New - Impact of FII On Indian Equity Market

PROJECT REPORT
On
IMPACT OF
FOREIGN INSTITUTIONAL INVESTORS
(FII)
ON INDIAN EQUITY MARKET
SUBMITTED BY
NAME:
REG NO.:
SUBMITTED TO SCDL
In partial fulfillment of the requirements for the award of degree of
POST GRADUATE DIPLOMA IN international business

DECLARATION
This is to declare that I “_____________” have carried out this project work myself in part
fulfillment of the POST GRADUATE DIPLOMA IN INTERNATIONAL BUSINESS
Program of SCDL.
The work is original, has not been copied from anywhere else and has not been submitted to
any other University/Institute for an award of any degree/diploma.
Date: Name:
Signature: Reg No:
Impact Of Foreign Institutional Investors On Indian Equity Market Page 2

CERTIFICATE OF SUPERVISOR
Certified that the work incorporated in this Project Report IMPACT OF FOREIGN
INSTITUTIONAL INVESTORS (FII) ON INDIAN STOCK MARKET submitted by
_______________________ is his/her original work and completed under my supervision.
Material obtained from other sources has been duly acknowledged in the Project Report
Date: Signature of Guide

PREFACE
The Indian capital markets may appear mysterious and puzzling to many foreign investors and
even to domestic Indian investor. To my knowledge, however, there is no current information
material that comprehensively addresses invertors’ concerns about this rapidly growing
market. I have no power to solve its inherent problems; but what I have tried to do is shed
some light on practices and rules in the Indian market, including problematic ones, so that
foreign as well as Indian investors can look at the market more rationally for their portfolio
investments in Indian securities.
The Indian financial system is a vast universe. This universe is regulated and supervised by
two government agencies under the Ministry of Finance.
(i). The Reserve bank of India, India’s Central Bank, and

(ii). The Securities Exchange Board of India, the country’s capital market regulator.
All parts of the system are interconnected with one another, and the jurisdictions of the central
bank and the capital market regulator overlap in some fields of Indian financial activities. This
research focuses on the FII (foreign institutional investor) flows to Indian capital market, its
portfolio investment and determinants of investing in Indian market and deciding the portfolio
preferences. This research also gives the suggestions on the investment avenues available for
the FII in Indian with the help of Gap analysis.

INDEX
Chapter I: Introduction ………………………………………………..……………………6

i) Background ……………………………….…………………………..………………….. 9
ii) Research Review ……………………………………………………………………….. 13
Chapter II: Research Methodology………………………………….……………….…….15

i) Research Process ………………………………………………………………………. 16
ii) Scope of the study ………………………………………………………………………..21
Chapter III: descriptive work ……..……………………………………………………….22

i) Regulatory information ………………………………………………………………… 23
ii) FII flow to India: nature and causes ………………………………………………… 30
iii) Liberalization of foreign institutional investor in India. ………………………….. 43
iv) Foreign institutional investment in India …………………………………………… 61
v) Determinants of foreign institutional investor ……………………………………….73
Chapter IV: Data Analysis And Interpretation .………………………………………….75

i) Conceptual model for analysis ………………………………………………………… 77
ii) Gap analysis for investment avenues ………………………………………………… 80
iii) Findings …………………………………………………………………………………. 88
Chapter V: Suggestions And Conclusion ………………………………………………….91

i) Bibliography…………………………………………………………………………………..
..96
ii) Annexure……………………………………………………………………………………...
…98

Chapter – 1
Introduction of the Topic

INTRODUCTION
Foreign investment refers to investments made by the residents of a country in the financial
assets and production processes of another country. After the opening up of the borders for
capital movement, these investments have grown in leaps and bounds. The effect of foreign
investment, however, varies from country to country. It can affect the factor productivity of
the recipient country and can also affect the balance of payments. In developing countries
there has been a great need for foreign capital, not only to increase the productivity of labor
but also because foreign capital helps to build up the foreign exchange reserves needed to
meet trade deficits. Foreign investment provides a channel through which developing
countries can gain access to foreign capital. It can come in two forms: foreign direct
investment (FDI) and foreign institutional investment (FII). Foreign direct investment involves
in direct production activities and is also of a medium- to long-term nature. But foreign
institutional investment is a short-term investment, mostly in the financial markets. FII, given
its short-term nature, can have bidirectional causation with the returns of other domestic
financial markets such as money markets, stock markets, and foreign exchange markets.
Hence, understanding the determinants of FII is very important for any emerging economy as
FII exerts a larger impact on the domestic financial markets in the short run and a real impact
in the long run. The present study examines the role, impact and relationship of FII’s and
Indian capital market, and also determinants of foreign institutional investment in India, a
country that opened its economy to foreign capital following a foreign exchange crisis.
India, being a capital scarce country, has taken many measures to attract foreign investment
since the beginning of reforms in 1991. Up to the end of January 2003, India succeeded in
attracting a total foreign investment of around U.S.$48 billion out of which U.S.$12 billion
was in the form of FII. These figures show the importance of FII in the overall foreign
investment program. India is in the process of liberalizing its capital account, and this has a
significant impact on foreign investment and particularly on FII, which affects short-term
stability in the financial markets.

Hence, there is a need to determine the push and pull factors behind any change in the FII, so
that we can frame our policies to influence the variables that attract foreign investment. Also,
FII has been the subject of intense discussion, as it is held to be responsible for having
intensified the currency crises of the 1990s in East Asia and elsewhere in the world.
The present study aims to examine the role, impact, determinants and avenues of investment
for FII in the Indian context.
We attempt to analyze the effect of return, risk, and inflation, which in the research are
considered to be the major determinants of FII. The proposed relationship among the factors
(discussed in detail later) is that inflation and risk in the domestic country and return in the
foreign country adversely affect the FII flowing to the domestic country, whereas inflation and
risk in the foreign country and return in the domestic country have a favorable effect on the
flow of FII. In the next section we will briefly consider the existing studies of this topic. In
Section III, we discuss the theoretical model. Section IV briefly assesses the trends in FII in
India. The database and methodology adopted in this study are explained in Section V. In
Section VI, we discuss the estimated results of the study, and appropriate conclusions are
drawn in the last section.
There is another concept called “foreign portfolio investments” (FPI), which is a broader one
compared to FII. Foreign portfolio investments include FII and other components like GDR
(Global Depositary Receipts), ADR (American Depositary Receipts), and off-shore funds and
others. As the components in FPI other than FII are not dependent on market forces and they
are not volatile, we consider only FII in this study.

THE BACKGROUND
An FII means an entity established or incorporated outside India, which proposes to undertake
investment in India; while an FII sub-account includes those foreign corporate, foreign
individuals, institutions, funds or portfolios established or incorporated outside India on whose
behalf investments are proposed to be made in India by an FII
The national common minimum programmed of the present UPA government envisages
policies, which encourage foreign institution investors (FIIs), but reduce exposure to the
Indian financial system to speculative capital flows.
The character of global capital flows to developing countries underwent significant changes
on many counts during the 'nineties. By the time the East Asian financial crisis surfaced, the
overall size of the flows more than tripled. It stood at US$ 100.8 bn. in 1990 and rose to US$
308.1 bn. by 1996. The increase was entirely due to the sharp rise in the flows under private
account that rose from US$ 43.9 bn. to 275.9 billion during the same period. In relative terms
the percentage of private account capital flows increased from 43.55 to 89.55 per cent.
Simultaneously, the Official Development Assistance (ODA), declined both in relative and
absolute terms. All the main components of the private account capital transfers, namely, (a)
commercial loans, (b) foreign direct investments (FDI), and (c) foreign portfolio investments
(equity and bonds) (FPI) recorded significant increases. Portfolio flows increased at a faster
rate than direct investments on private account. As a result, starting with a low level of 11.16
per cent, the share of capital flows in the form of portfolio investments quadrupled to reach
37.22 per cent in 1996 reflecting the enhanced emphasis on private capital flows with portfolio
investments forming the second important constituent of the flows during the 'nineties. In this
process multilateral bodies led by the International Finance Corporation (IFC) played a major
role.
Following the East Asian financial crisis, initially there was a slow down followed, by a
decline in private capital flows. While bonds and portfolio equity flows reacted quickly and
declined in 1997 itself, loans from commercial banks dropped a year later in 1998. Decline in

FDI was also delayed. But the fall in FDI was quite small compared to the other three major
forms of private capital flows. While flows on official account increased, following the crisis,
they continue to constitute only a small portion of the total flows. Thus, starting with the
resolve by the developed countries to provide one per cent of their GNP as developmental aid,
the industrialised world preferred to encourage private capital transfers through direct
investments instead of official assistance. The declining importance of official development
finance is attributed to budgetary constraints in donor countries and the optimism of private
investors in the viability of the developing countries.
Portfolio investments spread risk for foreign investors, and provide an opportunity to share the
fruits of growth of developing countries, which are expected to grow faster. Investing in
emerging markets is expected to provide a better return on investments for pension funds and
private investors of the developed countries. For developing countries, foreign portfolio equity

investment has different characteristics and implications compared to FDI. Besides
supplementing domestic savings, FDI is expected to facilitate transfer of technology, introduce
new management and marketing skills, and helps expand host country markets and foreign
trade. Portfolio investments supplement foreign exchange availability and domestic savings
but are most often not project specific. FPI, are welcomed by developing countries since these
are non-debt creating. FPI, if involved in primary issues, provides critical risk capital for new
projects. Since FPI takes the form of investment in the secondary stock market, it does not
directly contribute to creation of new production capabilities. To enable FPI flows which
prefer easy liquidity, multilateral bodies, led by the International Finance Corporation (IFC),
have been encouraging establishment and strengthening of stock markets in developing
countries as a medium that will enable flow of savings from developed countries to
developing countries.
FPI, it is expected, could help achieve a higher degree of liquidity at stock markets, increase
price-earning (PE) ratios and consequently reduce cost of capital for investment. FPI is also
expected to lead to improvement in the functioning of the stock market, as foreign portfolio
investors are believed to invest on the basis of well-researched strategies and a realistic stock
valuation. The portfolio investors are known to have highly competent analysts and access to a
host of information, data and experience of operating in widely differing economic and
political environments. Host countries seeking foreign portfolio investments are obliged to
improve their trading and delivery systems, which would also benefit the local investors. To
retain confidence of portfolio investors’ host countries are expected to follow consistent and
business friendly liberal policies. Having access to large funds, foreign portfolio investors can
influence developing country capital markets in a significant manner especially in the absence
of large domestic investors. Portfolio investments have some macroeconomic implications.
While contributing to build-up of foreign exchange reserves, portfolio investments would
influence the exchange rate and could lead to artificial appreciation of local currency. This
could hurt competitiveness. Portfolio investments are amenable to sudden withdrawals and
therefore these have the potential for destabilizing an economy.

The volatility of FPI is considerably influenced by global opportunities and flows from one
country to another. Though it is sometime argued that FDI and FPI are both equally volatile,
the Mexican and East Asian crises brought into focus the higher risk involved in portfolio
investments. The present paper has two objectives. One, to assess the importance of different
types of foreign portfolio investments in capital flows to India. And two, to understand the
investment behaviour of foreign portfolio investors through an analysis of the portfolios of
US-based India specific funds. Such an exercise, it is hoped, would explain the relationship
between foreign institutional investments and trading pattern in the Indian stock market better
than aggregate level analysis.

RESEARCH REVIEW
There have been several attempts to explain FII behavior in India. All the existing studies have
found that equity return has a significant and positive impact on FII (Agarwal 1997;
Chakrabarti 2001; Trivedi and Nair 2003). But given the huge volume of investments, foreign
investors can play the role of market makers and book their profits, that is, they can buy
financial assets when the prices are declining, thereby jacking-up the asset prices, and sell
when the asset prices are increasing (Gordon and Gupta 2003). Hence, there is a possibility of
a bidirectional relationship between FII and equity returns.
Following the Asian financial crisis and the bursting of the info-tech bubble internationally in
1998/99, net FII declined by U.S.$61 million. This, however, exerted little effect on equity
returns. This negative investment might possibly disturb the long-term relationship between
FII and other variables such as equity returns, inflation, and so on. Chakrabarti (2001) has
perceived a regime shift in the determinants of FII following the Asian financial crisis and
found that in the pre–Asian crisis period, any change in FII had a positive impact on equity
returns. But it was found that in the post–Asian crisis period, a reverse relationship has been
the case, namely, that change in FII is mainly due to change in equity returns. This is a fact
that needs to be taken into account in any empirical investigation of FII. Investments, either
domestic or foreign, depend heavily on risk factors. Hence, while studying the behavior of FII,
it is important to consider the risk variable. Further, realized risk can be divided into ex-ante
and unexpected risk. Ex-ante risk is an observed component and is negatively related to FII.
But the relationship between unexpected risk and FII is obscure. Therefore, while examining
the impact of risk on FII, one needs to separate the unobserved component from the realized
risk. Trivedi and Nair (2003) have used only the realized risk. Another possible determinant of
FII is the operation of foreign factors such as returns in the source country’s financial markets
and other real factors in the source economy. So far, however, studies have found that both
return in the source country stock market and the inflation rate have not exerted any impact on
FII. Agarwal (1997) found that world stock market capitalization had a favorable impact on
the FII in India.

