportation costs, additional costs for acting in a new

country, or of having different parts of production in different countries.

2.1.2 Foreign portfolio investments or Portfolio Investment:

Foreign portfolio investment is the entry of funds into a country where foreigners

make purchases in the country’s stock and bond markets, sometimes for speculation.

Portfolio investments typically involve transactions in securities that are highly liquid,

i.e. they can be bought and sold very quickly. A portfolio investment is an investment

made by an investor who is not involved in the management of a company. This is in

contrast to direct investment, which allows an investor to exercise a certain degree of

managerial control over a company. Equity investments where the owner holds less

than 10% of a company's shares are classified as portfolio investment. These

transactions are also referred to as "portfolio flows" and are recorded in the financial

account of a country's balance of payments. According to the Institute of International

Finance, portfolio flows arise through the transfer of ownership of securities from one

country to another.

Foreign portfolio investment is positively influenced by high rates of return and

reduction of risk through geographic diversification. The return on foreign portfolio

investment is normally in the form of interest payments or non-voting dividends.

With the ongoing globalization the role of institutional investors in foreign capital

flows has increased to a great extent. They are being regarded as kingpin of financial

globalization. But what are the possible gains from foreign institutional investments.

The developing countries like India generally have a chronic shortage of capital. The

entry of FIIs is expected to bring that much needed capital. However, as most of

purchases by FIIs are on secondary market, their direct contribution to investment

may not be very significant. Yet, FIIs contribute indirectly in a number of ways

towards increasing capital formation in the host country. Increased participation of

foreign investors increases the potentially available capital for investment and thus

lowers the cost of capital. Further, purchases of FIIs give an upward thrust to

http://en.wikipedia.org/wiki/Funds

http://en.wikipedia.org/wiki/Foreign_direct_investment

http://en.wikipedia.org/wiki/Corporate_management

http://en.wikipedia.org/wiki/Speculation

http://en.wikipedia.org/wiki/Bond_market

http://en.wikipedia.org/wiki/Stock_market

domestic stock prices and thus increase the price-earnings ratio of firm. Both these

factors are expected to increases overall level of investment in an economy. Thus,

FIIs can prove to be an important boost for capital formation.

Portfolio investment is also expected to improve the functioning of domestic stock

exchanges. The host country seeking foreign portfolio investment has to improve its

trading and delivery system. Also, consistent and business friendly policies have to be

followed in order to retain the confidence of foreign investors. Further, portfolio

investors are known to have highly competent financial analyst. They have access to

most advanced technology, best possible information and vast and global experience

in investment business. Due to these qualities the entry of FIIs can substantially

increase the allocative efficiency of domestic stock market.

However, increased activities of FIIs in developing countries can also have negative

impacts. Since the 1996 Mexican crises and widespread Asian crises, many

economists have questioned the wisdom of policy-makers in developing world in

discriminately inviting portfolio flows. Institutional investments are highly volatile

and even in case of small economic problem investors can destabilize the economy by

making large and concerted withdrawals. Many possible reasons have been mentioned

in literature for explaining the volatility of portfolio investment. A straight forward

reasoning follows from the fact that institutional investors actually act as agents of

principle fund owners. The later generally observe the performance of agent investors

at a short notice, often on the basis of quarterly reports. Because of this FIIs face very

short-term performance targets. So they do not afford to stick to a lose making

position even for a short period and withdraw at the first sign of trouble. Further, as

the fund owners can shift between agent investors in very short period, the later

follow the performance and activities of each other very closely.

When one agent withdraws from an economy realizing the initial sign of trouble, the

others also follow the suit. Thus, a small economic problem can be converted into an

economic disaster due to the herding behavior of FIIs.

Another problem with portfolio investment is that it influences the domestic exchange

rate and can cause its artificial appreciation. The inflow of foreign capital raises the

demand for non-tradable goods, which results in appreciation of the real exchange

rate. With a floating exchange rate regime and no central bank invention, the

appreciation will take place through nominal rate.

The net impact of foreign institutional investment in a country therefore depends upon

the policy response of concerned authority regarding the problems posed by such

investment.

2.1.3 Investment in GDRs, ADRs, FCCBs

Foreign currency convertible bonds (FCCBs

Foreign currency convertible bonds (FCCBs) are a special category of bonds. FCCBs

are issued in currencies different from the issuing company's domestic currency.

Corporate issue FCCBs to raise money in foreign currencies. These bonds retain all

features of a convertible bond, making them very attractive to both the investors and

the issuers.

These bonds assume great importance for multinational corporations and in the

current business scenario of globalization, where companies are constantly dealing in

foreign currencies.

FCCBs are quasi-debt instruments and tradable on the stock exchange. Investors are

hedge-fund arbitrators or foreign nationals.

FCCBs appear on the liabilities side of the issuing company's balance sheet.

Under IFRS provisions, a company must mark-to-market the amount of its

outstanding bonds.

The relevant provisions for FCCB accounting are International Accounting Standards:

IAS 39, IAS 32 and IFRS 7.

FCCB are issued by a company which can be redeemed either at maturity or at a price

assured by the issuer. In case the company fails to reach the assured price, bond issuer

is to get it redeemed. The price and the yield on the bond moves on the opposite

direction. The higher the yield, lower is the price.

Foreign currency convertible bonds are equity linked debt securities that are to be

converted into equity or depository receipts after a specified period. Thus a holder of

FCCB has the option of either converting it into equity share at a predetermined price

or exchange rate, or retaining the bonds.

American depositary receipt (ADR)

American depositary receipt (ADR) is a negotiable security that represents securities

of a non-US company that trades in the US financial markets. Securities of a foreign

company that are represented by an ADR are called American depositary shares

(ADSs).

Shares of many non-US companies trade on US stock exchanges through ADRs.

ADRs are denominated and pay dividends in US dollars and may be traded like

regular shares of stock. Over-the-counter ADRs may only trade in extended hours.

The first ADR was introduced by J.P. Morgan in 1927 for the British retailer

Selfridges.

ADRs are one type of depositary receipt (DR), which are any negotiable securities

that represent securities of companies that are foreign to the market on which the DR

trades. DRs enable domestic investors to buy securities of foreign companies without

the accompanying risks or inconveniences of cross-border and cross-currency

transactions.

Each ADR is issued by a domestic custodian bank when the underlying shares are

deposited in a foreign depositary bank, usually by a broker who has purchased the

shares in the open market local to the foreign company. An ADR can represent a

fraction of a share, a single share, or multiple shares of a foreign security. The holder

of a DR has the right to obtain the underlying foreign security that the DR represents,

but investors usually find it more convenient to own the DR. The price of a DR

generally tracks the price of the foreign security in its home market, adjusted for the

ratio of DRs to foreign company shares.

Global depository receipt (GDR)

A Global depository receipt (GDR) also known as International depository receipt

(IDR), is a certificate issued by a depository bank, which purchases shares of foreign

companies and deposits it on the account. They are the global equivalent of the

original American Depository Receipts (ADR) on which they are based. GDRs

represent ownership of an underlying number of shares of a foreign company and are

commonly used to invest in companies from developing or emerging markets by

investors in developed markets.

Prices of global depositary receipt are based on the values of related shares, but they

are traded and settled independently of the underlying share. Typically 1 GDR is

equal to 10 underlying shares, but any ratio can be used. It is a negotiable instrument

which is denominated in some freely convertible currency. GDR enables a company

(issuer) to access investors in capital markets outside of its home country.

Several examples international banks issue GDRs, such as JPMorgan Chase,

Citigroup, Deutsche Bank, The Bank of New York Mellon. GDRs are often listed in

the Frankfurt Stock Exchange, Luxembourg Stock Exchange and in the London Stock

Exchange, where they are traded on the International Order Book (IOB).

