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A PROJECT REPORT

ON

STUDY OF IMPACT AND INFLUENCE OF FOREIGN

INVESTMENT IN INDIA

BY:

SOHAM A PARINGE

ROLL NO: 9

EXECUTIVE SUMMARY

Foreign Direct Investment (FDI) flows are usually preferred over other forms

of external finance because they are non-debt creating, non-volatile and their returns

depend on the performance of the projects financed by the investors. FDI also

facilitates international trade and transfer of knowledge, skills and technology. In a

world of increased competition and rapid technological change, their complimentary

and catalytic role can be very valuable.

1

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Over the years, FDI inflow in the country is increasing. However, India has

tremendous potential for absorbing greater flow of FDI in the coming years. Serious

efforts are being made to attract greater inflow of FDI in the country by taking

several actions both on policy and implementation front. An essential requirement of

the foreign investing community in making their investment decision is availability of

timely and reliable information about the policies and procedures governing FDI in

India.

Foreign direct investment (FDI) in India has played an important role in the

development of the Indian economy. FDI in India has - in a lot of ways - enabled

India to achieve a certain degree of financial stability, growth and development. This

money has allowed India to focus on the areas that may have needed economic

Attention, and address the various problems that continue to challenge the country.

India has continually sought to attract FDI from the world’s major investors. In 1998

and 1999, the Indian national government announced a number of reforms designed

to encourage FDI and present a favorable scenario for investors. FDI investments are

permitted through financial collaborations, through private equity or preferential

allotments, by way of capital markets through Euro issues, and in joint ventures.

TABLE OF CONTENTS

CAHPTER 1

1.1 INTRODUCTION……………………………………………………………………

………………………. 1

1.2 RESEARCH

PROBLEM………………………………………………………………………………

………. 3

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1.3 LITERATURE

REVIEW……………………………………………………………………………………….

. 4

1.4 RESEARCH

METHODOLOGY…………………………………………………………………………….

7

1.5

LIMITATIONS…………………………………………………………………………………

……………….. 8

CHAPTER 2

2.1 FOREIGN DIRECT INVESTMENT (FDI)

…………………………………………………………………. 9

2.2 WHAT IS

FDI………………………………………………………………………………………………

……….. 14

2.3 ADVANTAGES OF

FDI…………………………………………………………………………………………. 17

2.4 DISADVANTAGES OF

FDI……………………………………………………………………………………. 19

2.5 IMPACT OF FDI ON HOSTCOUNTRY………………………………………………………………….. 20

2.6 DETERMINANTS OF

FDI……………………………………………………………………………………… 21

2.7 RECENT GLOBAL AND REGIONAL FDI

TRENDS……………………………………………………. 23

CHAPTER 3

3.1 FOREIGN INSTITUTIONAL INVESTMENT (FII)

……………………………………………………… 36

3.2 DIVERGENT VIEWS ON

FII…………………………………………………………………………………… 42

3.3 ISSUES CONCERNING FII IN

INDIA………………………………………………………………………... 49

CHAPTER 4

4.1

FINDINGS…………………………………………………………………………………………………………….. 53

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4.2

RECOMMENDATIONS………………………………………………………………………

………………….. 54

4.3

CONCLUSION………………………………………………………………………………

……………………….. 56

4.4

BIBLIOGRAPHY………………………………………………………………………………

…………………….. 57

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CHAPTER – I

INTRODUCTION

The Government of India has recognized the key role of the foreign direct investment

(FDI) and foreign institutional investment (FII) in its process of economic

development, not only as an addition to its own domestic capital but also as an

important source of technology and other global trade practices. In order to attract the

required amount of FDI and FII, it has bought about a number of changes in its

economic policies and has put in its practice a liberal and more transparent FDI and

FII policy with a view to attract more foreign direct institutional investment inflows

into its economy. These changes have heralded the liberalization era of the foreign

investment policy regime into India and have brought about a structural breakthrough

in the volume of FDI and FII inflows in the economy.

Growth of Indian economy is playing hide and seek with the double digit growth

(Gross Domestic Product) mark. The latter is a key index, which the foreign investorscheck before committing large sums of money for investment. Of its own, the Indian

economy will find it difficult to reach this target, except for an occasional burst of

activity; like the one in 2003. To sustain it, outside help is needed and domestic house

is to be placed under strict discipline.

Democracy is a great buzzword, if it translates into order and political stability. Labor

unrest, political opportunism and corporate irregularities are a few issues, which

tarnish democracy and discourage outside investors. But the current government in

both its terms has opened up the economy to welcome foreign investment to keep up

with the strong domestic demand for quality goods and services. This has attracted

unprecedented amount of foreign investment in the last decade, but of the two forms

of foreign investment – foreign portfolio investment (FPI) and foreign direct

investment (FDI), the former has reached our shores much more than the latter.

As FPI essentially interacts with the real economy via the stock market, the effect of

stock market on the country’s economic development will also be examined.

STUDY ON IMPACT AND INFLUENCE OF FOREIGN INVESTMENT IN INDIA1

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Research shows that the perceived benefits of foreign portfolio investment have not

been realized in India. It can be seen that the mainstream argument that the entry of

foreign portfolio investors will boost a country's stock market and consequently the

economy, does not seem be working in India.

The influx of FIIs has indeed influenced the secondary market segment of the Indian

stock market. But the supposed linkage effects with the real economy have not

worked in the way the mainstream model predicts. Instead there has been an

increased uncertainty and skepticism about the stock market in this country. On the

other hand, the surge in foreign portfolio investment in the Indian economy has

introduced some serious problems of macroeconomic management for the

policymakers like inflation, currency appreciation etc.

On the other hand FDI is what the government really needs to attract in various

sectors like infrastructure, education etc. it is much more stable than the foreign

institutional investment which comes via the stock market route, and has more

accountability and brings fundamental and tangible benefits to the economy.

The dependence on FPI is pushing many developing countries, including India,

towards a more stock market oriented financial system. This makes it imperative to

evaluate the relative merits and demerits of a stock market based financial system in a

developing country as compared to the Chinese model where conditions are

conducive to foreign investment in the real sector. The global recession in 2008

proved how volatile the money pumped in by the FIIs into the secondary segment of

the financial market is, leading to huge losses for the domestic investors who had to

bear the brunt even though the economy as such was insulated from the adverse

effects of the recession. Whereas the sectors where there was FDI didn’t experiencesuch knee-jerk reactions.

In this context, this report is going to analyze the trends and patterns of foreign direct

investment (FDI) and foreign institutional investment (FII) flows into India during the

post liberalization period.


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RESEARCH PROBLEM

The opening up of the Indian economy served as a great boon for our country as the

foreign investors saw vast opportunities in it and started investing through the various

routes allowed by the government of India. It is important to keep record of all such

inflows to form strict regulatory procedures, search for areas or sectors that needs

more investment etc, which is what this research proposes to do i.e. collect data

regarding inflow of foreign direct investment and foreign institutional investment

from credible sources for a specified timeline and tabulate such data to perform trend

analysis of these investments to understand whether these investments fluctuate

rapidly or move in a fixed pattern and also what provides impetus to these

investments or what are the parameters that trigger a massive pull-out of them. As it

is seen that FII is a volatile investment as compared to FDI the factors affecting the

inflow of both types of investment are explored and their investment annually is

compared on the basis of certain common parameters.


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RESEARCH METHODOLOGY

The research has been carried out by collection of secondary data with the use of

primarily the internet, books on banking and finance, various business magazines,

journals, newspapers. No primary data has been used here like face to face interviews

or telephonic interviews, questionnaires etc.

For FDI The study takes into account a sample of top 10 investing countries e.g.

