A

PROJECT REPORT
ON
ROLE AND IMPACT OF FIIs ON INDIAN CAPITAL MARKET

Submitted by
FARHAN KHAN
ROLL NO:16
BATCH: 2016-2017
Under the guidance of
PROF. PRASANNA CHOUDHARI

ACKNOWLEDGEMENT

I take this opportunity to thank The University of Mumbai for giving me a chance to do this
project
I express my deepest thanks to my mentor, Prof. Prasanna Choudhari for his precious advice that
helped in selecting my study site in the initial but the most crucial stage of my project. His
constructive comments and feedback have been very useful towards the completion of my
project. I am greatly indebted to for his invaluable advices on the quantitative research part of
my project. I would like to thank him for bearing with me very patiently in the process. I also
express my thanks to my friends and colleagues for their continuous help and support.
Finally, I thank my parents and all my close relatives who encouraged and supported my decision
to work on this project and dedicate this to them without their support and encouragement this
could have never been realized.

(FARHAN HASAN KHAN)

Certificate

This is to certify Mr. FARHAN KHAN student of Post Graduation

Diploma in Business Management (Finance) batch of Bharati
Vidyapeeths Institute Of Management & Information Technology,
Navi Mumbai has satisfactorily completed final project on Role
And Impact Of Fiis On Indian Capital Market Under my supervision &
guidance as partial fulfillment of requirement of PGDBM 20102012.

(PROF. VEENA CHAVAN)

(DR.D.Y.PATIL)

PROJECT GUIDE

DIRECTOR
(ii)

EXECUTIVE SUMMARY
Since the beginning of liberalization FII flows to India have steadily grown in
importance. As a part of its initiative to liberalize its financial markets, India opened her doors to
Foreign Institutional Investors in September 1992. This event represents a landmark event since it
resulted in effectively globalizing its financial services industry.
The foreign institutional investors (FIIs) have emerged as important players in the Indian
equity market in the recent past. This study makes an attempt to develop an understanding of the
dynamics of the trading behavior of FIIs. Along with this the purpose of study is to find out the
impact of FII inflows on Indian stock market, do we need FII inflows? Do FII play an important
role in Indian equity market? And at last should we encourage FII inflows?
For this monthly, yearly data of FII inflow is taken into consideration. First, the
introduction about the Indian economy and FIIs is given followed by the conceptual framework,
guidelines, investing limits in Indian companies is observed. Second, trends in FII flows and FII
activities up to March 2012 are considered. This is followed by the role of FIIs in the Indian stock
market.
As per the study done it is found out that the trading behavior of FII do not have a
destabilizing impact on the equity market. It can be said that we can encourage FII inflows into
India through appropriate regulation of PNs and sub-accounts and invent a series of check and
balances system so as to protect the economy and look over the fact that the economy works best
with such kind of filters system. Thus, it can be said that FII do play an important role in Indian
equity market.

(iii)

Table of Contents
PARTICULARS

PAGE NO:

Acknowledgement

(i)

Certificates

(ii)

Executive Summary

(iii)

Table of Contents

(v)

Chapter 1: Introduction of the Project

1.1: Objective of the Study

1.2: Type of Research

1.3: Scope and Limitations

1.4: Literature Review

Chapter 2: Introduction to Topic

2.1: Indian Capital Market : An overview

2.2: Foreign Institutional Investments(FIIs)

2.3: Foreign Institutional Investors

2.4: Background of FIIs

2.5: Introduction of FIIs in India

2.6: Investment Limits

12

2.7: Eligibility criteria for entering as an FII in India

15

2.8: FIIs and their impact on Indian stock exchanges

22

2.9: FIIs and their impact on Indian economy

23

(Positive and Negative effects)

2.10: FII activity in India from 1992-2006

27

2.11: FII activity in India from 2006-2010

32

2.12: FII activity in India 2010-2011(present scenario)

37

2.13: FII activity in 2012 in India

47

Chapter 3: Research Methodology

3.1: Research Design

51

3.2: Data Collection Techniques and Tools

51

3.3: Sample Design

52

3.4: Research Analysis Tools

52

3.5 :Analysis and Interpretation

54

Chapter 4: Future Prospects

4.1: Reasons why FII will keep pumping in Indian Market

56

4.2: U.S ratings downgraded

64

Chapter 5: Conclusions and Suggestions

65

Bibliography

67

CHAPTER 1 : INRODUCTION TO THE PROJECT

Objective:

FII inflow and outflow trends in Indian Capital Markets during the post liberalization
period that is 1991 to 2012

Influence of FII inflow and outflow trends on Indian Capital Markets

To study the importance of FII on Indian economy as a whole

Type of Research
Exploratory Research method applied for the study. As an exploratory study is conducted with an
objective to gain familiarity with the phenomenon or to achieve new insight into it, this study
aims to find the new insights in terms of finding the relationship between FII'S and Indian Stock
Markets.
Rationale and Scope of the Study and Limitations
Foreign Institutional Investors are said to be the driver of the market. Those are the one cause
behind the rise and fall of Sensex and Nifty. FII investment trends tell us about many effects that
the Indian market is experiencing. The companies in which they invest are getting overvalued.
Whenever FII find any trouble they withdraw their investments.
Scope of the study is very broader and covers Capital Market Indices and its comparison with
foreign institutional investments. But, study is only going to cover foreign investments in form of
equity. The time period is from liberalization year 1992 to March 2012 as it will give exact
impact in both the bullish and bearish trend. The study will provide a very clear picture of the
impact of foreign institutional investors on Indian stock indices. It will also describe the market
trends due to FIIs inflow and outflow. The study would be helpful for further descriptive studies
and moreover, it would be beneficial to gain knowledge regarding foreign institutional
investments, their process of registration and their impact on Indian stock market.
The data on daily basis can give more positive results.In the study only FII equity investment and
sales were considered. Other economic variables of macro and micro environment such as
foreign exchange rate, speculative trading, interest rate prevailing in the market, political factors,
government policies related to specific sectors etc. which can affect the performance of Indian
capital market and FII inflow to the Indian capital market were not considered. Inclusion of these
factors can provide more accurate insight to the findings of the present study
Literature Review
1

According to India Report, Astaire Research

A Balance of Payments crisis in 1991 pushed the country to near bankruptcy. In return for
an IMF bailout, gold was transferred to London as collateral, the rupee devalued and
economic reforms were forced upon India. That low point was the catalyst required to
transform the economy through badly needed reforms to unshackle the economy. Controls
started to be dismantled, tariffs, duties and taxes progressively lowered, state monopolies
broken, the economy was opened to trade and investment, private sector enterprise and
competition were encouraged and globalization was slowly embraced. The reforms process
continues today and is accepted by all political parties, but the speed is often held hostage by
coalition politics and vested interests.
As a part of the reforms process, the Government under its New Industrial Policy
revamped its foreign investment policy recognizing the growing importance of foreign direct
investment as an instrument of technology transfer, augmentation of foreign exchange reserves
and globalization of the Indian economy. Simultaneously, the Government, for the first time,
permitted portfolio investments from abroad by foreign institutional investors in the Indian
capital market. The entry of FIIs seems to be a follow up of the recommendation of the
Narsimhan Committee Report on Financial System. While recommending their entry, the
Committee, however did not elaborate on the objectives of the suggested policy. The committee
only suggested that the capital market should be gradually opened up to foreign portfolio
investments. In India, the purchase of domestic securities by FIIs was first allowed in September
1992 as part of the liberalization process that followed the balance of payment crisis in 1990-91.
From September 14, 1992 with suitable restrictions, FIIs were permitted to invest in all
the securities traded on the primary and secondary markets, including shares, debentures and
warrants issued by companies which were listed or were to be listed on the Stock Exchanges in
India. The Indian market was integrated with the world economy and international investors
were invited to participate in India. Consequently, the committee on the reforms of the financial
system under the chairmanship of Mr M. Narsimham Rao was made which sought for reforms
in the financial sector.
Now days, a significant portion of Indian corporate sector's securities are held by Foreign
Institutional Investors, such as pension funds, mutual funds and insurance companies. These
investors are often viewed as sophisticated investors as these institutional investors are better
informed and better equipped to process information than individual investors
The impact study of FIIs flows on domestic stock market is important from government
as well as investor point of view, for example, does the opening up of the market for FII increase
2

speculation in the market and thus make the market more volatile and more vulnerable to foreign
shocks
The Impact of FII in equity investment behavior in stock Market is studied in this project
and its relative performance of Indian stock market. In this project the researcher has studied
about the idea, that financial liberalization increases the efficiency of financial market and
permission of FIIs equity investment are an important example of financial liberalization. Apart
from net investment of FII's the purchase and sale behavior of FIIs were also analyzed in the
study. The researcher has studied and analysed FII flows and examined if the overall experience
has been stabilizing or destabilizing for the Indian capital market.

CHAPTER 2: INTRODUCTION TO THE TOPIC

2.1 Indian Capital Markets: An Overview

It all started in India, when twenty-two agents started the Bombay Stock Exchange (BSE). That
was way back in 1875. From then on, Indian markets have evolved continuously. Transparency is
a buzzword in the Indian business finance scene. Characterized by operational excellence, and
conformity to rules and regulations, the Indian financial market is a beacon of the economy. The
Indian stock market is probably the oldest in Asia. In 1994, the National Stock Exchange (NSE)
was commenced. NSEs objectives are to provide for speedy transactions. It also encouraged
small investors.
The Company Act of 1956 governs the securities market in India. Having the powers to regulate
companies, the central government and the company law board abide by the companies act of
1956. Powers such as auditing of accounting information, reviewing the business finance model
and looking into the other affairs of the company are given to the government. Investigators from
the directorate of investigation do the audits.
The Securities Contracts (Regulation) Act of 1956 and the Securities and Exchange Board of
India (SEBI) Act of 1992.are the other body of rules that govern the Indian capital markets.
Control of stocks, listings, contracts and a variety of other things are dealt by the former act.
SEBI is concerned with the growth of the securities and business finance market in India. It
looks into various other things like eligibility criteria for registration, developing the code of
conduct, and so on. One of SEBIs main activities is to protect the business finance interests of
investors, by providing the facilities to safeguard their wealth. In many ways, SEBI is
instrumental in attracting investments, due to the safe nature in the Indian business finance scene.
At a broad level, the Indian security market can be grouped into the savers and the spenders. The
savers are normal households, and the spenders are companies and the government. If the money
of the savers is put in financial securities, then spenders get money to operate, and in turn the
savers get interest or dividend to enjoy. Hence the security market is where the companies meet
the savers.
The changes in economic scenario(after the liberalization) and the economic growth have raised
the interest of Indian as well as Foreign Institutional Investors(FIIs) in the Indian capital
market. The recent massive structural reforms on the economic and industry front in the form of
de-licensing rupee convertibility, tapping of foreign funds, allowing foreign investors to come to
India, have resulted, on one hand, in the quantum leap in activities/volume in the Indian capital
market, and on the other hand and more importantly, that the Indian capital market has
undergone a metamorphosis in terms of institutions, instruments, etc. The capital market in India
is rightly termed as an emerging and promising capital market. During last 20 years or so, the
Indian capital market has witnessed growth in volume of funds raised as well as of.
The buoyancy in the capital market has appeared as a result of increasing industrialisation,
growing awareness globalisation of the capital market, etc. Several financial institutions,
4

financial instruments and financial services have emerged as a result of economic liberalisation
policy of the Government of India.
The capital market has two interdependent segments : the primary market and the secondary
market. The primary market is the channel for creation of new securities. These securities are
issued by public limited companies or by government agencies In the primary market, the
resources are mobilized either through the public issue or through private placement route. It is a
public issue if anybody and everybody can subscribe for it, whereas if the issue is made available
to a selected group of persons it is termed as private placement. There are two major types of
issuers of securities, the corporate entities who issue mainly debt and equity instruments and the
Government (Central as well as State) who issue debt securities. These new securities issued in
the primary market are traded in the secondary market. The secondary market enables
participants who hold securities to adjust their holdings in response to changes in their
assessment of risks and returns.
2.2 Foreign Institutional Investments (FIIs)
In present era of globalization no country or economy has been left untouched from international
trade and commerce. More access to international capital markets and foreign investments has
helped developing countries surmount their less developed capital markets. During the past few
years, a flow of capital has been seen from the developed part of the world to the less developed
economies which has led to decrease in the vulnerability of developing countries to financial
crisis by reduction in their external debt burden from 39% of gross national income in 1995 to
26% in 2006 and increase in foreign exchange reserves to 92% of long term debt and 423% of
more volatile short term debt in 2006. Over the years same scenario has been witnessed in the
Indian economy also. And thus, today most of the market entities are interested in attracting
foreign capital as it not only helps in creating liquidity for the firms stock and the stock market
but also leads to lowering of the cost of the capital for the firms and allows them to compete
more effectively in the global market place.

Foreign Investment
It has been defined as a transfer of funds or materials from one country (called capital exporting
country) to another country (called host country) in return for a direct or indirect participation in
the earnings of that enterprise. Foreign investments provide a channel through which one can
have access to foreign capital and after the opening up of the Indian economy; these have grown
in leaps and bounds.
Basically foreign investment can be made through following routes:

Foreign Direct Investment (FDI)

Foreign Portfolio Investment (FPI).