2.1.4 Investment by Foreign Institutional Investors (FIIs)

The Foreign Institutional Investors (FIIs) have emerged as noteworthy players in the

Indian stock market and their growing contribution adds as an important feature of the

development of stock market in India. To facilitate foreign capital flows, developing

countries have been advised to strengthen their stock market. As a result, the Indian

stock markets have reached new heights and became more volatile making the

research work in this dimension of establishing the link between FIIs and stock

market volatility. Foreign institutional investors have gained a significant role in

Indian stock markets. The dawn of 21st century has shown the real dynamism of stock

market and the various benchmarking of sensitivity index (Sensex) in terms of its

highest peaks and sudden falls.

Chapter: 3

Foreign Institutional Investors (FII) – An overview

3.1 Foreign Institutional Investors (FII)

FIIs are contributing to the foreign exchange inflow as the funds from multilateral

finance institutions and FDI are insufficient,

THE RECENT spat over the tax authorities issuing notices to foreign institutional

investors (FIIs) which take advantage under the Indo-Mauritius Bouble Taxation

Avoidance Agreement, has once again drawn attention to the role that FII investment

is playing in the capital markets in India. This article endeavours to place the overall

picture in perspective.

The Union Government allowed the entry of FIIs in order to encourage the capital

market and attract foreign funds to India. Today, FIIs are permitted to invest in all

securities traded on the primary and secondary markets, including equity shares and

other securities listed or to be listed on the stock exchanges. The original guidelines

were issued in September 1992. Subsequently, the Securities and Exchange Board of

India (SEBI) notified the SEBI (Foreign Institutional Investors) Regulations, 1995 in

November 1995.

Over the years, different types of FIIs have been allowed to operate in Indian stock

markets. They now include institutions such as pension funds, mutual funds,

investment trusts, asset management companies, nominee companies,

incorporated/institutional portfolio managers, university funds, endowments,

foundations and charitable trusts/societies with a track record. Proprietary funds have

also been permitted to make investments through the FII route subject to certain

conditions.

The SEBI is the nodal agency for dealing with FIIs, and they have to obtain initial

registration with SEBI. The registration fee is $10,000. For granting registration to an

FII, the SEBI takes into account the track record of the FII, its professional

competence, financial soundness, experience and such other criteria as may be

considered relevant by SEBI. Besides, FIIs seeking initial registration with SEBI will

be required to hold a registration from an appropriate foreign regulatory authority in

the country of domicile/incorporation of the FII. The broad based criteria for FII

registration has recently been relaxed. An FII is now considered as broad based if it

has at least 20 investors with no investor holding more than 10 per cent of shares/units

of the company/fund.

The SEBI's initial registration is valid for five years. The Reserve Bank of India's

general permission to FIIs will also hold good for five years. Both will be renewable.

There are approximately 500 FIIs registered with SEBI, but not all of them are active.

The RBI, by its general permission, allows a registered FII to buy, sell and realise

capital gains on investments made through initial corpus remitted to India,

subscribe/renounce rights offerings of shares, invest in all recognised stock exchanges

through a designated bank branch and appoint domestic custodians for custody of

investments held.

FIIs can invest in all securities traded on the primary and secondary markets. Such

investments include equity/debentures/warrants/other securities/instruments of

companies unlisted, listed or to be listed on a stock exchange in India including the

Over-the-Counter Exchange of India, derivatives traded on a recognised stock

exchange and schemes floated by domestic mutual funds. A major feature of the

guidelines is that there are no restrictions on the volume of investment - minimum or

maximum - for the purpose of entry of FIIs. There is also no lock-in period prescribed

for the purpose of such investments.

Further, FIIs can repatriate capital gains, dividends, incomes received by way of

interest and any compensation received towards sale/renouncement of rights offering

of shares subject to payment of withholding tax at source. The net proceeds can be

remitted at market rates of exchange.

All secondary market operations would be only through the recognised intermediaries

on the Indian stock exchanges, including OTCEI. Forward exchange cover can be

provided to FIIs by authorised dealers both in respect of equity and debt instruments,

subject to prescribed guidelines. Further, FIIs can lend securities through an approved

intermediary in accordance with stock lending schemes of SEBI.

3.2 History of Foreign Institutional Investors (FII)

Date Policy change

September

1992 FIIs allowed to invest by the Government Guidelines in all securities

in both primary and secondary markets and schemes floated by

mutual funds. Single FIIs to invest 5 per cent and all FIIs allowed to

invest 24 per cent of a company’s issued capital. Broad based funds

to have50 investors with no one holding more than 5 per cent.

The objective was to have reputed foreign investors, such as, pension

funds, mutual fund or investment trusts and other broad based

institutional investors in the capital market.

April 1997

Aggregated limit for all FIIs increased to 30 per cent subject to

special procedure and resolution.

The objective was to increase the participation by FIIs.

April 1998

FIIs permitted to invest in dated Government securities subject to a

ceiling. Consistent with the Government policy to limit the short-

term debt, a ceiling of US $ 1 billion was assigned which was

increased to US $ 1.75 billion in 2004.

June 1998

Forward cover allowed in equity.

February

2000 Foreign firms and high net-worth individuals permitted to invest as

sub-accounts of FIIs. Domestic portfolio manager allowed to be

registered as FIIs to manage the funds of sub- accounts. The

objective was to allow operational flexibility and also give access to

domestic asset management capability.

March

2001 FII ceiling under special procedure enhanced to 49 per cent. The

objective was to increase FII participation.

September

2001 FII ceiling under special procedure raised to sectoral capital.

December

2003 FII dual approval process of SEBI and RBI changed to single

approval process of SEBI. The objective was to streamline the

registration process and reduce the time taken for registration.

November

2004

Outstanding corporate debt limit of USD 0.5 billion prescribed. The

objective was to limit short term debt flows.

April 2006

Outstanding corporate debt limit increased to USD 1.5 billion

prescribed.

The limit on investment in Government securities was enhanced to

USD 2 bn. This was an announcement in the Budget of 2006-07.

November,

2006 FII investment upto 23% permitted in infrastructure companies in the

securities markets, viz. stock exchanges, depositories and clearing

corporations. This is a decision taken by Government following the

mandating of demutualization and corporatization of stock

exchanges.

January

And October

2007

FIIs allowed to invest USD 3.2 billion in Government Securities

(limits were raised from USD 2 billion in two phases of USD 0.6

billion each in January and October).

June, 2008

While reviewing the External Commercial Borrowing policy, the

Government increased the cumulative debt investment limits from

US $3.2 billion to US $5 billion and US $1.5 billion to US $3 billion

for FII investments in Government Securities and Corporate Debt,

respectively.

October

2008

1: While reviewing the External Commercial Borrowing policy, the

Government increased the cumulative debt investment limits from

US $3 billion to US $6 billion for FII investments in Corporate Debt.

2: Removal of regulation for FIIs pertaining to restriction of 70:30

ratio of investment in equity and debt respectively.

3: Removal of Restrictions on Overseas Derivatives Instruments

(ODIs) Disapproval of FIIs lending shares abroad.

March

2009

E-bids platform for FIIs

August

2009 FIIs allowed to participate in interest rate futures

April 2010

FIIs allowed to offer domestic Government Securities and foreign

sovereign securities with AAA rating, as collateral to the recognized

stock exchanges in India, in addition to cash, for their transactions in

the cash segment of the market.

November

2010 Investment cap for FIIs increased by US $ 5 billion each in

Government securitiesand corporate bonds to US $ 10 billion and US

$ 20 billion respectively.

3.3 Types of foreign Institutional Investors

1. Pension funds:

A pension fund is a pool of assets that form an independent legal entity that are

bought with the contributions to a pension plan for the exclusive purpose of financing

pension plan benefits. It manages pension and health benefits for employees, retirees,

and their families. FII activity in India gathered momentum mainly after the entry of

CAlPERS (California Public Employees’ Retirement System), a large US-based

pension fund in 2004.