Mauritius, Singapore, USA etc. and top 10 sectors e.g. service sector, computer

hardware and software, telecommunications etc. which had attracted larger inflow of

FDI from different countries.

For FII Correlation tool has been used to determine whether two ranges of data move

together — that is, how the Sensex, Foreign exchange reserves and exchange rates are

related to the FII which may be positive relation, negative relation or no relation.

For the purpose of comparison between FDI and FII the raw data has been arranged

into a table for better observation and then this numerical data has been incorporated

into bar charts and line charts. These are statistical tools used to read their pattern and

conduct trend analysis.


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LIMITATIONS

Limitations are conditions that restrict the scope of the study period or may affect the

results of the research. It cannot be controlled by the researchers and can even affect

the analysis of research adversely.

One of the limiting factors of my project was that I have taken only three variables for

a time period of about seven to ten years for analysis due to time constraints. Since

the sample size is small so the results can be different from actual facts and may not

give an appropriate judgements.

Also all the data have been collected from secondary sources. Information collectedfirst hand from professionals and scholars through interviews would have given the

report a larger perspective.


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CHAPTER – II

FOREIGN DIRECT INVESTMENT

– AN OVERVIEW

INTRODUCTION

Foreign direct investment (FDI) plays an extraordinary and growing role in global

business. It can provide a firm with new markets and marketing channels, cheaper

production facilities, access to new technology, products, skills and financing. For a host

country or the foreign firm which receives the investment, it can provide a source of new

technologies, capital, processes, products, organizational technologies and management

skills, and as such can provide a strong impetus to economic development.

Foreign direct investment, in its classic definition, is defined as a company from one

country making a physical investment into building a factory in another country. The

direct investment in buildings, machinery and equipment is in contrast with making a

portfolio investment, which is considered an indirect investment. In recent years, given

rapid growth and change in global investment patterns, the definition has been broadened

to include the acquisition of a lasting management interest in a company or enterprise

outside the investing firm’s home country. As such, it may take many forms, such as a

direct acquisition of a foreign firm, construction of a facility, or investment in a joint

venture or strategic alliance with a local firm with attendant input of technology, licensing

of intellectual property, In the past decade, FDI has come to play a major role in the

internationalization of business.

Reacting to changes in technology, growing liberalization of the national regulatory

framework governing investment in enterprises, and changes in capital markets profound

changes have occurred in the size, scope and methods of FDI. New information

technology systems, decline in global communication costs have made management of

foreign investments far easier than in the past. The sea change in trade and investment

policies and the regulatory environment globally in the past decade, including trade policy


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and tariff liberalization, easing of restrictions on foreign investment and acquisition in

many nations, and the deregulation and privatization of many industries, has probably

been the most significant catalyst for FDI’s expanded role.

One of the most striking developments during the last two decades is the spectacular

growth of FDI in the global economic landscape. This unprecedented growth of global

FDI in 1990 around the world make FDI an important and vital component of

development strategy in both developed and developing nations and policies are designed

in order to stimulate inward flows. Infact, FDI provides a win – win situation to the host

and the home countries. Both countries are directly interested in inviting FDI, because

they benefit a lot from such type of investment. The ‘home’ countries want to take the

advantage of the vast markets opened by industrial growth. On the other hand the ‘host’

countries want to acquire technological and managerial skills and supplement domestic

savings and foreign exchange. Moreover, the paucity of all types of resources viz.

financial, capital, entrepreneurship, technological know- how, skills and practices, access

to markets- abroad- in their economic development, developing nations accepted FDI as a

sole visible panacea for all their scarcities. Further, the integration of global financial

markets paves ways to this explosive growth of FDI around the globe.

A SHORT HISTORY

After getting independence in 1947, the government of India envisioned a socialist

approach to developing the countries economy – broadly based on the USSR system.

The government decided to adopt an economic agenda that would follow five year

plans. Each five year plan was focused on certain sectors of the economy that thegovernment felt needed to be developed for the countries progress. The government

followed an interventionist policy and dictated most of the norms of running a

business by favoring certain sectors and ignoring others.

Until 1991, India was primarily a closed economy. The industrial environment in

India was highly regulated and a license system – known as “ licence raj” - was in

place to ensure compliance with the government regulations and directives. Under the

Industries Development and Regulations act (1951) starting and operating any


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industry required approval - in the form of a licence - from the government. Any

change in production capacity or change in the product mix also called for obtaining

government approval. This led to the development of increasingly complex and

opaque procedures for obtaining a licence and led to a burgeoning bureaucracy. The

licence system thus shifted lot of power and perverse incentives in the hands of file

pushing bureaucrats (or “ Babus”). This directly led to increased corruption as the

procedure for obtaining a licence was vaguely defined and left open to individual

interpretations. In addition, there was no monitoring system in place to ensure speedy

disposal of licence applications. Also, the labor markets were highly regulated and the

government did not allow the companies to lay off its workers. This meant that even

in severe downturns the companies kept bleeding but could not rationalize itsworkforce. Eventually these companies - majority of them public sector companies –

would become chronically sick and the government kept subsidizing them at huge

costs to the taxpayer.

One draconian measure was the introduction of the Foreign Exchange Regulation act

(FERA) of 1973 which curtailed foreign investment to 40% in Indian companies. in

1973. Foreign companies also came under the Monopolies and Restrictive Policy

(MRTP), 1969 Act during this period. MRTP (1969) Act restricted companies on the

size of operation and the pricing of products and services. The Reserve Bank of India

geared itself to implement the above act. As a result, many companies that did not

want to increase equity participation of Indians as per section (2) of FERA, 1973

decided to cease their operations in India. As many as 54 companies applied to wind

up their operations by 1977-78 since the implementation of the above Act in 1974 and

9 companies applied to wind up their operations in 1980-81

(Annual Reports, Reserve Bank of India 1977, 1978, 1981).

This had a very adverse impact and companies such as Coca-Cola and IBM exited

the country. The government also adopted a policy of import substitution and the idea

was to help the domestic industry improve in a safe environment until the local

industries could compete internationally. This was implemented by levying extremely

high tariffs or completely banning imported goods. Due to the government’s

protection most of the industries failed to catch up with the technological innovations

taking place around the world. As they were shielded from imports due to extremely


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high import tariffs the industries had no incentive to improve their operations. This

led to a vicious circular logic where the tariffs were not reduced since domestic

companies could not compete and the high tariffs prevented industries from

innovating. Corruption and opaqueness of the system added to the difficulties and the

situation became extremely complex.

THE BOP CRISIS

Gulf war broke out in 1990 and the resulting oil shock was enough to trigger a serious balance of payment (BoP) crisis for India in 1991. The cost of oil imports went up to

10,820 crores from the estimated 6,400 crores. Traditionally, India received lot of

remittances from the expatriates working in the Gulf countries and this source also

dried up as the migrant Indian workers were forced to return home due to the war.

The problem was compounded due to an extremely high inflation of about 16% and a

fiscal deficit of about 8.5%. The situation was so severe that India had foreign

reserves of only around $1 Billion - barely enough to cover two weeks of its payment

obligations. India’s credit rating was downgraded as its debt servicing capability was

critically impaired and the government had to pledge its gold reserves to soothe

creditors. Ostensibly, the trigger for the BoP crisis was the oil shock but the deeper

issue was that the government’s heavy hand in trying to regulate businesses and to

move the country towards economic progress had failed to produce results and drastic

measures were now called for.

Faced with these insurmountable problems, the Indian government turned to the IMF

and thus began a series of far reaching reforms in the India economy which

envisioned transforming the country’s economy from an interventionist and overly-

regulated economy to a more market oriented one.