Private Equity investments-Foreign venture capital investor(FVCI)

Firstly, foreign direct investment pertains to international investment in which the investor
obtains a lasting interest in an enterprise in another country. Mostly it takes the form of buying or
constructing a factory in a foreign country or adding improvements to such a facility in form of
property, plants or equipments and thus is generally long term in nature. On the other hand, a
private equity investment is one made by foreign investors in Indian Venture Capital
Undertakings (VCU) and Venture Capital Funds (VCF). Thirdly, a foreign portfolio investment
is a short-term to medium- term investment mostly in the financial markets and is commonly
6

made through foreign Institutional Investors (FIIs), non resident Indian (NRI) and persons of
Indian origin (PIO).
2.3 FOREIGN INSTITUTIONAL INVESTORS
The term FII is used to denote an investor, mostly in the form of an institution or entity which
invests money in the financial markets of a country different from the one where in the
institution or the entity is originally incorporated. According to Securities and Exchange Board
of India (SEBI) it is an institution that is a legal entity established or incorporated outside India
proposing to make investments in India only in securities. These can invest their own funds or
invest funds on behalf of their overseas clients registered with SEBI. The client accounts are
known as sub-accounts. A domestic portfolio manager can also register as FII to manage the
funds of the sub-accounts. From the early 1990s, India has developed a framework through
which foreign investors participate in the Indian capital market. A foreign investor can either
come into India as a FII or as a sub-account. As on March 31, 2011, there were 1,722 FIIs
registered with SEBI and 5,686 sub-accounts registered with SEBI as on March 31, 2011
Basically FIIs have a huge financial strength and invest for the purpose of income and capital
appreciation. They are no interested in taking control of a company. Some of the big American
mutual funds are fidelity, vanguard, Merrill lynch, capital research etc. They are permitted to
trade in securities in primary as well as secondary markets and can trade also in dated
government securities, listed equity shares, listed non convertible debentures/bonds issued by
Indian company and schemes of mutual funds but the sale should be only through recognized
stock exchange. These also include domestic asset management companies or domestic portfolio
managers who manage funds raised or collected or bought from outside India for the purpose of
making investment in India on behalf of foreign corporate or foreign individuals. In the Indian
context, foreign institutional investors (FIIs) and their sub-accounts mostly use these instruments
for facilitating the participation of their overseas clients, who are not interested in participating
directly in the Indian stock market.
FIIs contribute to the foreign exchange inflow as the funds from multilateral finance institutions
and FDI are insufficient.

It lowers cost of capital, access to cheap global credit.

It supplements domestic savings and investments.

It leads to higher asset prices in the Indian market.

And has also led to considerable amount of reforms in capital market and financial sector.

2.4 BACKGROUND
In the late 1980s India suffered an acute financial crunch. At that time Indian foreign exchange
stood at mere US $1.2 bn which could barely finance 3 weeks worth of imports. And India had
to pledge its gold reserve with IMF to secure a loan of just US $457 mn. The gross fiscal deficit
of the government rose from 9.0% of GDP in 1980-81 to 10.4 percent in 1985-86 and to 12.7%
in 1990-91. Since these deficits had to be met by borrowings, the internal debt of the government
accumulated rapidly, rising from 35% of GDP at the end of 1980-81 to 53% of GDP at the end of
1990-91.
According to India Report, Astaire Research
A Balance of Payments crisis in 1991 pushed the country to near bankruptcy. In return for an
IMF bailout, gold was transferred to London as collateral, the rupee devalued and economic
reforms were forced upon India. That low point was the catalyst required to transform the
economy through badly needed reforms to unshackle the economy. Controls started to be
dismantled, tariffs, duties and taxes progressively lowered, state monopolies broken, the
economy was opened to trade and investment, private sector enterprise and competition were
encouraged and globalization was slowly embraced. The reforms process continues today and is
accepted by all political parties, but the speed is often held hostage by coalition politics and
vested interests.

Thus it was decided to open up the economy, the economic policies were liberalized and private
sector was given the freedom to participate in the Indian economy more effectively. The Indian
market was integrated with the world economy and international investors were invited to
participate in India. Consequently, the committee on the reforms of the financial system under
the chairmanship of Mr M. Narsimham Rao was made which sought for reforms in the financial
sector. One of its recommendation included developing an active government securities market
and strengthening the open market operations as an instrument of monetary policy. And thus this
reform paved way for foreign investments which were at that time the need of the hour. As a
result of this, Indian stock market witnessed metamorphic changes and a transition-from a dull
to a highly buoyant stock market. Improved market surveillance system, trading mechanism
8

and introduction of new financial instruments made it a center of attraction for the international
investors.
Until the 1980s, Indias development strategy was focused on self-reliance and Importsubstitution. Current account deficits were financed largely through debt flows and official
development assistance. There was a general disinclination towards foreign investment or private
commercial flows. Since the initiation of the reform process in the early 1990s, however, Indias
policy stance has changed substantially, with a focus on harnessing the growing global foreign
direct investment (FDI) and portfolio flows. The broad approach to reform in the external sector
after the Gulf crisis was delineated in the Report of the High Level Committee on Balance of
Payments (Chairman: C. Rangarajan). It recommended:

a compositional shift in capital flows away from debt to non-debt creating flows;
strict regulation of external commercial borrowings, especially short-term debt;
discouraging volatile elements of flows from non-resident Indians (NRIs);
gradual liberalisation of outflows;
disintermediation of Government in the flow of external assistance.

2.5 Introduction to FII

Since 1990-91, the Government of India embarked on liberalization and economic reforms with
a view of bringing about rapid and substantial economic growth and move towards globalization
of the economy. As a part of the reforms process, the Government under its New Industrial
Policy revamped its foreign investment policy recognizing the growing importance of foreign
direct investment as an instrument of technology transfer, augmentation of foreign exchange
reserves and globalization of the Indian economy. Simultaneously, the Government, for the first
time, permitted portfolio investments from abroad by foreign institutional investors in the Indian
capital market. The entry of FIIs seems to be a follow up of the recommendation of the
Narsimhan Committee Report on Financial System. While recommending their entry, the
Committee, however did not elaborate on the objectives of the suggested policy. The committee
only suggested that the capital market should be gradually opened up to foreign portfolio
investments. From September 14, 1992 with suitable restrictions, FIIs were permitted to invest in
all the securities traded on the primary and secondary markets, including shares, debentures and
warrants issued by companies which were listed or were to be listed on the Stock Exchanges in
India. While presenting the Budget for 1992-93, the then Finance Minister Dr. Manmohan Singh
had announced a proposal to allow reputed foreign investors, such as Pension Funds etc., to
invest in Indian capital market. To operationalise this policy announcement, it had become
necessary to evolve guidelines for such investments by Foreign Institutional Investors (FIIs).

A major development in our country post 1991 has been liberalization of the financial sector,
especially that of capital markets. Our country today has one of the most prominent and followed
stock exchanges in the world. Further, India has also been consistently gaining prominence in
various international forums, though we still have a long way to go.

EVOLUTION OF FII POLICIES IN INDIA

After the launch of the reforms in the early 1990s, there was a gradual shift towards capital
account convertibility. From September 14, 1992, with suitable restrictions, FIIs and Overseas
Corporate Bodies (OCBs) were permitted to invest in financial instruments.
The policy framework for permitting FII investment was provided under the Government of
India guidelines, which enjoined upon FIIs to obtain an initial registration with SEBI and also
RBIs general permission under FERA. The Government guidelines of 1992 also provided for
eligibility conditions for registration, such as track record, professional competence, financial
soundness and other relevant criteria, including registration with a regulatory organisation in the
home country. The guidelines were suitably incorporated under the SEBI (FIIs) Regulations,
1995.With coming into force of the Foreign Exchange Management Act, (FEMA), 1999 foreign
exchange related transactions of FIIs were permitted by RBI. Right from 1992, FIIs have been
allowed to invest in all securities traded on the primary and secondary markets, including shares,
debentures and warrants issued by companies which were listed or were to be listed on the Stock
Exchanges in India and in schemes floated by domestic mutual funds. The holding of a single
FII, and of all FIIs, NRIs and OCBs together in any company were initially subject to the limit of
5 per cent and 24 per cent of the companys total issued capital, respectively. Furthermore, to
ensure a broad base and prevent such investment acting as a camouflage for individual
investment in the nature of FDI and requiring Government approval, funds invested by FIIs have
to have at least 50 participants (changed to 20 investors in August, 1999) with no single
participant holding more than 5 per cent (revised to 10 per cent in February, 2000).
However, this was allowed to be increased subject to passing of resolution by the Board of
Directors of the company followed by passing of a special resolution by the General Body of the
company. The ceiling limit under special procedure was enhanced in stages as follows:

to 30 per cent from April 4, 1997

to 40 per cent from March 1, 2000,
to 49 per cent from March 8, 2001,and
to sectoral cap/statutory ceiling from September 20,2001.

10

The Government guidelines for FII of 1992 allowed, inter-alia, entities such as asset management
companies, nominee companies and incorporated/institutional portfolio managers or their power
of attorney holders (providing discretionary and non discretionary portfolio management
services) to be registered as FIIs. While the guidelines did not have a specific provision
regarding clients, in the application form the details of clients on whose behalf investments were
being made were sought. While granting registration to the FII, permission was also granted for
making investments in the names of such clients. Asset management companies/portfolio
managers are basically in the business of managing funds and investing them on behalf of their
funds/clients. Hence, the intention of the guidelines was to allow these categories of investors to
invest funds in India on behalf of their clients. These clients' later came to be known as subaccounts. The broad strategy consisted of having a wide variety of clients, including individuals,
intermediated through institutional investors, who would be registered as FIIs in India. A
Working Group for Streamlining of the Procedures relating to FIIs, constituted in April, 2003,
inter alia, recommended streamlining of SEBI registration procedure, and suggested that dual
approval process of SEBI and RBI be changed to a single approval process of SEBI. This
recommendation was implemented in December 2003.
Under eligibility conditions, the definition of broad based funds was relaxed in August, 1999 and
in February, 2000 and newer entities, such as foreign firms were allowed to invest as subaccounts. In order to have a level playing field in intermediation, domestic portfolio managers
were allowed in February, 2000 to manage the funds of sub-accounts, so as to give endcustomers a greater choice about the identity of their fund manager in India. FIIs were initially
allowed to only invest in listed securities of companies. Gradually, they were allowed to invest in
unlisted securities, rated government securities, commercial paper and derivatives traded on a
recognised stock exchange. 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 In order to increase
transparency, SEBI issued a circular on October 31, 2001 to all FIIs and their custodians advising
the FIIs to report as and when any derivative instruments with Indian underlying securities are
issued/renewed/redeemed by them, either on their own account or on behalf of sub-accounts
registered under them. In 2003 this circular was further revised to include disclosure of more
details about terms, nature and contracting parties.
The overall cap on investments in Government securities, both through the normal route and the
100 per cent debt fund route, was revised from US$1 billion to US$1.75 billion in November,
2004. 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 included
subsequently from May, 1998.In April 2006 there was a rise in the cumulative debt investment

11

limits from US $1.75 billion to US $2 billion and US $0.5 billion to US $1.5 billion for FII/Sub
Account investments in Government securities and Corporate Debt, respectively.

2.6 Investments by FIIs

A FII may invest through 2 routes:

Equity Investment
100% investments could be in equity related instruments or upto 30% could be invested
in debt instruments i.e.70 (Equity Instruments): 30 (Debt Instruments)

100% Debt
100% investment has to be made in debt securities only

Equity Investment route: In case of Equity route the FIIs can invest in the following
instruments:
A Securities in the primary and secondary market including shares which are unlisted, listed
or to be listed on a recognized stock exchange in India.
B Units of schemes floated by the Unit Trust of India and other domestic mutual funds,
whether listed or not.
C Warrants
100% Debt route: In case of Debt Route the FIIs can invest in the following instruments:
A Debentures (Non Convertible Debentures, Partly Convertible Debentures etc.)
B Bonds
C Dated government securities

12

D Treasury Bills
E Other Debt Market Instruments
It should be noted that foreign companies and individuals are not be eligible to invest through the
100% debt route.

The evolution of FII policy in India has displayed a steady and cautious approach to
liberalisation of a system of quantitative restrictions (QRs). The policy liberalization has taken
the form of,
(i) relaxation of investment limits for FIIs;
(ii) relaxation of eligibility conditions;
(iii) liberalisation of investment instruments accessible for FIIs

Market design in India for foreign institutional investors

Foreign Institutional Investors means an institution established or incorporated outside India
which proposes to make investment in India in securities. A Working Group for Streamlining of
the Procedures relating to Foriegn Institutional Investors, constituted in April, 2003, inter alia,
recommended streamlining of SEBI registration procedure, and suggested that dual approval
process of SEBI and RBI be changed to a single approval process of SEBI. This recommendation
was implemented in December 2003.
Currently, entities eligible to invest under the FII route are as follows:

As FII: Overseas pension funds, mutual funds, investment trust, asset management
company, nominee company, bank, institutional portfolio manager, university funds,
endowments, foundations, charitable trusts, charitable societies, a trustee or power of
attorney holder incorporated or established outside India proposing to make proprietary
investments or with no single investor holding more than 10 per cent of the shares or
units of the fund.

As Sub-accounts: The sub account is generally the underlying fund on whose behalf the
FII invests. The following entities are eligible to be registered as sub-accounts, viz.
partnership firms, private company, public company, pension fund, investment trust, and
individuals.
13

FIIs registered with SEBI fall under the following categories:

Regular FIIs- those who are required to invest not less than 70 % of their investment in
equity-related instruments and 30 % in non-equity instruments.

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

The Government guidelines for FII of 1992 allowed, inter-alia, entities such as asset management
companies, nominee companies and incorporated/institutional portfolio managers or their power
of attorney holders (providing discretionary and non-discretionary portfolio management
services) to be registered as Foreign Institutional Investors. While the guidelines did not have a
specific provision regarding clients, in the application form the details of clients on whose behalf
investments were being made were sought.
While granting registration to the FII, permission was also granted for making investments in the
names of such clients. Asset management companies/portfolio managers are basically in the
business of managing funds and investing them on behalf of their funds/clients. Hence, the
intention of the guidelines was to allow these categories of investors to invest funds in India on
behalf of their clients. These clients later came to be known as sub-accounts. The broad
strategy consisted of having a wide variety of clients, including individuals, intermediated
through institutional investors, who would be registered as FIIs in India. FIIs are eligible to
purchase shares and convertible debentures issued by Indian companies under the Portfolio
Investment Scheme.
Prohibitions on Investments:
Foreign Institutional Investors are not permitted to invest in equity issued by an Asset
Reconstruction Company. They are also not allowed to invest in any company which is engaged
or proposes to engage in the following activities:

Business of chit fund

Nidhi Company

Agricultural or plantation activities

Real estate business or construction of farm houses (real estate business does not include
development of townships, construction of residential/commercial premises, roads or
bridges).
14

Trading in Transferable Development Rights (TDRs).

Trends of Foreign Institutional Investments in India.