A survey of the literature shows that existing studies do not account for volatility, which can
be expected in most of the monthly financial time series data. Yet given the increase in
financial market integration, both domestically and in foreign financial markets, accounting
for volatility is unavoidable. Further, the existing studies either do not incorporate risk in
foreign and domestic markets or make use of realized risk, an approach that does not always
yield robust results.
This is because standard deviation/variance (realized risk variable) increases irrespective of

the direction in which stock returns move, while movement of FII is determined by bull/bear
phases. It is preferable, therefore, to divide the realized risk into ex-ante risk and unpredictable
risk. Since investment in stock markets is sentiment driven, and is affected more or less by
everything, the crucial task is to identify a few critical determinants. This research makes a
modest attempt to explore the relation between FII and its pivotal determinants, for the
particular case of India. More specifically, a few important variables believed to be affecting
FII are chosen and then a theoretical model is built and empirically tested for India. The focus
of this research is the study of the critical determinants of FII, so as to provide a better
understanding of FII behavior that helps while liberalizing the capital account and investment
avenues for FII in Indian capital market. We hope that the study will be important from a
policy perspective, as FII constitutes an important element for the smooth functioning of
domestic financial markets.

Chapter – 2
Research Methodology

RESEARCH MATHEDOLOGY
The purpose of research is to discover answers to the questions through the application of
scientific procedures. The main aim of research is to find out the truth which is hidden and
which has not been discovered as yet. Though each research study has its own specific
purpose, we may think of research objectives as falling into a number of following broad
categories:
1) To gain familiarity with a phenomenon or to achieve new insights into it.
2) To portray accurately the characteristics of a particular individual, situation or a
group.
3) To determine the frequency with which something occurs or with which it is
associated with something else.
4) To test a hypothesis of a casual relationship between variables.
Research methodology is a way to systematically solve the research problem. It may be

understood as a science of studying how research is done scientifically.
Research methodology has many dimensions and research methods do constitute a part of the
research methodology. The scope of research methodology is wider than that of research
methods. Thus, when we talk of research methodology we not only talk of the research
methods but also consider the logic behind the methods we use in the context of our research
study and explain why we are using a particular method or technique and why we are not
using others so that research results are capable of being evaluated either by the researcher
himself or by others. Why a research study has been undertaken, what data have been
collected and what particular method has been adopted, why particular technique of analyzing
data has been used and a host of similar other question are usually answered when we talk of
research methodology concerning a research problem or study.

RESEARCH PROCESS
Research process consists of series of actions or steps necessary to effectively carry out
research and the desired sequencing of these steps.
Review the
Literature Feed forward
Review
concepts &
Define theories
research Formulate
hypotheses Design Collect Analyze
problem research data data
Review
previous
research &
findings Feed
back
Interpre
t and
report
A brief description of the above steps is stated below:
1) Formulating the research problem

At the very outset the researcher must single out the problem he wants to study, i.e. that is he
must decide the general area of interest or aspect of a subject matter that he would like to
inquire into. Initially the problem may be stated in a broad general way and then the
ambiguities, if any, relating to the problem be resolved. Then the feasibility of a particular
solution has to be considered before a working formulation of the problem can be set up. In
fact, formulation of the problem often follows a sequential pattern where a number of
formulations are set up, each formulation more specific than the preceding one, each one
phrased in more analytical terms, and each more realistic in terms of the available data and
resources.

2) Extensive literature survey
Once the problem is formulated, a brief summary of it should be written down. At this
juncture I have undertaken extensive literature survey connected with the problem. The earlier
studies, which are similar to the study in hand, have been carefully studied.
3) Development of the working hypothesis

After extensive literature survey, researcher should state in clear terms the working hypothesis
or hypotheses. Working hypothesis is tentative assumption made in order to draw out and test
its logical or empirical consequences. The manner in which research hypothesis are developed
is particularly important since they provide the focal point for research. They also affect the
manner in which tests must be conducted in the analysis of the data and indirectly the quality
of data, which is required for the analysis.
4) Preparing the research design

The research problem having been formulated in clear-cut terms, the researcher will be
required to prepare a research design i.e. he will have to state the conceptual structure within
which research would be conducted. In other words the function of research design is to
provide for the collection of relevant evidence with minimal expenditure of effort, time and
money.
The preparation of the research design, involves usually the consideration of the following:
a) The means of obtaining the information:
b) The availability and skills of the researcher and his staff;
c) Explanation of the way in which selected means of obtaining information will be
organized and the reasoning leading to the selection;
d) The time available for research; and
e) The cost factor relating to research.

5) Determining sample design
All the items under consideration in any field of inquiry constitute a ‘universe’ or
‘population’. Quite often we select only a few items from the universe for our study purposes.
The items so selected constitute what is technically called a sample.
The researcher must decide the way of selecting a sample or what is popularly known as the
sample design. In other words, a sample design is a definite plan determined before any data
are actually collected for obtaining a sample from a given population
6) Collecting the data

In dealing with any real life problem it becomes necessary to collect data that are appropriate.
There are several ways of collecting the appropriate data.
Primary data can be collected either through experiment or through survey.but in case of
survey; data can be collected by any one of the following ways:
a) By observation.
b) Through personal interview.
c) Through telephone interview.
d) By mailing of questionnaires.
e) Through schedules.
The researcher should select one of these methods of collecting the data taking into
consideration the nature of investigation, objective and scope of the inquiry.
7) Execution of the project

Execution of the project is a very important step in the research process. The researcher should
see that the project is executed in a systematic manner and in time. A careful watch should be
kept for unanticipated factors in order to keep the survey as much realistic as possible.

8) Analysis of the data
After the data have been collected, the researcher turns to the task of analyzing them.the
analysis of data requires a number of closely related operations such as establishment of
categories, the application of these categories to raw data through coding, tabulation and then
drawing statistical inferences.
Analysis work after tabulation is generally based on the computation of various percentages,
coefficients, etc. in brief the researcher can analyse the collected data with the help of various
statistical tools.
9) Hypothesis-testing
After analyzing the data, the researcher is in a position to test the hypothesis, if any, he had
formulated earlier. Do the facts support the hypothesis or they happen to be contrary? This is
the usual question, which should be answered while testing the hypothesis.
10) Generalizations and interpretation

If a hypothesis is tested and upheld several times, it may be possible for the researcher to
arrive at generalization, i.e., to build a theory. As a matter of fact, the real value of research
lies in its ability to arrive at certain generalization.
11) Preparation of the report

Finally the researcher has to prepare the report of what has been done by him. Writing of
report must be done with great care keeping in view the following:
1) In its preliminary pages the report should carry the title and data followed by
acknowledgements and foreword.
2) Report should be written in a concise and objective style.
3) Charts and illustrations in the main report should be used only if they present the
information more clearly and forcibly.

SCOPE OF THE STUDY
A number of studies in the past have observed that investments by FIIs and the movements of
Sensex are quite closely correlated in India and FIIs wield significant influence on the
movement of sensex. There is little doubt that FII inflows have significantly grown in
importance over the last few years. In the absence of any other substantial form of capital
inflows, the potential ill effects of a reduction in the FII flows into the Indian economy can be
severe. From the point of attracting foreign capital, the initial expectations have not been
realised. Investment by FIIs directly in the Indian stock market did not bring significantly
large amount compared to the GDR issues. GDR issues, unlike FII investments, have the
additional advantage of being project specific and thus can contribute directly to productive
investments. FII investments, seem to have influenced the Indian stock market to a
considerable extent.
Results of this study show that not only the FIIs are the major players in the domestic stock
market in India, but their influence on the domestic markets is also growing. Data on trading
activity of FIIs and domestic stock market turnover suggest that FII’s are becoming more
important at the margin as an increasingly higher share of stock market turnover is accounted
for by FII trading. Moreover, the findings of this study also indicate that Foreign Institutional
Investors have emerged as the most dominant investor group in the domestic stock market in
India. Particularly, in the companies that constitute the Bombay Stock Market Sensitivity
Index (Sensex), their level of control is very high. Data on shareholding pattern show that the
FIIs are currently the most dominant non-promoter shareholder in most of the Sensex
companies and they also control more tradable shares of Sensex companies than any other
investor groups.

Chapter – 3
Descriptive Work On Subtopics

REGULATORY INFORMATION
FII flows to India formally began in September 1992 under the foreign portfolio investment
(FPI) scheme, when the Government of India issued the Guidelines for Foreign Institutional
Investment. In November 1995, the Securities and Exchange Board of India (SEBI) 6 enforced
the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995
(henceforth, referred to as SEBI FII Regulations) to regulate matters relating to FII investment
flows. At present, investment by FIIs is jointly regulated by this and Regulation 5(2) of the
Foreign Exchange Management Act (FEMA), 1999.
The SEBI regulations require FIIs to register with the SEBI and also obtain approval from the
Reserve Bank of India (RBI) under the FEMA for securities trading, operating foreign
currency and rupee bank accounts and remitting and repatriating funds. In the entire process of
FII registration and regulation, the SEBI acts as the nodal authority and once SEBI registration
has been obtained, an FII does not require any further permission for trading securities or for
transferring funds into or out of India. The SEBI FII Regulations and RBI policies are
amended and modified from time to time in response to the gradual maturing of the Indian
financial market and changes taking place in the global economic scenario. Such modification,
needless to mention, is required to be done to ensure quantitative as well as qualitative
improvements in the portfolio flows through the FII route, as India has to compete with other
Asian nations and other emerging markets of the world for global capital inflows.
In India, FII investment (in shares and debentures) started in January 1993. FII regulations by
the SEBI were first introduced on November 14, 1995 in the form of the SEBI FII
Regulations. Over the years, the SEBI and the RBI together, through a variety of measures, are
trying to improve the scope, coverage and quality of FII investment.

These measures include (a) widening the array of instruments in which
FIIs are allowed to trade, (b) expanding the list of the types of funds that can be registered as
FIIs in India and the entities on behalf of whom they can invest, (c) raising the caps for FII
investment in different sectors and companies, (d) easing the norms for FII registration,
reducing procedural delays, lowering fees, etc., and (e) mandating stricter disclosure norms,
etc. A summary of the major regulatory changes relating to FIIs along with their reference
dates is presented in Table 1.
The hypothesis underlying the present empirical analysis is essentially that both strengthening
of the regulatory infrastructure by the SEBI and the RBI on the one hand and further
liberalization and easing of regulatory curbs for FIIs at various time points in history on the
other have had a positive impact on the flows to the national stock markets.

THE PRE- AND POST-FII REGULATION PERIODS
The SEBI FII Regulations, introduced in mid-November 1995, formally set forth in detail:
 Conditions and procedures for grant or renewal of certificates to FIIs (and their sub-
accounts) permitting them to operate directly in the Indian stock market. (This includes
the eligibility criteria for being permitted to be registered as an FII in India;
verification of whether it is legally permissible for the applicant to invest in securities
outside the country of its incorporation; whether the applicant has been registered with
any statutory authority in that country; and whether any legal proceeding has been
initiated by any statutory authority against the applicant.)
 Conditions for and restrictions on investment, which include the type of instruments an
FII is allowed to invest in, and the applicable caps or ceilings in respect of different
types of instruments (or sectors), etc.
 General obligations and responsibilities, which include appointment of a domestic

custodian; appointment of a branch of a bank approved by the RBI for opening of
foreign currency denominated accounts and special non-resident rupee accounts;
maintenance of proper books of accounts, records, etc.
 Procedure for action in case of default and suspension/cancellation of certificate.
 The fees and taxes to be paid.
 Provisions for appeal in case of any grievances.

It is obviously of interest to see whether the introduction of the SEBI FII Regulations
had any immediate repercussions on FII equity investments, causing a major gap
between the pre- and post- regulation flows. We use the monthly data series of FII net
equity inflows (FIINM) to study this impact. However, in the post-regulation period,
the Asian currency crisis had a very strong negative effect on global capital flows,
particularly to emerging Asian economies. In order to filter out this effect, we compare

our pre-regulation period with the post-regulation period up to the beginning of the
Asian crisis (which is taken to be up to June 1997). Comparing the monthly inflows
prior to the introduction of the SEBI Regulations with the corresponding post
regulation (pre-Asian crisis) period inflows, it is easy to see that the average (and
median) monthly inflows during these two sub-periods were quite different, with the
post-regulation period having a much higher average (and median) inflow. A research
confirms that the difference between the means (and medians) of the two sub-periods
are indeed statistically significant with the post-regulation period experiencing much
higher flows on an average. Next we consider the result of a Chow break point test,
which helps us detect any significant shift in the flows immediately after the
introduction of the SEBI FII Regulations. To carry out this test, we regress the monthly
net equity flows (FIINM) (for the 54-month preceding the Asian crisis) on returns on
the BSE Sensex (BSER). The result of the Chow test strongly suggests existence of a
structural break in the time series data on FII flows under consideration at the time
point of the introduction of the SEBI Regulations in November 1995, thus confirming
that the introduction of a comprehensive set of laws to govern FII flows had definitely
helped to attract more foreign portfolio investment flows into the country until the
onset of the Asian financial crisis.