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THE BEGINING OF A NEW ERA

The year 1991 marks a new growth phase of FDI in India with an all time high flow

of FDI. Following the Industrial Policy (1991) , a large number of foreign companies

from different parts of the world rushed into India. In this period, in addition to

thousands of foreign collaborations in India, as many as 145 foreign companies

registered in India within a span of 10 years from 1991-2000. Companies like General

Motors, Ford Motors, and IBM that divested from India in the 1950s and 1970s

reentered India during this period. A large number of Asian companies like Daewoo

Motors, Hyundai Motors and LG Electronics from S. Korea, Matsushita Television

and Honda Motors from Japan invested in India during this period.

With the legislation of the Industrial Licensing Policy, 1991, industrial licensing was

abolished except for 18 industries. FDI up to 51% equity was allowed in 34 formerly

high priority industries and the concept of phased manufacturing requirement on

foreign companies was removed. Further, the tariffs on imports have been steadily

reduced in every budget since 1991. Subsequently, GOI replaced FERA, 1973 that

regulated all foreign exchange transactions with Foreign Exchange Management Act

(FEMA), 1999. The objectives of FEMA have been to facilitate external trade and

payments and to promote orderly development and maintenance of foreign exchange

market. The total number of foreign collaborations increased from 976 in the year

1991 to 2144 in the year 2000.


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WHAT IS FOREIGN DIRECT INVESTMENT?

Is the process whereby residents of one country (the source country) acquire

ownership of assets for the purpose of controlling the production, distribution, and

other activities of a firm in another country (the host country). The international

monetary fund’s balance of payment manual defines FDI as an investment that is

made to acquire a lasting interest in an enterprise operating in an economy other than

that of the investor. The investors purpose being to have an effective voice in the

management of the enterprise. The united nations 1999 world investment report

defines FDI as ‘an investment involving a long term relationship and reflecting a

lasting interest and control of a resident entity in one economy (foreign direct investor

or parent enterprise) in an enterprise resident in an economy other than that of the

foreign direct investor ( FDI enterprise, affiliate enterprise or foreign affiliate).

TYPES OF FDI


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A)BY DIRECTION

Inward FDIs:

Inward FDI for an economy can be defined as the capital provided from a foreign

direct investor (i.e. the coca cola company) residing in a country, to that economy,

which is residing in another country. (I.e. India's economy).

EXAMPLE: General Motors decides to open a factory in India. They are going to

need some capital. That capital is inward FDI for India.

Different economic factors encourage inward FDIs. These include interest

loans, tax breaks, grants, subsidies, and the removal of restrictions and limitations.

Outward FDIs:

A business strategy where a domestic firm expands its operations to a foreign country

either via a Green field investment, merger/acquisition and/or expansion of an

existing foreign facility. Employing outward direct investment is a natural

progression for firms as better business opportunities will be available in foreign

countries when domestic markets become too saturated.

In recent years, emerging market economies (EMEs) are increasingly becoming a

source of foreign investment for rest of the world. It is not only a sign of their

increasing participation in the global economy but also of their increasing

competence. More importantly, a growing impetus for change today is coming from

developing countries and economies in transition, where a number of private as well

as state-owned enterprises are increasingly undertaking outward expansion through

foreign direct investments (FDI). Companies are expanding their business operations

by investing overseas with a view to acquiring a regional and global reach.

B) BY TARGET

Greenfield investment:

A form of foreign direct investment where a parent company starts a new venture in a

foreign country by constructing new operational facilities from the ground up. In

addition to building new facilities, most parent companies also create new long-term

jobs in the foreign country by hiring new employees.


http://www.economywatch.com/foreign-direct-investment/

http://www.economywatch.com/foreign-direct-investment/

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Green field investments occur when multinational corporations enter into developing

countries to build new factories and/or stores. Developing countries often offer

prospective companies tax-breaks, subsidies and other types of incentives to set up

green field investments. Governments often see that losing corporate tax revenue is a

small price to pay if jobs are created and knowledge and technology is gained to boost

the country's human capital.

Horizontal FDI:

Horizontal FDI arises when a firm duplicates its home country-based activities at the

same value chain stage in a host country through FDI. For example, Ford assembles

cars in the United States. Through horizontal FDI, it does the same thing in differenthost countries such as the United Kingdom (UK), France, Taiwan, Saudi Arabia, and

India. Horizontal FDI therefore refers to producing the same products or offering the

same services in a host country as firms do at home.

Vertical FDI:

Vertical Foreign Direct Investment takes two forms:

1. Backward vertical FDI: where an industry abroad provides inputs for afirm's domestic production process like exploiting the available raw materialsin the host country.

2. Forward vertical FDI: in which an industry abroad sells the outputs of afirm's domestic production i.e to be nearer to the consumers through theaquisition of distribution outlets.

C) BY MOTIVE

Resource seeking:

Investments which seek to acquire factors of production that is more efficient than

those obtainable in the home economy of the firm. In some cases, these resources

may not be available in the home economy at all (e.g. natural resources,naturally

occurring materials such as coal, fertile land, etc., that can be used by man, and cheap

labor). This characterizes Foreign Direct Investment into developing countries, for


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example seeking cheap labor in India and China, or natural resources in the Middle

East and Africa.

Market seeking:

Market seeking FDI is driven by access to local or regional markets. Investing locally

can be driven by regulations or to save on operational costs such as transportation.

General Motors’ investment in China is market seeking because the cars built in

China are sold in China, the size and growth of host country markets are among the

most important FDI determinants.

Efficiency seeking:

Investments which firms hope will increase their efficiency by exploiting the benefits

of economies of scale and scope, and also those of common ownership. It is

suggested that this kind of Foreign Direct Investment comes after either resource or

market seeking investments have been realized, with the expectation that it further

increases the profitability of the firm.

Efficiency seeking FDI is commonly described as off shoring, or investing in foreignmarkets to take advantage of a lower cost structure. A credit card company opening a

call center in India to serve U.S. customers is a form of efficiency seeking FDI.

ADVANTAGES OF FDI

1. Raising the Level of Investment: Foreign investment can fill the gap

between desired investment and locally mobilized savings. Local capital markets

are often not well developed. Thus, they cannot meet the capital requirements for

large investment projects. Besides, access to the hard currency needed to purchase

investment goods not available locally can be difficult. FDI solves both these

problems at once as it is a direct source of external capital. It can fill the gap

between desired foreign exchange requirements and those derived from net export

earnings.


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2. Up gradation of Technology: Foreign investment brings with it technological

knowledge while transferring machinery and equipment to developing countries.

Production units in developing countries use out-dated equipment and techniques

that can reduce the productivity of workers and lead to the production of goods of

a lower standard.

3. Improvement in Export Competitiveness: FDI can help the host country

improve its export performance. By raising the level of efficiency and the

standards of product quality, FDI makes a positive impact on the host country’s

export competitiveness. Further, because of the international linkages of MNCs,

FDI provides to the host country better access to foreign markets. Enhancedexport possibility contributes to the growth of the host economies by relaxing

demand side constraints on growth. This is important for those countries which

have a small domestic market and must increase exports vigorously to maintain

their tempo of economic growth.

4. Employment Generation/Development: Foreign investment can create

employment in the modern sectors of developing countries. Recipients of FDI

gain training of employees in the course of operating new enterprises, which

contributes to human capital formation in the host country.

5. Benefits to Consumers: Consumers in developing countries stand to gain

from FDI through new products, and improved quality of goods at competitive

prices.

6. Revenue to Government: Profits generated by FDI contribute to corporate

tax revenues in the host country.