2. Mutual fund.

A mutual fund is a type of professionally managed collective investment scheme that

pools money from many investors to purchase securities. While there is no legal

definition of the term "mutual fund", it is most commonly applied only to those

collective investment vehicles that are regulated and sold to the general public. They

are sometimes referred to as "investment companies" or "registered investment

companies". Most mutual funds are "open-ended", meaning stockholders can buy or

sell shares of the fund at any time by redeeming them from the fund itself, rather than

on an exchange. Hedge funds are not considered a type of mutual fund, primarily

because they are not sold publicly.

Mutual funds have both advantages and disadvantages compared to direct investing in

individual securities. They have a long history in the United States. Today they play

an important role in household finances, most notably in retirement planning.

There are 3 types of U.S. mutual funds: open-end, unit investment trust, and closed-

end. The most common type, the open-end fund, must be willing to buy back shares

from investors every business day. Exchange-traded funds (or "ETFs" for short) are

open-end funds or unit investment trusts that trade on an exchange. Open-end funds

are most common, but exchange-traded funds have been gaining in popularity.

Mutual funds are generally classified by their principal investments. The four main

categories of funds are money market funds, bond or fixed income funds, stock or

equity funds and hybrid funds. Funds may also be categorized as index or actively

managed.

Investors in a mutual fund pay the fund’s expenses, which reduce the fund's

returns/performance. There is controversy about the level of these expenses. A single

mutual fund may give investors a choice of different combinations of expenses (which

may include sales commissions or loads) by offering several different types of share

classes.

3: Investment trust:

An Investment trust is a form of collective investment. Investment trusts are closed-

end funds and are constituted as public limited companies. A collective investment

scheme is a way of investing money with others to participate in a wider range of

investments than feasible for most individual investors, and to share the costs and

benefits of doing so.

4: Investment banks:

An investment bank is a financial institution that raises capital, trades in securities and

manages corporate mergers and acquisitions. Investment banks profit from companies

and governments by raising money through issuing and selling securities in capital

markets (both equity, debt) and insuring bonds (e.g. selling credit default swaps), as

well as providing advice on transactions such as mergers and acquisitions.

5: University Fund:

The purpose of investments of these funds is to establish an asset mix for each of the

University funds according to the individual fund’s spending obligations, objectives,

and liquidity requirements. It consists of the University’s endowed trust funds or other

funds of a permanent or long-term nature. In addition, external funds may be invested

including funds of affiliated organizations and funds where the University is a

beneficiary.

6: Endowment fund:

It is a transfer of money or property donated to an institution, usually with the

stipulation that it be invested, and the principal remain intact in perpetuity or for a

defined time period. This allows for the donation to have an impact over a longer

period of time than if it were spent all at once.

7: Insurance Funds:

An insurance company’s contract may offer a choice of unit-linked funds to invest in.

All types of life assurance and insurers pension plans, both single premium and

regular premium policies offer these funds. They facilitate access to wide range and

types of assets for different types of investors.

8: Asset Management Company:

An asset management company is an investment management firm that invests the

pooled funds of retail investors in securities in line with the stated investment

objectives. For a fee, the investment company provides more diversification, liquidity,

and professional management consulting service than is normally available to

individual investors. The diversification of portfolio is done by investing in such

securities which are inversely correlated to each other. They collect money from

investors by way of floating various mutual fund schemes.

9: Nominee Company:

Company formed by a bank or other fiduciary organization to hold and administer

securities or other assets as a custodian (registered owner) on behalf of an actual

owner (beneficial owner) under a custodial agreement.

10: Charitable Trusts or Charitable Societies:

A trust created for advancement of education, promotion of public health and comfort,

relief of poverty, furtherance of religion, or any other purpose regarded as charitable

in law. Benevolent and philanthropic purposes are not necessarily charitable unless

they are solely and exclusively for the benefit of public or a class or section of it.

Charitable trusts (unlike private or non-charitable trust) can have perpetual existence

and are not subject to laws against perpetuity. They are wholly or partially exempt

from almost all taxes.

Chapter 4:

FOREIGN DIRECT INVESTMENT (FDI) VS. FOREIGN

INSTITUTIONAL INVESTORS (FII)

On the basis types of Investments

FDI typically brings along with the financial investment, access to

moderntechnologies and export market. The impact of the FDI in India is far more

than thatof FII largely because the former would generally involve setting up of

productionbase - factories, power plant, telecom networks, etc. that enables direct

generation ofemployment. There is also multiplier effect on the back of the FDI

because of furtherdomestic investment in related downstream and upstream projects

and a host ofother services. Korean Steel maker Posco’s US$ 8 billion steel plant in

Orissa wouldbe the largest FDI in India once it commences. Maruti Suzuki has been

an exemplarycase in the India's experience. However, the issue is that it puts an

impact on localentrepreneur as he may not be able to always successfully compete in

the face ofsuperior technology and financial power of the foreign investor. Therefore,

it is oftenregulated that Foreign Direct Investments should ensure minimum level of

localcontent, have export commitment from the investor and ensure foreign

technologytransfer to India.

FII investments into a country are usually not associated with the direct benefits

interms of creating real investments. However, they provide large amounts of

capitalthrough the markets. The indirect benefits of the market include alignment of

localpractices to international standards in trading, risk management, new

instrumentsand equities research. These enable markets to become deeper, liquid,

feeding inmore information into prices resulting in a better allocation of capital to

globallycompetitive sectors of the economy. Since, these portfolio flows can

technicallyreverse at any time, the need for adequate and appropriate economic

regulations are imperative.

On the basis of Government’s Preference

FDI is preferred over FII investments since it is considered to be the most

beneficialform of foreign investment for the economy as a whole. Direct investment

targets aspecific enterprise, with the aim of enhancing capacity and productivity or

changingits management control. Direct investment to create or augment capacity

ensuresthat the capital inflow translates into additional production. In the case of

FIIinvestment that flows into the secondary market, the effect is to increase

capitalavailability in general, rather than availability of capital to a particular

enterprise.

Translating an FII inflow into additional production depends on productiondecisions

by someone other than the foreign investor — some local investor has todraw upon

the additional capital made available via FII inflows to augmentproduction. In the

case of FDI that flows in for acquiring an existing asset, noaddition to production

capacity takes place as a direct result of the FDI inflow. Justlike in the case of FII

inflows, in this case too, addition to production capacity doesnot result from the

action of the foreign investor – the domestic seller has to investthe proceeds of the

sale in a manner that augments capacity or productivity for theforeign capital inflow

to boost domestic production. There is a widespread notionthat FII inflows are hot

money — that it comes and goes, creating volatility in thestock market and exchange

rates. While this might be true of individual funds, cumulatively, FII inflows have

only provided net inflows of capital

On the basis of Stability

FDI tends to be much more stable than FII inflows. Moreover, FDI brings not

justcapital but also better management and governance practices and, often,

technologytransfer. The knowhow thus transferred along with FDI is often more

crucial thanthe capital per se. No such benefit accrues in the case of FII inflows,

although thesearch by FIIs for credible investment options has tended to improve

accounting andgovernance practices among listed Indian companies.

CHAPTER 5:

REGULATIONS OF FOREIGN INSTITUTIONAL INVESTORS

(FII)

Modes of Investment by Foreign Investors in India

5.1 Policy Developments for Foreign Investments

5.1.1 Allocation of Government debt & corporate debt investment limits to FIIs

SEBI, vide its circular dated November 26, 2010 has made the following decisions:

5.1.1.1 Increased investment limit for FIIs in Government and Corporate debt:

In an attempt to enhance FII investment in debt securities, government has increased

the currentlimit of FII investment in Government Securities by US $ 5 billion raising

the cap to US $ 10billion. Similarly, the current limit of FII investment in corporate

bonds has also been increasedby US $ 5 billion raising the cap to US $ 20 billion.

This incremental limit shall be invested incorporate bonds with residual maturity of

over five years issued by companies in the infrastructure sector...

