Class Notes 7.docx

CHAPTER –I

Introduction to Foreign Institutional Investment

Post liberalization period of India had witnessed rapid expansion & enrichment of various industrial activities. After the independence India followed

socialist-inspired approach for most of its independent history, with strict government control over private sector participation, foreign trade, & foreign direct investment. However, since the early 1990s, India had gradually opened up its markets through economic reforms by reducing government controls onto foreign trade & investment.

The

privatization

of

publicly

owned

industries & the opening up of certain sectors to private & foreign interests had proceeded slowly amid political debate. Foreign Investment refers to investments made by residents of country into financial assets & production process of another country. After the opening up of the borders for capital movement these investments had grown into leaps & bounds. But it had varied effects across the countries. Into developing countries there was great need of foreign capital, not only to increase their productivity of labor but also helps to build the foreign exchange reserves to meet the trade deficit. Foreign investment provides channel through which these countries can had access to foreign capital. It can come into two forms: foreign direct investment (FDI) & foreign portfolio investment (FPI). Foreign direct investment involves into the direct production activity & also of medium to long-term nature. But the foreign portfolio investment was short-term investment

mostly into the financial markets & it consists of Foreign Institutional Investment (FII). The present study examines the determinants of foreign portfolio investment into the Indian context as the country after experiencing the foreign exchange crisis opened up the economy for foreign capital. India, being capital scarce country, had taken lot of measures to attract foreign investment since the beginning of reforms into 1991. Till the end of January 2003 it could attract total foreign investment of around US$ 48 billion out of which US$ 23 billion was into the form of FPI. FII consists of around US$ 12 billion into the total foreign investments. This shows the importance of FII into the overall foreign investment programmed. As India was into the process of liberalizing the capital account, it would had significant impact onto the foreign investments & particularly onto the FII, as this would affect short-term stability into the financial markets. Hence, there was need to determine the push & pull factors behind any change into the FII, so that we can frame our policies to influence the variables which drive-in foreign investment. Also FII had been subject of intense discussion, as it was held responsible for intensifying currency crisis into 1990’s elsewhere. The present study would examine the determinants of FII into Indian context. Here we make attempt to analyze the effect of return, risk & inflation, which were treated to be major determinants into

the literature, onto FII. The proposed relation (discussed into detail later) was that inflation & risk into domestic country & return into foreign country would adversely affect the FII flowing to domestic country, whereas inflation & risk into foreign country & return into domestic country would had favorable affect onto the same. Into the next section we would briefly discuss the existing studies. Into section 3, we discuss the theoretical model. There was strong growth into Foreign Direct Investment (FDI) flows with three quarters of such flows into the form of equity. As per the economic survey, the growth rate was 27.4 per cent into 2008-09, which was followed by 98.4 per cent into April-September 2006. At US$ 4.2 billion during the first six months of this fiscal, FDI was almost twice its level into April-September, 2005. Capital flows into India remained strong onto overall basis even after gross outflows under FDI with domestic corporate entities seeking global presence to harness scale, technology & market access advantages through acquisitions overseas. Total FDI inflows for April-December 2006 stood at US$ 9.3 billion, as compared to US$ 3.5 billion into the corresponding period last fiscal. According to certain estimates, India was likely to receive US$ 12 billion of FDI during the current financial year as compared to US$ 5.5 billion into the previous fiscal.

In the past two years, FDI had jumped 100 per cent, from US$ 3.75 billion into 2004-05 to US$ 7.231 billion till November

2006.

However,

these

figures

may

be

underestimation, say Finance Ministry officials, since these numbers do not include the amount that was reinvested by foreign companies operating into the country. The figure for 2009-2010 was likely to be close to US$ 10 billion if one takes into account profits reinvested by foreign players into Indian operations. The number of foreign institutional investors (FIIs) registered with the Securities & Exchange Board of India (Sebi) had now increased to 1,030. Into the beginning of calendar year 2006, the figure was 813. As many as 217 new FIIs opened their offices into India during 2006. This was the highest number of registrations by FIIs into year till date. The previous highest was 209 into 2005. The net investments made by the institutions during 2006 was US$ 9,185.90 million against US$ 9,521.80 million into 2005. Some investment highlights of FII Billionaire investor George Soros-owned fund Dacecroft & New York-based investment firm Blue Ridge were picking 21 per cent equity stake into Anil Dhirubhai Ambani Group's Reliance Asset Reconstruction Company (Reliance ARC).