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DISADVANTAGES OF FDI

FDI is not an unmixed blessing. Governments in developing countries have to be very

careful while deciding the magnitude, pattern and conditions of private foreign

investment. Possible adverse implications of foreign investment are the following:

1. When foreign investment is competitive with home investment, profits in

domestic industries fall, leading to fall in domestic savings.

2. Contribution of foreign firms to public revenue through corporate taxes iscomparatively less because of liberal tax concessions, investment allowances,

disguised public subsidies and tariff protection provided by the host government.

3. Foreign firms reinforce dualistic socio-economic structure and increase

income inequalities. They create a small number of highly paid modern sector

executives. They divert resources away from priority sectors to the manufacture

of sophisticated products for the consumption of the local elite. As they are

located in urban areas, they create imbalances between rural and urban

opportunities, accelerating flow of rural population to urban areas.

4. Foreign firms stimulate inappropriate consumption patterns through excessive

advertising and monopolistic market power. The products made by multinationals

for the domestic market are not necessarily low in price and high in quality. Their

technology is generally capital-intensive which does not suit the needs of a

labour-surplus economy.

5. Foreign firms able to extract sizeable economic and political concessions from

competing governments of developing countries. Consequently, private profits of

these companies may exceed social benefits.


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6. Profit distribution, investment ratios are not fixed: Continual outflow of

profits is too large in many cases, putting pressure on foreign exchange reserves.

Foreign investors are very particular about profit repatriation facilities.

7. Political Lobbying: Foreign firms may influence political decisions in

developing countries. In view of their large size and power, national sovereignty

and control over economic policies may be jeopardized. In extreme cases, foreign

firms may bribe public officials at the highest levels to secure undue favours.

Similarly, they may contribute to friendly political parties and subvert the political

process of the host country.


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1. Size of the Market: Large developing countries provide substantial markets

where the consumers demand for certain goods far exceed the available supplies.

This demand potential is a big draw for many foreign-owned enterprises. In

many cases, the establishment of a low cost marketing operation represents the

first step by a multinational into the market of the country. This establishes a

presence in the market and provides important insights into the ways of doing

business and possible opportunities in the country.

2. Political stability: In many countries, the institutions of government are still

evolving and there are unsettled political questions. Companies are unwilling to

contribute large amounts of capital into an environment where some of the basics political questions have not yet been resolved.

3. Macro-economic Environment: Instability in the level of prices and exchange

rate enhance the level of uncertainty, making business planning difficult. This

increases the perceived risk of making investments and therefore adversely

affects the inflow of FDI.

4. Legal and Regulatory Framework : The transition to a market economy entails

the establishment of a legal and regulatory framework that is compatible with

private sector activities and the operation of foreign owned companies. The

relevant areas in this field include protection of property rights, ability to

repatriate profits, and a free market for currency exchange. It is important that

these rules and their administrative procedures are transparent and easily

comprehensive.

5. Access to Basic Inputs: Many developing countries have large reserves of

skilled and semi-skilled workers that available for employment at wages

significantly lower than in developed countries. This provides an opportunity for

foreign firms to make investments in these countries to cater to the export

market. Availability of natural resources such as oil and gas, minerals and

forestry products also determine the extent of FDI.


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The determinants of FDI differ among countries and across economic sectors. These

factors include the policy framework, economic determinants and the extent of

business facilitation such as macro-economic fundamentals and availability of

infrastructure.

Recent global and regional FDI trends

The rise of FDI flows in 2011 was widespread in all three major groups – developed,

developing and transition economies. Developing economies continued to absorb

nearly half of global FDI and transition economies another 6 per cent.


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This graph gives a pretty good indicator of how relative FDI inflows have changed

since 2002 we can see that right from the year 2002 there has been an increase in FDI

investments in the developing economies. The increase in the GDP growth or the bull

phase which most of the developing economies experienced from 2003-2008 could be

attributed to the increased FDI.

FDI flows, by region, 2009–2011

Amount in billions of dollarsSource: UNCTAD

In 2011, FDI inflows increased in all major economic groups − developed,

developing and transition economies. Developing countries accounted for 45 per cent

of global FDI inflows in 2011. The increase was driven by East and South-East Asia

and Latin America. East and South-East Asia still accounted for almost half of FDI in


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developing economies. Inflows to the transition economies of South-East Europe, the

Commonwealth of Independent States (CIS) and Georgia accounted for another 6 per

cent of the global total.

FII ACCORDING TO TYPE OF INVESTMENT

Source:UNCTADCross-border mergers and acquisitions are rising, but Greenfield investment still

dominates, as the following graph shows.

Greenfield investment and M&A differ in their impacts on host economies, especially

in the initial stages of investment. In the short run, M&A’s clearly do not bring the

same development benefits as Greenfield investment projects, in terms of the creation

of new productive capacity, additional value added, employment and so forth. The

effect of M&As on, for example, host-country employment can even be negative, in

cases of restructuring to achieve synergies.


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TNCs’ top prospective host economies for 2012–2014

The importance of developing regions to TNCs as locations for international

production is also evident in the economies they selected as the most likely

destinations for their FDI in the medium term. Among the top five, four are

developing economies .Indonesia rose into the top five in this year’s survey,

displacing Brazil in fourth place. South Africa entered the list of top prospective

economies, ranking 14th with the Netherlands and Poland. Among developed

countries, Australia and the United Kingdom moved up from their positions in last

year’s survey, while Germany maintained its position.

Source: UNCTAD survey 2011


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If we analyze the above survey it can be said that the global capital which is not

providing good returns in the developed economies is moving rapidly towards

developing economies.

Major developing economies like India,China,Brazil etc have emerged as the top

destinations for FDI worldwide because the potential impact of the economic crisis

enforce the shifting of geographical focus to developing and transition economies

because of their much better economic performance than the developed countries

.Factors such as weaker economic growth in developed countries and abnormal

functioning of the world credit are putting pressures on the pace of recovery of FDI

flows towards developed economies.

FDI Approval Route

Foreign direct investments in India are approved through two

routes–


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1. Automatic approval by RBI –

The Reserve Bank of India accords automatic approval within a period of two weeks

(subject to compliance of norms) to all proposals and permits foreign equity up to

24%; 50%; 51%; 74% and 100% is allowed depending on the category of industries

and the sectoral caps applicable. The lists are comprehensive and cover most

industries of interest to foreign companies. Investments in high priority industries or

for trading companies primarily engaged in exporting are given almost automatic

approval by the RBI.

2. The FIPB Route – Processing of non-automatic approval cases –

FDI in activities not covered under the automatic route requires prior approval of theGovernment which are considered by the Foreign Investment Promotion Board

(FIPB), Department of Economic Affairs, Ministry of Finance. Indian companies

having foreign investment approval thr ough FIPB route do not require any further

clearance from the Reserve Bank of India for r eceiving inward remittance and for

the issue of shares to the non-resident investors.

SECTOR SPECIFIC CONDITIONS ON FDI

PROHIBITED SECTORS.

• Retail Trading (except single brand product retailing)

• Lottery Business including Government /private lottery, online lotteries, etc.

• Gambling and Betting including casinos etc.

• Chit funds

• Nidhi company

• Trading in Transferable Development Rights (TDRs)

• Real Estate Business or Construction of Farm Houses

•

Manufacturing of Cigars, cheroots, cigarillos and cigarettes substitutes


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• Activities / sectors not open to private sector investment e.g. Atomic Energy

• Railway Transport (other than Mass Rapid Transport System

PERMITTED SECTORS

In the following sectors/activities, FDI up to the limit indicated against each

sector/activity is allowed, subject to applicable laws/ regulations; security and other

conditionality. In sectors/activities not listed below, FDI is permitted upto 100% onthe automatic route, subject to applicable laws/ regulations; security and other

conditions.