5.1.1.2 Time period for utilization of the debt limits:

In July 2008, some changes pertaining to the methodology for the allocation of debt

limit hadbeen specified. In continuation of the same, SEBI has decided that the time

period forutilization of the corporate debt limits allocated through bidding process

(for both old and longterm infra limit) shall be 90 days. However, time period for

utilization of the government debtlimits allocated through bidding process shall

remain 45 days. Moreover, the time period forutilization of the corporate debt limits

allocated through first come first serve process shall be22 working days while that for

the government debt limits shall remain unchanged at 11working days.

Further, it was decided to grant a period of upto 15 working days for replacement of

the disposed off/ matured debt instrument/ position for corporate debt while that for

Governmentdebt will continue to be at 5 working days.

5.1.1.3 Government debt long terms:

SEBI, vide its circular dated February 2009, had decided that no single entity shall be

allocatedmore than ` 10,000 crore of the investment limit. In a partial amendment to

this, SEBI, vide itscircular dated November 26, 2010, has decided that no single entity

shall be allocated more than 2000 crore of the investment limit. Where a singly entity

bids on behalf of multipleentities, then such bid would be limited to ` 2,000 crore for

every such single entity. Further, the minimum amount which can be bid for has been

made ` 200 crore and the minimum ticksize has been made ` 100 crore.

5.1.1.4 Corporate debt - Old limit:

SEBI has decided that no single entity shall be allocated more than ` 600 crore of

theinvestment limit. Where a singly entity bids on behalf of multiple entities, then

such bid wouldbe limited to ` 600 crore for every such single entity. Further, the

minimum amount which canbe bid for has been made ` 100 crore and the minimum

tick size has been made ` 50 crore.

5.1.1.5 Multiple bid order from single entity:

SEBI has allowed the bidder to bid for more than one entity in the bidding process

provided:

1) It provides due authorization to act in that capacity by those entities

2) It provides the stock exchanges, the allocation of the limits interse for the entities it

has bidfor to exchange with 15 minutes of close of bidding session.

5.1.1.6 FII investment into ‘to be listed’ debt securities

The market regulator has decided that FIIs will be allowed to invest in primary debt

issues onlyif listing is committed to be done within 15 days. If the debt issue could

not be listed within 15days of issue, then the holding of FIIs/subaccounts if disposed

off shall be sold off only todomestic participants/investors until the securities are

listed. This is in contrast to the earlierregulations issued in April 2006, wherein FII

investments were restricted to only listed debtsecurities of companies.

5.1.2 Maintenance of Collateral by FIIs for Transactions in the Cash Segment

RBI, vide its circular dated April 12, 2010 has decided, in consultation with the

Government ofIndia and the SEBI, to permit the FIIs to offer domestic Government

securities and foreignsovereign securities with AAA rating, as collateral to the

recognized stock exchanges in India,in addition to cash, for their transactions in the

cash segment of the market.

5.1.3 Reporting of Lending of Securities bought in the Indian Market

SEBI, vide its circular dated June 29, 2010 has decided that the FIIs’ reporting of

lending ofsecurities bought in the Indian market will be done on weekly basis instead

of the erstwhiledaily submissions. In accordance with this change in periodicity of

reports, with effect fromJuly 02, 2010, FIIs are required to submit the reports every

Friday. Further, in view of thechange in the periodicity of the reporting, PN issuing

FIIs are required to submit the followingundertaking along with the weekly report:

"Any fresh short position shall be immediately reported to SEBI"

5.1.4 FII participation in Interest Rate Futures

FIIs have been allowed to participate in interest rate futures which were introduced

for tradingat NSE on August 31, 2009.

5.1.5 Rationalization of SEBI Fees for FIIs and FVCIs

SEBI has reduced its fees to be charged to FVIs and FIIs. This was effective from

July 2009onwards.

5.2 Evolution of policy framework

Until the 1980s, India’s development strategy was focused on self-reliance and

import-substitution. Current account deficits were financed largely through debt flows

and official development assistance. There was a general disinclination towards

foreign investment or private commercial flows. Since the initiation of the reform

process in the early 1990s, however, India’s policy stance has changed substantially,

with a focus on harnessing the growing global foreign direct investment (FDI) and

portfolio flows. The broad approach to reform in the external sector after the Gulf

crisis was delineated in the Report of the High Level Committee on Balance of

Payments. It recommended, inter alia, a compositional shift in capital flows away

from debt to non-debt creating flows; strict regulation of external commercial

borrowings, especially short-term debt; discouraging volatile elements of flows from

non-resident Indians (NRIs); gradual liberalization of outflows; and dis-

intermediation of Government in the flow of external assistance.

After the launch of the reforms in the early 1990s, there was a gradual shift towards

capital account convertibility. From September 14, 1992, with suitable restrictions,

FIIs and Overseas Corporate Bodies (OCBs) were permitted to invest in financial

instruments. The policy framework for permitting FII investment was provided under

the Government of India guidelines vide Press Note dated September 14, 1992, which

enjoined upon FIIs to obtain an initial registration with SEBI and also RBI’s general

permission under FERA. Both SEBI’s registration and RBI’s general permissions

under FERA were to hold good for five years and were to be renewed after that

period. RBI’s general permission under FERA could enable the registered FII to buy,

sell and realize capital gains on investments made through initial corpus remitted to

India, to invest on all recognized stock exchanges through a designated bank branch,

and to appoint domestic custodians for custody of investments held.

The Government guidelines of 1992 also provided for eligibility conditions for

registration, such as track record, professional competence, financial soundness and

other relevant criteria, including registration with a regulatory organization in the

home country. The guidelines were suitably incorporated under the SEBI (FIIs)

Regulations, 1995. These regulations continue to maintain the link with the

government guidelines through an inserted clause that the investment by FIIs would

also be subject to Government guidelines. This linkage has allowed the Government

to indicate various investment limits including in specific sectors. With coming into

force of the Foreign Exchange Management Act, (FEMA), 1999 in 2000, the Foreign

Exchange Management (Transfer or issue of Security by a Person Resident outside

India) Regulations, 2000 were issued to provide the foreign exchange control context

where foreign exchange related transactions of FIIs were permitted by RBI.

A philosophy of preference for institutional funds, and prohibition on portfolio

investments by foreign natural persons has been followed, except in the case of Non-

resident Indians, where direct participation by individuals takes place. Right from

1992, FIIs have been allowed to invest in all securities traded on the primary and

secondary markets, including shares, debentures and warrants issued by companies

which were listed or were to be listed on the Stock Exchanges in India and in schemes

floated by domestic mutual funds.

5.3 Market Design - FIIs

I. Entities eligible to invest under FII route:

i. An institution established or incorporated outside India as a pension fund,

mutual fund, investment trust, insurance company or reinsurance company;

ii. An International or Multilateral Organization or an agency thereof or a

Foreign Governmental Agency, Sovereign Wealth Fund or a Foreign Central

Bank;

iii. An asset management company, investment manager or advisor, bank or

institutional portfolio manager, established or incorporated outside India and

proposing to make investments in India on behalf of broad based funds and its

proprietary funds, if any;

iv. A Trustee of a trust established outside India, and proposing to make

investments in India on behalf of broad based funds and its proprietary funds, if

any

v. University fund, endowments, foundations or charitable trusts or charitable

societies. Broad based fund means a fund established or incorporated outside

India, which has at least 20 investors with no single individual investor holding

more than 49 percent of the shares or units of the fund. If the broad based fund

has institutional investor(s), then it is not necessary for the fund to have 20

investors. Further, if the broad based fund has an institutional investor who holds

more than 49 percent of the shares or units in the fund, then the institutional

investor must itself be a broad based fund. Sub-account means any person

resident outside India, on whose behalf investments are proposed to be made in

India by a foreign institutional investor and who is registered as a subaccount

under the SEBI (FII) Regulations, 1995. Applicant for sub-account can fall into

any of the following categories, namely:

i. Broad based fund or portfolio which is broad based, incorporated or

established outside India.

ii. Proprietary fund of a registered foreign institutional investor.

iii. Foreign corporate (which has its securities listed on a stock exchange

outside India, having asset base of not less than US $ 2 billion and having an

average net profit of not less than US $ 50 million. A non-resident Indian shall

not be eligible to invest as sub-account.