Portfolio investments in India include investments in American Depository Receipts (ADRs)/
Global Depository Receipts (GDRs), Foreign Institutional Investments and investments in
offshore funds. Before 1992, only Non-Resident Indians (NRIs) and Overseas Corporate Bodies
were allowed to undertake portfolio investments in India. Thereafter, the Indian stock markets
were opened up for direct participation by FIIs. They were allowed to invest in all the securities
traded on the primary and the secondary market including the equity and other
securities/instruments of companies listed/to be listed on stock exchanges in India.
Procedure for Registration: The Procedure for registration of FII has been given by SEBI
regulations. It states- no person shall buy, sell or otherwise deal in securities as a Foreign
Institutional Investor unless he holds a certificate granted by the Board under these regulations.
An application for grant of registration has to be made in Form A, the format of which is
provided in the SEBI (FII) Regulations, 1995.

2.7 Entities which can register as FIIs in India- Eligibility

Entities who propose to invest their proprietary funds or on behalf of broad based funds (fund
having more than twenty investors with no single investor holding more than 10 per cent of the
shares or units of the fund) or of foreign corporate and individuals and belong to any of the under
given categories can be registered for Foreign Institutional Investors (FIIs)

Pension Funds

Mutual Funds

Investment Trust

Insurance or reinsurance companies

Endowment Funds

15

University Funds

Foundations or Charitable Trusts or Charitable Societies who propose to invest on their

own behalf

Asset Management Companies

Nominee Companies

Institutional Portfolio Managers

Trustees

Power of Attorney Holders

Banks

Foreign Government Agency

Foreign Central Bank

International or Multilateral Organization

or an Agency thereof

Some of the above mentioned types are described below:

Pension funds: A pension fund is a pool of assets that form an independent legal entity that are
bought with the contributions to a pension plan for the exclusive purpose of financing pension
plan benefits. It manages pension and health benefits for employees, retirees, and their families.
FII activity in India gathered momentum mainly after the entry of CalPERS (California Public
Employees Retirement System), a large US-based pension fund in 2004.
Mutual funds: A mutual fund is a professionally managed type of collective investment scheme
that pools money from many investors and invests it in stocks, bonds, short-term money market
instruments, or other such securities. The mutual fund will have a fund manager that trades the
pooled money on a regular basis. The net proceeds or losses are then distributed to the investors.
Investment trust: An Investment trust is a form of collective investment .Investment trusts are
closed-end funds and are constituted as public limited companies. A collective investment
16

scheme is a way of investing money with others to participate in a wider range of investments
than feasible for most individual investors, and to share the costs and benefits of doing so
Investment banks: An investment bank is a financial institution that raises capital, trades in
securities and manages corporate mergers and acquisitions. Investment banks profit from
companies and governments by raising money through issuing and selling securities in capital
markets (both equity, debt) and insuring bonds (e.g. selling credit default swaps), as well as
providing advice on transactions such as mergers and acquisitions.
Hedge funds: A hedge fund is an investment fund open to a limited range of investors that is
permitted by regulators to undertake a wider range of investment and trading activities than other
investment funds, and that, in general, pays a performance fee to its investment manager. Every
hedge fund has its own investment strategy that determines the type of investments and the
methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of
investments including shares, debt and commodities. Many hedge funds investments in India
were facilitated by global investors borrowing at near zero interest rates in Japan and investing
the proceeds in High interest markets like India.
University Fund: The purpose of investments of these funds is to establish an asset mix for each
of the University funds according to the individual funds spending obligations, objectives, and
liquidity requirements. It consists of the Universitys endowed trust funds or other funds of a
permanent or long-term nature. In addition, external funds may be invested including funds of
affiliated organizations and funds where the University is a beneficiary.
Endowment fund: It is a transfer of money or property donated to an institution, usually with
the stipulation that it be invested, and the principal remain intact in perpetuity or for a defined
time period. This allows for the donation to have an impact over a longer period of time than if it
were spent all at once.
Insurance Funds: An insurance companys contract may offer a choice of unit-linked funds to
invest in. All types of life assurance and insurers pension plans, both single premium and regular
premium policies offer these funds. They facilitate access to wide range and types of assets for
different types of investors.
Asset Management Company: An asset management company is an investment management
firm that invests the pooled funds of retail investors in securities in line with the stated
investment objectives. For a fee, the investment company provides more diversification,
liquidity, and professional management consulting service than is normally available to
individual investors. The diversification of portfolio is done by investing in such securities which
are inversely correlated to each other. They collect money from investors by way of floating
various mutual fund schemes.
17

Nominee Company: Company formed by a bank or other fiduciary organization to hold and
administer securities or other assets as a custodian (registered owner) on behalf of an actual
owner (beneficial owner) under a custodial agreement.
Charitable Trusts or Charitable Societies: A trust created for advancement of education,
promotion of public health and comfort, relief of poverty, furtherance of religion, or any other
purpose regarded as charitable in law. Benevolent and philanthropic purposes are not necessarily
charitable unless they are solely and exclusively for the benefit of public or a class or section of
it. Charitable trusts (unlike private or non-charitable trust) can have perpetual existence and are
not subject to laws against perpetuity. They are wholly or partially exempt from almost all taxes.
An application for registration has to be made in Form A, the format of which is provided in the
SEBI(FII) Regulations, 1995 and submitted with under mentioned documents in duplicate
addressed to SEBI as well as to Reserve Bank of India (RBI) and sent to the following address
within 10 to 12 days of receipt of application.
Address for application
The Division Chief
FII Division
Securities and Exchange Board of India,
224, Mittal Court, 'B' Wing, 1st Floor,
Nariman Point, Mumbai - 400 021.
INDIA.
Supporting documents required are

Application in Form A duly signed by the authorised signatory of the applicant.

Certified copy of the relevant clauses or articles of the Memorandum and Articles of
Association or the agreement authorizing the applicant to invest on behalf of its clients

Audited financial statements and annual reports for the last one year , provided that the
period covered shall not be less than twelve months.

A declaration by the applicant with registration number and other particulars in support of
its registration or regulation by a Securities Commission or Self Regulatory Organisation
or any other appropriate regulatory authority with whom the applicant is registered in its
home country.

A declaration by the applicant that it has entered into a custodian agreement with a
domestic custodian together with particulatrs of the domestic custodian.
18

A signed declaration statement that appears at the end of the Form.

Declaration regarding fit & proper entity.

The eligibility criteria for applicant seeking FII registration

As per Regulation 6 of SEBI (FII) Regulations,1995, Foreign Institutional Investors are required
to fulfill the following conditions to qualify for grant of registration:

Applicant should have track record, professional competence, financial soundness,

experience, general reputation of fairness and integrity;

The applicant should be regulated by an appropriate foreign regulatory authority in the

same capacity/category where registration is sought from SEBI. Registration with
authorities, which are responsible for incorporation, is not adequate to qualify as Foreign
Institutional Investor.

The applicant is required to have the permission under the provisions of the Foreign
Exchange Management Act, 1999 from the Reserve Bank of India.

Applicant must be legally permitted to invest in securities outside the country or its incorporation / establishment.

The applicant must be a "fit and proper" person.

The applicant has to appoint a local custodian and enter into an agreement with the
custodian. Besides it also has to appoint a designated bank to route its transactions.

Payment of registration fee of US $ 5,000.00

SUB-ACCOUNT REGISTRATION
a) Institution or funds or portfolios established outside India, whether incorporated or not.
b) Proprietary fund of FII.
c) Foreign Corporates
d) Foreign Individuals.
The FII should apply on the behalf of the Sub-account. Both the FII and the Sub-account are
required to sign the Sub-account application form.
"Annexure B" to "Form A" (FII application form) needs to be filled when applying for sub19

account registration. No document is needed to be sent with annexure B. The fee for sub-account
registration is US$ 1,000. The fee is to be submitted at the time of submitting the application.
The mode of payment is Demand Draft in the name of "Securities and Exchange Board of India"
payable at New York. SEBI generally takes three working days in granting FII registration.
However, in cases where the information furnished by the applicants is incomplete, three days
shall be counted from the days when all necessary information sought, reaches SEBI. The
validity of sub-account registration is co-terminus with the FII registration under which it is
registered. The process of renewal of sub-account is same as initial registration. Renewal fee in
this case is US $ 1,000. OCBs / NRIs are not permitted to get registered as FII/sub-account.

FII Regulations:
Investment by FIIs is regulated under SEBI (FII) Regulations, 1995. Following are some of
important regulations by SEBI and RBI:
1. A Foreign Institutional Investor may invest only in the instruments mentioned earlier.
2. The total investments in equity and equity related instruments (including fully convertible
debentures, convertible portion of partially convertible debentures and tradable warrants) made
by a FII in India, whether on his own account or on account of his sub- accounts, should be at
least 70% of the aggregate of all the investments of the FII in India, made on his own account
and through his sub-accounts.
3. The cumulative debt investment limit for FII investments in Corporate Debt is US $15 billion.
The amount was increased from US $6 billion to USD 15 billion in March 2009.
4. US $8 billion will be allocated to the FIIs and Sub-Accounts through an open bidding platform
while the remaining amount is allocated on a first come first served basis subject to a ceiling of
Rs.249 cr. per registered entity.
5. The debt investment limit for FIIs in government debt is currently capped at $5 billion and
cumulative investments under 2% of the outstanding stock and no single entity can be allocated
more than Rs. 1000 crores of the government debt limits.
Further, in 2008 amendments were made to attract more foreign investors to register with
SEBI, these amendments are:
1. The definition of broad based fund under the regulations was substantially widened allowing
several more sub accounts and FIIs to register with SEBI.
20

2. Several new categories of registration viz. sovereign wealth funds, foreign individual, foreign
corporate etc. were introduced,
3. Registration once granted to foreign investors was made permanent without a need to apply
for renewal from time to time thereby substantially reducing the administrative burden,
4. Also the application fee for foreign investors applying for registration has recently been
reduced by 50% for FIIs and sub accounts
5. Also, institutional investors including FIIs and their sub-accounts have been allowed to
undertake short-selling, lending and borrowing of Indian securities from February 1, 2008.
6. Also the rigid criteria of requiring FIIs and sub-account to register as a 70:30 FII/ sub-account
or 100% debt FII/sub-account has recently been done away with(as has been discussed above in
the essay).

With regard to investments in the secondary market, SEBI states that:

The Foreign Institutional Investor is allowed to transact business only on the basis of
taking and giving deliveries of securities bought and sold.

Short selling in securities is not allowed. However, in December 2007, abroad regulatory
framework enabling short selling by FIIs was put in place. Which stipulated that naked
short selling was not permitted and settlement of securities sold short would be through a
mechanism for borrowing of securities.

FIIs are not permitted to short sell equity shares which are in the caution list of RBI.

Equity shares can be borrowed by FIIs only for the purpose of delivery into short sale.

No transactions on the stock exchange can be carried forward.

Transaction of business in securities can be carried out only through stock brokers who
has been granted a certificate by the Board.

A Foreign institutional Investor or a sub-account having an aggregate of securities worth

rupees ten crore or more, as on the latest balance sheet date, can settle their only through
dematerialised securities.

21

Securities have to be registered in the name of the Foreign Institutional Investor, if he is

making investments on his own behalf or in his name on account of his sub-account, or in
the name of the sub-account, in case he is investing on behalf of the sub-account.

The purchase of equity shares of each company by a Foreign Institutional Investor

investing on his own account cannot exceed ten percent of the total issued capital of that
company.

Investment by individual FIIs cannot exceed 10% of paid up capital. Investment by

foreign registered as sub accounts of FII cannot exceed 5% of paid up capital. All FIIs
and their subaccounts taken together cannot acquire more than 24% of the paid up capital
of an Indian Company. An Indian Company can raise the 24% ceiling to the Sectoral
Cap / Statutory Ceiling by passing a resolution by its Board of Directors followed by
passing a Special Resolution to that effect by their General Body.

For FIIs investing in the equity shares of a company on behalf of his sub-accounts, the
investment on behalf of each such sub-account cannot exceed ten percent of the total
issued capital of that company.

The FII position limits in a derivative contracts (Individual Stocks)

The FII position limits in a derivative contract on a particular underlying stock i.e. stock
option contracts and single stock futures contracts are:

For stocks in which the market wide position limit is less than or equal to Rs. 250 Cr, the
FII position limit in such stock is 20% of the market wide limit.

For stocks in which the market wide position limit is greater than Rs. 250 Cr, the FII
position limit in such stock is Rs. 50 Cr.

FII Position limits in Index options contracts

FII position limit in all index options contracts on a particular underlying index is Rs. 250 Crore
or 15 % of the total open interest of the market in index options, whichever is higher, per

22

exchange. This limit is applicable on open positions in all option contracts on any underlying
index.

FII Position limits in Index futures contracts

FII position limit in all index futures contracts on a particular underlying index is Rs. 250 Crore
or 15 % of the total open interest of the market in index futures, whichever is higher, per
exchange.
This limit is applicable on open positions in all futures contracts on a particular underlying index.
In addition to the above, FIIs can take exposure in equity index derivatives subject to the
conditions that :

Short positions in index derivatives (short futures, short calls and long puts) cannot
exceed (in notional value) the FIIs holding of stocks.

Long positions in index derivatives (long futures, long calls and short puts) can not
exceed (in notional value) the FIIs holding of cash, government securities, TBills and
similar instruments.

FII Position Limits in Interest rate derivative contracts

At the level of the FII The notional value of gross open position of a FII in exchange
traded interest rate derivative contracts is US $ 100 million.

In addition to the above, FIIs can take exposure in exchange traded in interest rate
derivative contracts to the extent of the book value of their cash market exposure in
Government Securities.

At the level of the sub-account The position limits for a Sub-account in near month
exchange traded interest rate derivative contracts is the higher of: Rs. 100 Cr Or 15% of
total open interest in the market in exchange traded interest rate derivative contracts.

2.8 FIIs and their impact on Indian Stock market

It is influence of the FIIs which changed the face of the Indian stock markets. Screen based
trading and depository are realities today largely because of FIIs. Equity research was something
unheard of in the Indian market a decade ago. It was FII which based the pressure on the rupee
23

from the balance of payments position and lowered the cost of capital to Indian business. It is
due to the FIIs that a concept like corporate governance is being increasingly adopted by Indian
companies; this is benefiting domestic investors also. FIIs are the trendsetters in any market.
They were the first ones to identify the potential of Indian technology stocks. When the rest of
the investors invested in these scrips, they exited the scrips and booked profits. Before the arrival
of FIIs, the activity in stocks used to be evenly attributed with little differences between volumes
in specified and cash groups. However since FIIs concentrate on the top 200 companies against
the 6,000 listed companies on BSE, the stock trading activity has concentrated to these liquid
scrips making them less liquid scrips totally illiquid. Thus, FIIs have become the driving force
behind the movements of the stock indices on the Indian stock markets.
Rolling settlement was introduced at the insistence of FIIs as they were uncomfortable with the
badla system. The major beneficiaries of the rolling settlement system are FIIs as short
settlement cycles offer them quick exit from the market.
With their massive financial muscle FIIs have almost replaced conventional market of the Indian
bourse. Today financial institutions and mutual funds including UTI can do little to help the
stock markets at a time of crisis. Even UTI, which used to be counter force for FIIs has ceased to
play that role in the Indian stock markets.
It is expected that with the adoption of international practices such as rolling settlement and
derivatives FII participation will increase and more money will flow into the Indian capital
market.