FII FLOWS TO INDIA: NATURE AND CAUSES
Portfolio investment flows from industrial countries have become increasingly important for
developing countries in recent years. The Indian situation has been no different. In the year
2000-01 portfolio investments in India accounted for over 37% of total foreign investment in
the country and 47% of the current account deficit. The corresponding figures in the previous
year were 59% and 64% respectively. A significant part of these portfolio flows to India
comes in the form of Foreign Institutional Investors’ (FIIs’) investments, mostly in equities.
Ever since the opening of the Indian equity markets to foreigners, FII investments have
steadily grown from about Rs. 2600 crores in 1993 to over Rs.11,000 crores in the first half of
2001 alone. Their share in total portfolio flows to India grew from 47% in 1993-94 to over
70% in 1999-20001. The nature of the foreign investor’s decision-making process, which lies
at the heart of the portfolio flows, is briefly described below.
The International Portfolio Investor’s decision-making problem

International portfolio flows, as opposed to foreign direct investment (FDI) flows, refer to
capital flows made by individuals or investors seeking to create an internationally diversified
portfolio rather than to acquire management control over foreign companies. Diversifying
internationally has long been known as a way to reduce the overall portfolio risk and even
earn higher returns. Investors in developed countries can effectively enhance their portfolio
performance by adding foreign stocks particularly those from emerging market countries
where stock markets have relatively low correlations with those in developed countries. For
instance, according to Morgan Stanley Capital International’s estimates, between 1985 and
1990, an investor holding an all-US portfolio could improve her returns by over 25% by
holding the MSCI world index instead and at the same time, reduce her risk by about 2%.
The portfolio investor’s problem may be thought of as deciding upon appropriate country
weights in the portfolio so as to maximize portfolio returns subject to a risk constraint, or in
the absence of a pre-specified risk level, to reach the optimum portfolio, that which has the
highest Sharpe ratio, S where the Sharpe ratio is the ratio of expected excess return (excess
over the risk-free rate) to the dispersion (standard deviation) of the return.

While it is generally held that portfolio flows benefit the economies of recipient countries,
policy-makers worldwide have been more than a little uneasy about such investments.
Portfolio flows – often referred to as “hot money” – are notoriously volatile compared to other
forms of capital flows. Investors are known to pull back portfolio investments at the slightest
hint of trouble in the host country often leading to disastrous consequences to its economy.
They have been blamed for exacerbating small economic problems in a country by making
large and concerted withdrawals at the first sign of economic weakness. They have also been
held responsible for spreading financial crises – causing ‘contagion’ in international financial
markets. In the wake of the Asian crisis, prominent economists have, for these reasons,
expressed doubts about the wisdom of the IMF view of promoting free capital mobility among
countries.
International capital flows and capital controls have emerged as an important policy issues in
the Indian context as well. The danger of Mexico-style ‘abrupt and sudden outflows’ inherent
with FII flows and their destabilizing effects on equity and foreign exchange markets have
been stressed. Some authors have argued that FII flows have, in fact, had no significant
benefits for the economy at large.
While these concerns are all well-placed, comparatively less attention has been paid so far to
analyzing the FII flows data and understanding their key features. A proper understanding of
the nature and determinants of these flows, however, is essential for a meaningful debate
about their effects as well as predicting the chances of their sudden reversals. In an attempt to
address this lacuna, this paper undertakes an empirical analysis of FII investment flows to
India.
The broad objective of the present paper is to gain a better understanding of the nature and
determinants of FII flows. Towards this end we first take a look at the FII investment flow
data to bring out the key features of these flows. Next we study the relationship between FII
flows and the stock market returns in India with a close look at the issue of causality. Finally
we study the impact of other factors identified in the portfolio flows literature on the FII flows
to India. In all of these investigations we make a distinction between the pre-Asian crisis

period and the post-Asian crisis period to check if there was a regime shift in the relationships
owing to the Asian crisis.
The paper is arranged as follows. The next section sketches a brief review of the recent
literature in the area. The third section provides an overview of the nature and sources of
portfolio flows in India pointing out their main characteristics. The fourth section probes into
the possible determinants of FII flows to India. The fifth and final section concludes with a
summary of the major findings and their policy implications.
International Portfolio Flows

International portfolio flows are, as opposed to foreign direct investment, liquid in nature and
are motivated by international portfolio diversification benefits for individual and institutional
investors in industrial countries. They are usually undertaken by institutional investors like
pension funds and mutual funds. Such flows are, therefore, largely determined by the
performance of the stock markets of the host countries relative to world markets. With the
opening of stock markets in various emerging economies to foreign investors, investors in
industrial countries have increasingly sought to realize the potential for portfolio
diversification that these markets present. While the Mexican crisis of 1994, the subsequent
‘Tequila effect’, and the widespread ‘Asian crisis’ have had temporary dampening effects on
international portfolio flows, they have failed to counter the long-term momentum of these
flows. Indeed, several researchers5 have found evidence of persistent ‘home bias’ in the
portfolios of investors in industrial countries in the 90’s. This ‘home bias’ – the tendency to
hold disproportionate amounts of stock from the ‘home’ country – suggests substantial
potential for further portfolio flows as global market integration increases over time.
It is important to note that global financial integration, however, can have two distinct and in
some ways conflicting effects on this ‘home bias’. As more and more countries – particularly
the emerging markets – open up their markets for foreign investment, investors in developed
countries will have a greater opportunity to hold foreign assets. However, these flows
themselves, along with greater trade flows will tend to cause different national markets to
increasingly become parts of a more unified ‘global’ market, reducing their diversification

benefits. Which of these two effects will dominate is, of course, an empirical issue, but given
the extent of the ‘home bias’ it is likely that for quite a few years to come, FII flows would
increase with global integration.
In recent years, international portfolio flows to developing countries have received the
attention of scholars in the areas of finance and international economics alike. In the 90’s
several papers have explored the causes and effects of cross-border Portfolio investment.
While papers in the finance tradition have focused on the nature and determinants of portfolio
flows from the perspective of the diversifying investors, those from the international
macroeconomics perspective have focused on the recipient country’s situation and appropriate
policy response to such flows. For the present purposes, we shall focus only on papers that
address the issue of portfolio flows exclusively.
Previous research has also attempted to identify the factors behind these capital flows. The
main question is whether capital flew in to these countries primarily as a result of changes in
global (largely US) factors or in response to events and indicators in the recipient countries
like its credit rating and domestic stock market return. The question is particularly important
for policy makers in order to get a better understanding of the reliability and stability of such
flows. The answer is mixed – both global and country-specific factors seem to matter, with the
latter being particularly important in the case of Asian countries and for debt flows rather than
equity flows.
As for the motivation of US equity investment in foreign markets, recent research8 suggest
that US portfolio managers investing abroad seem to be chasing returns in foreign markets
rather than simply diversifying to reduce overall portfolio risk. The findings include the well-
documented ‘home bias’ in OECD investments, high turnover in foreign market investments
and that, in general, the patterns of foreign equity investment were far from what an
international portfolio diversification model would recommend. The share of investments
going to emerging markets has been roughly proportional to the share of these markets in
global market capitalization but the volatility of US transactions were even higher in emerging
markets than in other OECD countries.

Furthermore there was no relation between the volume of US transactions in these markets
and their stock market volatility.
The Mexican and Asian crises and the widespread outcry against international portfolio
investors in both cases have prompted analyses of short-term movements in international
portfolio investment flows. The question of ‘feedback trading’ has received For the related
literature on international capital flows in general (comprising both FDI and portfolio flows)
considerable attention. This refers to investors’ reaction to recent changes in equity prices. If a
gain in equity values tends to bring in more portfolio inflows, it is an instance of ‘positive
feedback trading’ while a decline in flows following a rise in equity values is termed ‘negative
feedback trading’. Between 1989 and 1996 unexpected equity flows from abroad raised stock
prices in Mexico with at the rate of 13 percentage points for every 1% rise in the flows. There
has been, however, no evidence of ‘feedback trading’ among foreign investors in Mexico. In
the period leading to the Asian crisis, on the other hand, Korea witnessed positive feedback
trading and significant ‘herding’ among foreign investors. Nevertheless, contrary to the belief
in some segments, these tendencies actually diminished markedly in the crisis period and there
has been no evidence of any ‘destabilizing role’ of foreign equity investors in the Korean
crisis. While FII flows to the Asian Crisis countries dropped sharply in 1997 and 1998 from
their pre-crisis levels, it is generally held that the flows reacted to the crisis (possibly
exacerbating it) rather than causing it.
More recent studies find that the effect of ‘regional factors’ as determinants of portfolio flows
have been increasing in importance over time. In other words portfolio flows to different
countries in a region tend to be highly correlated. Also the flows are more persistent than
returns in the domestic markets. Feedback trading or return-chasing behavior is also more
pronounced. The flows appear to affect contemporaneous and future stock returns positively,
particularly in the case of emerging markets. Finally stock prices seem to behave on the
assumption of persistent portfolio inflows. It is commonly argued that local investors possess
greater knowledge about a country’s financial markets than foreign investors and that this
asymmetry lies at the heart of the observed ‘home bias’ among investors in industrialized

countries. A key implication of recent theoretical work in this area is that in the presence of
such information asymmetry, portfolio flows to a country would be related to returns in both
recipient and source countries. In the absence of such asymmetry, only the recipient country’s
returns should affect these flows.

FOREIGN INSTITUTIONAL INVESTMENT IN INDIA: AN OVERVIEW
India opened its stock markets to foreign investors in September 1992 and has, since 1993,
received considerable amount of portfolio investment from foreigners in the form of Foreign
Institutional Investor’s (FII) investment in equities. This has become one of the main channels
of international portfolio investment in India for foreigners. In order to trade in Indian equity
markets, foreign corporations need to register with the SEBI as Foreign Institutional Investors
(FII). SEBI’s definition of FIIs presently includes foreign pension funds, mutual funds,
charitable/endowment/university funds etc. as well as asset management companies and other
money managers operating on their behalf.
The trickle of FII flows to India that began in January 1993 has gradually expanded to an
average monthly inflow of close to Rs. 1900 crores during the first six months of 2001. By
June 2001, over 500 FIIs were registered with SEBI. The total amount of FII investment in

India had accumulated to a formidable sum of over Rs. 50,000 crores during this time (see Fig.
1). In terms of market capitalization too, the share of FIIs has steadily climbed to about 9% of
the total market capitalization of BSE (which, in turn, accounts for over 90% of the total
market capitalization in India).
The sources of these FII flows are varied. The FIIs registered with SEBI come from as many
as 28 countries (including money management companies operating in India on behalf of
foreign investors). US-based institutions accounted for slightly over 41%, those from the UK
constitute about 20% with other Western European countries hosting another 17% of the FIIs
(Fig. 2). It is, however, instructive to bear in mind The closed-end country fund, “The India
Fund” launched in June 1986 provided a channel for portfolio investment in India before the
stock market liberalization in 1992. Global Depository Receipts, American Depository
Receipts, Foreign Currency Convertible Bonds and Foreign Currency Bonds issued by Indian
companies and traded in foreign exchanges provide other routes for portfolio investment in
India by foreign investors. It is also possible for foreigners to trade in Indian securities without

registering as an FII but such cases require approval from the RBI or the Foreign Investment
Promotion Board. that these national affiliations do not necessarily mean that the actual
investor funds come from these particular countries. Given the significant financial flows
among the industrial countries, national affiliations are very rough indicators of the ‘home’ of
the FII investments. In particular institutions operating from Luxembourg, Cayman Islands or
Channel Islands, or even those based at Singapore or Hong Kong are likely to be investing
funds largely on behalf of residents in other countries. Nevertheless, the regional breakdown
of the FIIs does provide an idea of the relative importance of different regions of the world in
the FII flows.

FACTORS AFFECTING FII FLOWS
In this section we shall study the relationship between FII flows and possible economic factors
affecting it, particularly stock returns in the Indian market.
FII flows and stock returns – determining the cause and the effect
FII flows and contemporaneous stock returns are strongly correlated in India. The correlation
coefficients between different measures of FII flows and market returns on the Bombay Stock
Exchange during different sample periods are shown in the different panels of Table 1. While
the correlations are quite high throughout the sample period, they exhibit a significant rise
since the beginning of the Asian crisis.