5.3.1 Investment Restrictions OF FII

An FII can invest only in the following:

1: securities in the primary and secondary markets including shares, debentures and

warrants of companies, unlisted, listed or to be listed on a recognized stock exchange

in India.

2: units of schemes floated by domestic mutual funds including Unit Trust of India,

whether listedor not listed on a recognized stock exchange; units of scheme floated by

Collective InvestmentScheme.

3: dated Government securities and

4: derivatives traded on a recognized stock exchange

5: commercial paper

6: security receipts

7: Indian Depository Receipts

In case foreign institutional investor or sub-account holds equity shares in a company

whose shares arenot listed on any recognized stock exchange, and continues to hold

the shares after initial public offering and listing thereof, such shares would be subject

to lockin for the same period, if any is applicable to shares held by a foreign direct

investor placed in similar position, under the policy of the Central Government

relating to foreign direct investment for the time being in force.

The total investments in equity and equity related instruments (including fully

convertible debentures, convertible portion of partially convertible debentures and

tradable warrants) made by a FII in India, whether on his own account or on account

of his sub- accounts, should not be less than 70 per cent of the aggregate of all the

investments of the Foreign Institutional Investor in India, made on his ownaccount

and on account of his subaccounts.

However, this is not applicable to any investment of the FII either on its own account

or on behalf ofits sub-accounts in debt securities which are unlisted or listed or to be

listed on any stock exchange ifthe prior approval of the SEBI has been obtained for

such investments.

Further, SEBI while grantingapproval for the investments may impose conditions as

are necessary with respect to the maximum amount which can be invested in the debt

securities by the foreign institutional investor on its ownaccount or through its sub-

accounts. A foreign corporate or individual shall not be eligible to invest through the

100 percent debt route.

Investments made by FIIs in security receipts issued by securitization companies or

asset reconstruction companies under the Securitization and Reconstruction of

Financial Assets and Enforcement of Security Interest Act, 2002 are not eligible

for the investment limits mentioned above.

No foreign institutional investor can invest in security receipts on behalf of its sub-

accounts.

5.3.2 FII Investment in secondary markets:

SEBI regulations provide that a foreign institutional investor or sub-account can

transact in the Indiansecurities market only on the basis of taking and giving delivery

of securities purchased or sold.

However, this does not apply to any transactions in derivatives on a recognized stock

exchange.Further, SEBI has, in December, 2007 permitted FIIs and sub-accounts can

enter into short sellingtransactions only in accordance with the framework specified

by SEBI. No transaction on the stockexchange can be carried forward and the

transaction in securities would be only through stock brokerwho has been granted a

certificate by SEBI. They have also been allowed to lend or borrow securitiesin

accordance with the framework specified by SEBI in this regard.

The purchase of equity shares of each company by a FII investing on his own account

should notexceed 10 percent of the total issued capital of that company. FII investing

in equity shares of acompany on behalf of his sub-accounts, the investment on behalf

of each such sub-account should notexceed 10 percent of the total issued capital of

that company. In case of foreign corporate orindividuals, each of such sub-account

should not invest more than five percent of the total issuedcapital of the company in

which such investment is made.

A Foreign institutional investor can issue, or otherwise deal in offshore derivative

instruments, directly of indirectly wherein the offshore derivative instruments are

issued only to persons who are regulatedby an appropriate foreign regulatory

authority and the ODIs are issued after compliance with ‘know your client’ norms.

5.3.3 General Obligations and Responsibilities

Certain general obligations and responsibilities relating to appointment of domestic

custodians, designated bank, investment advice in publicly accessible media etc. have

been laid down on the FIIs operating in the country in the SEBI (FII) Regulations,

1995.

5.3.4 Private Placement with FIIs

SEBI registered FIIs have been permitted to purchase shares/convertible debentures of

an Indian company through offer/private placement subject to the ceiling of 10

percent of the paid up capital of the Indian company for individual FII/sub account

and 24 percent for all FIIs/sub-accounts put together. Indian company is permitted to

issue such shares provided that:

5.3.4.1 In the case of public offer, the price of shares to be issued is not less than the

price at which shares are issued to residents and

5.3.4.2 In the case of issue by private placement, the price is not less than the price

arrived at in termsof SEBI guidelines or guidelines issued by the erstwhile Controller

of Capital issues asapplicable. Purchases can also be made of Partially Convertible

debentures, Fully Convertibledebentures, Rights/Renunciations/Warrants/Units of

Domestic Mutual Fund Schemes.

5.4 Risk Management

5.4.1 Forward Cover & Cancellation and Rebooking

Authorized Dealer Banks can offer forward cover to FIIs to the extent of total inward

remittance of liquidated investment. Rebooking of cancelled forward contracts is

allowed up to a limit of 2 percent of the market value of the entire investment of FIIs

in equity and/or debt in India. The limit for calculating the eligibility for rebooking

will be based upon market value of the portfolio as at the beginning of the financial

year (April-March).

The outstanding contracts have to be duly supported by underlying exposure at all

times.

The AD Category-I bank has to ensure that (i) that total forward contracts outstanding

does not exceed the market value of portfolio and (ii) forward contracts permitted to

be rebooked does not exceed 2 percent of the market value as determined at the

beginning of the financial year. The monitoring of forward cover is to be done on a

fortnightly basis.

5.4.1.1 FII Position Limits In Derivatives Contracts

SEBI registered FIIs are allowed to trade in all exchange traded derivative contracts

on the stock exchanges in India subject to the position limits as prescribed by SEBI

from time to time. Clearing Corporation monitors the open positions of the FII/sub-

accounts of the FII for each underlying security and index, against the position limits

specified at the level of FII/sub accounts of FII respectively, at the end of each trading

day.

5.4.2 Monitoring of investment position by RBI

The Reserve Bank of India (RBI) monitors the investment position of FIIs in listed

Indian Companies, reported by Custodian/designated AD banks on a daily basis, in

Forms LEC (FII).

5.4.3 Caution List

When the total holdings of FIIs under the Scheme reach the limit of 2 percent below

the sectoral cap, RBI issues a notice to all designated branches of AD Category - 1

banks cautioning that any further purchases of shares of the particular Indian company

will require prior approval of RBI. RBI gives case-by case approvals to FIIs for

purchase of shares of companies included in the Caution List. This is done on a first-

come-first served basis.

5.4.4 Ban List

Once the shareholding by FIIs reaches the overall ceiling/sectoral cap/statutory limit,

RBI places the company in the Ban List. Once a company is placed on the Ban List,

no FII or NRI can purchase the shares of the company under the Portfolio Investment

Scheme.

5.4.5 Margin Requirements

SEBI registered FIIs/sub-accounts are allowed to keep with the trading

member/clearing member amount sufficient to cover the margins prescribed by the

exchange/Clearing House and such amounts as may be considered to meet the

immediate

5.4.6 Reporting of FII Investments

An FII may invest in a particular share issue of an Indian Company either under the

FDI scheme or the Portfolio Investment Scheme. The AD Category-I banks have to

ensure that the FIIs who are purchasing the shares by debit to the Special Non-

Resident Rupee Account report these details separately in the Form LEC (FII).

5.4.7 Investment by FIIs under Portfolio Investment Scheme

RBI has given general permission to SEBI registered FIIs/sub-accounts to invest

under the Portfolio Investment Scheme (PIS).

Total holding of each FII/sub account under this scheme should not exceed

10% of the total paid up capital or 10% of the paid up value of each series of

convertible debentures issued by the Indian company.

Total holding of all the FIIs/sub-accounts put together should not exceed 24%

of the paid up capital or paid up value of each series of convertible debentures. This

limit of 24% can be increased to the sectoral cap / statutory limit as applicable to the

Indian Company concerned, by passing a resolution of its Board of Directors followed

by a special resolution to that effect by its General Body.