2.9 EFFECTS ON INDIAN ECONOMY

The various reforms introduced by Indian government to encourage FIIs to invest in Indian
market have been effective to such an extent that in November 2010 FIIs stood at 5426 whereas
it stood at 1713 in early 1990s. The changes have led to increase in liquidity, reduce risk,
improve disclosure and thus FIIs have become the corner stone in the phenomenal rise of the
Indian stock market. From the table below it becomes apparent that from just Rs 4 crores of net
investment in 1992-93, the investment rose to Rs 5445 the next financial year when the
economic changes were introduced and further today in 2010-11 it stands at Rs 133,049.

YEAR

Net Investments by FIIs (rs cr.)

24

1992-93

1993-94

5445

1994-95

4777

1995-96

6721

1996-97

7386

1997-98

5908

1998-99

-729

1999-00

9765

2000-01

9682

2001-02

8273

2002-03

2669

2003-04

44000

2004-05

41416

2005-06

47,602

25

2006-07

36,396.60

2007-08

71,952

2008-09

-53,796

2009-2010

84,269

2010-2011

133,049

In 1993 the first and only FII to invest in India was Pictet Umbrella Trust Emerging Markets
Fund, an institutional investor from Switzerland but today Indian growth story has attracted
global majors like CLSA, HSBC, Citigroup, Merrill Lynch, Crown Capital, Fidelity, Goldman
Sachs and Morgan Stanley, among others to enter the Indian financial market. Goldman Sachs
and Macquarie have acquired a 20% stake each in PTC India Financial services Ltd. Temasek
Holdings, Investment Corporation of Dubai, Goldman Sachs, Macquarie, AIF Capital, Citigroup
and India Equity Partners (IEP) have picked a combined stake of 10% in Bharti Infratel. Also an
entity of Merrill Lynch has picked up 49% stake in seven residential projects of real estate major,
DLF.
This boost, though good for Indian economy has led to a number of negative consequences. Let
us study the positive and the negative side of this rise of investments by FIIs one by one.
Positive impact: It has been emphasized upon the fact that the capital market reforms like
improved market transparency, automation, dematerialization and regulations on reporting and
disclosure standards were initiated because of the presence of the FIIs. But FII flows can be
considered both as the cause and the effect of the capital market reforms. The market reforms
were initiated because of the presence of them and this in turn has led to increased flows.
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. Not
only it can help in supplementing the domestic savings for the purpose of development projects
like building economic and social infrastructure but can also help in growth of rate of
investment, it boosts the production, employment and income of the host country.
26

B. Managing uncertainty and controlling risks: FIIs promote financial innovation and
development of hedging instruments. These because of their interest in hedging risks, are known
to have contributed to the development of zero-coupon bonds and index futures. FIIs not only
enhance competition in financial markets, but also improve the alignment of asset prices to
fundamentals. FIIs in particular are known to have good information and low transaction costs.
By aligning asset prices closer to fundamentals, they stabilize markets. In addition, 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. By increasing the availability
of riskier long term capital for projects, and increasing firms incentives to supply more
information about them, 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.
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 endeavor. 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.
Negative impact: If we see the market trends of past few recent years it is quite evident that
Indian equity markets have become slaves of FIIs inflow and are dancing to their tune. And this
dependence has to a great extent caused a lot of trouble for the Indian economy. Some of the
factors are:
A. Potential capital outflows: Hot money refers to funds that are controlled by investors who
actively seek short-term returns. These investors scan the market for short-term, high interest rate
investment opportunities. Hot money can have economic and financial repercussions on
countries and banks. When money is injected into a country, the exchange rate for the country
gaining the money strengthens, while the exchange rate for the country losing the money
weakens. If money is withdrawn on short notice, the banking institution will experience a
shortage of funds.

27

B. Inflation: Huge amounts of FII fund inflow into the country creates a lot of demand for
rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created. This
situation leads to excess liquidity thereby leading to inflation where too much money chases too
few goods.
C. Problem to small investors: The FIIs profit from investing in emerging financial stock
markets. If the cap on FII is high then they can bring in huge amounts of funds in the countrys
stock markets and thus have great influence on the way the stock markets behaves, going up or
down. The FII buying pushes the stocks up and their selling shows the stock market the
downward path. This creates problems for the small retail investor, whose fortunes get driven by
the actions of the large FIIs.
D. Adverse impact on Exports: FII flows leading to appreciation of the currency may lead to
the exports industry becoming uncompetitive due to the appreciation of the rupee.
E. Issue related to participatory notes: When Indian-based brokerages buy India-based
securities and then issue participatory notes to foreign investors. Any dividends or capital gains
collected from the underlying securities go back to the investors. Any entity investing in
participatory notes is not required to register with SEBI (Securities and Exchange Board of
India), whereas all FIIs have to compulsorily get registered. Trading through participatory notes
is easy because participatory notes are like contract notes transferable by endorsement and
delivery. Secondly, some of the entities route their investment through participatory notes to take
advantage of the tax laws of certain preferred countries. Thirdly, participatory notes are popular
because they provide a high degree of anonymity, which enables large hedge funds to carry out
their operations without disclosing their identity. The hedge funds borrow money cheaply from
western markets and invest these funds into stocks in emerging economies. It is also feared that
the hedge funds, acting through participatory notes, will cause economic volatility in Indian
exchange and generally these are blamed for the sudden fall in indices. These unlike FIIs are not
directly registered under SEBI, but they operate through sub accounts with FIIs and according to
a number of studies it has been found that more than 50% of the funds are flowing through this
anonymous route, which can lead to a great loss to the Indian economy.
Further, FIIs have contributed a lot in making Indian economy one of the fastest growing
economy in the world today. Foreign institutional investment can play a useful role in
development by adding to the savings of low and middle income developing countries. And India
among the world inventors is believed to be a good investment destination inspite of all the
political uncertainty and infrastructural inefficiencies. After the liberalization of financial policies
India has been able to attract a lot of FII from rest of the world and which in turn has played its
part very well by helping in development of Indian economy from what it was in early 1990s to a
would be super power that it is today. But still the harsh consequences of FIIs should not be
ignored by the government and further reforms should be introduced in the economic sector to
28

counter the tendency of the FIIs to destabilize the emerging equity market. And also attempts
should be made to encourage small domestic investors to participate in the equity market.

2.10 FII activity in India from 1992-2006

The Indian financial market was opened to the foreign institutional investors in 1992 to
widen and broaden the Indian capital market. Since then, the net investment by FIIs in India has
been positive every year except in 1998-99. During the last few years, there has been a
phenomenal increase in the portfolio investment by FIIs in the Indian market. (Table 1 & Chart
1). The gross purchases of debt and equity together by FIIs increased by 59.9 per cent to
Rs.3,46,978 crore in 2005-06 from Rs.2,16,953 crore in 2004-05. The gross sales by FIIs also
rose by 78.6 per cent to Rs.3,05,512 crore from Rs. 1,71,072 crore during the same period.
However, the net investment by FIIs in 2005-06 declined by 9.6 per cent to Rs.41,467 crore in
2005-06 from Rs.45,881 crore in 2004-05 mainly due to large net outflows from the debt
segment. The cumulative net investment by FIIs at acquisition cost, which was US$15.8 billion
at the end of March 2003, rose to US$ 45.3 billion at the end of March 2006. (Chart 2) The
provisional net investment figure as of March 2007 was US $ 3225 million as per RBI

29

Table1:InvestmentsbyFIIs

Source : SEBI Annual Report 2005-06

Chart 1 : FII Investments in India

30

Source : SEBI Annual Report 2005-06

Chart 2: Trends in FII Investment

The FII investment in equity increased significantly since 2003-04. During 2005-06, FIIs
increased their net investment in equities, but reduced their commitments in debt Securities
(Table 2). The net FII investment in equity during 2005-06 was Rs.48,801 crore, the highest ever
in a single year. Buoyancy in the markets was sustained in 2005-06 on account of surge in net
investment by the institutional investors with FIIs playing a major role. Month-wise, FII
investment was negative in the months of April, May and October 2005. However, during the
remaining months of the financial year, there was large net equity investment by FIIs,
particularly in the second half of 2005-06, which drove the benchmark indices to surpass the
earlier record highs on several occasions. The net FII investment in December 2005 was the
31

highest for 2005-06, followed by July 2005 and February 2006. However, month-wise, the FII
investment in the debt segment was negative in all the months in 2005-06. The total net
investment in the debt segment in 2005-06 declined by Rs.7,334 crore mainly due to firming up
of the yield rate of G-sec across the entire maturity spectrum.
Table 2: Investments by MFs & FIIs

Source : SEBI Annual Report 2005-06

Several factors are responsible for increasing confidence of FIIs on the Indian stock
market which include, inter alia, strong macro-economic fundamentals of the economy,
transparent regulatory system, abolition of long-term capital gains tax and encouraging corporate
results. Reflecting the congenial investment climate, the total number of FIIs registered with
SEBI increased to 882 as on March 31, 2006 compared to 685 a year ago, an increase of 197

32

over the year ( Table 3). The diversity of FIIs has been increasing with the number of registered
FIIs in India steadily rising over the years.

Table 3: FIIs Registered in India

FINANCIAL YEAR

DURING THE YEAR

TOTAL REGISTERED AT
THE END OF THE YEAR

1992-93

1993-94

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

2002-03

51

502

2003-04

83

540

2004-05

145

685

2005-06

210

882

Source : Expert Group Report, GOI 2005

SOURCES OF FIIS

33

As on March 31, 2006, SEBI had registered FIIs from 37 countries. The highest number of FIIs,
as on March 31, 2006, was from the USA (342), followed by the UK (148). About 90 per cent
FIIs come from the top 13 countries. There has been increase in the number of FII registrations
from non-traditional countries like Malaysia, Australia, Saudi Arabia, Trinidad and Tobago,
Denmark, Italy, Belgium, Canada, Sweden, Ireland etc. (chart 3). These developments have
helped improve the diversity of the set of FIIs operating in India.
Chart 3: Country-wise FIIs Registered with SEBI as on 31st March 2006

Several factors were responsible for increasing confidence of FIIs on the Indian stock market
which include:

Strong economic fundamentals and attractive valuations of companies.

Improved regulatory standards, high quality of disclosure and corporate governance
requirement, accounting standards, shortening of settlement cycles, efficiency of clearing
and settlement systems and risk management mechanisms.
Product diversification and introduction of derivatives.

Strengthening of the rupee dollar exchange rate and low interest rates in the US.

34

2.11 FII ACTIVITY FOM 2006-2010

2008 FII sell-off the largest ever
The Indian equity market kept on sliding in September 2008 with the S&P CNX NIFTY,
showing the second sharpest fall since January 2008, with a decline of around 10%. With all
courtesy to the US financial markets and its crisis bug, an estimated amount of Rs 2.3 trillion of
shareholders' wealth were eroded in the Indian stock markets.
We hear a lot about sales and purchases made by foreign institutional investors (FIIs) in
Indian equity markets, with these numbers often making headlines. Why are we so obsessed with
FIIs? The answer, is "Indian markets are primarily driven by FII fund flows."
The market slide can be attributed to lower FII inflows in 2011. A look at stock indices since
2006 shows that the markets peak when FII inflows are the highest and fall when FIIs are
missing in action. For instance, in 2008, the BSE Sensex fell almost 50% due to the global
financial meltdown, wiping out the gains of 2007. The year 2008 has seen the biggest ever FIIs
sell-off for the Indian markets. FIIs were allowed to invest since 1991 when the economy opened
up. FIIs sell-off of USD 13.16 billion or Rs 53,000 crores has accounted for a 20% sell-off of the
total FII's equity investment since 1991. FIIs have invested USD 53.16 billion or Rs 2.3 lakh
crores.
The number of registered FIIs have increased from 1,219 in 2007 to 1,595 in 2008, while
the number of registered sub-accounts have increased from 3644 in 2007 to 4872 in 2008. In
2008, there were negative FIIs' flows seen for 10 months, and the longest selling streak was seen
from May to November. Since 1999, there have been 32 months of negative FIIs flows as against
88 months of positive flows. Since 2003, there have been 19 months of negative FIIs' flows as
against 53 months of positive flows. October and January were two carnage months, where USD
3.8 billion and UDS 3.2 billion, respectively, were sold.
The depreciation by 23% in rupee and the 51% sell-off in the markets has resulted in the
Defty falling 61%, making India one of the worst emerging market performers for 2008. The
biggest sell-off was seen in March, when the FIIs sold Rs 1,881 crore. In January, a correction
bought the most at Rs 7,702 crore follwed by Rs 3,179 crore in June.
"What hurt in 2008 was not the performance of companies but rapid outflow of $13
billion (Rs 55,000 crore) as investors fled risky assets," says Nick Paulson-Ellis, India head,
Espirito Santo Securities.The markets were flat during the first three months of 2009 as FIIs
stayed away. After that, governments across the globe implemented plans to boost their
economies. India, helped by robust economic growth, became a preferred destination for
investors.
35

85% was the surge in the Sensex in 2009 with FIIs investing a net Rs 84,000 cr, crossing the
2007 level.
With FIIs investing a net $19 billion (Rs 93,100 crore) in 2009, crossing the 2007 level, the
Sensex surged 85%. In 2010, the trend continued and FIIs pumped in $30 billion(Rs 1.3 lakh
crore) into Indian equities, helping the Sensex gain 25%. Between December 2006 and July
2011, the number of FIIs registered in India rose from 1,024 to 1,730.
Table 1: Net FIIs Investment in Equity (2007-10)
MONTH
JAN
FEB
MARCH
APRIL
MAY
JUNE
JULY
AUG
SEPT
OCT
NOV
DEC