These positive correlations have often been held as evidence of FII actions determining Indian
equity market returns. However, correlation itself does not imply causality. A positive
relationship between portfolio inflows and stock returns is consistent with at least four distinct
theories: 1) the “omitted variables” hypothesis; 2) the “downward sloping demand curve”
view; 3) the “base-broadening” theory; and 4) the “positive feedback strategy” view.
The “omitted variables” view is the classic case of spurious correlation – that the correlated
variables, in fact, have no causal relationship between them but are both affected by one or
more other variables missed out in the analysis. The “downward sloping demand curve” view
contends that foreign investment creates a buying pressure for stocks in the emerging market
in question and causes stock prices to rise much in the same way as suddenly higher demand
for a commodity would cause its price to rise. The ‘base-broadening’ argument contends that
once foreigners begin to invest in a country, the financial markets in that country are now no
longer moved by national economic factors alone but rather begin to be affected by foreign
market movements as well. As the market itself is now affected by more factors than before,
its exposure to domestic shocks decline. Consequently the ‘risk’ of the market itself falls,
people demand a lower risk premium to buy stocks, and stock prices rise to higher levels.
Finally the ‘positive feedback view’ asserts that if investors ‘chase’ returns in the immediate
past (like the previous day or week) then aggregating their fund flows over the month can lead
to a positive relationship in the contemporaneous monthly data. In the present context, both
directions of causation are equally plausible.
Further returns on the BSE Index explain close to a third of the total variation in FII flows
during the entire period. They also indicate, however, that the Asian crisis marked a regime
shift in the relationship between FII flows and Indian stock market return. During and after the
crisis, the returns explained about 40% of the total variation in FII flows. The positive
relationship between market return and FII flows, however, serves only as a first-pass in
understanding the nature of such flows and their implications for the Indian markets. Since the
FII flows essentially serve to diversify the portfolio of foreign investors, it is only normal to
expect that several factors – both domestic as well as external to India – are likely to affect
them along with the expected stock returns in India. Past research suggests that the declining

world interest rates have been among the important “push” factors for international portfolio
flows in the early 90’s. The “usual suspects” in the literature include US and world equity
returns, changes in interest rates, stock market volatility, some measure of the country risk and
the exchange rate. In the Indian case, however these factors do not appear to have had a
prominent role in motivating FII flows. Finally it also appears that there has been no
significant informational disadvantage for FIIs vis-à-vis the local investors in the Indian
market.
Other factors that may affect FII flows

Country risk measures, that incorporate political and other risks in addition to the usual
economic and financial variables, may be expected to have an impact on portfolio flows to
India though they are likely to matter more in the case of FDI flows. In order to check the
impact of such country risk on FII flows, semi-annual country risk scores for India were taken
from the Institutional Investor magazine, an important country-rating agency. These raw
ratings were then divided by the world average rating to obtain normalized ratings. The
intuition behind this normalization is as follows. If India’s credit rating improves but that of
other countries improve even more, then India may not improve its relative attractiveness as a
destination of investment flows. The relation between the normalized country rating and the
average monthly FII flows (as a proportion of the preceding month’s BSE capitalization) is
shown in Figure 5. The correlation between the two variables is –0.15. No relationship is
evident from the figure itself and statistical testing confirms this view. Thus we can conclude
that broadly speaking there is no evidence of India’ credit rating affecting FII flows.

It is also conceivable that the extent to which the Indian market moves out of step with the
world market is a factor in determining its attractiveness to foreign investors.
The lower the co-movement, the greater the protection that investment in India provides to
investors against world market shocks.

LIBERALIZATION OF FOREIGN INSTITUTIONAL INVESTMENT
Following the announcement by the Government in the Budget 2002-03 that suggested those
foreign institutional investors’ (FII) portfolio investments would not be subject to the sectoral
limits for foreign direct investment except in specified sectors, a Committee was constituted
with representation from the Department of Economic Affairs as well as the Department of
Industrial Policy and Promotion.
The Committee was reconstituted twice. After the second reconstitution, the Committee had 5
meetings, the last being held on June, 24, 2004. The report gives an evolution of FII policy in
India, examines the pros and cons of FII investment, especially in an era with no balance of
payment pressures, and also provides a perspective on FII investment restrictions in peer
countries in Asia. The recommendations are as follows:
(i) In general, FII investment ceilings, if any, may be reckoned over and above prescribed
FDI sectoral caps. The 24 per cent limit on FII investment imposed in 1992 when
allowing FII inflows was exclusive of the FDI limit. The suggested measure will be in
conformity with this original stipulation.
(ii) Special procedure for raising FII investments beyond 24per cent upto the FDI limit in a
company may be dispensed with by amending the relevant SEBI (FII) Regulations.
(iii) In order to provide dispersed investments and prevent concentration, the existing limit
of 10per cent by a FII in a single company may continue.
Recommendations in above would apply, in general, to all sectors.
Specific recommendations are being made for the following sectors with overall composite
caps :
a. Telecom services.
b. Defence production
c. Public sector banks.
d. Insurance companies.

FII investments are currently not permitted in print media, sectors which are not yet opened
for private investment and in gambling, betting, lottery. The Committee recommends the same
may continue.
FDI investment in retail trading is prohibited. FII investments, however, are permitted up to 24
per cent in all listed companies, except in print media companies. The Committee
recommends the same may continue as this would help in developing supply chains in a wide
range of products including that of agriculture.
In his Budget Speech on February 28, 2002, the Finance Minister announced that: “Foreign
Institutional Investors (FIIs) can invest in a company under the portfolio investment route
beyond 24 per cent of the paid-up capital of the company with the approval of the general
body of the shareholders by a special resolution. I propose that now FII portfolio investments
will not be subject to the sectoral limits for foreign direct investment except in specified
sectors. Guidelines in this regard will be issued separately.”
2. Following this announcement, with the approval of Finance Minister, a committee was set
up on March 13, 2002 to identify the sectors in which FIIs’ portfolio investments will not be
subject to the sectoral limits for Foreign Direct Investment (FDI).
Evolution of FII Investment Policy

India embarked on a gradual shift towards capital account convertibility with the launch of
the reforms in the early 1990s. Although foreign natural persons – except NRIs – are
prohibited from investing in financial assets, such investments were permitted by FIIs and
Overseas Corporate Bodies (OCBs) with suitable restrictions. Ever since September 14, 1992,
when FIIs were first allowed to invest in all the securities traded on the primary and secondary
markets, including shares, debentures and warrants issued by companies which were listed or
were to be listed on the Stock Exchanges in India and in the schemes floated by domestic
mutual funds, the holding of a single FII and of all FIIs, Non-resident Indians (NRIs) and
OCBs in any company were subject to the limit of 5 per cent and 24 per cent of the company’s
total issued capital, respectively. Furthermore, funds invested by FIIs had to have at least 50

participants with no one holding more than 5 per cent to ensure a broad base and preventing
such investment acting as a camouflage for individual investment in the nature of FDI and
requiring Government approval.
Initially the idea of allowing FIIs was that they were broad-based, diversified funds, leaving
out individual foreign investors and foreign companies. The only exceptions were the NRI and
OCB portfolio investments through the secondary market, which were subject to individual
ceilings of 5 per cent to prevent a possible “take over.” Individuals were left out because of
the difficulties in checking on their antecedents, and of their lack of expertise in market
matters and relatively short-term perspective. OCB investments through the portfolio route
have been banned since November, 2001.
In February, 2000, the FII regulations were amended to permit foreign corporates and high
net worth individuals to also invest as sub-accounts of Securities and Exchange Board of India
(SEBI)-registered FIIs. Foreign corporates and high net worth individuals fall outside the
category of diversified investors. FIIs were also permitted to seek SEBI registration in respect
of sub-accounts for their clients under the regulations. While initially FIIs were permitted to
manage the sub-account of clients, the domestic portfolio managers or domestic asset
management companies were also allowed to manage the funds of such sub-accounts and also
to make application on behalf of such sub-accounts. Such sub-accounts could be an institution,
or a fund, or a portfolio established or incorporated outside India, or a broad-based fund, or a
proprietary fund, or even a foreign corporate or individual. So, in practice there are common
categories of entities, which could be registered as both FIIs and sub-accounts. However,
investment in to a sub account is to be made either by FIIs, or by domestic portfolio manager
or asset Management Company, and not by itself directly.
In view of the recent concerns of some unregulated entities taking positions in the stock
market through the mechanism of Participatory Notes (PNs) issued by FIIs, the issue was
examined by the Ministry of Finance in consultation with the Reserve Bank of India (RBI) and
SEBI. Following this consultation, in January 2004, SEBI stipulated that PNs are not to be
issued to any non-regulated entity, and the principle of "know your clients” may be strictly

adhered to. SEBI has indicated that the existing non-eligible PNs, will be permitted to expire
or to be wound-down on maturity, or within a period of 5 years, whichever is earlier. Besides,
reporting requirement on a regular basis has been imposed on all the FIIs.
The following entities, established or incorporated abroad, are eligible to be registered as FIIs:
a. Pension Funds,
b. Mutual Funds,
c. vestment Trusts,
d. Asset Management Companies,
e. Nominee Companies,
f. Banks,
g. Institutional Portfolio Managers,
h. Trustees,
i. Power of Attorney holders,
j. University funds, endowments, foundations or charitable trusts or charitable societies.
Besides the above, a domestic portfolio manager or domestic asset management company is
now also eligible to be registered as an FII to manage the funds of subaccounts.
The FIIs can also invest on behalf of sub-accounts. The following entities are entitled to be
registered as sub-accounts: i) an institution or fund or portfolio established or incorporated
outside India, ii) a foreign corporate or a foreign individual.
FIIs registered with SEBI fall under the following categories:
(a) Regular FIIs – those who are required to invest not less than 70 per cent of their
investment in equity-related instruments and up to 30 per cent in non-equity
instruments.
(b) 100 per cent debt-fund FIIs – those who are permitted to invest only in debt
instruments.

A Working Group for Streamlining of the Procedures relating to FIIs constituted in April,
2003 by the Government, 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 has since been implemented.
Forward cover in respect of equity funds for outstanding investments of FIIs over and above
such investments on June 11, 1998 was permitted. Subsequently, forward cover up to a
maximum of 15 per cent of the outstanding position on June 11, 1998 was also permitted. This
15 per cent limit was liberalized to 100 per cent of portfolio value as on March 31, 1999 in
January 2003.
Like in other countries, the restrictions on FII investment have been progressively liberalized.
From November 1996, any registered FII willing to make 100 per cent investment in debt
securities were permitted to do so subject to specific approval from SEBI as a separate
category of FIIs or sub-accounts as 100 per cent debt funds. Such investments by 100 per cent
debt funds were, however, subject to fund-specific ceilings specified by SEBI and an overall
debt cap of US$ 1-1.5 billion. Moreover, investments were allowed only in debt securities of
companies listed or to be listed in stock exchanges. Investments were free from maturity
limitations.
From April 1998, FII investments were also allowed in dated Government securities. Treasury
bills being money market instruments were originally outside the ambit of such investments,
but were subsequently included from May, 1998. Such investments, which are external debt of
the Government denominated in rupees, were encouraged to deepen the debt market. From
April, 1997, the aggregate limit for all FIIs, which was 24 per cent, was allowed to be
increased up to 30 per cent by the Indian company concerned by passing a resolution by its
Board of Directors followed by a special resolution to that effect by its General Body.
While permitting foreign corporates/high net worth individuals in February, 2000 to invest
through SEBI registered FII/domestic fund managers, it was noted that there was a clear
distinction between portfolio investment and FDI. The basic presumption is that FIIs are not

interested in management control. To allay fears of management control being exercised by
portfolio investors, it was noted that adequate safety nets were in force, for example, (i)
transaction of business in securities on the stock exchanges are only through stock brokers
who have been granted a certificate by SEBI, (ii) every transaction is settled through a
custodian who is under obligation to report to SEBI and RBI for all transactions on a daily
basis, (iii) provisions of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations,
1997 (iv) monitoring of sectoral caps by RBI on a daily basis.
In 1998, the aggregate portfolio investment limits of NRIs/PIOs/OCBs and FIIs were
enhanced from 5 per cent to 10 per cent and the ceilings of FIIs and NRIs/OCBs were declared
to be independent of each other.
Aggregate FII portfolio investment ceiling was enhanced from 30 per cent to 40 per cent of
the issued and paid up capital of a company [March 01 2000]. The enhanced ceiling was made
applicable only under a special procedure that required approval by the Board of Directors and
a Special Resolution by the General Body of the relevant company. The FII ceiling under the
special procedure was further enhanced [March 08 2001] from 40 per cent to 49 per cent.
Subsequently, the FII ceiling under the special procedure was raised up to the sectoral cap in
September, 2001.
Sectoral Caps
Quite apart from the ceilings on FII investment, there were and are ceilings on FDI, and in
some cases, unified ceilings for nonresident investments. There are two types of ceilings on
FII investment: statutory and administrative.
Currently non-resident investments in public sector banks and insurance sector are capped
under Acts at 20 per cent and 26 per cent respectively. Accordingly, FDI plus portfolio
investments by FIIs and NRIs are capped at 20 per cent and 26 per cent under the above
statutes.