Sr.

No.

Sector/Activity FDI cap/Equity Entry/Route

1. Hotel & Tourism 100% Automatic

2. NBFC 49% Automatic

3. Insurance 26% Automatic

4. Telecommunication:

cellular, value added services

ISPs with gateways, radio-paging

Electronic Mail & Voice Mail

49%

74%

100%

Automatic

Above 49% need

Govt. licence

5. Trading companies:

primarily export activities

bulk imports, cash and carry

wholesale trading

51%

100%

Automatic

Automatic

6. Power(other than atomic reactor


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power plants) 100% Automatic

7. Drugs & Pharmaceuticals 100% Automatic

8. Roads, Highways, Ports and Harbors 100% Automatic

9. Pollution Control and Management 100% Automatic

10 Call Centers 100% Automatic

11. BPO 100% Automatic

13. Airports:

Greenfield projects

Existing projects

100%

100%

Automatic

Beyond 74% FIPB

14 Assets reconstruction company 49% FIPB

15. Cigars and cigarettes 100% FIPB

16. Courier services 100% FIPB

17. Investing companies in infrastructure

(other than telecom sector)

49% FIPB

Foreign Direct Investment in India in the last 10 Years


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It can be seen that the flow of FDI has consistent and gradually increasing over the

years. There has been an increase of 129% i.e. Rs. 13851 Crores from the year 2000-

01 to 2005-06 while the increase from 2005-06 to 2011-12 has been a phenomenal

607% i.e. from Rs. 24584 Cr to Rs. 173947 Cr which can be attributed to relaxation

of foreign investment rules. Despite the global financial credit squeeze brought by the

recession India continues to be an attractive destination for investment as there is

tremendous potential for growth in the vast and diverse markets of our country.

The bars from 2000-01 to 2004-05 have been almost hovering the same levels but

importantly haven’t gone down which is because the foreign investors saw immense

potential but were not getting enough incentives to enter with huge business

propositions. The breakout came from the year 2005-06 when the investment nearly

doubled as compared to 2000-01, after which there was no looking back as consistent

economic growth, de-regulation, liberal investment rules, and operational flexibilityhelped increase the inflow of Foreign Direct Investment or FDI. So much so that even

during the year 2008-09 when the recession had taken its toll on the western countries

there was no indication of falling investment via the FDI route as can be seen from

the chart. In fact during 2008-09 the chart shows that FDI breached the Rs. 1 lakh

crore marks. In percentage terms FDI inflow increased by 28% from 2007-08 to

2008-09.


http://www.economywatch.com/foreign-direct-investment

http://www.economywatch.com/foreign-direct-investment

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DIFFERENT SECT O RS ATTRACTING HIG H EST FDI EQUITY INFLOW S


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DIFFERENT COUNTRIES ATTRACTING HIG H EST FDI EQUITY

INFLOW S :


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CHAPTER – III


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FOREIGN INSTITUTIONAL INVESTMENT

FOREIGN INSTITUTIONAL INVESTMENT (FII)

Background

Indian Markets have been one of the most attractive investment places for the FII's.

India being a developing nation attracts the foreign flows looking at the growth

potential in the Indian Economy. The FII's contribute a major chunk of volumes on

the Indian bourses and this in turn impacts the market moves. In case of recession in

the world economies, the foreign investors look for saver bets and India with a risingGDP where other nations GDP / Growth is shrinking has always offered greater

investment avenues. Indian Markets have been the clear outperformers vis-a-vis the

global markets in the past years.

HISTORY OF FOREIGN INSTITUTIONAL INVESTORS

Since 1990-91, the Government of India embarked on liberalization and economic

reforms with a view of bringing about rapid and substantial economic growth and

move towards globalization of the economy. As a part of the reforms process, the

Government under its New Industrial Policy revamped its foreign investment policy

recognizing the growing importance of foreign direct investment as an instrument of

technology transfer, augmentation of foreign exchange reserves and globalization of

the Indian economy. Simultaneously, the Government, for the first time, permitted

portfolio investments from abroad by foreign institutional investors in the Indian

capital market. The entry of FIIs seems to be a follow up of the recommendation of

the Narsimhan Committee Report on Financial System. While recommending their

entry, the Committee, however did not elaborate on the objectives of the suggested

policy. The committee only suggested that the capital market should be gradually

opened up to foreign portfolio investments. From September 14, 1992 with suitable

restrictions, Foreign Institutional Investors were permitted to invest in all the

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

and warrants issued by companies which were listed or were to be listed on the Stock

Exchanges in India. While presenting the Budget for 1992-93, the then Finance


http://www.mbaknol.com/managerial-economics/an-overview-of-foreign-direct-investment-fdi-in-india/

http://www.mbaknol.com/managerial-economics/an-overview-of-foreign-direct-investment-fdi-in-india/

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Minister Dr. Manmohan Singh had announced a proposal to allow reputed foreign

investors, such as Pension Funds etc., to invest in Indian capital market.

Foreign Institutional Investment—

As defined by the European Union Foreign Institutional Investment is an investment

in a foreign stock market by the specialized financial intermediaries managing

savings collectively

on behalf of investors, especially small investors, towards specific objectives in term

of risk, return and maturity of claims.

SEBI’s Definition of FIIs presently includes foreign pension funds, mutual funds,

charitable/endowment/university funds, asset management companies and other

money managers operating on their behalf in a foreign stock market. Foreign

institutional investment is liquid nature investment, which is motivated by

international portfolio diversification benefits for individuals and institutional

investors in industrial country.

Explanation

It refers to the purchase of stocks, bonds, debentures or other securities by an FII. FIIs

include pension funds, mutual funds, investment trusts, asset management companies,

nominee companies and incorporated/institutional portfolio managers.

In contrast to FDI, FIIs do not invest with the intention of gaining controlling interest

in a company. They typically make short-term investments. These investments are

made-to- book profits. Compared to FDI, a portfolio investor can enter and exit

countries with relative ease. This is a major contributing factor to the increasing

volatility and instability of the global financial system. Because of the very nature of

such investment, FII money is also called ‘hot money’. The rapid outflow of ‘hot

money’, in the recent past, has created exchange-rate problems in Argentina and in

Southeast Asia. Since FIIs are very sensitive, a mere change in perception about an

economy can prompt them to pull out investments from a country.

Market design in India for foreign institutional investors in India –


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Foreign Institutional Investors means an institution established or incorporated

outside India which proposes to make investment in India in securities. A Working

Group for Streamlining of the Procedures relating to FIIs, constituted in April, 2003,

inter alia, recommended streamlining of SEBI registration procedure, and suggested

that dual approval process of SEBI and RBI be changed to a single approval process

of SEBI. This recommendation was implemented in December 2003.

Currently, entities eligible to invest under the FII route are as follows:

• As FII: Overseas pension funds, mutual funds, investment trust, asset

management company, nominee company, bank, institutional portfolio

manager, university funds, endowments, foundations, charitable trusts,charitable societies, a trustee or power of attorney holder incorporated or

established outside India proposing to make proprietary investments or with

no single investor holding more than 10 per cent of the shares or units of the

fund.

• As Sub-accounts: The Sub account is generally the underlying fund on

whose behalf the FII invests. The following entities are eligible to be registered as

sub-accounts, viz. partnership firms, private company, public company, pension fund,

investment trust, and individuals. A domestic portfolio manager or a domestic asset

management company shall also be eligible to be registered as FII to manage the

funds of sub-accounts.

FIIs registered with SEBI fall under the following categories:

• Regular FIIs- those who are required to invest not less than 70 % of their

investment in equity-related instruments and 30 % in non-equity instruments.