2007
94.45
6065
1403.30
5431.80
4574.50
7939.60
18132.80
-7526.80
18948.50
15577.60
-4597.40
4896.70

2008
-17326.30
5419.90
124.40
979.00
-4917.30
-10577.70
-1012.90
-2065.80
-7937.00
-14248.60
-2820.30
1330.90

2009
-3009.50
-2690.50
269
7384.20
20606.90
3224.90
11625.30
4028.70
19939.50
8304.10
5317.80
10367.20

2010
5902.40
2113.50
18833.60
9764.50
-8629.90
10244.60
17120.60
11185.30
29195.80
24770.80
18519.90
1476.10

Table shows the position of FIIs investment in equity from 2006-10. It is clear from the
above table that during 2007, apart from August 2007, FIIs showed keen interest in purchasing
the equity in the Indian market. But so far as the month of August was concerned, FIIs turned
towards net selling in equity for profit booking and seeing the massive sell out of shares in global
markets including India especially on August 16 & 17 when there was massive equity selling.
Consequently the SENSEX broke down to even 4 to 5% of its previous levels. Moreover, the
bears took command of the market and some brokers also started off-loading their positions
anticipating a further fall and stop loss button was pressed by many investors. So far as the
month of October was concerned, the impact of supportive level was pulling the FIIs money in
India. As a result positive impact in the net position was seen. Again a bearing trend could be
noticed during November due to the fact that new norms about PNs were announced which
ordered the winding up of PNs within next 18 months.
The analysis of the above table depicts a negative view of the FIIs investment in India
during 2008. The main reason could be tremendous selling at the beginning of the year. The next
three months i.e. February, March & April showed a consistent pattern in the trading activities.
36

But from the month of May to November, FIIs again showed the exit mode from the stock
market. This was due to the fact that impact of international recession had started affecting
Indian markets also. Further the famous subprime crisis of USA e.g. the crash of Banks and
investment firms like Lehman Brother had also started impacting global economy. Market
analysts feel that the foreign fund managers were trying to play safe and therefore rushed
towards risk aversion and taking off their money. Due to this reason a negative impact of FIIs
was reflected showing immense selling and taking back their money from the Indian stock
market.
During the year 2009, FIIs investment in equity showed an initial sell off in the first two
months, may be the impact of 2008 was still continuing. This year market sentiments seemed to
improve from March onwards as the foreign investors starting returning with their investments.
India emerged out as one of the better performing markets since October crash and the growth
potential was seen. The trend turned positive with the sign of revival of economies. The trend of
FIIs inflows witnessed during quarter from April to June continued further and FIIs proved to
be the prime investors in the month of September. The reasons for such huge investments by
FIIs in this month could be attributed to number of positive news about Indian economy.
During the year 2010, the same trend of revival of economic activity could be observed. As a
result, FIIs went on to purchase more equity during this year with the exception of the month of
May. This showed positive view of FIIs about Indian market. FIIs started pumping funds into
emerging markets like India because of its growth potential and stability of Indian Stock Market.
Table No: 2 FII Inflows in Equity (2006-10)
YEARS
NET PURCHASE/ SALES
RS. (IN CRORES)

TREND %

2006
2007
2008
2009
2010

32254.08
100.00
70940.05
226.978
-530517.70
-169.743
85367.2
264.494
140497.2
436.949
It is evident from this table that apart from the year 2008, in all other years, there has
been a positive trend in FII inflows in India. The year 2008, as we all know, was the year of
worldwide recession. The value of the trend is higher during last two years of this study i.e. 2009
and 2010 because of the fact that Indian economy could recover well from the shocks of
worldwide recession due to its strong fundamentals and rules and regulations.
Table 3: FII Investments in Debt (2006-10)
YEARS
NET PURCHASE/
SALES
RS. (IN CRORES) DEBT

TREND (%)

37

2006
2007
2008
2009
2010

3629.18
100.00
8356.13
230.248
12340.40
147.68
3458.40
28.025
54442.80
1574.219
The analysis of the above table depicts the positive trend of FIIs investment in debt
market. The sharp rise in the FII inflows into the debt market came after a sharp rise in the
interest rates over the past couple of years which attracted the foreign investors towards the
Indian market. Besides that market observers believed that the huge inflow into the Indian equity
market also led to FIIs parking a portion of their capital into the debt market as a hedge against
any potential downslide in the stocks. The sharp rally in rupee against the US dollar also led to
an increase in the FII interest in the debt market.
Table 4: Comparison between FII inflows & Industrial Growth Rate
YEARS
NET FII INFLOWS
INDUSTRIAL
GROWTH RATE (%)
2006
32254.08
7.4
2007
70940.05
7.6
2008
-530517.70
9.8
2009
85367.2
6.3
2010
140497.2
5.8
The analysis of above table shows that there is a Low Degree of Correlation between FII
inflows & Industrial Growth Rate. It means that during the period under study, with the increase
of FII inflows, the industrial growth of India also rose up. Industrial growth plays a pivotal role
in increasing the GDP. In the year 2008, in spite of major outflows, the industrial growth rate still
increased. During the next two years, a fall in industrial growth can be observed. Thus it can be
safely said that industrial growth rate has not been much influenced by the FII inflows.
Table 5: Relationship between FII Inflows & SENSEX
YEAR
SENSEX
FII INFLOWS
2006
13786
31254.08
2007
20826
70940.05
2008
9647
-53051.70
2009
17464
85367.20
2010
20509
140497.20
Table 5 shows the impact of FIIs on SENSEX. In 2006 the foreign institutional investors
(FII) inflows were a bit slow, but they once again proved that they were the drivers of the Indian
equity market. Interestingly, the dependence of the Indian equity markets on the foreign investors
was further proved by the fact that in the period between May 10, 2006 to June 14, 2006, when
the SENSEX moved from a high of 12,612.38 to a low of 8,928.44.

38

In the year 2007 when FIIs were pumping money in stock market and were Net Buyers of Equity
worth Rs. 70940.05 Crores; the SENSEX was moving upwards on the weekly basis. It took
nearly two months for the SENSEX to move from the level of 15000 to 17000. But from 17000
to 20000 it moved in a span of few weeks i.e. from 26th September 2007 to 29th October 2007.
As the Indian markets move from one peak to another this year, foreign institutional investors
(FIIs) have pumped top dollar into stocks. Investments during 2007 by foreign funds were the
most influential group of investors in the market. In September, FIIs injected $2.7 billion into the
markets, sending the benchmark indices to record peaks. The bulk of this amount came in after
the US Fed cut interest rates on September 18 which ultimately led to increasing liquidity in
global markets.
In January 2008 the SENSEX touched the new height of 21000. This rally of 1000 points
of SENSEX infused Rs. 2403 Crores during a period of just 49 trading days. But in the later part
of 2008 the SENSEX crashed affecting large number of investors. The major cause of this crash
was attributed to the recession in the global economies, especially with the US dollar losing its
strength to the Indian rupee. A large amount of equity in the form of shares was floated in the
Indian economy as an impact of Foreign Institutional Investors (FIIs) withdrawing their money
from the Indian markets. This has disturbed the demand and supply ratio to a great extent
resulting in easy availability of shares of well-performing companies, thus leading to a dip in the
selling price of these shares.
However, in 2009 with the sign of revival of economies, the trend turned positive and overseas
investors started betting big on the domestic bourses as the liquidity conditions started
improving. In 2010 most of the stocks which have shown an increase in prices were driven by
huge FII buying. India continued to be a favored destination for FIIs and would continue to be so
because of its strong fundamentals. This could well be reflected in the FII inflows towards the
country, which had already reached all-time highs. Thus it can be observed that there is a positive
correlation between FII inflows and SENSEX.
PROPPING UP STOCKS
Investing in stocks with high FII interest can give good returns. For instance, the FII holding in
HDFC has been 58-60% since 2008. Similarly, the FII holding in ICICI Bank has been 38-40%
for years. Between March 2008 and 29 September 2011, HDFC Bank and ICICI Bank have risen
35% and 20%, respectively.

2.12 PRESENT SCENARIO (2010-2011)

Recent Trends in Foreign Institutional Investment
Foreign Institutional Investors play an important role in Indian securities markets.Since 1992-93,
when FIIs were allowed entry into Indian financial markets, foreign institutional investment has
39

increased over the years except in 2008-09. In tandem with the boom in stock markets and a
better global scenario, investments by FIIs into India were quite high in last few years,
particularly since 2003-04. FIIs made a record investment in the Indian equity market in
2010-11, surpassing the 2009-10 inflows.

Chart: Trends in Foreign Institutional Investment

The gross purchases of debt and equity by FIIs increased by 17.3 percent to 9,92,599 crore in
2010-11 from 8,46,438 crore in 2009-10 (Table 2.50). The combined gross sales by FIIs also
increased by 20.2 percent to 8,46,161 crore from ` 7,03,780 crore during the same period in
previous year. The total net investment of FII was 1,46,438 crore as compared to of 1,42,658
crore in 2009-10. This was the highest net FII investments into Indian securities market in
any financial year so far.

Table : Investment by Foreign Institutional lnvestors

40

Cumulative investment by FIIs at acquisition cost, which was US$ 89,335 million at the end of
March, 2010, increased to US$ 1,21,561 million at the end of March, 2011. During 2010-11, FIIs
invested 1,10,121 crore in equity and 36,317 crore in debt as compared to an investment of
1,10,220 crore in equity and 32,438 crore in debt during 2009-10 respectively (Table 2.51 and
Chart 2.12). Month-wise, the net FII investment was the highest in equity segment in October,
2010 (28,563 crore) followed by September,2010 ( 24,979 crore) and November,2010 (18,293
crore). In debt segment, FII investment was the highest in January, 2011 (10,177 crore) followed
by July, 2010 (8,107 crore) and September, 2010(7,690 crore).

41

The FIIs have been permitted to trade in the derivatives market since February, 2002. The
cumulative FIIs trading in derivatives was 5,34,748 crore as on March 31, 2011 as compared to
3,88,310 crore as on March 31,2010. Open interest position of FIIs in index options was the
highest at 11,33,838 crore by end-March 2011, followed by stock futures( 6,22,875 crore), index
futures (2,83,890 crore) and stock options ( 22,547 crore) (Table 2.52).

Table 2.51: Investments by Mutual Funds and Foreign Institutional lnvestors

42

Chart: Net Institutional Investment (crore) and Monthly Average Nifty

Registration of Foreign Institutional Investors and Custodians of Securities
There was a small increase in the number of Foreign Institutional Investors (FIIs) registered with
SEBI. As on March 31, 2011, there were 1,722 FIIs registered with SEBI as compared to 1,713 a
year ago, showing an increase of 0.53 percent during the year. There were 5,686 sub-accounts
registered with SEBI as on March 31, 2011 as compared to 5,378 as on March 31, 2010, an
increase of 5.73 percent The number of custodians registered with SEBI under the SEBI
(Custodian of Securities) Regulations, 1996 was 19, as on March 31, 2011, as compared to 17 a
year ago. Status of registration of FIIs, sub-accounts and custodians during 2010-11 is provided
in below Table
Table : Number of Registered FIIs, Subaccounts and Custodians

43

The Indian economy has successfully proved its mettle time and again in terms of financial
stability and economic sustainability as it has resiliently weathered global financial turmoil.
Where majority of emerging economies are experiencing huge capital outflows by foreign
institutional investors (FIIs), Indian markets have managed to hold their confidence as well as
investments during such times. A report titled 'Doing Business in India' by Ernst & Young (E&Y)
further supports the fact by highlighting India as the second most preferred destination for
foreign investors, next only to China.
Overseas entities are among the important drivers for Indian stock markets. FII flows account for
about 45 per cent of the market free-float.
The overview further discusses recent developments, investments, facts & figures and
Government initiatives pertaining to foreign investments in India.
FII Recent Developments

According to the data released by Securities and Exchange Board of India (SEBI), FIIs
purchased stocks worth Rs 600,000 crore (US$ 113.81 billion) during 2011. FIIs were
also seen attracted to the debt market in 2011 wherein they infused Rs 42,067 crore (US$
7.98 billion). This intense interest in debt markets helped India get a net FII inflow of Rs
39,353 crore (US$ 7.46 billion) for the year (taking both- debt and stocks- into account).

Global rating agency Moody's has uplifted Indian bond market by upgrading credit rating
of the Indian government's bonds from the speculative to investment grade. The move is
expected to attract higher investments from FIIs and help companies raise funds at
competitive rates abroad.

India's foreign exchange reserves stood at US$ 297 billion as on December 30, 2011.

According to the data available with the Bombay Stock Exchange (BSE), FIIs have
consolidated their holdings in 11 out of the 30-Sensex firms during the July-September
quarter of 2011. They majorly enhanced their holdings in auto stocks such as Mahindra &
Mahindra, Maruti Suzuki, Hero MotorCorp and Bajaj Auto.

The number of FIIs registered with SEBI stood at 1,749 as of October 2011, while the
number of FII sub-accounts was 6,058 during the month. The statistics revealed that there
were 1,743 FII accounts and 6, 028 sub-accounts at the end of September 2011

44

FII- Key Investments

FIIs have bought stakes in BSE and National Stock Exchange of India (NSE) recently.
Argonaut Ventures (a US-based private equity firm) increased its stake in BSE from 2.54
per cent at the end of May 2010 to 4.75 per cent at the end of June 2011, while couple of
SEBI-registered FIIs and sub-accounts bought stakes in NSE.

India-based micro-lender SKS Microfinance has raised investment limit for foreign
institutional investors in the company to 74 per cent from 24 per cent and the company
plans to raise funds of up to Rs 5 billion (US$ 94.84 million) through a share sale to
institutional investors by March 2012.

World Bank's private equity arm IFC has made its single-largest country exposure to
India at 8.8 per cent of total committed portfolio in fiscal 2011. Also, India is expected to
take the lead during the fund allocation for the current fiscal (year ending June 2012),
when IFC's approved funding is estimated at US$ 10 billion. According to market
insiders, IFC plans to scale up equity investments over debt funding in private firms in
India.