There are also sectors where administrative caps for non-resident investments have been
prescribed. In these sectors (viz. telecom services, media, private sector 10 banks) FDI plus
portfolio investments by FIIs and NRIs cannot exceed the administrative caps fixed.
Caps can be of three types:
i) a separate cap on FDI,
ii) a separate cap on FII, and
iii) a composite caps on FDI and FII combined together.
Separate caps on FDI and FII, in turn, can be of five types:

I) ban on both FDI and FII (e.g. lottery business, gambling and betting),
II) non-zero separate caps on both FDI and FII ([e.g., DTH-broadcasting]), [DTH has
composite ceiling with a sub-ceiling for FDI at 20 per cent]
III) a composite non-zero cap on FDI and FII (banking, insurance, telecom)
IV) ban on FDI with a non-zero cap on FII (e.g.,Terrestrial broadcasting FM,
i) retail trading), and
V) ban on FII with a non-zero cap on FDI (e.g. print media).
For example, for private sector banks falling within the purview of the RBI’s regulatory
jurisdiction, no distinction is made either between different categories of nonresident investors
or the nature of foreign investment, whether portfolio or FDI.
Similarly, no distinction is made either between different categories of sub-sectors of FM

radio broadcasting and satellite uplinking, cable network and Direct-to-home. The sectoral
equity caps as of May 13, 2004 are given in Table 1 (at annex1).
In August, 2002, the Steering Group on Foreign Direct Investment headed by Shri N.K.Singh,
Member, Planning Commission, submitted its report.1 In this report, six reasons given for
imposing caps and bans on FDI national security, culture and media, natural monopolies,
monopoly power, natural resources, and transition costs, were discussed in some detail.

The Steering Group observed that while all governments prefer vital defence industries to be
controlled by their own resident nationals, there was not much justification for restrictions on
the production of civilian goods used by the defence forces, and production of those goods
that are either imported or are banned for exports from developed countries for strategic
reasons. On culture and media, the Steering Group observed that there was a need for true
cultural globalization – not a one-way process of only India having access to the culture of the
rest of the world but a two-way street – and in the field of current affairs and news
programmes, editorial control must vest with Indian nationals and eventually could be
replaced by limits on aggregate market share (25 – 49 per cent) that can accrue to foreign
controlled news/current affairs companies taken together.
As regards natural monopolies, the Steering Group observed that in the absence of a proper
regulatory system with the requisite expertise, “It can be argued that when such expertise does
not exist in the regulatory system it may be better for monopoly profits to accrue to resident
nationals than to foreigners. Though this argument has some validity in the short term it is a
defeatist approach in the long term. Domestic monopolies are more likely to succeed in
distorting the regulatory process in their favour (‘regulatory capture’) than foreign
monopolies, because of their more intimate knowledge of and association with domestic
political processes. Any such restrictions therefore must be temporary with continuous efforts
made to improve regulatory structures and skills.” On abuse of monopoly power, the Steering
Group argued that foreign investment can in fact enhance domestic competition and any
potential problem arising from a foreign producer with very high global share tying up with an
existing domestic producer should be addressed under the Competition Law.
With ownership of natural resources, such as, the electro-magnetic spectrum and sites for
dams and harbours vesting with the people and their Government, the Steering Group noted
that if extraction of the resource rent, which arises from the difference between the market
price and efficient costs of exploitation of the particular resource, is effectively designed to
maximize such resource rent to Government through appropriate tax and auction systems there
would be no need to discriminate between foreign and domestic investments.

Considerable difficulties were encountered in the monitoring of the sector specific composite
ceilings on foreign investment because of the problems in identifying the sector of investment
merely by the name of the company and the existence of companies with diversified activities.
Supply and Demand

Various supply and demand factors have made investing via institutions a rapidly growing
sector in many developed countries.2 There is enhanced supply of funds from investors to
institutions because of the aging of population, funded pension systems, and growing wealth.
Institutions are also able to give better services and attractive returns because of ease of
diversification, better corporate governance, liquidity, deregulation and fiscal incentives.
Given this background, there is likely to be a large and growing demand for Indian stocks by
FIIs.
It is of some importance to note that the bouts of liberalization of the FII regime has coincided
with pressure on the foreign exchange and balance of payments fronts, for example, in the
aftermath of the 1991 crisis and around the 1997 East Asian crisis. Now that there is no
apparent balance of payments problem, the critical question is whether there are any reasons
for liberalizing the FII regime.
FIIs have a natural advantage in processing information. One of the problems noted for such
investment in emerging markets consists in the lower amount of reliable and quality
information available in such countries relative to developed ones. It can be expected that with
rapid progress in disclosure norms, accounting standards, shareholder rights, legal framework,
and corporate governance in general, FII investments are going to accelerate in India. FII
investments in some companies are already at their ceiling level, and the ceiling is much
below the stakes that FIIs have acquired in some of the top Korean chaebols.
Countries that have liberalized their FII regimes did not do it out of balance of payments
compulsions. Taiwan, for example, removed all restrictions – previously 10 per cent
individually and 25 per cent collectively until March 1998, and 15 per cent and 30 per cent

until January 1, 2001 – from the beginning of 2001. People’s Republic of China, without a
balance of payments problem, opened itself up to FII investment in 2003.
Swiss Bank UBS, by buying into four of China’s A-share stocks – Baoshan Iron and Steel,
Shanghai Port Container, Sinotrans Air, and ZTE Corp – became the first FII to enter the
Chinese market on Wednesday, July 9, 2003.
Pros of FII Investment

The advantages of having FII investments can be broadly classified under the following
categories.
A. Enhanced flows of equity capital

FIIs are well known for a greater appetite for equity than debt in their asset structure. For
example, pension funds in the United Kingdom and United States had 68 per cent and 64 per
cent, respectively, of their portfolios in equity in 1998. Thus, opening up the economy to FIIs
is in line with the accepted preference for non-debt creating foreign inflows over foreign debt.
Furthermore, because of this preference for equities over bonds, FIIs can help in compressing
the yield-differential between equity and bonds and improve corporate capital structures.
Further, given the existing savings-investment gap of around 1.6 per cent, FII inflows can also
contribute in bridging the investment gap so that sustained high GDP growth rate of around 8
per cent targeted under the 10th Five Year Plan can materialize.
B. Managing uncertainty and controlling risks

Institutional investors promote financial innovation and development of hedging instruments.
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, not only enhance
competition in financial markets, but also improve the alignment of asset prices to
fundamentals.

Institutions in general and FIIs in particular are known to 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 as stable as the fundamentals themselves.
Furthermore, a variety of FIIs with a variety of risk-return preferences also help in dampening
volatility.
C. Improving capital markets

FIIs as professional bodies of asset managers and financial analysts enhance competition and
efficiency of financial markets. Equity market development aids economic development.3 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.
D. 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 makes equity
finance a costly option. With boards often captured by managers or passive, ensuring the
rights of shareholders is a problem that needs to be addressed efficiently in any economy.
Incentives for shareholders to monitor firms and enforce their legal rights are limited and
individuals with small share-holdings often do not address the issue since others can free-ride
on their endeavour. What is needed is large shareholders with leverage to complement their
legal rights and overcome the free-rider problem, but shareholding beyond say 5 per cent can
also lead to exploitation of minority shareholders.
FIIs constitute professional bodies of asset managers and financial analysts, who, by
contributing to better understanding of firms’ operations, improve corporate governance.

Among the four models of corporate control – takeover or market control via equity, leveraged
control or market control via debt, direct control via equity, and direct control via debt or
relationship banking – the third model, which is known as corporate governance movement,
has institutional investors at its core. In this third model, board representation is supplemented
by direct contacts by institutional investors.
Institutions are known for challenging excessive executive compensation, and remove under
performing managers. There is some evidence that institutionalization increases dividend
payouts, and enhances productivity growth.
Cons:
Management Control and Risk of Hot Money Flows
The two common apprehensions about FII inflows are the fear of management takeovers and
potential capital outflows.
A. 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 from owning 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
a resident 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 per cent.

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 have been imposed on FIIs and currently Participatory Notes cannot be issued to
un-regulated entities abroad.
B. Potential capital outflows

FII inflows are popularly described as “hot money”, because of the herding
behaviour and potential for large capital outflows. Herding behaviour, 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.4 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.
Value at Risk models followed by FIIs may destabilize markets by leading to simultaneous
sale by various FIIs, as observed in Russia and Long Term Capital Management 1998
(LTCM) crisis. Extrapolative expectations or trend chasing rather than focusing on
fundamentals can lead to destabilization. Movements in the weightage attached to a country
by indices such as Morgan Stanley Country Index (MSCI) or International Finance
Corporation ( IFC) also leads to en masse shift in FII portfolios.
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.
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) benchmarking 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 markets have some restrictions either in terms of
quantitative limits across the board or in specified sectors, such as, telecom, media, banks,
finance companies, retail trading medicine, 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 now
in place the special procedure mechanism for raising FII investments beyond 24 per cent may
be dispensed with. The restrictions on foreign ownership of companies in emerging markets
have been summarised in

Annex-III

FOREIGN INSTITUTIONAL INVESTMENT IN INDIA
India opened its stock market to foreign investors in September 1992 and since then has
received portfolio investment from foreigners in the form of foreign institutional investment in
equities. This has become one of the main channels of FII in India. In order to trade in the
Indian equity market, foreign corporations need to register with the Securities and Exchange
Board of India (SEBI) as foreign institutional investors. India allows only authorized foreign
investors to invest in pension funds, investment trusts, asset management companies,
university funds, endowments, foundations, charitable interests and charitable societies that
have a track record of five years and which are registered with a statutory authority in their
own country of incorporation or settlement. It is possible for foreigners to trade in Indian
securities without registering as an FII but such cases require approval from the Reserve Bank
of India (RBI) or the Foreign Investment Promotion Board (FIPB).
Foreign institutional investors generally concentrate on the secondary market. The total
amount of foreign institutional investment in India has accumulated to the formidable sum of
over U.S.$120,243 million as of January 2007.
Daily FII Activity

DATE PURCHASES SALES NET INV
(Rs m) (Rs m) (Rs m)
Mon, 8 Jan,2007 13,853 44,610 (30,757)
Tue, 9 Jan,2007 17,520 28,588 (11,068)

Wed, 10 Jan,2007 17,520 28,588 (11,068)
Thu, 11 Jan.2007 24,603 23,010 1,593
Fri, 12 Jan,2007 26,331 24,261 2,070
Total 99,827 149,057 (49,230)
Contribution by FIIs
The diversity of FIIs has been increasing over 30 countries registered with SEBI as at march
31st, 2006.Of these 40% originate from 20% and US from UK. Recently FIIs from Japan and

continental Europe are increasing their India exposure. FIIs contributed approx. 11% of the
total market and approx.10% of the total market turnover.
Of the new issuances in FY 2006
 Domestic IPOs aggregated $5.4 billion
 Overseas issuance by the way of ADRs and GDRs were $5billion
 Foreign currency convertible bonds (FCCBs) were for $6 billions
 FIIs contributed over 75% of the new equity and equity linked issuances
The FII inflows into India have been on account of:

 Strong economic fundamentals and attractive valuations of companies
 High quality of corporate governance
 Efficient market mechanisms for settlement and clearing
 Product diversification and availability of active derivatives market.

Portfolio of FIIs
Chart Title
CEMENT AUTO IT
POWER PHARMA REFINERIES
ENGG METALS CONSUMER GOODS
TEXTILE TELECOMUNICATION PETROLEUM
FMGC BANKS
0%
1% 1%
1%
6%
12% 0%
1%
25%
26%
0%
25% 1%
1%
Shareholding pattern of FIIs.
Companies FII Total outstanding FII shareholding as a

shareholding shares percent of total
NIFTY 3227 23285 13.85
NON-NIFTY 1508 35060 4.3
TOTAL 4735 58345 8.12

FIIs registered with SEBI
Financial year During the year Total registered at the end of the year
1992-93 0 0
1993-94 3 3
1994-95 153 156
1995-96 197 353
1996-97 99 439
1997-98 59 496
1998-99 59 450
1999-00 56 506
2000-01 84 528
2001-02 48 490
2001-03 51 502
2003-04 83 540
2004-05 145 685
2005-06 131 803
EFFECT OF FII ON STOCK MARKET

The FIIs are major institutional investors in Indian capital market. Movement in the sensex has
clearly been driven by the behavior of foreign institution investors. The presence of foreign
institution investor in the sensex companies and their active trading behaviours, their role in
determining the share price movements must be considerable. Indian stock markets are known
to be known narrow and shallow in the sence that there are few companies whose shares are
actively traded. Although there are 4700 companies listed with stock exchange.the BSE
sensex incorporates only 30 companies, trading on whose shares are seen as indicative f
market activity. This shallowness also means that the FIIs can also affect the behavior of other
retail investors, who tend to follow the FIIs when making their investment decision.
These features of Indian stock markets induce a high degree of instability for four reasons
First, increase in investment by FIIs cause sharp price increase. It would provide additional
incentives for FII investment and this encourages further investment so that there is a tendency
for any correction of price unwaeeabted by price earnings ratios to be delayed. And when the

correction begins it would have to lead by an FII pullout and can take the form of extremely
sharp decline in the share prices.
Second, as and when FIIs are attracted to the market by expectations of a price increase that
tend to be automatically realized, the inflow of foreign capital can result in an appreciation of
the rupee. This increases the return earned in foreign exchange, when rupee assets are sold and
the revenue converted into dollars. As a result, the investments turn even more attractive
triggering an investment twisting that would imply a sharper fall when any correction begins.
Third, the growing realization by the FIIs of the power they wield in what are shallow
markets, encourages speculative investment aimed at pushing the market up and choosing an
appropriate moment to exit. This implicit manipulation of the market if resorted to often
enough would obviously imply a substantial increase in volatility.
Finally, in volatile markets, domestic speculators too attempt to manipulate markets in periods
of unusually high prices.

shareholding pattern of sensex companies
banks,Fis,insurance cos mutual funds and UTI

promoters FIIs
private Corporate bodies indian public
NRIs/OCBs Others
Above fig masks the fact that FIIs hold a much higher percentage of shares that are normally
available for trading in the market therefore to judge the real influence of the FIIs on the share
prices of sensex companies, it is important to see what percentage of free-floats shares are
controlled by FIIs.it shows that average equity holding by FIIs is more than 20% in the sensex
companies.it also shows that an investor group, FIIs are the biggest non-promoter shareholders
of the sensex companies.