A domestic asset management company or portfolio manager, who is

registered with SEBI as an FII for managing the fund of a sub-account can make

investments under the Scheme on behalf of:

1) A person resident outside India who is a citizen of a foreign state or

2) A body corporate registered outside India.

However, such investment should be made out of funds raised or collected or

brought from outside through normal banking channel. Investments by such entities

should not exceed 5% of the total paid up equity capital or 5% of the paid up value of

each series of convertible debentures issued by an Indian company, and should also

not exceed the overall ceiling specified for FIIs.

5.5 Unique Risks of and Institutional Constraints for Foreign

InstitutionalInvestors

5.5.1 Unique Risks of International Portfolio Investment

Unfortunately, there are not only benefits from IPI that simply wait to be taken

advantage of, but thereare also some unique risks and constraints that arise when

extending the scope of securities held to an international scale. These are easily

overlooked, but nevertheless have to be included in the analysis when

comprehensively assessing the IPI phenomenon, since they might influence the

investmentdecision or its implementation considerably.

5.5.1.1 Currency Risk

In what follows, the unique aspects of risk due to international diversification of

investment portfolioswill be analyzed in more detail. The major point is that improved

portfolio performance as a result of international portfolio investment must be shown

after allowing for these risk and cost components.

For convenience as well as analytical clarity, the unique international risk can be

divided into two components:

A: exchange risk (broadly defined)

B: political (or country) risk.

5.5.1.2 Country Risk

The fact that a security is issued or traded in a different and sovereign political

jurisdiction than that of the consumer-investor gives rise to what is referred to as

country risk or political risk. Country risk ingeneral can be categorized into transfer

risks (restrictions on capital flows), operational risks (constraints on management and

corporate activity) and ownership-control risks (government policieswith regard to

ownership/managerial control). It embraces the possibility of exchange controls,

expropriation of assets, changes in tax policy (like withholding taxes being

imposedafter the investment is undertaken) or other changes in the business

environment of the country. Ineffect, country risk are local government policies that

lower the actual (after tax) return on the foreign investment or make the repatriation

of dividends, interest, and principal more difficult. Malaysia's actions in 1997/98

represents a textbook example why country risk is still a concern to foreign portfolio

Investors. Political risk also includes default risk due to government actions and the

general uncertainty regarding political and economic developments in the foreign

country. In order to deal with these issues, theinvestor needs to assess the country's

prospects for economic growth, its political developments, and itsbalance of payments

trends. Interestingly, political risk is not unique to developing countries.

In addition to assessing the degree of government intervention in business, the ability

of the labor forceand the extent of a country's natural resources, the investor needs to

appraise the structure, size, andliquidity of its securities markets. Information and data

from published financial accounting statementsof foreign firms may be limited;

moreover, the information available may be difficult to interpret due

to incomplete or different reporting practices,

This information barrier is another aspect ofcountry risk. Indeed, it is part of the

larger issue of corporate governance and the treatment of foreign (minority) investors,

mentioned earlier. At this point it is worth noting that in many countries

foreigninvestors are under a cloud of suspicion which often stems from a history of

colonial domination.

5.5.2 Institutional Constraints for International Portfolio Investment

Institutional constraints are typically government-imposed, and include taxes, foreign

exchangecontrols, and capital market controls, as well as factors such as weak or

nonexistent laws protecting therights of minority stockholders, the lack of regulation

to prevent insider trading, or simply inadequaterules on timely and proper disclosure

of material facts and information to security holders. Their effecton international

portfolio investment appears to be sufficiently important that the theoretical

benefitsmay prove difficult to obtain in practice. This is, of course, the very reason

why segmented marketspresent opportunities for those able to overcome the barriers.

However, when delineating institutional constraints on international portfolio

investment, it must berecognized that these barriers are somewhat ambiguous.

Depending on one's viewpoint, institutionalconstraints can turn out to be incentives:

what is a constraint in one market (high transaction costs, forexample), turns into an

incentive for another market. Or, while strict regulation of security issues may

be designed for the protection of investors, if administered by an inept bureaucracy it

can prove to be aconstraint for both issuers and investors.

5.5.2.1 Taxation

When it comes to international portfolio investment, taxes are both an obstacle as well

as an incentive to cross-border activities. Not surprisingly, the issues are complex -- in

large part because rulesregarding taxation are made by individual governments, and

there are many of these, all having verycomplex motivations that reach far beyond

simply revenue generation. In the present context, it is notdetails but a framework or

"pattern" of tax considerations affecting IPI that is of foremost interest.

It is obvious then, since tax laws are national, that it is individual countries that

determine the tax ratespaid on various returns from portfolio investment, such as

dividends, interest and capital gains. All these rules differ considerably from country

to country. Countries also differ in terms of institutionalarrangements for investing in

securities, but in all countries there are institutional investors which maybe tax

exempt (e.g. pension funds) or have the opportunity for extensive tax deferral

(insurancecompanies).

5.5.2.3 Capital Market Regulations

Regulations of primary and secondary security markets typically aim at protecting the

buyer offinancial securities and try to ensure that transactions are carried out on a fair

and competitive basis.

These functions are usually accomplished through an examining and regulating body,

such as theSecurities and Exchange Commission (SEC) in the United States, long

regarded as exemplary inguarding investor interests, or the "Commitee des Bourses et

Valeurs" in France. Supervision andcontrol of practices and information disclosure by

a relatively impartial body is important formaintaining investors' confidence in a

market; it is crucial for foreign investors who will have even lessdirect knowledge of

potential abuses, and whose ability to judge the conditions affecting returns

onsecurities may be very limited.

Most commonly, capital market controls manifest themselves in form of restrictions

on the issuance ofsecurities in national capital markets by foreign entities, thereby

making foreign securities unavailable

to domestic investors. Moreover, some countries put limits on the amount of

investment local investorscan do abroad or constrain the extent of foreign ownership

in national companies. While fewindustrialized countries nowadays prohibit the

acquisition of foreign securities by private investors, institutional investors face a

quite different situation. Indeed, there is almost no country where

financialinstitutions, insurance companies, pension funds, and similar fiduciaries are

not subject to rules andregulations that make it difficult for them to invest in foreign

securities.

In the United States, for example, different state regulations severely constrain the

proportion ofinsurance company portfolios invested in foreign securities. In some

states, institutions, such aspension funds for public employees including teachers,

cannot invest in foreign securities at all.

Similarly, state banking regulations specify severe limits for commercial banks, and

trustees of evenprivate pension funds have been plagued by the uncertainties of legal

interpretation of the "prudentman's rule," effectively limiting the acquisition of

foreign securities. In most other countries, there are similar or even more binding

restrictions.

5.5.2.4 Transaction Costs

Transaction costs associated with the purchase of securities in foreign markets tend to

be substantiallyhigher compared to buying securities in the domestic market. Clearly,

this fact serves as an obstacle toIPI. Trading in foreign markets causes extra costs for

financial intermediaries, because access to themarket can be expensive. The same is

true for information about prices, market movements, companies

and industries, technical equipment and everything else that is necessary to actively

participate intrading. Moreover, there are administrative overheads, costs for the data

transfer between the domesticbank and its foreign counterpart (be it a bank

representative or a local partner institution. Therefore, financial institutions try to pass

these costs on to their customers, i.e. the investor. Simply timedifferences can be a

costly headache, due to the fact that someone has to do transactions at timesoutside

normal business hours.

However, transactions costs faced by international investors can be mitigated by the

characteristic of "liquidity," providing depth, breadth, and resilience of certain capital

markets, thus reducing thisconstraint and -- as a consequence -- inducing international

portfolio investment to these countries.

Issuers from the investors' countries will then have a powerful incentive to list their

securities on the exchange(s) of such markets.

The development of efficient institutions, the range of expertise and experience

available, the volume of transactions and breadth of securities traded, and the

readiness with which the market can absorb large, sudden sales or purchases of

securities at relatively stable prices all vary substantially fromcountry to country. The

U.S. and British markets have a reputation for being superior in these respects, and

have attracted a large amount of international portfolio investment as a result. These

markets can offer and absorb a wide variety of securities, both with regard to type

(bonds, convertibles, preferred shares, ordinary shares, money market instruments,

etc.) and with regard to issuer (public authorities, banks, non bank financial

institutions, private companies, foreign and international institutions, etc.).