According to data released by auditing and consultancy firm KPMG, first three quarters
of 2011 witnessed a 31 per cent increment in private-equity (PE) investment to US$ 7.89
billion. Private equity firms like Blackstone India and Kohlberg Kravis Roberts & Co
(KKR & Co) are betting high on Indian markets. The Blackstone India chief was reported
to have said that he intends to close 5-6 deals a year in India whose financial valuations
would revolve around roughly US$ 100 million to US$ 120 million each.

As on October 31, 2011, FIIs injected Rs 41,253 crore (US$ 7.82 billion) in Government
securities (G-secs) and Rs 68,289 crore (US$ 12.95 billion) in corporate bonds.

Government Initiatives
Government of India keeps taking different initiatives in order to attract FII investments. For
instance, investment limit in infrastructure bonds was raised from US$ 5 billion to US$ 25
billion in March 2011. Similarly, in November 2011, the Ministry of Finance enhanced
investment limit for FIIs in G-secs and corporate bonds by US$ 5 billion each, increasing the cap
to US$ 15 billion and US$ 20 billion respectively. The Government intends to increase capital
flows in Indian markets through such measures that would eventually increase the availability of
resources for Indian corporate.

45

Also, along with the debt instruments issued by infrastructure companies, FIIs can now also
invest in debt instruments issued by non-banking financial companies (NBFCs) categorised as
'Infrastructure Finance Companies' by the Reserve Bank of India (RBI).
In a bid to attract more FII funds into the Indian infrastructure sector, the Government is
considering a trim on the lock-in-period in the corresponding bonds to one year from three years.
The Government's top priority seems to be the enhancement of investor base for the Indian
markets. That is why the Ministry of Finance started 2012 with a happy announcement by
allowing foreign nationals, trusts and pension funds to invest directly in the country's listed
companies from mid-January 2012.
EPISODES OF VULNERABILITY IN INDIA
There have been some episodes of vulnerability in India, which are negative shocks affecting the
economy, and influencing the behavior of investors. These are: the East Asian crisis in 1997, the
Pokhran Nuclear explosion (May 1998) and the attendant sanctions, the stock market scam of
early 2001, and the Black Monday of May 17, 2004. The investment behavior of the FIIs vis-vis the movements of the stock market indices during these episodes
FII investment behavior during these four specific events indicates that these events did affect
the behaviour of the foreign portfolio investors. But, these events did affect domestic investors
behaviour as well. The critical question to ask is: whether there was any perceptible difference,
particularly with a bias towards destabilization, in the behaviour of the FIIs vis--vis that of
domestic investors?
Table 7: India: FII Behaviour During East Asian Crisis

46

Table 8: India : FII Behaviour in the aftermath of Pokhran Nuclear Explosion

Table 9: India : FII Behaviour during the Stock Market Scam 2001

Table 10: India: FII Behaviour around Black Monday, May 17, 2004

These experiences show that FII outflow of as much as a billion dollars in a month which
corresponds to an average of $40 million or Rs.170 crore per day has never been observed.
These values Rs.170 crore per day are small when compared with equity turnover in India. In
calendar 2004, gross turnover on the equity market of Rs.88 lakh crore contained Rs.5 lakh crore
of gross turnover by FIIs. This suggests that as yet, FIIs are a small part of the Indian equity
market. Transactions by FIIs of Rs.5 lakh crore in a year might have been large in 1993, but the
success of a radical new market design in the Indian equity market have led to enormous growth
47

of liquidity and market efficiency on the equity market. Through this, Indias ability to absorb
substantial transactions on the equity market appears to be in place.

RECENT DEVELOPMENTS
FII investment limit in government securities, bonds hiked
The finance ministry on Nov 18, 2011 decided to increase investment limit of Foreign
Institutional Investor (FIIs) in government securities and corporate bonds by $5 billion as the
current limit for this year has almost been exhausted. Now, an FII can invest up to $15 billion in
government securities , and for the corporate bonds the cap has been enhanced to $20 billion.
The changes will be effective in the next few days after the Securities and Exchange Board of
India issues a circular and notifies it.
FII investment in India has reached its current limit for both government papers and corporate
bonds, reflecting confidence of foreign investors in Indian economy. As on October 31, 2011,
FIIs have invested more than Rs 41,000 crore in government papers and Rs 68,000 crore in
corporate bonds. The present ceiling for government securities is Rs 43,650 crore and for the
corporate bonds it is 74,000 crore. The changes are likely to enhance capital flows and
investments at lower cost. Indian corporates also have enough room to borrow through the
External Commercial Borrowing route where the cap is $30 billion, of which, so far, this year's
borrowings have touched $21 billion.
In September, the government had relaxed norms for FIIs investment in long-term infrastructure
bonds, reducing the residual maturity period to one year for investments of up to $5 billion.
Though the government had raised investment limit of FIIs in long-term infrastructure bonds
48

from $5 billion to $25 billion in the 2011-12 Budget, investments under this scheme had a
minimum residual maturity of five years and were subject to a minimum lock-in period of three
years.
From the table below, we can see that as on October 31, 2011, FIIs have nearly exhausted the
investment limit in government securities and corporate bonds. This move will further give an
investment opportunity of approximately Rs 25000 cr in each, government security and
corporate bond (assuming a conversion rate of Rs 50). However, the investment in long term
infrastructure bonds is merely Rs 2837 cr (in the first 7 months of FY12 ) versus the limit of Rs
112095cr
Since infrastructure is a key area where India is still lacking, the government should bring in
reforms and attract investments in infrastructure, which can further boost the country's economic
growth. The move will help in cooling the 10-year government bond yields, and will reduce the
borrowing cost for the government. Further, this will also help in developing our bond market.
We further feel that this move will attract a lot of FIIs, as the interest rate cycle in India is almost
at its peak. Going forward, there could be a rise in the prices of the bonds, leading to better
capital gains. It will also ease some pressure from the government with respect to the rupee,
which has depreciated in the past couple of quarters.
Overall, the move has multiple purposes. such as moving a step ahead for developing the bond
market, helping the rupee stabilise, a cool off in the 10-year bond yield to some extent and
attracting foreign investment in the country.
Particulars

Government
Securities
Corporate
Debt
Corporate
Debt - Long

New Cap
for
Investment
(In USD bn)

Old Cap for

Investment
(In USD bn)

Investment
limit
according to
old cap
(Converted
into INR
Cr)

Investment
made by FII
according to
old cap
(Converted
into INR
Cr)

15

10

43650

Additional
Investment
could be
made
(Assuming
Conversion
rate of Rs
50) in INR
Cr
41253
25000

20

15

74416

68289

25

25

112095

25000

2837 -

49

Term Infra

2.13 FII activity in 2012

The investment by overseas investors into Indian stock market since the beginning of 2012 has
crossed $7 billion level, out of which more than $5 billion were pumped in the month of
February. Foreign Institutional Investors (FIIs) purchased equities and debt securities worth a
gross amount of Rs 76,548 crore in January 2012, while their gross sales for the month were
worth Rs 50,219 crore, translating into a net inflow of Rs 26,329 crore, as per data compiled by
the market regulator Sebi.
Overseas investors poured in over Rs 26,000 crore ($5.08 billion) in Indian markets in January
2012, the highest one-month net inflow in 16 months, as
sentiments got a boost from easing inflation concerns and
attractive valuations.
The Foreign Institutional Investors (FIIs) infused a net amount of
$ 5.12 billion (about Rs 25,212 crore) during February, taking
the total for 2012 so far to $7.16 billion for the Indian stocks.
Market analysts attributed strong FII inflows to signs of a
reversal in RBIs monetary policy and the subsequent impact of improved liquidity position.
They expect the positive trend to continue further, given that the liquidity conditions remain
50

strong.Market analysts attributed strong FII inflows to signs of a reversal in RBI's monetary
policy and the subsequent impact of improved liquidity position.
During February, FIIs were gross buyers of shares worth Rs 79,898.6 crore, while they sold
equities amounting to Rs 54,686.6 crore, translating into a net investment of Rs 25,212 crore ($
5.12 billion), as per data available with market regulator Sebi. This is the highest monthly net
investment by FIIs in equities since October 2010, where they had infused Rs 28,563 crore.
The foreign fund houses also infused Rs 1,0016 crore ($2.03 billion) in the debt market last
month. This takes the overall net investments by FIIs into debt markets to Rs 25,987 crore ($5.08
billion) so far this year. FIIs have been infusing money into the Indian market due to change in
RBIs monetary policy that have added liquidity to the system. This liquidity will help in growth
of the country, Wellindia Executive Director Hemant Mamtani said. Indian market will
continue to witness inflows in the whole year, if the liquidity conditions remain strong, he
added. Strong surge in FII inflows in 2012 so far has helped boost the equity markets, as also
the rupee.
The stock market barometer Sensex has gained 15 per cent in 2012, despite a fall of about 3.25
percent last month. The index finished at 17,752.68 on February 29. FIIs had mostly stayed away
from Indian equities in 2011. They flocked towards the debt market last year with a net
investment of Rs 20,293 crore, while pulling out Rs 2,812 crore from equities.
In the year 2011, FIIs purchased stocks and bonds worth Rs 8 lakh crore, but sold securities
worth Rs 7.9 lakh crore, resulting in a net investment of Rs 17,480 crore during the year. Strong
surge in FII inflow in 2012 has helped boost the equity markets as well as helped the Indian
rupee to strengthen. The foreign fund houses have also infused Rs 17,281 crore in the debt
market so far this year. Strong surge in FII inflow in 2012 has helped boost the equity markets as
well as helped the Indian rupee to strengthen.
It is not only India which has witnessed an upsurge in investment, equity funds focused on all
emerging markets put together have seen an inflow of over $24 billion in 2012. "FIIs investments
in debt market are rising because of higher yields on local bonds," Bandyopadhyay said. In terms
of equity investment, foreign funds have poured in maximum money in infrastructure and
pharma stocks, he added. This is the highest net investment by FIIs in stocks and bonds since
September 2010.
In 2012, FIIs infused money into the Indian market mainly on account of easing inflation, a
relaxing of foreign investor restrictions and the RBIs policy moves, CNI Research Head Kishor
Ostwal said. Stock market inflows in the first 17 days of February, at Rs 13,867 crore, were
higher than that for the entire month of January 2012, which stood at Rs 10,358 crore.

51

Secret of the Sensex: Biggest FII turn-on since 2000

The Sensex crossed the 18,000 mark and closed at a six-month high. India, which was among the
worst performing markets by December 2011, is one of the best performing ones today.
Fundamentally, nothing seems to have changed, either in India or in the world. In fact, after the
December quarter corporate numbers, the outlook is even more bleak.
So what is the secret behind this sudden rally? The answer is the largest foreign inflows since the
turn of the decade.

52

The main reason for the sharp 18 percent rise in indices is the Rs 22,000 crore FII money that
has entered the country, the highest ever, since Sebi started disclosing the data in 2000. Inflows
in the first 15 days of February, at Rs 11,681.7 crore, were higher than that for the entire month
of January 2012, which stood at Rs 10,907 crore. This means around $4 billion of money has
already flown into the country in the first 45 days of this year. It has resulted in Sensex moving
from a low of 15,358 0n 2 January 2012 to 18,231 on 15 February.
While emerging markets trade at a valuation of 12 times their reported profits, developed
markets are trading at 14 times their reported profits. Reuters
The MSCI (Morgan Stanley Capital International) Emerging Markets Index has already gained
15 percent in 2012, the best start to a year since 1991. It has outperformed the MSCI World
Index by 6 percentage point.
According to a report in Bloomberg, Jonathan Garner, the chief Asia and emerging markets
strategist at Morgan Stanley, said the surge in optimism is a contrarian indicator that may signal
the rally has gone too far, too fast. Michael Hartnett, chief global equity strategist at Bank of
America Investor, says holdings in emerging markets have climbed to a level that historically
foreshadowed short-term underperformance.

From the chart below, its clear that the banking sector has been the favourite among sector
investments. The banking sector retained its top position for eight of the the nine quarters
analysed by the investment research firm. FIIs had an 11 percent exposure to this sector in the
53

December quarter. Power and metal companies also received allocations of 6.6-7.9 percent,
although their shares have declined slightly from the September quarter.
At the moment, its difficult to tell whether foreigners will continue to invest robustly in Indias
capital markets. Some experts believe the results could inhibit the government from taking any
bold reform measures and lower the prospects of the economy, which could dampen the appetite
of foreign investors. Indeed, the Sensex reported volatility as it closed lower at 17,173 points on
Tuesday, 500 points lower from its intra-day high on the elections results, as investors sensed
more economic policy-making delays ahead. The rupee also plunged below 50 against the
dollar.

CHAPTER 3: Research Methodology

The study carried out is analytical and empirical in nature in which it explores the relationship
between the Inflows of FII and their impact on Indian Capital Market. The study focuses on
Bombay Stock Exchange. In this research the sale and gross purchases data was used to find
therelation with sensex

Framing Of Hypothesis:Following hypotheses were developed for the study and tested at 5% level of significance.
Hypothesis 1
Hypothesis (H1) There is significant relationship between Sensex and FII equity
investment
Null Hypothesis (Ho): There is no significant relationship between Sensex and FII
equity investment
Hypothesis 2
Hypothesis (H2) Sensex is significantly correlated with FII equity purchases

54

Null Hypothesis (Ho): There is no significant relationship between Sensex and FII
equity purchases

Hypothesis 3
Hypothesis (H3) Sensex is significantly correlated with FII equity sale
Null Hypothesis (Ho): There is no significant relationship between Sensex and FII
equity sale

3.1 Research Design

Exploratory Research method applied for the study. As an exploratory study is conducted with an
objective to gain familiarity with the phenomenon or to achieve new insight into it, this study
aims to find the new insights in terms of finding the relationship between FII'S and Indian Stock
Markets.

3.2 Data Collection

Data for the study collected primarily from Secondary sources. For this various literatures,
books, journals, magazines, web links were used. Monthly closing data of sensex (1992-2012),
Monthly data of FII flow in equity (1992-2012), Yearly data of FII flow in equity (19922012),Yearly data of sensex (1992-2012)
3.3 Sampling Method
Convenient Sampling method used for the Study. Convenience sampling is a non-probability
sampling technique where subjects are selected because of their convenient accessibility and
proximity .
3.4 Research Analysis Tools
The data was classified and tabulated using MS EXCEL and SPSS 12.0. Correlation analysis
used as statistical tool for data analysis. Correlation analysis measures the relationship between
two data sets that are scaled to be independent of the unit of measurement. The population
correlation calculation returns the covariance of two data sets divided by the product of their
standard deviations. We can use the Correlation tool to determine whether two ranges of data
move together - that is, whether large values of one set are associated with large values of the
other (positive correlation), whether small values of one set are associated with large values of
the other (negative correlation), or whether values in both sets are unrelated (correlation near
zero). Data were analyzed with the help of SPSS 12.