MONTHLY FII INVESTMENTS
Month Net Month end Month end Current Cumm. % %

Ended inv. rs / us$ index value Inv. Gain Gain
(rs mn.) (rs mn) (rs mn.) (rs (us
mn.) $ mn.)
Jan - 2008 37,983 44.07 9,920 53,823 37,983 41.7 42.0
Feb - 2008 75,720 44.39 10,370 102,642 113,703 37.6 37.2
Mar - 2008 59,778 44.62 11,280 74,495 173,481 33.1 32.8
Apr - 2008 39,771 44.97 12,043 46,422 213,252 30.1 30.1
May -2008 (82,473) 46.37 10,399 (111,484) 130,779 26.9 24.4
Jun - 2008 9,094 46.04 10,609 12,050 139,873 27.2 25.1
Jul - 2008 12,764 46.56 10,744 16,700 152,637 27.5 24.9
Aug - 2008 47,739 46.54 11,699 57,361 200,376 25.8 25.1
Sep - 2008 59,282 45.94 12,454 66,912 259,658 22.8 23.2
Oct - 2008 65,995 45.03 12,962 71,570 325,653 19.9 20.6
Nov - 2008 93,142 44.69 13,617 96,152 418,795 16.2 16.9
Dec - 2008 (35,936) 44.27 13,787 (36,640) 382,859 17.5 18.3

As per the data available for the current month and presented in the above table shows the
monthly flow of the FII during January 2008 to dec. 2008. in the year 2008 the flow was
37,987 mn. Rs. Or net investment by the FII and at the end of December the total flow was
382,859mn.rs. we can also see that there is a continuous increase in the BSE sesex from 9,920
to 13,787 excepted may. This just because of heavy withdrawn by the FII and lesser
investment in the month of June. So we can say that there is a direct relationship between the
index and FII flow.

Monthly FII inflows and BSE sensex.
Time Sensex Net Investment

Jan-99 3315 446
3399 339 Net Inv
3739 123
Apr-99 3325 825 12000
3963 1772 10000
4140 283 8000
Jul-99 4542 1411 6000
Net Investment
4898 21 4000
4764 -743 2000
Oct-99 4444 1280
0
4622 -790
5005 1576 -2000
Jan-00 5205 151 -4000
5446 2923 -6000
5001 1067 -8000
-10000
Jan-99
Jul-99
Jul-00
Jan-01
Jan-02
Jan-00
Jul-01
Oct-99
Oct-00
Apr-99
Apr-00
Apr-01
Oct-01
Apr-02
The economic literature is prosperous with research pointing towards the close correlation of
the BSE Sensex and FII fund flows. Interestingly, a note by National Stock Exchange “Indian
Securities Markets: A review Vol IV, 2001” observes that FIIs have a disproportionately high
level of influence on the sentiments and price trends in the Indian equity market as other
market participants perceive the FIIs to be infallible in their assessment of the market and tend
to follow decisions taken by FIIs. Such ‘herd mentality’ displayed by market participants
amplifies the role of the FIIs in the Indian stock market. Over the years, as the ceiling for FII
investments were relaxed, there has also been a progressive increase in the share of FII
holdings in leading Indian companies (and also in the Sensex companies). A big role of the
FIIs in determining the Sensex level is therefore not out of place.
That the BSE Sensex is closely correlated with the trend of FII inflows is clearly brought out
from the above fig. It is evident that the equity markets were more or less in a steady state till
around April 2003 when FII inflows per month tended to follow a normal historical trajectory.
The upswings in the FII inflows from around May 2003 have also led to quantum jumps in the
BSE Sensex. But despite the general upward trajectory of the BSE sensex there have been
some months of correction and such corrections occurred in months with negative FII flows.

Little doubts therefore that the BSE Sensex fell by around 14% in May 2006 compared to
April 2006 after FIIs turned net seller to the extent of USD 1.6 bn in that month.
Importance of FII flow in India
net investment
60000
50000
40000
30000
20000
10000
-10000
3 4 5 6 7 8 9 0 1 2 3 4 5 6
2 -9 3 -9 4 -9 5 -9 6 -9 7 -9 8 -9 9 -0 0 -0 1 -0 2 -0 3 -0 4 -0 5 -0
1 99 1 99 1 99 1 99 1 99 1 99 1 99 1 99 2 00 2 00 2 00 2 00 2 00 2 00
fig; net flow of investment by FIIs in India
FII investments are non-debt creating flows, also a reason why Indian policy makers sought
to liberalize such flows in the wake of the BoP crisis in 1990-91. Theoretically, FII
investments bring in global liquidity into the equity markets and raise the price-earning ratio
and thereby reduce the cost of capital domestically. FII inflows help supplement domestic
savings and smoothen inter-temporal consumption. Studies indicate a positive relationship
between portfolio flows and the growth performance of an economy, though such specific
studies for India were not found.

fig ;Rising shares of FII investment in FX reserves and total foreign
investment.
India, in the recent past few years seems to have received a disproportionately large part of its
foreign investment flows via the FII investments in the equity markets. While in the last three
years the average share of FII in the total foreign investments was above 70%, this is almost
double the average share of around 36% of FII investments in the three years of FY01 to
FY03. More so, FII inflows have significantly contributed to the Balance of Payments surplus
in the last three years. Our analysis indicates that FII inflows as a percentage of the BOP
surplus was at around 35% in the most recent last three years while the average from FY95 to
FY03 had been only around 4.5%. Exhibit 3 also indicates that FII inflows had significantly
contributed to the sharp increase in the foreign exchange reserves of the economy.
The large build-up of foreign exchange reserves through FII inflows poses a potential threat of
destabilization of the economy. Portfolio flows are most often referred to as “hot money” that
can be notoriously volatile when compared to other forms of capital flows.

ADVANTAGES OF FII INVESTMENT
Enhance flow of equity capital
FIIs are well known for a greater appetite for equity than debt in their asset structure. In
pension funds in the UK and USA had 68% and 64%, respectively, of their portfolio in equity
in 1998.thus, opening up the economy to FIIs in the line with accepted preferences for non-
debt creating foreign inflows over foreign debt. Because of this preference for equities over
bonds, FIIs can help in compressing the yield differential between equity and bonds and
improve corporate capital structure.
Managing uncertainty and controlling risks
FIIs promote financial innovation and development of hedging instruments. FIIs as

professional bodies of asset managers and financial analysts, not only enhance competition in
the financial markets, but also improve the alignment of asset prices to fundamentals.
Improving capital markets
FIIs enhance competition and efficiency in the markets. Equity development aids economic
development by the viability 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.
Improved corporate governance
Bad corporate governance makes equity finance a costly option .incentives for shareholders to
monitor firms and enforce their legal rights are limited and individuals with small-holdings
often do not address the issue since others can free-ride on their endeavor. What is needed is
large shareholders with leverage to complaint their legal rights and overcome the free-rider
problem.

Knowledge flows
The activities of FIIs help strengthen Indian finance .FIIs advocate modern ideas in market
design, promote innovation, development of sophisticated products such as financial
derivatives, and enhance competition in financial intermediation.
COSTS
Herding and positive feedback trading
There are concern that foreign investors are chronically ill-informed about India, and this lack
of sound information may generate herding and positive feedback trading (buying after
positive return and selling after negative returns these kind of behaviour can exacerbate
volatility, and pushes price away from fair values
Possibilities of taking over companies
While FIIs arne seen as pure portfolio investors, without interest in control, portfolio investor
can occasionally behave like FDI investors, and seek control of companies.
Complexities of monetary management
The problem showed up in terms of very large foreign exchange reserve inflows requiring
considerable sterilization operations by RBI to maintain stability.

DETERMINANTS OF FII INVESTMENT
There have been several attempts to explain FII behavior in India. All the existing studies have
found that equity return has a significant and positive impact on FII. But given the huge
volume of investments, foreign investors can play the role of market makers and book their
profits, that is, they can buy financial assets when the prices are declining, thereby jacking-up
the asset prices, and sell when the asset prices are increasing (Gordon and Gupta 2003).
Hence, there is a possibility of a bidirectional relationship between FII and equity returns
.
Following the Asian financial crisis and the bursting of the info-tech bubble internationally in
1998/99, net FII declined by U.S.$61 million. This, however, exerted little effect on equity
returns. This negative investment might possibly disturb the long-term relationship between
FII and other variables such as equity returns, inflation, and so on. Chakrabarti (2001) has
perceived a regime shift in the determinants of FII following the Asian financial crisis and
found that in the pre–Asian crisis period, any change in FII had a positive impact on equity
returns. But it was found that in the post–Asian crisis period, a reverse relationship has been
the case, namely, that change in FII is mainly due to change in equity returns. This is a fact
that needs to be taken into account in any empirical investigation of FII. Investments, either
domestic or foreign, depend heavily on risk factors. Hence, while studying the behavior of FII,
it is important to consider the risk variable. Further, realized risk can be divided into ex-ante
and unexpected risk. Ex-ante risk is an observed component and is negatively related to FII.
But the relationship between unexpected risk and FII is obscure. Therefore, while examining
the impact of risk on FII, one needs to separate the unobserved component from the realized
risk. Trivedi and Nair (2003) have used only the realized risk.
Another possible determinant of FII is the operation of foreign factors such as returns in the
source country’s financial markets and other real factors in the source economy. So far,
however, studies have found that both return in the source country stock market and the
inflation rate have not exerted any impact on FII. Agarwal (1997) found that world stock
market capitalization had a favorable impact on the FII in India.

The research shows that existing studies do not account for volatility, which can be expected
in most of the monthly financial time series data. Yet given the increase in financial market
integration, both domestically and in foreign financial markets, accounting for volatility is
unavoidable. Further, the existing studies either do not incorporate risk in foreign and
domestic markets or make use of realized risk, an approach that does not always yield robust
results. This is because standard deviation/variance (realized risk variable) increases
irrespective of the direction in which stock returns move, while movement of FII is
determined by bull/bear phases. It is preferable, therefore, to divide the realized risk into ex-
ante risk and unpredictable risk. Since investment in stock markets is sentiment driven, and is
affected more or less by everything, the crucial task is to identify a few critical determinants.
This paper makes a modest attempt to explore the relation between FII and its pivotal
determinants, for the particular case of India. More specifically, a few important variables
believed to be affecting FII are chosen and then a theoretical model is built and empirically
tested for India. The focus of this paper is the study of the critical determinants of FII, so as to
provide a better understanding of FII behavior that helps while liberalizing the capital account.
We hope that the study will be important from a policy perspective, as FII constitutes an
important element for the smooth functioning of domestic financial markets.

Chapter – 4
Data Analysis & Interpretation

DESCRIPTION OF THE DATA
The data used in this paper comes from several sources. We use monthly net FII investment
figures obtained from the websites of the RBI and SEBI. Market capitalization data are
obtained from the BSE web site. Other financial data like the exchange rate, short-term
interest rate in India, returns on the MSCI world index, S&P 500 as well as the BSE national
index are obtained from Data stream. Country credit rating data are obtained from several
issues of the Institutional Investor magazine.
The FII net investment series starts from January 1993 and the BSE market capitalization
series starts in April 1993. The series of FII flows as a proportion of preceding month’s BSE
market capitalization therefore begins in May 1993.
Since the net monthly FII flows and the returns in the Indian equity markets constitute two key
variables in this study, we present, in the three panels of Figure 1, the net FII flows, the BSE
National Index and net FII flows as a proportion of the preceding month’s BSE market
capitalization from May 1993 to June 2001. The BSE National Index immediately reveals the
massive and short-lived ‘bubble’ during 2000, a phenomenon that is likely to have caused
temporary but marked deviations from the long-term relationship between FII flows and
Indian market returns. In order to avoid misleading results from this potentially ‘tainted’
period, we restrict our sample to the end of 1999 for carrying out empirical analyses.
In order to check if the Asian crisis marked a structural break in the relationships studied here;
we sub-divide the sample period into two sub-samples. Dating the Asian crisis to begin in July
1997, the pre-Asian Crisis sub-sample runs from May 1993 to June 1997 (50 months) and the
Asian crisis sub-sample runs from July 1997 to December 1999 (30 months).
In order to study the causal linkage between FII flows and contemporaneous stock returns in
greater detail, we also use daily FII flows data and daily returns on the BSE National Index for
the year 1999. The daily FII flows data come from the SEBI website while the daily returns
data are, once again, obtained from Datastream.