• 100 % debt-fund FIIs- those who are permitted to invest only in debt

instruments.

The Government guidelines for FII of 1992 allowed, inter-alia, entities such as asset

management companies, nominee companies and incorporated/institutional portfolio

managers or their power of attorney holders (providing discretionary and non-

discretionary portfolio management services) to be registered as FIIs. While the


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guidelines did not have a specific provision regarding clients, in the application form

the details of clients on whose behalf investments were being made were sought.

While granting registration to the FII, permission was also granted for making

investments in the names of such clients. Asset management companies/portfolio

managers are basically in the business of managing funds and investing them on

behalf of their funds/clients. Hence, the intention of the guidelines was to allow these

categories of investors to invest funds in India on behalf of their 'clients'. These

'clients' later came to be known as sub-accounts. The broad strategy consisted of

having a wide variety of clients, including individuals, intermediated through

institutional investors, who would be registered as FIIs in India. FIIs are eligible to

purchase shares and convertible debentures issued by Indian companies under the

Portfolio Investment Scheme.

Who can be registered as an FII?

The applicant should be any of the following categories:

1. Pension funds

2. Mutual funds

3. Investment trust

4. Insurance or reinsurance companies

5. Endowment funds

6. University funds

7. Foundations or charitable trusts or charitable societies who propose to invest on

their own behalf and

a) Asset management companies

b) Nominee companies

c) Institutional portfolio managers

d) Trustees

e) Power of attorney holders

f) Bank

Who propose to invest their proprietary funds or on behalf of “broad based” funds or

on of foreign corporate and individuals.


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Prohibitions on Investments:

Foreign Institutional Investors are not permitted to invest in equity issued by an Asset

Reconstruction Company. They are also not allowed to invest in any company which

is engaged or proposes to engage in the following activities:

• Business of chit fund

• Nidhi Company

• Agricultural or plantation activities

• Real estate business or construction of farm houses (real estate business does

not include development of townships, construction of residential/commercial

premises, roads or bridges)

Reasons for strong flow of FIIs in India

FIIs attracted by the fast growing economy of India and strong performance of Indian

companies have been attracted towards India to an extent that India has gone on to

become the preferred investment destination.

The primary reasons for India being a preferred destination for FIIs are:

• Global liquidity into the equity markets.

• Improved performance and competitiveness of Indian firms.

• Opening up of Indian economy.

• Cheap labor and other factors of production.

• Highly developed stock market and high degree of vigilance over it.

• Tax Incentives.

• Regulation and Trading Efficiencies

• F and O Segment

Role of FIIs:

• The Indian stock market has come of age and has substantially aligned itself

with the international order.

• Market has also witnessed a growing trend of 'institutionalization' that may be

considered as a consequence of globalization.

•

It is influence of the FIIs which changed the face of the Indian stock markets.Screen based trading and depository are realities today largely because of FIIs.


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• FII which based the pressure on the rupee from the balance of payments

position and lowered the cost of capital to Indian business.

• FIIs are the trendsetters in any market. They were the first ones to identify the

potential of Indian technology stocks. When the rest of the investors invested

in these scrips, they exited the scrips and booked profits.

• Rolling settlement was introduced at the insistence of FIIs as they were

uncomfortable with the badla system.

• The FIIs are playing an important role in bringing in funds needed by the

equity market.

• The increase in the volume of activity on stock exchanges with the advent of

on screen trading coupled with operational inefficiencies of the former

settlement and clearing system led to the emergence of a new system called

the depository System.

• Flow of money into Indian economy via FIIs has been increasing at a rapid

rate. This has forced economist and policy makers to consider impacts of this

inflow on the macro economic factors as well. This has resulted in deeper

analysis of factors like Interest Rate, Inflation Rate, GDP and Exchange Rate

etc. both in short term as well as long term


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Divergent views on FII

FIIs inducing instability to Stock Markets

Many experts consider FIIs to be "Fair Weather Friends", who come in bulk when

there is money to be made and leave abruptly at the first sign of impending trouble in

the host country, thereby inducing undesirable risk and uncertainty into markets. A

good recent example is evident from FII behavior in last eighteen months itself.

Better fundamentals of Indian economy as compared to the western economies,

attracted and prompted FIIs to invest aggressively here, raising the total to a

astronomical figure of $ 20 billion. This almost single handily took the Sensex to

touch the 20,000 mark again. However, come November 2010, few local factors like

inflation, lower IIP and internal political drama, resulted in major square off of FII

positions in no time, thereby pushing the market into a sluggish and corrective mode.

There are other disturbing instances when the FIIs became the agents triggering a

blood bath at Dalal Street. On 16th Oct, 2007 Finance Minister Mr. P. Chidambaram

made a statement expressing his apprehensions over the usage offshore derivativeinstrument: P-notes, through which the FIIs made about 60% of their investment in

India. Little did the market analysts or the Finance Minister knew that this seemingly

ordinary statement would have the potential to inflict a deadly free fall of the market

indices. The markets crashed by a staggering 9% within few hours, registering one of

the biggest absolute fall in Indian stock market history. The consequences were so

severe that the markets had to be closed down for an hour and Mr. Chidambaram had

to call a press conference to rephrase his statements. It was yet another alarming callto the domestic investors that woke them up to the rising dominance and influence of

the FIIs on Indian Stock Markets.

The Alternate View

There is another set of experts who believe that FIIs are life blood for an emerging

economy like India. They augment domestic saving without increasing foreign debt,

provide vital liquidity to Indian companies to sustain road to growth, reduce cost of


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equity capital and help reduce deficit of Balance of payments (BOP). Also these

experts believe that FIIs, like any other investors buy or sell according to prevailing

sentiments in the market, rather than creating any sentiments that drive the markets.

Hence there lies a conflict between the pros and cons of FIIs and the all important

question regarding the role of FIIs in deciding the fate of our stock markets

Relationship between FII inflow and Sensex

Source:BSE & SEBI


YEAR NET FII

INVESTMENTS

BSE SENSEX

CLOSING2005 47181.9 9397.93

2006 36540.2 13786.91

2007 71486.3 20286.99

2008 -52987.4 9647.31

2009 83424.2 17464.81

2010 133266.8 20509.1

2011 2714.2 15454.9

2012 42263.3 16950

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From the above charts it is clear that net FII investments at BSE show a similar

pattern to the Yearly average closings. The blue bars denoting the net FII can be

called a volatile from the chart as there are sudden sharp drops and sharp rises. It has

no fixed pattern. The net FII started declining from 2007-08 till the middle of 2008-

09 which caused a sharp fall in Sensex also which went below the 10000 level in

2007-08 falling by almost 52% as compared to the previous year. But the FIIs started

pouring in again from the end of 2009 after the governments abroad started providing

bail-out packages, sops and various other incentives to the ailing companies. The

Sensex also rises sharply from 2008-09 after the FIIs turned into net buyers and hence

a similar pattern can be found between these two.

Conclusion & Recommendations

The study conducted for the time frame from 2005 to 2012, supports the “FII

inducing volatility and driving the market indices” theory to a substantial level.

Compared to security markets in developed economies, Indian markets being

narrower and shallower, allows foreign investors with access to significant funds, to

become the dominant player in determining the course of markets. Because of their

over sensitive investment behavior and herding nature, FIIs are capable of causing

severe capital out flight abruptly, tumbling share prices in no time and making stock

markets unstable and unpredictable. In the process, more often than not, the domestic

individual investors are on the receiving end, losing their precious savings in such

outrageous speculative trading.