55

Table 1 Correlation among FII & Sensex for entire period from liberalization 1992-2011

Correlations
sensex

NetFII

Pearson Correlation
Sig. (2-tailed)
N
Pearson Correlation
Sig. (2-tailed)
N

sensex
1
.
20
.770**
.000
20

NetFII
.770**
.000
20
1
.
20

**. Correlation is significant at the 0.01 level

(2-tailed).

Tabl

e 2 Correlation among FII & Sensex from Jan 2006- Dec 2011

Correlations

sensex

GrossPurchase

GrossSales

NetInvst

Pearson Correlation
Sig. (2-tailed)
N
Pearson Correlation
Sig. (2-tailed)
N
Pearson Correlation
Sig. (2-tailed)
N
Pearson Correlation
Sig. (2-tailed)
N

sensex
1
.
72
.668**
.000
72
.528**
.000
72
.334**
.004
72

Gross
Purchase
GrossSales
NetInvst
.668**
.528**
.334**
.000
.000
.004
72
72
72
1
.883**
.310**
.
.000
.008
72
72
72
.883**
1
-.170
.000
.
.154
72
72
72
.310**
-.170
1
.008
.154
.
72
72
72

**. Correlation is significant at the 0.01 level (2-tailed).

Table 3 Correlation among FII & Sensex from Jan 2010- 23 March 2012

56

Correlations

sensex

GrossPurchase

GrossSales

NetInvst

Pearson Correlation
Sig. (2-tailed)
N
Pearson Correlation
Sig. (2-tailed)
N
Pearson Correlation
Sig. (2-tailed)
N
Pearson Correlation
Sig. (2-tailed)
N

sensex
1
.
27
.605**
.001
27
.337
.085
27
.437*
.023
27

Gross
Purchase
GrossSales
.605**
.337
.001
.085
27
27
1
.614**
.
.001
27
27
.614**
1
.001
.
27
27
.723**
-.095
.000
.638
27
27

NetInvst
.437*
.023
27
.723**
.000
27
-.095
.638
27
1
.
27

**. Correlation is significant at the 0.01 level (2-tailed).

*. Correlation is significant at the 0.05 level (2-tailed).

3.5 Analysis and Interpretation

Table 1
It is revealed from table 1 that performances of indices are positively correlated with FII and the
strength of correlation is very strong. It was also revealed that the performances of indices were
also highly and positively related. Degree of correlation between Net FII flows and BSE Sensex
is 0.770 hence hypothesis H1 is accepted
Table 2
Table 2 also indicates that performance of indices is positively correlated with FII and the
strength of correlation is very strong. It was also revealed that the performances of indices were
also highly and positively related. Degree of correlation between FII purchase and BSE Sensex is
0.668 hence hypothesis H2 is accepted Table 2 also indicates that performance of indices is
positively correlated with FII and the strength of correlation is very strong. It was also revealed
that the performances of indices were also highly and positively related Degree of correlation
between FII sale and sensex is 0.528 hence hypothesis H3 is accepted
Table 3
Table 3 also indicates that performance of indices is positively correlated with FII and the
strength of correlation is very strong. It was also revealed that the performances of indices were
57

also highly and positively related. Degree of correlation between FII purchase and BSE Sensex is
0.605 hence hypothesis H2 is accepted Table 3 also indicates that performance of indices is
positively correlated with FII and the strength of correlation is very strong. It was also revealed
that the performances of indices were not affected by the performance of gross sales. Degree of
correlation between FII sale and sensex is 0.337 hence hypothesis H3 is rejected
Results and Findings
So for the study of data from 1992 to March-2012, FII equity investment yearly and monthly
and closing of Sensex Indices were considered. Correlation Test has been carried out to find the
degree of association between the FII Gross Purchases and Sensex and FII Gross sales and
sensex. First of all correlation between sensex and FII gross purchase and FII gross sale and
sensex is carried out to verify relation between them Sensex of Bombay Stock Exchange is
considered as the barometer of Indian Capital Market. This inference is further supported by high
degree of correlation coefficient obtained between two variables in the Table-1, 2 & 3. This high
degree of correlation further suggests that there is direct correlation between the Midcap &
Smallcap Indices and FIIs investments. FIIs gross purchases have been taken as independent
variable to find the impact of FII because net investments involve negative values when there are
more sales as compared to purchases FII invest in scripts of these Indices because they provide
higher returns as compared to large cap scripts.

This analysis indicates the impact of FIIs on Indices. An FII driven market can impact the real
economy indirectly, when their behavior in the market exerts pressure on policy makers.
Secondly, the wealth effect' where capital gains are translated into increased consumption and
investment, can act as a more direct link between equity and physical markets. FIIs are always
considered to increase the volatility of market. Volatility is often viewed as a negative in that it
represents uncertainty and risk. However, volatility can be good in that if one shorts on the
peaks, and buys on the lows one can make money, with greater money coming with greater
volatility. The possibility for money to be made via volatile markets is how short term market
players like day traders hope to make money, and is in contrast to the long term investment view
of buy and hold. Foreign institutional investment is certainly volatile in nature and its volatility
has certainly posed some threats to the Indian stock market considering its influence on the
market. 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 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 Indices because only FIIs are
not responsible for the fluctuations instead there are other factors like company specific factors,
speculative trading, interest rate prevailing in the market, political factors, government policies
related to specific sectors etc. which cause a significant change in the price.
Findings of the study can be summarized as:
58

1. Growth potential of Indian Capital Market has attracted the continuous increase in the
number of registered FIIs and the Gross purchases made by them.
2. The movements in Midcap & Smallcap Indices and Sensex are highly correlated with FII
equity investment in Indian Capital market.
3. The movement of FIIs gross purchases follows almost significant influence on the
movement of Midcap & Smallcap Indices. When there is a downward trend in FIIs due to
huge selling, there is decline in Midcap & Smallcap Indices. On the other hand if there is
an upward trend in FII due to more gross purchases as compared to selling, Indices rises.
4. The high degree of volatility in Indian stock market is caused by the increase in
investment by FIIs which increases stock indices that in turn increases the price and
encourages further investments. In this event when any correction takes place the stock
prices decline and there will be pull out by the FII in a large number as earning per shares
declines.
5. The FIIs manipulate the situation of boom in such a manner that they will wait till the
index rises up to a certain height and exit at an appropriate time. This tendency increases
the volatility further.

CHAPTER 4: FUTURE PROSPECTS

4.1 Reasons Why FIIs Will Keep Pumping Money Into Indian Market
The Foreign Institutional Investors (FIIs) infused a net amount of $ 5.12 billion (about Rs 25,212
crore) during February, taking the total for 2012 so far to $7.16 billion for the Indian stocks. For
some, it may be just another factoid, but when we look at it from the perspective of the Indian
equity market the massive inflow has far-reaching consequences. The inflow helped Indian
equity market to turn around from the negative return of year 2011 and post one of the best
returns in the last two decades . The last time we witnessed return in excess of 75 per cent was in
1991. That was mainly because the then Finance Minister and present Prime Minister Dr
Manmohan Singh ushered in new economic policy of liberalization, privatization and
globalization and creating euphoria that resulted in historic market returns. So will India be lucky
to repeat the inflows of 2007 again in 2012? But before we come to that, we will try to
understand the nature of FII investments and their importance in shaping the market direction
and returns.
India may attract better portfolio flows this year. Various conducive factors are present that can
encourage these flows. To begin, there is little risk to the long-term GDP growth in our country.
Over the last 30 years, India's real GDP growth has averaged about 6.2 per cent. With little
dependence on the western world for its growth, a slowdown elsewhere in the world will have
little impact on India.
59

Domestic consumption continues to be key factor driving growth. Good monsoons and higher
farm prices should keep the rural economy humming.
Those worried about inflation need to remember that, for India, this is not new phenomenon. In
the early 1990s, India had grown despite the high interest rates and inflation. However, for FIIs
coming into India with an 8-9 per cent GDP growth assumption, a 6.5 per cent growth could be a
disappointment.
The second factor is that valuations of Indian stocks are attractive and earnings growth is good.
If the price-to-earnings multiple of our market is considered, stocks are not as cheap as they were
in 2003 or 2008 when valuations were less than 10x. If the euro crisis escalates further, we might
see those kinds of valuations; however, at the current levels, given the current earnings growth
rates in India, it is still attractive as it is below the long-term average of 17.6x. According to
Bloomberg's consensus estimate, earnings is expected to grow 25.6 per cent in FY2012 and 16.8
per cent in 2013. Based on these growth estimates, valuations appear reasonable. While no one
prefers the policy freeze in New Delhi, a rate of growth in GDP of 6.5- 7 per cent with more
equitable growth is far better than a 9 per cent growth number with massive corruption.
In the first half of 2012, slowing inflation and lower economic activity would set the stage for the
RBI to reverse its monetary policy by cutting interest rates and adding liquidity, thus improving
investment sentiment.
As things stand today, foreign investors get to buy more Indian assets for the same dollar due to a
weaker rupee. On a long-term basis, given the huge deficits in India, we are of the view that the
rupee will depreciate. However, the 16 per cent depreciation in the rupee since August seems
unwarranted. So there is a case for currency appreciation, which is positive for an FII. Year-todate, the rupee has appreciated 7.6 per cent.
Shaky Beginning
At the dawn of year 2009 we were staring at uncertainty in the global markets and also facing
one of the worst corporate governance issues (Satyam Computers) in India. But as we stand at
the dusk of 2012, we find most of the crises have blown away and although certain patches of
uncertainty in the global recovery still remain, things are clearer than they were at the start of the
year. Undoubtedly, this has helped attract record inflow of FII money into Indian equity market,
despite 70 per cent fall in new registrations of FIIs in 2009 (see graph)

60

. In 2008, when market was down 53 per cent and FIIs pulled out about Rs 53,000 crore (USD
11.3 billion) from Indian market, 375 new FIIs got registered in India as compared to just 111 in
2009. At the end of November 2009, there were 1705 FIIs registered in India. One of the reasons
for such low registration numbers might be that many of the hedge funds that were very active
during pre-crisis time have either liquidated or significantly cut down their exposure to emerging
markets and are still treading with caution. This means that the amount has been pumped by the
existing FIIs only, which is also substantiated by the fact that registration of new sub-accounts
has declined by 60 per cent. There was a small increase in the number of Foreign Institutional
Investors (FIIs) registered with SEBI. As on March 31, 2011, there were 1,722 FIIs registered
with SEBI as compared to 1,713 a year ago, showing an increase of 0.53 percent during the year.
There were 5,686 sub-accounts registered with SEBI as on March 31, 2011 as compared to 5,378
as on March 31, 2010, an increase of 5.73 percent
How Hot is Hot Money?
FIIs have fuelled rallies in stock markets across the world, but they have been also accused of
fuelling volatility. If the past evidence of FIIs investing pattern in a different country is anything
to go by, FIIs seem to be more sensitive to bad news than good news. This means FIIs are more
cautious while investing than while withdrawing it. The explanation to this behaviour is that FIIs
are risk-averse, which makes them react in a knee-jerk fashion to bad news. Moreover, they view
every market as an asset in their global portfolio and, therefore, they tend to restructure and
rebalance their portfolio dynamically across countries to minimize and maintain healthy returns
on their portfolio. Even among FIIs it is investment through participatory notes (P-Notes), which
is considered as prime source of hot money and hence volatility. This is because there is little
clarity on who the actual investors are and the source of their money. To keep tabs on this hot
money, SEBI banned investment through P-Notes on October 17, 2007, resulting in crash of the
benchmark Sensex and suspension of trading for an hour. But the latest SEBI figures suggest that
supplies of this hot money are on the decline. In 2007, investment through P-Notes constituted
45.5 per cent of FIIs total assets under management, which has come down to just 16.21 per cent
61

in 2009 (see graph). This is on the backdrop of SEBI lifting the ban on investment through PNotes. The drop may be attributed to the fear of the regulator imposing the ban
again.

FII Inflows & Their Impact

One of the reasons for FII money seeking global investment avenues was the fiscal stimulus
packages provided by governments across the world as also the lack of demand from the real
economy. The FII money found its way to the different financial asset classes, including
emerging markets. To understand how important and effective these FII investments are for
Indian equity market, we analyzed data for FII inflows (or outflows) and the returns generated by
BSE Sensex in the corresponding period. It was not surprising to find that Sensex had given
positive returns only eight times despite negative flows from FIIs. In almost 70 per cent of the
times, Sensex and inflows moved in tandem. Therefore, it is no coincidence that in the history of
the Indian equity market the only time when Sensex and Nifty were closed due to upper circuit in
May 2009 also happens to be the month when FII inflows were highest at Rs 20,607 crore.
Now, let us check where all this money got parked. After the second quarter of FY10, FIIs have
raised their stake in more than 200 companies. The sectors where they particularly evinced keen
interest were construction, infrastructure and heavy engineering. These are also the sectors where
demand has more to do with domestic consumption. These were also the sectors that suffered the
worst last year due to credit crisis and got hammered on the bourses. So how do these fare in
terms of returns as compared to the broader market and peers? We find that these outperformed,
both sector-wise and company-wise. For example, HCC, Sobha Developers whose returns were
227 per cent and 223 per cent, respectively, between April-Sept. 2009 outpaced their respective
indices by a wide margin. HCC, which is part of BSE 200 and Sobha Developers, which is part
of BSE Realty are up by just 80 per cent and 174 per cent, respectively. Similarly, BSE Realty
gave returns of 174 per cent as compared to 73 per cent by Sensex.