THEORETICAL MODEL FOR FII
To build the theoretical model, well-known “uncovered interest parity” (UIP) and “purchasing
power parity” (PPP) conditions have been combined. To bring the model closer to reality, the
assumption of equal riskiness in domestic and foreign assets (made under UIP) is relaxed.
When there is both perfect capital mobility and equal risk of both home and foreign bonds,
then home and foreign bonds are said to be perfect substitutes. Perfect substitutability of
domestic and foreign bonds implies that the uncovered interest parity condition will hold on a
continuous basis.
Let the rate of return to foreign investor by investing in domestic stock market be id and return
in the same market if. By investing in the domestic market the foreign investor makes two
investments, one being in the Indian stock market and the other in the Indian rupee.
Accordingly, the overall return to the investor can be divided into a return on the stock and a
return on the investment in the rupee. If the foreign investor subsequently sells the rupee at the
end of the period, the return on the foreign currency would be ic and this can be presented as
if =id+ ic
If we consider the nominal exchange rate as rupees per U.S. dollar, e, initially only
expectations can be formed with regard to the exchange rate movement, hence
If = id − E(˙e / e),
where E(˙e / e) is the expected rate of change in value of the rupee against the dollar. This
equation represents the uncovered interest parity condition. Uncovered interest parity dictates
that the expected rate of depreciation of the rupee-dollar exchange rate is equal to the interest
rate differential between Indian and U.S. stocks.
Now we incorporate the PPP condition, according to which the real exchange rate that is
defined as the ratio of the two countries’ price level, expressed in a common currency, should

be equated to unity for all pairs of countries and at all times. This can be expressed as e = QPd
/ Pf ;
where e is the nominal exchange rate,

Q is the real exchange rate,
Pd is the domestic price level, and
Pf is the foreign price level.
PPP theory also asserts that Q can be taken as exogenously determined (Q = Q¯ ).

Hence, e = Q¯ Pd / Pf implying that over a period of time the exchange rate moves in
proportion to movements in the ratio of price level, pd / pf. Taking log and differentiating with
respect to time, we get ˙e / e =p˙d / pd −p˙f / pf. Hence, the changes in the exchange rate
and E(˙e / e) would depend on the inflation rate differentials.
Putting this result in the uncovered interest parity condition, we have
id =I f +  d − f, (1)
where  is the inflation rate in respective countries.
Now, to be more realistic, we relax the assumption of equal risk for domestic and foreign
assets under UIP. By dropping this assumption we have
id −if = E(˙e / e) + P,
where P is risk premium. In other words, a large interest rate differential implies a market
expectation of large exchange rate depreciation or currency risk. Risk averse investors expect
higher returns for investing in relatively riskier assets and therefore the risk premium
represents compensation to the investor for assuming risk.

The above equation is modeled as
id −if = E(˙e / e) + d −f,

where  is a measure of dispersion (standard deviation) representing risk in respective
countries. Hence, the return differentials depend on the inflation rate differentials and the risk
premium. This can be represented as
id −if = d − f + d − f,

where we have drawn three domestic and three foreign variables affecting FII. In a functional
form, it can be represented as
FII =f(id, if, d, f, d,f). (2)

Briefly the signs for the coefficients of each variable and the rational for it are as follows:
Investors are believed to follow a higher return, hence when the return in the domestic
market increases, FII flows to the domestic market.
Since FII follows higher returns, an increase in the return in the U.S. (foreign) market
will induce investors to withdraw from the Indian (domestic) stock market to invest in the U.S.
(foreign) market.
Investors are considered to be risk averse, hence when risk in the domestic market
increases they will withdraw from the domestic market.
Considering investors as risk averse, when risk in the foreign (U.S.) market increases,
investors will withdraw from the foreign (U.S.) market and invest in the Indian (domestic)
market.
When inflation in the domestic country increases, the purchasing power of the funds
invested declines, hence investors will withdraw from the domestic market.
Similarly, when inflation in the foreign country increases, the purchasing power of
funds invested in the foreign country declines, causing institutional investors to withdraw from
the foreign (U.S.) market and make investment in the domestic (Indian) market.

A GAP ANALYSIS OF FIIS INVESTMENTS – AN ESTIMATION OF FIIS
INVESTMENTS AVENUES IN INDIAN
EQUITY MARKET
India embarked on a programme of economic reforms in the early 1990s to tie over its balance
of payment crisis and also as a step towards globalization. An important milestone in the
history of Indian economic reforms happened on September 14, 1992, when the FIIs (Foreign
Institutional Investors) were allowed to invest in all the securities traded on the primary and
secondary markets, including shares, debentures and warrants issued by companies which
were listed or were to be listed on the stock exchanges in India and in the schemes floated by
domestic mutual funds. Initially, the holding of a single FII and of all FIIs, NRIs (Non-
Resident Indians) and OCBs (Overseas Corporate Bodies) in any company were subject to a
limit of 5% and 24% of the company’s total issued capital respectively. In order to broad base
the FII investment and to ensure that such an investment would not become a camouflage for
individual investment in the nature of FDI (Foreign Direct Investment), a condition was laid
down that the funds invested by FIIs had to have at least 50 participants with no one holding
more than 5%. Ever since this day, the regulations on FII investment have gone through
enormous changes and have become more liberal over time. From November 1996, FIIs were
allowed to make 100% investment in debt securities subject to specific approval from SEBI as
a separate category of FIIs or sub-accounts as 100% debt funds. Such investments were, of
course, subjected to the fund-specific ceiling prescribed by SEBI and had to be within an
overall ceiling of US $ 1.5 billion. The investments were, however, restricted to the debt
instruments of companies listed or to be listed on the stock exchanges. In 1997, the aggregate
limit on investment by all FIIs was allowed to be raised from 24% to 30% by the Board of
Directors of individual companies by passing a resolution in their meeting and by a special
resolution to that effect in the company’s General Body meeting. From the year 1998, the FII
investments were also allowed in the dated government securities, treasury bills and money
market instruments. In 2000, the foreign corporates and high net worth individuals were also
allowed to invest as sub-accounts of SEBI-registered FIIs. FIIs were also permitted to seek
SEBI registration in respect of sub-accounts. This was made more liberal to include the
domestic portfolio managers or domestic asset management companies. 40% became the

ceiling on aggregate FII portfolio investment in March 2000. This was subsequently raised to
49% on March 8, 2001 and to the specific sectoral cap in September 2001. As a move towards
further liberalization, the Finance Minister announced in his budget speech on February 28,
2002 that, “Foreign Institutional Investors (FIIs) can invest in a company under the portfolio
investment route beyond 24 per cent of the paid up capital of the company with the approval
of the general body of the shareholders by a special resolution. I propose that now FII
portfolio investments will not be subject to the sectoral limits for foreign direct investment
except in specified sectors. Guidelines in this regard will be issued separately.” Accordingly, a
committee was set up on March 13, 2002 to identify the sectors in which FIIs portfolio
investments will not be subject to the sectoral limits for FDI.
The committee has proposed that, ‘In general, FII investment ceilings, if any, may be
reckoned over and above prescribed FDI sectoral caps. The 24 per cent limit on FII investment
imposed in 1992 when allowing FII inflows was exclusive of the FDI limit. The suggested
measure will be in conformity with this original stipulation.’ The committee also has
recommended that the special procedure for raising FII investments beyond 24 per cent up to
the FDI limit in a company may be dispensed with by amending the relevant regulations.
Meanwhile, the increase in investment ceiling for FIIs in debt funds from US $ 1 billion to US
$ 1.75 billion has been notified in 2004. The SEBI also has reduced the turnaround time for
processing of FII applications for registrations from 13 working days to 7 working days except
in the case of banks and subsidiaries. All these are indications for the country’s continuous
efforts to mobilize more foreign investment through portfolio investment by FIIs. The FII
portfolio flows have also been on the rise since September 1992. Their investments have
always been net positive, but for 1998-99, when their sales were more than their purchases.

TABLE 1
TRENDS IN FII INVESTMENT
the increase. But the years 2001-02 and 2002-03 saw some reversal in the trend. From a net
inflow of US $ 2.1 billion in 2000-01, such inflows declined to US $ 1.8 billion in 2001-02,
and further dropped to US $ 0.562 billion in 2002-03. The decline is because of the lower
portfolio inflows, as a result of which the net investment has dropped in these years. However,
this decline witnessed a sharp reversal in the year 2003-04. FIIs have made a net investment of
Rs. 45,764 crores during this year registering a growth of 1602% over the previous year,
creating a record in the history of FII investment in India. Gross purchases in this year
amounted to Rs.144,857 crores, a growth rate of 208% compared to the year before. This trend
continued in April 2004, only to suffer reversal again during May and June 2004, when the net
investment became negative. Fortunately, this year from July 2004 has been seeing a net
positive portfolio flows by FIIs. As of September 2004, the net FII portfolio investment stands
at US $ 27,637 million. This study is undertaken to assess what is the net FII investment in

specific companies’ vis-à-vis the FII investment cap in them. This is done to bring to light that
though the FII investment, if studied over time in India, shows a positive trend of increase in
general, they are still insufficient and very much below the level envisaged and permitted by
the regulations. If it is so, then increasing the FII investment cap per se will not just be helpful
The country has to work on specific measures to encourage more FII investments.
The Study
The study has undertaken an analysis of the FII investment gap in the companies included in
the S & P CNX 500 index of National Stock Exchange, by comparing the FII investment in
each of these companies as of September 30, 2004 with the FII investment cap. The FII
investment gap, the difference between the investment allowed under the FII investment cap
provision for the company and the actual investment, is estimated in terms of the market value
prevailing as on the estimate date of September 30, 2004. Information on the shareholding
pattern of these companies as of September 30, 2004, the closing market price of these shares
is downloaded from the NSE site, www.nseindia.com. Since information is not available for
31 companies they are excluded from the study. In all the findings of this study relates to 469
companies included in the S & P CNX 500 index of National Stock Exchange as of September
30, 2004. The information on the FII investment cap for each of these companies is assessed
from the Reserve Bank of India site, www.rbi.org.in The reason for choosing the companies
included in this index is because this index is fairly comprehensive and includes companies
from different sectors in the same proportion of how they are in the population of all the listed
companies.
Sample Profile
The FIIs hold 8.12 per cent of the total outstanding shares of the 469 companies studied as of
September 2004, emerging as the biggest institutional investor, ahead of the mutual funds,
domestic financial institutions and the private corporate bodies. In an overall ranking they
occupy the third position after the promoters and the Indian public holding higher levels of
investment than FIIs.

However, when the companies are grouped into those included in the S & P CNX NIFTY
index(referred to as NIFTY companies from now onwards) and those which are not included,
a specific concentration of FIIs investment in NIFTY companies. The FIIs shareholding is
around 13.85 per cent in NIFTY companies as against 4.30 per cent in the Non-NIFTY
companies.
The table above shows that the FIIs investment is certainly more concentrated in the NIFTY
companies than in Non-NIFTY companies. But, this analysis is not complete because a mere
comparison of the number of shares held by FIIs is meaningless as the market price per share

varies across companies and it takes different quantum of money to acquire the same number
of shares in different companies. Hence, this analysis is further extended to include the
monetary value of the FIIs investment as of September 30, 2004 by multiplying the number of
shares held by the closing market price per share as of the same day. This will give an
understanding of the value of the FIIs investment at market value as of a particulate date. This
is done as a proxy as the cost of their investments in each of these companies is not readily
available.
TABLE 4
VALUE OF FIIS INVESTMENT
Table 4 clearly brings out that when the shareholding of FIIs is analysed in terms of the
market value of their investment as of September 30, 2004, about 85 per cent of the total value
of their investment is held in NIFTY companies and only about 15 per cent is in Non-NIFTY
companies. This shows, once again as mentioned above, that there is a clear concentration of
FIIs investments in few chosen companies. A separate analysis of the NIFTY and Non-NIFTY
companies bears evidence to this fact. About 25 per cent of the total market value of the FIIs
investments is in just two companies namely Infosys and Reliance Industries where the
investment is about 14 and 12 per cent respectively. 50 per cent of the total market value of
the FIIs investment is only in 6 companies namely Infosys Technologies (13.87%), Reliance
Industries (12.44%), ICICI Bank (7.51), HDFC (7.05), ONGC (5.25%) and Satyam (4.88).
The total value of the FIIs investment in these companies is around Rs.677,516 million. When

the companies are arranged in a decending order of their FIIs investment, it is found that 21 of
the companies account for around 81.67 per cent and the balance 29 companies share only
18.83 per cent of the total market value of the FIIs investments, each one accounting for less
than 1.5 per cent. In the bottom 13 companies, the FIIs investment is less than 0.5 per cent.
Dabur India, Tata Chemicals, VSNL, Colgate-Palmolive and Britannia enjoy less than 0.1 per
cent of the FIIs investments in value terms. In the Non-NIFTY category the top five
companies which are the most favoured destinations for FIIs investments are Container
Corporation, Bank of Baroda, Canara Bank, I-Flex and Asian Paints. As many as 71
companies of the 416 companies in this category have absolutely no FIIs investment in them.
The Analysis
The objective of the study is to bring to light the investment gap in the FIIs investments by
comparing the current investment levels of FIIs in the chosen sample companies against the
cap allowed. The cap on the individual companies has taken into account the generic cap of 24
per cent prevailing and also the increase of the cap to the sectoral cap by the individual
companies by passing of resolution in the Board and General Body.
It may be noticed from the above table that the percentage of the investment gap in case of
NIFTY companies is around 59 and is 84 for the Non-NIFTY companies. The total gap in
respect of all the companies works out to 72 per cent. This is in line with the findings
presented in Tables 3 and 4, where it is brought out that the FIIs investments in NIFTY

companies is higher than in Non-NIFTY companies, both in terms of number of shares held
by them and the market value of these shares.
This finding presented above is not surprising. Though the number of shares available for
further investment by FIIs is less in NIFTY companies than Non-NIFTY companies, in terms
of value the difference is not very wide as the average market price per share of the NIFTY
category is very much higher than that of the Non-NIFTY category. The top 5 companies
where the gap is at the maximum in NIFTY category of companies are Bharti Televentures,
Reliance Industries, ONGC, Hindustan Lever and Wipro. In the Non-NIFTY companies the
top 5 companies are Mphais BFL, Neyveli Lignite, LIC Housing Finance, Tata
Teleservices(Maharastra) and Himachal Futuristic.