They offer depth, being able to supply and absorb substantial quantities of different

securities at close to the current price, where as in Continental Europe and Asia one

often hears complaints about the"thinness" of the securities markets leading to

random volatility of prices. Therefore, all other factorsbeing equal, investors are

attracted to markets where transactions are conducted efficiently and at a low cost to

borrower and lender, buyer and seller. Historically, New York has provided foreign

investors with one of the most efficient securities markets in the world.

CHAPTER 6:

BENEFITS AND LIMITATIONS OF FOREIGN INSTUTIONAL

INVESTORS (FII)

6.1 BENEFITS OF FOREIGN INSTUTIONAL INVESTORS (FII)

Benefits of FII Investment:

6.1.1. Enhanced flows of equity capital:

FIIs are well known for a greater appetite for equity than debt in their assetstructure.

For examples, pension funds in the United Kingdom and United stateshad 68 percent

and 64 percent, respectively of their portfolios in equity in 1998. Thus, opening up the

economy to FIIs is in line with the accepted preference for non-debtcreating foreign

inflows over foreign debt. Furthermore, because of this preference for equities over

bonds, FIIs can help in compressing the yield-differential betweenequity and bonds

and improve corporate capital structures. Further, given theexisting saving investment

gap of around 1.6 percent, FII inflows can also contributein bridging the investment

gap. So that sustained high GDP growth rate of around 8percent targeted under the

10th five year plan can be materialize. Equity return has asignificant and positive

impact on the FII investment. But given the huge volume of investments,

foreigninvestment could play a role of market makers and book their profits and

enhancedequity capital in the host country.

6.1.2. Improving capital markets:

FIIs as professional bodies of asset managers and financial analyst’s enhance

competition and efficiency of financial markets. Equity market development aids

economic development. By increasing the availability of riskier long term capital for

projects, and increasing firms’ incentives to supply more information about

themselves, the FIIs can help in the process of economic development. Theincreasing

role of institutional investors has brought both quantitative and qualitative

developments in the stock markets viz., expansion of securities business,increased

depth and breadth of the market, and above all their dominant investment philosophy

of emphasizing the fundamentals has rendered efficient pricing of thestocks

suggested that foreign portfolio investmentswould help the stock markets directly

through widening investors’ base andindirectly by compelling local authorities to

improve the trading system.

6.1.3. Improved corporate governance:

Good corporate governance is essential to overcome the principal-agent problem

between share-holders and management. Information asymmetries and incomplete

contracts between share-holders and management are at the root of the agency costs.

Dividend payment, for example, is discretionary. Bad corporate governance

makesequity finance a costly option. With boards often captured by managers or

passive, ensuring the rights of shareholders is a problem that needs to be

addressedefficiently in any economy. Incentives for shareholders to monitor firms and

enforcetheir legal rights are limited and individuals with small share-holdings often

do notaddress the issue since others can free-ride on their endeavor. What is a needed

islarge shareholder with leverage to complement their legal rights and overcome

thefree-rider problem, but shareholding beyond say 5 per cent can also lead

toexploitation of minority shareholders. FIIs constitute professional bodies of

assetmanagers and financial analysts, who, by contributing to better understanding

offirms’ operations, improve corporate governance. Among the four models

ofcorporate control – takeover or market control via equity, leveraged control

ormarket control via debt, direct control via equity, and direct control via debt

orrelationship banking – the third model, which is known as corporate governance

movement, has institutional investors at its core. In this third model,

boardrepresentation is supplemented by direct contacts by institutional investors.

Institutions are known for challenging excessive executive compensation, and remove

underperforming managers.

6.1.4. Managing uncertainty and controlling risks:

Institutional investors promote financial innovation and development of

hedginginstruments. Institutions, for example, because of their interest in hedging

risks, are known to have contributed to the development of zero-coupon bonds and

index futures. FIIs, as professional bodies of asset managers and financial analysts,

notonly enhance competition in financial markets, but also improve the alignment

ofasset prices to fundamentals. Institutions in general and FIIs in particular are

knownto have good information and low transaction costs. By aligning asset prices

closer to fundamentals, they stabilize markets. Fundamentals are known to be

sluggish in their movements. Thus, if prices are aligned to fundamentals, they should

be asstable as the fundamentals themselves. Furthermore, a variety of FIIs with a

variety of risk-return preferences also help in dampening volatility.

6.1.5. Reduced cost of equity capital:

FII inflows augment the sources of funds in the Indian capital markets. In a

commonsense way, the impact of FIIs upon the cost of equity capital may be

visualized byasking what stock prices would be if there were no FIIs operating in

India. FII investment reduces the required rate of return for equity, enhances stock

prices, and foster investments by Indian firms in the country. From the perspective of

international investors, the rapidly growing emerging markets offer potentially higher

rates of return and help in diversifying portfolio risk. It is argued that FPI flows

increase the stock prices in the recipients markets, which in turn increases the Price-

Earning (P/E) ratio of the concerned firms. Increase in P/E ratio tends to reduce the

cost of capital and boosts the stock markets. This phenomenon has been witnessed in

the case of Asian and Latin American countries. The costof equity capital is also cut

down due to the sharing of risk by the foreign investors.

This reduction in the cost of equity could result in increased physical investment

(Henry, 2000). Some investment projects with a negative Net Present Value (NPV)

before the entry of foreign investors can turn into projects with positive NPV after

their entry. As a result, there is boost to primary issues in such markets.

6.1.6. Imparting stability to India’s Balance of Payments:

For promoting growth in a developing country such as India, there is need to augment

domestic investments, over and beyond domestic saving, through capitalflows. The

excess of domestic investment over domestic savings result in a current account

deficit and this deficit is financed by capital flows in the balance of payments

6.1.8. Knowledge Flows:

The activities of international institutional investors help strengthen Indian finance.

FIIs advocate modern ideas in market design, promote innovation development of

sophisticated products such as financial derivatives, enhance competition infinancial

intermediation, and lead to spillovers of human capital by exposing Indian

participants to modern financial techniques, and international best practices and

systems.

6.1.9. Improvements to market efficiency:

A significant presence of FIIs in India can improve market efficiency through two

channels. First, when adverse macro economic news, such as bad monsoons, unsettles

many domestic investors, it may be easier for a globally diversified portfolio manager

to be more dispassionate about India’s prospects and engage instabilizing trades.

Second, at a level of individual stocks and industries, FIIs may act as a channel

through which knowledge and ideas about valuation of a firm or an industry can more

rapidly propagate into India. For example, foreign investors were rapidly able to

assess the potential of the firms like Infosys, which are primarilyexpert oriented,

applying valuation principles, and the prevailed outside India forsoftware services

companies. In the Indian context, the FIIs are said to have seen instrumental in

promoting market efficiency and transparency (Chopra, 1995). The argument, in favor

of this conclusion, is that the advent of FIIs has benefited all investors by offering

them a wider range of instruments with varying degrees of risk, return and liquidity.

Hence, the policy measures have been targeted towards promoting more FII

investment.

6.2 Limitations of FII Investment

6.2.1 Volatility and capital outflows:

There is also increasing possibility of abrupt and sudden outflows of capital if

theinflows are of a short-term nature as in the case of portfolio inflows of FIls.

Therecent experience of reversal of private capital flows observed in Global crisis of

2008, Asian crisis in 1997 and in Mexico during the later part of 1994 due to sudden

change in FIIs' investment sentiment provides a vivid illustration of such risks.

FIls take into account some specific risks in emerging markets such as

(i) political instability and economic mismanagement,

(ii) liquidity risk and

(iii) Currency movement. Currency movement can have a dramatic impact on

equity returns of FIIs, a depreciation having an adverse effect.