India as an emerging economic power cannot afford to be intimidated down by the

FIIs every now and then. We need formidable Domestic Investors which can pump in

liquidity even during cash crunch circumstances thereby fuelling the development.

With savings to the tune of roughly 35% of GDP, India can use this to its strength by

formulating policies which ensure that domestic funds like Pension Funds, Provident

Funds & other Large Corpus Funds have a greater exposure to the equity market. The

foreign investment in India should be encouraged, but only from a strategic long term

perspective. Derivative instruments which facilitate long term foreign investment

with specified lock in periods should be introduced. Sustained long term foreign

investments would not only contribute to India's growth but also help in curbing


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volatility, maintaining currency stability and creating environment for inclusive

economic development.

FII’s IMPACT ON EXCHANGE RATES

To understand the implications of FII on the exchange rates we have to understand

how the value of one currency goes up (appreciates) or goes down against the other

currency. The simple way of understanding is through Demand and Supply. If say US

imports from India it is creating a demand for Rupee thus the Indian rupee appreciates

w.r.t the dollar. If India imports then the dollar appreciates w.r.t the Indian rupee.

Now considering FII’s for every dollar that they bring into the country, there is a

demand for rupee created and the RBI has to print and release the money in the

country. Since the FII’s are creating a demand for rupee, it appreciates w.r.t the

dollar. Thus if for e.g. if prior to the demand the exchange rate was 1 USD = Rs 40, it

could become 1 USD = Rs 39 after they invets. Similarly when FII withdraw the

capital from the markets, they need to earn back the U.S Dollar so that leads to a

demand for dollars the rupee depreciates. 1 USD goes back to Rs. 40. Thus FII

inflows make the currency of the country invested in appreciate and their selling and

disinvestment may lead to depreciation.

Depreciating currency not favorable to the FII’s: considering a simple hypothetical

example. I invested 1 USD in India at an exchange rate of 1 USD = Rs. 40. If rupee

appreciates the exchange rates become 1 USD = Rs. 20. Now if I disinvest I get 2

dollars, whereas I invested only 1 USD thereby a gain of 1 USD. (Though in real

terms the purchasing power of my dollar might decrease as my import cost would

increase, and cost of living back home may increase, but when I do consider practical

examples there is always a gain for FII whenever the currency of the country invested

in appreciates w.r.t the home currency)

Similarly when rupee depreciates w.r.t US Dollar and exchange rate becomes 1 USD

= Rs. 80 I get only 0.5 Dollar and I lose 0.5 of the 1 USD invested. Thus we observe

that for the FII’s to gain investing in India the rupee should appreciate w.r.t the dollar.


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Source:SEBI & Moneycontrol

The above diagram brings to light a very important occurrence regarding Net FII and

the Foreign Exchange Rate. It can be seen that whenever the red line (foreign

exchange rate) goes up the blue line (Net FII) goes down. If we look at the graph for

the last 5 years we find that during the recession of 2008 when the FIIs pulled out

money from nearly every emerging economy including India, we see that there is an

appreciation in the value of rupee from 39 to around 48, Similar relation can be

concluded from the year 2010 and 2011.


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Here also we can clearly see that when the FIIs were net purchasers in the month of

January and February the $ rates came down from 49.68 to 48.94 and similarly the

rupee started appreciating from the month of April when the FIIs turned net sellers.

The fall in April started after the passing of the union budget which leads us to

conclude that the fall in the value was majorly the implications of GAAR provisions

which speaks about retrospective taxation and also due to the worsening condition in

the Euro zone.


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This data is presented for a very short run period from May 28 to June 28.the value of

the rupee appreciated from 55.1846 on 28 may to 57.0147 on 25 June, this can be

considered to be a very big rise in less than a month and on may 28 the US dollar

settled at INR 56.8554.The reason for this is that FIIs have been net sellers for the

major part of june from the dates for which the data has been collected they have sold

worth Rs 2212 Cr and purchased worth Rs 1077.Now the appreciation in the rupee in

the last few days that is on 29 th June can be attributed to the government giving a

clarification on GAAR which is related to the FIIs coming to India via Mauritius and

also to the European Union leaders’ sensible decision to create a single supervisory

body for Euro zone banks with active involvement of the European Central bank bythe end 2012.


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Issues concerning FII’s in India

GAAR

GAAR originally proposed in the Direct Taxes Code, is targeted at arrangements or

transactions made specifically to avoid taxes. The government had decided to

advance the introduction of GAAR and implement it from the current financial year

itself. More than 30 countries have introduced GAAR provisions in their respective

tax codes to check evasion.

GAAR allows tax authorities to call a business arrangement or a transaction

'impermissible avoidance arrangement' if they feel it has been primarily entered into

to avoid taxes. Once an arrangement is ruled 'impermissible' then the tax authorities

can deny tax benefits. Most aggressive tax avoidance arrangements would be under

the risk of being termed impermissible. The rule can apply on domestic as well as

overseas transactions. It is a very broad based provision and can easily be applied to

most tax-saving arrangements. Many experts feel that the provision would give

unbridled powers to tax officers, allowing them to question any tax saving deal.

Foreign institutional investors are worried that their investments routed through

Mauritius could be denied tax benefits enjoyed by them under the Indo-Mauritius tax

treaty. The proposal has hit the stock market as FII inflows dropped on concerns, and

the rupee hit an all time low to the dollar.

The Indian law taxes gains derived from the sale of shares irrespective of whether the

shareholder is a resident or nonresident. Under India's tax treaty with Mauritius, gains

derived by a resident of Mauritius from the sale of shares in an Indian company are

taxable only in Mauritius and as it does not tax capital gains, the transaction escapes

tax in both countries. Foreign investors have been using the Mauritius holding

company structure to make investments in India right from the early 1990s.

Following the liberalization of the Indian economy, the Indo-Mauritius DTAA, was

"discovered" as an effective mechanism to avoid capital gains tax on sale of shares in

Indian companies. A Foreign enterprise can set up a subsidiary in Mauritius, and use

it to derive capital gains from acquisition and sale of shares. Although India follows


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the source rule for taxation of non-residents, which makes this transaction taxable

under the Income Tax Act, 1961, Article 13(4) of the DTAA gives Mauritius the right

to tax this transaction. Since such gains are exempt from tax in Mauritius, the

transaction becomes completely tax exempt, resulting in double non-taxation. As a

result, much of the Mauritian investment into India is actually round tripping by

Indian companies setting up a Mauritian entity to avoid capital gains tax in India.

Source:SEBI

The above figure illustrates daily movement of FII flows in India from 16 th March,

2012 when the Finance Minister announced the implementation of GAAR. It can be

observed there has been an outflow of dollars to the effect of $ 1 bn during this

period. This has also had an impact on the exchange rate which has depreciated from

Rs 50.31 on March 16th, 2012 to Rs 51.16 on March-end and further to Rs 52.51 and

Rs 53.72 on April end and May 4th, 2012 respectively. This was notwithstanding the

fact that forex reserves had remained largely stable, increasing from $294.8 bn on

March 16th to $ 295.4 bn on April 27 th.Clearly the sentiment was affected which

drove the rupee down further.


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Response of the Government

GAAR will now be applicable from April 1st, 2013. Further this rule would only be

invoked when there are specific complaints and it will not be easy for assessing tax

officers to invoke GAAR. The onus to prove that an arrangement is 'impermissible'

will lie with the tax department. Also to provide greater clarity and certainty in the

matters relating to GAAR, a Committee has been constituted under the chairmanship

of Director General of Income Tax to give recommendations for formulating the rules

and guideline for implementation of GAAR provision and to suggest safeguards so

that the provisions are not applied indiscriminately.