FINDINGS
1. The FIIs investments are highly concentrated in terms of their market value in a very
small number of companies.
2. There seems to be a clear distinction in the FIIs shareholding in NIFTY and Non-NIFTY
companies.
3. There is a wide gap between the actual investments by FIIs and the investments allowed
as per the cap.
4. The gap in their investments exist both in NIFTY and Non-NIFTY companies.
5. FII flows are correlated with contemporaneous returns in the Indian markets.
6. This high correlation is not necessarily evidence of FII flows causing ‘price pressure’ –
if anything, the causality is likely to be the other way around.
7. A collection of domestic and international variables likely to affect both flows and
returns fail to diminish the importance of contemporaneous returns in explaining FII
flows.
8. Since the US and world returns are not significant in explaining the FII flows, there is no
evidence17 of any informational disadvantage of FIIs in comparison with the domestic
investors in India.
9. Changes in country risk ratings for India do not appear to affect the FII flows.
10. The beta of the Indian market with respect to the S&P 500 index (but not the beta with
respect to the MSCI world index) seems to affect the FII flows inversely but the effect
disappears in the post-Asian crisis period.
11. There appears to be significant differences in the nature of FII flows before and after the
Asian crisis. In the post Asian crisis period it seems that the returns on the BSE National
Index have become the sole driving force behind FII flows.
The stylized facts listed above lead to a better understanding of FII flows to India.
The weakness of the evidence of causality from flows to returns contradicts the view that the
FIIs determine market returns in general, though ‘herding’ effects – particularly with domestic
speculators imitating FII moves – may well be present in cases of individual stocks.
Particularly since the Asian crisis – which seems to have brought about a regime shift in the

relationship between FII flows and stock market returns – the direction of causation seems to
be running from the returns to the flows. The relative stability in the exchange rate of the
Indian Rupee in the post-Asian crisis era seems to have outweighed fluctuations in the
country’s credit rating among foreign portfolio investors.
It is notable that the Asian crisis appears to have acted as a watershed in several of the key
relationships affecting the FII flows to India. This is not an overly surprising result. Recent
research18 has demonstrated that the Asian crisis caused several major changes in the
financial relationship among European countries halfway across the globe. In fact the crisis
appeared to have altered several of the ‘ground rules’ of international portfolio investing
around the world. Why exactly the relationships analyzed here demonstrate a structural break
at the outbreak of the Asian crisis is a matter of speculation. However, it is plausible that the
crisis and India’s relative imperviousness to it increased India’s attractiveness to portfolio
investors particularly as many other emerging markets began to appear extremely risky. This
‘substitution effect’ may well have drowned other long-term relationships. Besides, investors
may have started paying closer attention to obtaining and processing information in
destination countries in the wake of the Asian crisis causing an ‘information effect’ that could
have altered the past relationship as well. Finally behavioral changes among international
portfolio investors following the crisis cannot be ruled out either.
Another important area is the mild evidence towards the FII flows being affected by returns in
the Indian markets in the immediate past. Such a relationship suggests that given the thinness
of the Indian market and its evident susceptibility to manipulations, FII flows can, in fact,
aggravate the occurrence of equity market bubbles though they may not actually start them.
This is obviously an important concern for policy makers and market regulators. This paper
provides a preliminary analysis of FII flows to India and their relationship with several
relevant variables especially returns in the Indian stock market.
A more detailed study using daily data for a longer period or, better still, disaggregated data
showing the transactions of individual FIIs at the stock level can help address questions
regarding the extent of herding or return-chasing behavior among FIIs –indicators that can

help us estimate the probability of sudden Mexico-type reversals of these FII flows which now
account for a significant part of the capital account balance in our balance of payments. The
extent to which FII participation in Indian markets has helped lower cost of capital to Indian
industries is also an important issue to investigate. Broader and more long-term issues
involving foreign portfolio investment in India and their economy-wide implications have not
been addressed in this paper. Such issues would invariably require an estimation of the
societal costs of the volatility and uncertainty associated with FII flows. A detailed
understanding of the nature and determinants of FII flows to India would help us address such
questions in a more informed manner and allow us to better evaluate the risks and benefits of
foreign portfolio investment in India.

Chapter – 5
Suggestions And Conclusion

SUGGESTIONS
 Countries with higher levels of economic development tend to have more developed
capital markets and are believed to have greater ability to obtain foreign capital.
However, our results suggest that the availability of foreign capital also depends on
factors other than the country’s economic development and the firm’s financial
attributes. After controlling for the country effect, firms with better accounting quality
and corporate governance attract more foreign capital.
 Our results suggest that steps can be taken both at the country and the firm level to
create an environment conducive to foreign portfolio investment. The analysis is based
on a unique dataset consisting of 10,688 equity positions of U.S. mutual funds in
emerging markets.
 Our findings on emerging markets extend the growing literature on the determinants of
global investment flows and allocations. Prior research focuses on international
portfolio flows and examines the relationship between portfolio flows and stock
returns. These studies have analyzed the global, regional and local factors that
influence portfolio flows. A few studies have also examined allocations but they have
generally focused only on a specific country. We extend this analysis and undertake a
comprehensive analysis of all emerging markets and provide more detailed analysis of
country and firm-level factors that influence investment allocations by U.S. funds.
 Dahlquist and Robertsson (2001) undertake a detailed analysis of foreign ownership

and firm characteristics for the Swedish market. They find that foreigners have a
preference for large firms, firms paying low dividends, and firms with large cash
holdings. The finding on firm size is driven by liquidity and international presence as
measured by foreign listings and export sales.

 Foreigners tend to underweight firms with a dominant owner. Brennan and Cao (1997)
develop a theoretical model that accounts for information asymmetry between
domestic and foreign investors. Their empirical analysis shows that domestic investors
have informational advantages.
 Covrig, Lau, and Ng (2002) also conclude that foreign fund managers have less
information about domestic stocks than do domestic fund managers. They find that
ownership by foreign funds is related to size of foreign sales, index memberships, and
stocks with foreign listing. These findings are attributed to information asymmetries
between foreign and domestic investors.
 Similarly, Kang and Stulz (1994) report that foreign investment in Japan is
concentrated in large firms and in firms that have a larger proportion of export sales.
The findings suggest that foreigners invest in firms that they are better informed about.
 The FIIs investments, though shown an increasing trend over time, are still far below
the permissible limits. This means, the convergence of the sectoral cap for FIIs and
FDI investments alone may not really help bring in more funds unless some specific
measures are taken up.
 One such measure in this line could be the newly announced INDONEXT, the
platform for trading the small and mid-cap companies that 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. However, the real answers to the
questions on how to attract more FIIs investments lies to some extent on finding the
basis of selection of companies for investment by FIIs which the author is pursuing
currently.
 Given the necessity of boosting agricultural growth through development of agro

processing, and expanding industry by at least 10 per cent per year to integrate not
only the surplus labour in agriculture but also the unprecedented number of women

and teenagers joining the labour force every year, there is an urgent need to scale up
investment in the economy. FII inflows can help in augmenting the investible
resources in the economy.
 Similarly, gambling, betting, lottery, which are areas of dubious value added and
where FDI is prohibited, may also be kept out of bounds for FII investments.
 In retail trading currently FDI is prohibited. FII investments, however, are permitted
up to 24 per cent in all listed companies, except in print media companies.
Accordingly, FII investments in retail trading cannot exceed 24 per cent as no FDI is
permitted. This restriction may continue, as it will help develop supply chains in a
wide range of products, including that of agriculture.

CONCLUSIONS
A number of studies in the past have observed that investments by FIIs and the movements of
Sensex are quite closely correlated in India and FIIs wield significant influence on the
movement of sensex. There is little doubt that FII inflows have significantly grown in
importance over the last few years. In the absence of any other substantial form of capital
inflows, the potential ill effects of a reduction in the FII flows into the Indian economy can be
severe. From the point of attracting foreign capital,the initial expectations have not been
realised.Investment by FIIs directly in the Indian stock market did not bring significantly large
amount compared to the GDR issues. GDR issues,unlike FII investments, have the additional
advantage of being project specific and thus can contribute directly to productive
investments.FII investments, seem to have influenced the Indian stock market to a
considerable extent.
Results of this study show that not only the FIIs are the major players in the domestic stock
market in India, but their influence on the domestic markets is also growing. Data on trading
activity of FIIs and domestic stock market turnover suggest that FII’s are becoming more
important at the margin as an increasingly higher share of stock market turnover is accounted
for by FII trading. Moreover, the findings of this study also indicate that Foreign Institutional
Investors have emerged as the most dominant investor group in the domestic stock market in
India. Particularly, in the companies that constitute the Bombay Stock Market Sensitivity
Index (Sensex), their level of control is very high. Data on shareholding pattern show that the
FIIs are currently the most dominant non-promoter shareholder in most of the Sensex
companies and they also control more tradable shares of Sensex companies than any other
investor groups.

BIBLIOGRAPHY
BOOKS REFERRED:
 Indian securities market – AJAY SHAH AND TADASHI ENDO
 The stock market dictionary - PRAVEEN N. SHROFF
 Marketing Research – HARPER BOYD.
 Portfolio and investment management – FRANK J. FABOZZI
JOURNALS REFERRED:
 Annual Journal of SEBI
 Annual Journal of RBI
 Journal of ISMR
 Journal of finance
WEBSITES VISITED:
 www.nic.in/finmin/ (Finance Ministry)
 www.sebi.com (SEBI)
 www.reservbank.com
 www.nseindia.com
 www.bseindia.com
 www.moneycontrol.com
 www.investopedia.com
 www.equiymaster.com
NEWSPAPER AND MAGAZINES

 The economics times
 Business today
 Outlook business

REFERENCES
 Agarwal, R. N. 1997. “Foreign Portfolio Investment in Some Developing Countries:

A Studyof Determinants and Macroeconomic Impact.” Indian Economic Review 32,
no. 2: 217–29.
 Chakrabarti, Rajesh. 2001. “FII Flows to India: Nature and Causes.” Money and
Finance 2,no. 7.
 Glosten, Lawrence R.; Ravi Jaganathan; and David E. Runkle. 1993. “On the Relation
between the Expected Value and the Volatility of the Normal Excess Return on
Stocks.” Journal of Finance 48, no. 5: 1779–801.
 Gordon, James, and Poonam Gupta. 2003. “Portfolio Flows into India: Do Domestic
Fundamentals Matter?” IMF Working Paper no. 03/02. Washington, D.C.:
International Monetary Fund.
 Perron, Pierre. 1997. “Further Evidence on Breaking Trend Function in
Macroeconomic Variables.” Journal of Econometrics 80: 355–85.
 Trivedi, Pushpa, and Abhilash Nair. 2003. “Determinants of FII Investment Inflow to
India.” Paper presented at the Fifth Annual Conference on Money & Finance in the
Indian Economy, held by Indira Gandhi Institute of Development Research, Mumbai,
January 30–February 1.

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PROJECT REPORT

In partial fulfillment of the requirements for the award of degree of

POST GRADUATE DIPLOMA IN international business

Signature: Reg No:

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Date: Signature of Guide

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(i). The Reserve bank of India, India’s Central Bank, and

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Chapter I: Introduction ………………………………………………..……………………6

Chapter II: Research Methodology………………………………….……………….…….15

Chapter III: descriptive work ……..……………………………………………………….22

Chapter IV: Data Analysis And Interpretation .………………………………………….75

Chapter V: Suggestions And Conclusion ………………………………………………….91

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This is because standard deviation/variance (realized risk variable) increases irrespective of

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Research methodology is a way to systematically solve the research problem. It may be

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1) Formulating the research problem

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3) Development of the working hypothesis

4) Preparing the research design

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6) Collecting the data

7) Execution of the project

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10) Generalizations and interpretation

11) Preparation of the report

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 General obligations and responsibilities, which include appointment of a domestic

 Procedure for action in case of default and suspension/cancellation of certificate.

 The fees and taxes to be paid.

 Provisions for appeal in case of any grievances.

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The International Portfolio Investor’s decision-making problem

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International Portfolio Flows

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