The withdrawal of FIIs from ASEAN countries led to large inflow of funds to FIIs to

India for which equity market in India is buoyant at present. Thus, short-term flows

including portfolio flows of FIIs to developing countries in particular are inherently

unstable and increases volatility of the emerging equity markets. They are speculative

andrespond adversely to any instability either in the real economy or in financial

variables. Investment in emerging markets by FIIs can at times be driven more by

aperceived lack of opportunities in industrial countries than by sound fundamental sin

developing countries including India. Emerging stock markets of India and other

developing countries have a low, even negative correlation with the stock markets in

industrial nations. So, when the latter goes down, FIIs invest more in the former as a

means to reduce overall portfolio risk. On the other hand, if there is a boom in

industrial country, there may be reverse flow of funds of FIIs from India and other

developing countries. Of course, there is pull for international private portfolio

investment of FIIs due to the impact of wide-ranging macro-economic and structural

reforms including liberalization or elimination of capital restrictions, improved flow

of financial information, strengthening investors' protection and the removal

ofbarriers on FIIs' participation in equity markets in India and other emerging

markets.

However, to the extent, FIIs view emerging markets as a single-asset class, shocks in

one country or region can also be transmitted to other emerging markets producing

volatile collapsing share price behavior. FII inflows are popularly described as “hot

money”, because of the herding behavior and 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, and performance judged on the basis of how other funds are

doing, there is great incentive to suffer the consequences of being wrong when

everyone is wrong, rather than taking the risk of being wrong when some others are

right. The incentive structure highlights the danger of a contrarian bet going wrong

and makes it much more severe than performing badly along with most others in the

market. It not only leads to reliance on the same information as others but also

reduces the planning horizon to a relatively short one. Another source of concern are

hedge funds, who unlike pension funds, life insurance companies and mutual

funds,engage in short-term trading, take short positions and borrow more

aggressively,and numbered about 6,000 with $500 billion of assets under control in

1998.

6.2.2 Price rigging:

Bear hammering by FIIs has been alleged in case of almost all companies in India

tapping the GDR market. The cases of SBI and VSNL are most illuminating to

showhow the FIIs manipulates domestic market of a company before its GDR issues.

The manipulation of FIIs, working in collusion operates in the following way. First,

they sell en masse and then when the price has been pulled down enough pick up

thesome shares cheaply in the GDR market. Though FIIs have the freedom of entry

andexit, they alone have the access to both the domestic as well as the GDR market

butthe GDR market is not open to domestic investors. Hence FIIs gain a lot at the cost

ofdomestic investors due to their manipulation which is possible owing to integration

of Indian equity market with global market consequent upon liberalization.

6.2.3 Herding and positive feedback trading:

There are concerns that foreign investors are chronically ill-informed about India, and

this lack of sound information may generate herding (a larger number of FIIs buying

or selling together). These kinds of behavior can exacerbate volatility, andpush prices

away from fair values. FIIs behavior in India however, so far does not exhibit these

patterns. FIIs have come to play a dominant role in the India’s stock market like never

before. The pace of their inflows into equities is picking up momentum over the years.

6.2.4 BOP vulnerability:

There are concerns that in an extreme event, there can be a massive flight of foreign

capital out of India, triggering difficulties in the balance of payments front.

India’sexperience with FIIs so far, however, suggests that across episodes like the

Pokhran blasts, or the 2001 stock market scandal, no capital flight has taken place. A

billion ormore of US dollars of portfolio capital has never left India within the period

of onemonth. When juxtaposed with India’s enormous current account and capital

flows, this suggests that there is little evidence of vulnerability so far.

6.2.5 Possibility of taking over companies or backdoor control:

Besides price rigging, FIIs are trying to control indigenous companies through the

GDR route where they are also active. GDRs acquire the voting rights once an

ordinary share gets converted into equity within a specified limit. So, the GDR route

which is considered as FDI plus portfolio investment is a roundabout way adopted by

FIIs to gain control of indigenous companies. While FIIs are normally seen as pure

portfolio investors can occasionally behave like FDI investors, and seek control of

companies that they have a substantial shareholding in. Such outcome, however, may

not be inconsistent with India’s quest for greater FDI. Furthermore, SEBI’s takeover

code is in place and has functional fairly well, ensuring that all investors benefit

equally in the event of a takeover.

6.2.6 Money laundering:

The movement of hot money of FIIs due to integration of emerging markets of India

and other countries with global market have helped the hawala traders and criminal

elements an easy means to launder international money from illegal activities which

in consequence have also an impact on equity market. Sometimes FIIs act as an

agentfor money laundering. It is also argued that the FII indulgein price rigging by

collusive operation. Another ill effect of opening up of the capital market to FIIs has

been the possibility of FIIs trying to gain control of indigenous companies. Finally, it

is alleged that FIIs might indulge in money laundering transactions.

6.2.7 Management control

FIIs act as agents on behalf of their principals – as financial investors maximizing

returns. There are domestic laws that effectively prohibit institutional investors from

taking management control. For example, US law prevents mutual funds fromowning

more than 5 per cent of a company’s stock. According to the International Monetary

Fund’s Balance of Payments Manual 5, FDI is that category of international

investment that reflects the objective of obtaining a lasting interest by aresident entity

in one economy in an enterprise resident in another economy. The lasting interest

implies the existence of a long-term relationship between the direct investor and the

enterprise and a significant degree of influence by the investor in the management of

the enterprise. According to EU law, foreign investment is labeled direct investment

when the investor buys more than 10 per cent of the investment target, and portfolio

investment when the acquired stake is less than 10 percent. Institutional investors on

the other hand are specialized financial intermediaries managing savings collectively

on behalf of investors, especially small investors, towards specific objectives in terms

of risk, returns, and maturity of claims.

All take-overs are governed by SEBI (Substantial Acquisition of Shares and

Takeovers) Regulations, 1997, and sub-accounts of FIIs are deemed to be “persons

acting in concert” with other persons in the same category unless the contrary is

established. In addition, reporting requirement has been imposed on FIIs and currently

Participatory Notes cannot be issued to un-regulated entities abroad.

Some of these issues have been relevant right from 1992, when FII investments were

allowed in.

The issues, which continue to be relevant even today, are:

(i) Bench marking with the best practices in other developing countries that

compete with India for similar investments;

(ii) if management control is what is to be protected, is there a reason to put a

restriction on the maximum amount of shares that can be held by a foreign

investor rather than the maximum that can be held by all foreigners put

together; and;

(iii) Whether the limit of 24 per cent on FII investment will be over and above

the 51 per cent limit on FDI.

There are some other issues such as whether the existing ceiling on the ratio between

equities and debentures in an FII portfolio of 70:30 should continue or not, but this is

beyond the terms of reference of the Committee. It may be noted that all emerging

peer market shave some restrictions either in terms of quantitative limits across the

board or inspecified sectors, such as, telecom, media, banks, finance companies, retail

tradingmedicine, and exploration of natural resources. Against this background,

further across the board relaxation by India in all sectors except a few very specific

sectors to be excluded, may considerably enhance the attractiveness of India as a

destination for foreign portfolio flows. It is felt that with adequate institutional

safeguards no win place the special procedure mechanism for raising FII investments

beyond 24 percent may be dispensed with.

Chapter 7: Conclusion

(wrong)

The present research has clearly established the relation that in short run FIIs do not

cause volatility in Indian markets but, the volatility in the Indian market does make it

difficult for FIIs to retain the investment and they withdraw money from the Indian

market making the losses bigger for both domestic and foreign investors in India.

At last I would like to quote in the words of Allan Watts that

“A Myth is an image in which we try to make the sense of the world”

So, at the end one should always remember that before reaching to a conclusion it

better always, to check the real cause of an incident and then comment on it because,

what one see with his/her own eyes is sometimes not the correct picture. Before

blaming any one for a wrong doing we should always take due care that whatever we

speak is at least checked and proved correct.

foreign institutional investor (fii) their impact on indian stock market

Data & Analytics

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