HOT MONEY

Hot money is a term that is most commonly used in financial markets to refer to the

flow of funds (or capital) from one country to another in order to earn a short-term

profit on interest rate differences and/or anticipated exchange rate shifts. These

speculative capital flows are called "hot money" because they can move very quickly

in and out of markets, potentially leading to market instability

large and sudden inflows of capital with short term investment horizon have negative

macroeconomic effects, including rapid monetary expansion, inflationary pressures,

real exchange rate appreciation and widening current account deficits. Especially,

when capital flows in volume into small and shallow local financial markets, the

exchange rate tends to appreciate, asset prices to rally and local commodity prices to

boom. These favorable asset price movements improve national fiscal indicators and

encourage domestic credit expansion. These, in turn, exacerbate structural weakness

in the domestic bank sector. When global investors' sentiment on emerging markets

shift, the flows reverse and asset prices give back their gains, often forcing a painful

adjustment on the economy

The following are the details of the dangers that hot money presents to the receivingcountry's economy:STUDY ON IMPACT AND INFLUENCE OF FOREIGN INVESTMENT IN INDIA47

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• Inflow of massive capital with short investment horizon (hot money) could

cause asset price to rally and inflation to rise. The sudden inflow of large

amounts of foreign money would increase the monetary base of the receiving

country (if the central bank is pegging the currency), which would help create

credit boom. This, in turn, would result in such a situation in which "too much

money chase too few goods". Consequences of this would be inflation.

Furthermore, hot money could lead to exchange rate appreciation or even

cause exchange rate overshooting. And if this exchange rate appreciation

persists, it would hurt the competitiveness of respective country's export

sector by making the country's exports more expensive compared to similar

foreign goods and services.

• Sudden outflow of hot money, which would always certainly happen, would

deflate asset prices and could cause the collapse value of the currency of

respective country. This is especially so in countries with relatively scarce

internationally liquid assets. There is growing agreement that this was the case

in the 1997 East Asian Financial Crisis. In the run-up to the crises, firms and

private firms in South Korea, Thailand and Indonesia accumulated large

amounts of short term foreign debt (a type of hot money). The three countries

shared a common characteristic of having large ratio of short term foreign

debt to international reserves. When the capital starts to flow out, it caused a

collapse in asset prices and exchange rates. The financial panic fed on itself

causing foreign creditors to call in loans and depositors withdraw funds from

banks, all of these magnified the illiquidity of the domestic financial systemand forced yet another round of costly asset liquidations and price deflation.

In all of the three countries, the domestic financial institutions came to the

brink of default on their external short term obligations.


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CHAPTER – IV

FINDINGS

It is an accepted fact now that FIIs have significant influence on the

movements of the stock market indexes in India. If one looks at the

total FII trade in equity in India and its relationship with the stock

market major indexes like Sensex and Nifty, it shows a steadily

growing influence of FIIs in the domestic stock market.

FIIs and the movements of Sensex are quite closely correlated inIndia and FIIs wield significant influence on the movement of

Sensex. NSE also observes that in the Indian stock markets FIIs

have a disproportionately high level of influence on the market

sentiments and price trends. This is so because other market

participants perceive the FIIs to be infallible in their assessment of

the market and tend to follow the decisions taken by FIIs. This ‘herd

instinct’ displayed by other market participants amplifies theimportance of FIIs in the domestic stock market in India.


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RECOMMENDATIONS:

Some of the steps that can be taken to help influence the choices made by foreign

institutional investors include:

The Government should cut its fiscal deficits, which would result in

strengthening the economy as a whole.

Creating infrastructure and other facilities to attract foreign

investment. As described earlier, an array of services can help promote

foreign institutional investment in India, ranging from basic services such

as the provision of electricity and clean water, to fair and effective dispute

resolution systems.

The ability of governments to prevent or reduce financial crises also

has a great impact on the growth of capital flows. Steps to address these

crises include strengthening banking supervision, requiring more

transparency in international financial transactions and ensuring adequate

supervision and regulation of financial markets.

An attempt should be made to bring down the inflation level to attract

more foreign institutional investments into India.

The Banking system needs to be strengthened which could be

achieved by reducing the number of Non Performing Assets.

The FIIs investments, though shown an increasing trend over time, are

still far below the permissible limits. One such measure in this line could

be the newly announced INDONEXT, the platform for trading the small and

mid-cap companies, which might bring some focus on these companies

and hopefully add some liquidity and volume to their trading, which may

attract some further investments in them by FIIs.


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The fact is that developing country like India has its own compulsions

arising out of the very state of their social, political and economic

development. To attract portfolio investments and retain their confidence,

the host countries have to follow stable macro-economic policies,

The provision for clear procedures must be followed in the event of disputes

between investors and host governments, to ensure that rules are adhered to and that

arbitration may be established by mutual consent.

Countries may impose these kinds of measures like expropriation, domestic

content requirements, restrictions on capital outflows of short term investments, etc

with the intention of protecting domestic industries from international competition

and promoting their economic development, but this usually leads to misallocation of

resources away from the natural economic capabilities of nations.

There has been a significant shift in the character of global capital flows to the

developing countries in recent years in that the predominance of private account

capital transfer and especially portfolio investments (FPI) increased considerably. In

order to attract portfolio investments which prefer liquidity, it has been advocated to

develop stock markets.

The general perception about the foreign portfolio investments is that,

not only do they expand the demand base of the stock market, but they

can also stabilise the market through investor diversification.

Obstacles to investment prevent countries from making optimal use of their own and

other countries' resources. Countless billions of dollars of potential wealth - for

investors in the form of profits, for workers in the form of wages, and for consumers

in the form of lower prices - are lost every year due to barriers to trade and


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investment. Certain policy decisions of potential target countries of investment

receive close scrutiny from international investors. Consequently, a number of

international agreements have been written to specifically address those concerns.

CONCLUSION

What does India Need - FDI or FII

FDI usually is associated with export growth. It comes only when all the criteria to

set up an export industry are met. That includes, reduced taxes, favorable labor law,

freedom to move money in and out of country, government assistance to acquire land,

full grown infrastructure, reduced bureaucratic involvement etc. IT, BPO, Auto Parts,

Pharmaceuticals, unexplored service sectors including accounting; drug testing,

medical care etc are key sectors for foreign investment. Manufacturing is a brick and

mortar investment. It is permanent and stays in the country for a very long time. Huge

investments are needed to set this industry. It provides employment potential to semi

skilled and skilled labor. On the other hand the service sector requires fewer but

highly skilled workers. Both are needed in India. If India plays its cards right India

may be the hub for the service sector. Still high end manufacturing in auto parts and pharmaceuticals should be India’s target.

The FII (Foreign Institutional Investor) is monies, which chases the stocks in the

market place. It is not exactly brick and mortar money, but in the long run it may

translate into brick and mortar. Sudden influx of this drives the stock market up as too

much money chases too little stock. Where FDI is a bit of a permanent nature, the FII

flies away at the shortest political or economical disturbance. The Global Recession

of 2008 is a key example of the latter. Once this money leaves, it leaves ruined

economy and ruined lives behind. Hence FII is to be welcomed with strict political

and economical discipline.


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BIBLIOGRAPHY

www.dipp.nic.in

www.sebi.gov.in

www.bseindia.com

www.rbi.org.in

www.unctad.org

www.indiainfoline.com

www.thehindu.com

http://www.dipp.nic.in/

http://www.sebi.gov.in/

http://www.bseindia.com/

http://www.rbi.org.in/

http://www.thehindu.com/

http://www.dipp.nic.in/

http://www.sebi.gov.in/

http://www.bseindia.com/

http://www.rbi.org.in/

http://www.thehindu.com/

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