Role of foreign Institutional Investment in India

10/27/2007
- by Anuja Lele

Foreign investment in India is of two types: investment by foreign institutional investors (FII) and foreign
direct investment (FDI). Foreign investment can be in the form of investment in secondary financial markets
or as direct investment in companies (FDI). Foreign investment is a major source of capital for many
industries. In developing countries, not enough capital is readily available for expansion or setting up new
projects. Foreign investment in the form of portfolio investment adds depth and liquidity to secondary
markets.
Further in developing economies there is a great demand for foreign exchange within the economy exceeds
the supply. Inflows of foreign capital bridge the gap. In fact in India the reserves will now be used for
infrastructural development.
In India, there seems to be a very strong correlation between the unprecedented Bull Run that started in May
2003 when the BSE Sensex was at 3000 and the surge in inflow of foreign capital through foreign
institutional investors. We find that FII investment in India had shown some upswings and downswings
from around 1993-94 till about 2002- 2003, but thereafter there has been an upsurge in FII investment with
it averaging around $9599 million a year during 2003-05. This figure is around 5 times the average annual
inflows witnessed from 1993-94 to 1997-98 and from 1999 to 2002 and more than 20 times the average
annual inflows during 1997-99 and 2002-03. Also while cumulative net FII inflows into India from early
1990s to end of March 2003 amounted to $15,804 million, in the period thereafter till about December 2005,
the addition to this value was of $25,267 million.
At the same time we see that the Sensex which had fallen to about 3000 crossed 4000 and 5000 respectively
by August and November 2003. It broke through the 6000 level by January 2004 before crossing the 7000
mark in June 2005. After that the rise of the sensex quickened further over the year. It crossed 8000 in
September and 9000 in November of 2005. And from then on it has been quickening the pace of its rise
crossing 10,000 in February 2006 and 15,000 in July 2007.
One cannot expect the FIIs to take an active interest in the developmental concerns of the emerging
economies. If there is any benefit that accrues to the emerging economies it will only be incidental. The
main driving force behind the actions of these institutional investors is profit. FIIs tend to invest selectively
in companies that achieve good results or show potential for future profitability. The share prices of such
companies have risen substantially. This then can have a compounding effect on the size and nature of the
firm in that the firm can now acquire other firms and hence grow even more. What might ensue is also a
healthy competition among firms vying for foreign investment or foreign ownership in terms of
shareholders. In order to attract foreign investment these firms could possibly employ greater transparency
and improve corporate governance.
In terms of the macroeconomic impact of FII investments in India we also need to consider the effect of the
enormous inflows of foreign exchange that occur as a result of these capital inflows. This inflow of foreign
exchange exerts an upward pressure on the Rupee. The appreciation of the Rupee would mean that imports
into India become cheaper and exports become more expensive. As imports become cheaper and exports
become more expensive, importers stand to gain from cheaper imports and on the whole those industries that
use imported raw materials will face lower costs. This in turn will lead to lower prices and have a welcome
deflationary effect. The appreciation of the Rupee also simultaneously makes Indian exports less
competitive in the global economy, thus forcing organizations to be more productive and focus on quality.
Foreign institutional investors have played significant roles in other emerging economies too. In OECD
countries for instance, institutional investors have been major players in the development of their financial
markets and in the overall economic growth. In China too, with the introduction of the Qualified Foreign
Institutional Investor (QFII) scheme which took effect in 2003, the domestic markets were being opened up
to foreign investment. Taiwan too had implemented this strategy of QFIIs to prevent rapid inflow and
outflow of currency which was perceived as a threat to the economic stability of the economy. In Mexico,
significant economic, political and social advances have occurred simultaneously with its transition into a
preferred investment destination.
On the flip side though, we find that FII investment in a country would bring in a lot more volatility than
what may have been experienced before in the financial markets. A large outflow of funds due to FII
activities can leave behind a crisis situation in the domestic economy which threatens to spill over to the rest
of the world. This was what happened in the East Asian Crisis of 1998. Before the crisis period the East
Asian economies attracted a large proportion of the total capital inflows to the developing countries.
However, this situation changed around 1997-98 when capital flows reversed, and capital started flowing out
of these economies. The crisis affected not only the currencies but also the stock markets and other asset
prices. The effects of this crisis were felt not only within the East Asian region but also in countries like
Russia and the U.S.A.
In India too, by opening the economy to short term capital flows, we run the risk of becoming more
vulnerable to any sudden capital outflows from the economy. Even when there are no such sudden outflows,
the large inflows of funds can create problems by making Indian exports less competitive. In India, in 2004-
05, (figures in brackets indicate the value of exports as a percentage of total exports for the year) the major
commodities of export were gems and jewellery (17%), chemical and related products (15.7%), engineering
goods (18.11%) and textiles (14.9%) among others. When the Rupee appreciates because of the large capital
inflows, these sectors would become less competitive. Thus, these sectors could possibly experience a
slowdown in growth. Whereas earlier, exports would have contributed to the growth of these sectors, now
with a possible fall in exports, the overall growth rates in the sector may be lower. Thus, there is a
possibility of layoffs and slower growth rates in sectors like textiles in India.
However on the whole, it may not be wrong to say that in India, the FIIs have been instrumental in capital
formation in a significant way. Some might even attribute the buoyancy in the market and steady inflow of
dollars into the economy to this upsurge in FII activity in India. The resultant appreciation of the Rupee has
also had its own implications for the Indian economy. However on the downside there are some severe
implications in terms of increased volatility in financial markets. This volatility majorly impacts the small
local investors in these markets. Another significant development has been that the Indian markets are now
no longer insulated from the world markets not only through the international flow of goods and services but
also due to this international flow of capital. The jury is still out on the impact of FII investment in India
whether positive or negative.