62

Of course, FIIs have not increased their stake in all the companies, they have also lowered their
holdings in various companies, most of whom belong to media and entertainment. For example,
FIIs have reduced their holdings in NDTV from 23.14 per cent to 5 per cent in February 2012.
Similarly, they reduced it from 17.99 per cent to 11.37 per cent in TV Eighteen during the same
time period. However, when we calculate the returns of these companies in the same period we
do not find that they have underperformed the market. For example, NDTV has moved up 88 per
cent. Clearly, although FIIs are an important force that moves the stock market, they are not the
only ones to influence it.
When we analyzed the FII investments in terms of company categorized by market
capitalization, we came across a startling revelation that instead of choosing the large caps or
Nifty companies, FIIs have instead shown more interest in small and mid cap companies like
HDIL, Indiabulls Real Estate, 3i Infotech, etc. and this might be one of the reasons why returns
of these indices had outperformed Sensex and Nifty. Having established the fact that FIIs greatly
influence the stock market, we will now try to understand the factors that determine the FIIs
inflows and why they will invest in the Indian market in 2012.

As per belief FII investments in India will be driven by seven major factors that are listed
below.
Liquidity
Liquidity moves the markets, which in turn, attract more liquidity, says
Ambareesh Baliga, VP, Karvy Stock Broking and remains the single most important
factor which determines the FIIs inflow. We feel that global economy is still flush with
liquidity and will remain at this level till second quarter next year. The excess cash in the
US banking system has risen by USD 400 billion since March 2009 and has reached 3
trillion euros in Feb 2012 as quantitative easing (QE) exceeded the liquidation of credit
facilities. So with quarter ending there is little room for further reduction in various
credit facilities, the excess cash in the US banking system should stay close to a trillion
euro throughout 2012. Even in euro area, liquidity is expected to remain at higher level
till the second half of 2012. The amount of such excess liquidity in the euro area banking
system is estimated to be 776.941 billion ($1.034 trillion) ie in European Central Bank
(ECB)
63

In contrast to US Federal Reserve & ECB, is set to inject more liquidity into the
banking system. This is evident from the recent policies by these governments.Therefore,
we believe liquidity will not be sucked out of the global economy in a hurry and part of
this liquidity will definitely finds its way into Indian equity market.

Indian Growth Story

Liquidity and corresponding inflows is like a double-edged sword, and although it
helps create wealth by better market returns, it also creates bubbles in different asset
classes, including art and paints says Mohit Mirchandani, Head of Equity Investments,
Taurus Mutual Fund. Therefore, high liquidity creates the problem of absorbing the high
inflows with its side effects. But we feel this is not a big concern in case of India. If the
government goes for PSU divestment as planned, our market will become deeper and will
absorb this extra inflows in 2012 and yet avoid much of its pitfalls, says Mirchandani.
Apart from this, many fresh issues are lined up, which will take care of extra liquidity.
Fresh equity issuance (FPO/IPO/QIP) will continue over the next few quarters and will
remain an important source of capital for the private sector till deleveraging is complete
and credit growth improves and is incremental.
Indian economy is more dependent on domestic consumption, which contributes
more than 60 per cent of the GDP. This makes it less vulnerable than those economies,
which are more dependent on export sector and commodity cycle. The Indian
Government's 2012 economic survey has projected the economic growth at about 7.6%
in the next fiscal 2012-13, up from 6.9% estimated in 2011-12 on the back of declining
inflation and softening interest rate. It expects the economic growth to further improve to
8.6% in 2013-14.. We believe that once the global recovery comes back on track, Indias
GDP will accelerate further, giving more reasons for FIIs to be a part of the Indian growth
story.

Diversified Opportunity
India offers a much more diversified market than markets such Russia, Brazil or
even China. These economies are largely based on commodities like crude and less in
terms of primary articles and products. India offers opportunities in IT, banking, services
and the range of listed companies available in India is much broader than in Eastern
Europe or Russia. However, Chinese market provides a much bigger size in financial and
raw materials market, but India still offers more diversified stocks than any other
emerging market to an investor. India offers diversified exposure across various sectors
covering consumers, industries, materials, financials, healthcare, technology, etc. and
depending on the evolving economic outlook, one can definitely absorb flows in various
pockets, says V. Sriram. Moreover, India is less volatile than many emerging markets
and more transparent to international investor community something that would always
give a premium over the long-term. Hence, long-term investors such as pension funds
whose investment horizon is much longer (about 10-15 years) are also attracted
64

Opportunity in Indian Companies

Although Indian market ranks among the top half of the costliest emerging markets, so
certainly we are not cheap when trading. But when we speak of these stretched
valuations, it is mainly related to broader market indices like Sensex and Nifty and
earning multiples of companies on those indices. But if we scratch the surface and look
at mid caps and small caps, there are many companies which are available at very cheap
price. The year 2012 will be more of stock-picking rather than sector-specific. So, there
might be some scrips which might go up to 300 per cent, while the market may stay
range-bound, opines Mirchandani. Moreover, till now it was the government spending
(either directly through stimulus packages or indirectly through doling out money
through 6th Pay Commission) that has been the driving force of recovery but now what
will take the market forward is the investment cycle and capacity utilization which is
slated to accelerate next year, though it will remain below the pre-crisis level.
Nonetheless, it will translate into better growth numbers for India Inc. We believe that
there is still scope of upgrading of corporate earnings in certain pockets, which will take
care of some of the concerns on higher valuation.

Carry Trades
Other important factor in Indias favour and which is attracting FII inflows is the
relatively higher interest rate. The current near-zero interest rate in the USA and Japan as
against the 4-5 per cent in the Indian market gives rise to a strategy called 'carry trade',
which involves borrowing in lower yielding (US dollar or Japanese yen) assets and
investing in higher yielding assets (rupee) and pocket the difference. Ideally, whatever
gain one would have expected from this strategy should be negated by the expected
movement in exchange rate, but so far the strategy has worked profitably on an
average. Going forward, we do not find any compelling reasons to justify the reverse of
dollar carry trade. In addition,in terms of interest rate policy, the US Fed announced no
changes. It noted that the Fed funds rate would remain between 0 and 0.25 percent, and
reiterated that it was likely to maintain this exceptionally low interest rate stance through
late 2014. Other major central banks such European Central Bank and Bank of Japan are
expected to follow suit. Till the time differential interest rates remain at these levels and
other things remaining equal, we can expect the flow to continue.

US Dollar Index
The movement of dollar index, a measure of the performance of the US dollar
against a basket of currencies including the yen and euro is one of the most important
65

factors which will shape the future FII inflows. It has been observed that there is inverse
relationship between dollar index and Sensex (see graph). Therefore, when Sensex hit its
low on March 9th, it was no coincidence that dollar index too hit its high of 89. From
there, Sensex started its ascent and touched high of 17,360 on December 24, 2009,
whereas dollar index declined to 77.89 after hitting low of 74.26 on November 25, 2009.
And now in 2012 when sensex is 17300 dollar index is back on 79.34. Dollar index
actually measures risk aversion: when it declines, FIIs look at investing to riskier assets
and vice versa.. It is still premature to come to any conclusion about the future course of
dollar index and jury is still not out, but it is worth mentioning that despite such ascent of
the dollar, Sensex has continued its climb. Therefore, it appears that somehow the two
have decoupled as of now. In addition, the US dollar, after loosing ground to most of the
major currencies throughout 2009, resurrected after the Dubai crisis. We feel that this was
partly due to investors playing safe rather than sorry. This may also be explained by
investors tendency of taking away profit from the table as the year draws to a close like
what happened in last quarter of 2011

(The USD Index measures the performance of the US Dollar against a basket of
currencies: EUR, JPY, GBP, CAD, CHF and SEK)

Political Stability
India being the largest democracy in the world definitely inspires confidence in
the Indian economy. This also reduces the risk premium of the country from the FIIs
perspective. The FIIs confidence got a further boost after May 2009 general elections,
which gave a clear mandate to the Congress party and ushered in the Manmohan Singh
government once again. This was cheered by the market and for the first time Sensex and
Nifty hit the upper circuit. This led to the return of risk capital into Indian equity market.
Recognizing the importance of FIIs to the Indian stock market, the government has
played its own role and Finance Minister has constituted a working group to recommend
changes in the existing policies so as to attract more portfolio investments. The Finance
66

Minister has also gone on record stating that as of now there is no need to tax capital
inflows, which as a policy has been adopted by some of other emerging markets. Last,
but not the least, Indias democratic polity would always enable a premium over the long
term.
To conclude, the world recognizes that India and China will provide the growth
impetus for the global economy, but what differentiates India is its peculiar demographic
dividend which will last longer than many emerging economies, its political system and
new vigour in India Inc. to take on the challenges of global competition. Therefore, we
believe that the FII inflows will remain intact over the long term, although we might see
some temporary blips occasionally

4.2 US Rating Downgraded By S&P

The decision by S&P, the global ratings major, to cut US' sovereign rating by a notch to 'AA plus'
from 'AAA' is something that has no precedence. So for foreign fund managers as well as
institutional dealers in India, this is something they don't understand and hardly anyone has a
definite clue how to react to it. As a result, brokers are certain there could be some knee-jerk
reaction and selling during 2012 While the US rating downgrade is likely to trigger panic selling
in local markets, it may actually make India an attractive investment destination in the long term
- provided crude falls and RBI halts monetary tightening.
However, most FIIs are expected to be on the 'wait-and-watch' mode for a few months from now,
see how things pan out in other parts of the world and then take a decision on their India
portfolio, institutional dealers and fund advisors said. Infact, in one of the scenarios that could
emerge over a period, fund managers say that FIIs could actually look at India as a preferred
investment destination.The silver lining is that such volatility is expected to be short
lived.However, they warned that in case if any of the two other ratings majorsMoody's and
Fitchalso cut US sovereign ratings, volatility and uncertainty could increase.
THREE SCENARIOS :- As things stand now for FIIs, three phases are likely to unfold over
the next few months that could be assigned to this unthinkable incident of US ratings downgrade.
Some of the hedge funds, registered with Sebi as FIIs, will sell in 2012 like they did in last
quarter on 2011. This is because most hedge funds are momentum traders and in times of
uncertainty they prefer to be in cash.
On the other hand, long-term FII funds, like pension funds and insurance companies, will not sell
in a hurry but will wait to have a better understanding of the implications and then take a
67

decision on their India exposure. For the long term players, there are not many alternative
markets that offer them good growth and chance of a better return than India, institutional dealers
said. Since there are quite a few positives in the Indian market, after this downgrade, money will
not go back to the US
During the third phase, that is likely to unfold after a few months from now, India could actually
start attracting more foreign funds than before. This is because if crude prices fall, that could
bring down government's subsidy burden on petro products, pull down the rate of inflation, and
also might help RBI's in not raising the rate of interest in the economy. The combined effect,
market players believe, could again lure foreign fund managers to invest in the Indian economy.
This is something that was witnessed after the dust settled on the Lehman collapse and the
recession that followed in September 2008. So far this year, FIIs have pumped in just over $7.5
billion into the Indian market, compared to about $29.4 billion in 2010, Sebi data reveals.
Institutional dealers feel 2012 could be a much better year for FII inflows.

CHAPTER 5: CONCLUSION
From all the above discussions and data analysis, we conclude that FIIs have major
impact on Indian stock market. Particularly, the decline on October 17, 2007, in which just a
speculation about governments plan to control P-Notes had caused the biggest fall in Indian
stock market, even market had to be closed for one hour without trade. The impact is that even
the domestic players and MFs also follow a close look on FIIs. Therefore, if FIIs are confident in
Indian markets, there is a general perception that market is on a song.
But there is a note of caution too. The source of investment behind these FIIs should be
crystal clear. Otherwise this can cause a negative impact on stock market as was the cause of fall
on 17th October 2007. Further money launders and even terrorists can use this facility to pump
money to Indian market and their sudden withdrawal can cause volatility in markets. Even
during the current year also, the major fall in SENSEX has been caused amidst selling of FIIs
due to reasons like increased net selling by foreign funds during January or fear of interest Rate
hike by RBI or depreciation in the value of Rupee in comparison to dollars.
From above discussion it is clear that major falls in stock market were after effects of
withdrawal of money by FIIs. So there is a direct relation between the FII's money flow and the
movement of SENSEX. The biggest fall in stock markets occurred in 2007 and 2008. This means
that the volatility of market was more because during this period there was an increase in
registration of FIIs and the investments reached almost Rs. 283468.40 Crores by the end of 2007.

68

Correlation Test has been carried out to find the degree of association between the FII
Gross Purchases and Sensex and FII Gross sales and sensex. First of all correlation between
sensex and FII gross purchase and FII gross sale and sensex is carried out to verify relation
between them Sensex of Bombay Stock Exchange is considered as the barometer of Indian
Capital Market. This inference is further supported by high degree of correlation coefficient
obtained between two variables in the Table-1, 2 & 3. This high degree of correlation further
suggests that there is direct correlation between the Midcap & Smallcap Indices and FIIs
investments. So this analysis indicates the impact of FIIs on Indices. An FII driven market can
impact the real economy indirectly, when their behavior in the market exerts pressure on policy
makers. Secondly, the wealth effect' where capital gains are translated into increased
consumption and investment, can act as a more direct link between equity and physical markets.
FIIs are always considered to increase the volatility of market. Volatility is often viewed as a
negative in that it represents uncertainty and risk. However, volatility can be good in that if one
shorts on the peaks, and buys on the lows one can make money, with greater money coming with
greater volatility. The possibility for money to be made via volatile markets is how short term
market players like day traders hope to make money, and is in contrast to the long term
investment view of buy and hold. Foreign institutional investment is certainly volatile in nature
and its volatility has certainly posed some threats to the Indian stock market considering its
influence on the market. 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 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
Indices because only FIIs are not responsible for the fluctuations instead there are other factors
like company specific factors, speculative trading, interest rate prevailing in the market, political
factors, government policies related to specific sectors etc. which cause a significant change in
the price.
From all this analysis, we can safely say prime facie that the FIIs influence market.

69

Bibliography
http://www.moneycontrol.com/india/stockmarket/foreigninstitutionalinvestors/10/55/activity/FII
http://www.bseindia.com/histdata/hindices.asp
http://www.nseindia.com/content/equities/eq_fii_nsebse.htm
www.finance.indiamart.com
www.mydigitalfc.com/news/fii
http://www.sebi.gov.in/Index.jsp?contentDisp=Database
www.capitalvia.com
www.trak.in/Tags/Business/fii/
www.triplecrisis.com
www.ftalphaville.ft.com
http://www.reuters.com/finance
www.indianexpress.com
70

www.scribd.com
Dalal Street Investment Journal (Issue No.17) August 2011
Journal of Business and Economic Issues (Vol.1 Jan 2009)
Economic Outlook April 2011

71