Role of Government initiatives The Government was looking at reviewing regulation involving foreign investments into the country. Aimed at simplifying the investment process, the revised policy will treat foreign direct investment (FDI) & investment from foreign institutional investors (FII) into the same light. At present, investments by GE Capital, for instance, were termed as FII, while funds from GE were bracketed as FDI. This, despite the fact that GE Capital could be subsidiary of GE. & into sectors which had cap onto investments, matters were even more complicated. Into such situation, treating all foreign investments, irrespective of FDI or FII, as the same into terms of investment limits & conditions, can be more workable solution. Once the changes were into place, the policy will be more into tune with investments into developed countries where the distinctions between FDI & FII were fast disappearing. The sectors that will be affected by the revision include asset reconstruction companies, direct-to-home distribution of broadcast signals & real estate, where separate subceilings or conditions apply at present for FDI, leaving FII investments outside their ambit.

In move to bolster investments into the aviation sector, the Reserve Bank of India had said that FIIs can pick up stake into domestic airlines beyond the sectorial FDI cap of 49 per cent through secondary market purchases. Meanwhile, FDI into India was onto the verge of surpassing FII for the first time, the Prime Minister's Economic Advisory Council (EAC) had said. According to the EAC, net FDI for 2009-2010 would be around US$ 9 billion, up from US$ 4.7 billion last year while FII or portfolio inflows were likely to be US$ 7 billion.

Advantages of FII

The advantages of having FII investments can be broadly classified under the following categories. A. Enhanced flows of equity capital FIIs were well known for greater appetite for equity than debt into their asset structure. For example, pension funds into the United Kingdom & United States had 68 percent & 64 per cent, respectively, of their portfolios into equity into 1998. Thus, opening up the economy to FIIs was into line

with the accepted preference for non-debt creating foreign inflows over foreign debt. Furthermore, because of this preference for equities over bonds, FIIs can help into compressing the yield-differential between equity & bonds & improve corporate capital structures. B. Managing uncertainty & controlling risks Institutional investors promote financial innovation & development of hedging instruments. Institutions, for example, because of their interest into hedging risks, were known to have contributed to the development of zerocoupon bonds & index futures. FIIs, as professional bodies of asset managers & financial analysts, not only enhance competition into financial markets, but also improve the alignment of asset prices to fundamentals. 39. Institutions into general & FIIs into particular were known to have good information & low transaction costs. By aligning asset prices closer

to

fundamentals,

they

stabilize

markets.

Fundamentals were known to be sluggish into their movements. Thus, if prices were aligned to fundamentals, they should be as stable as the fundamentals themselves. Furthermore, variety of FIIs with variety of risk-return preferences also help into dampening volatility. C. Improving capital markets . FIIs as professional bodies of asset managers & financial analysts enhance competition & efficiency of financial

markets. Equity market development aids economic development. By increasing the availability of riskier long term capital for projects, & increasing firms’ incentives to supply more information about themselves, the FIIs can help into the process of economic development.

D. Improved corporate governance

Good corporate

governance was essential to overcome the principal-agent problem

between

share-holders

&

management.

Information asymmetries & incomplete contracts between share-holders & management were at the root of the agency costs. Dividend payment, for example, was discretionary. Bad corporate governance makes equity finance costly option. With boards often captured by managers or passive, ensuring the rights of shareholders was problem that needs to be addressed efficiently into any economy.

Management Control & Risk of Hot Money Flows The two common apprehensions about FII inflows were the fear of management takeovers & potential capital outflows. A. Management control FII fact as agents onto behalf of their principals – as financial investors maximizing

returns. There were

domestic laws that effectively prohibit institutional investors

from

taking management control. For example, US law

prevents mutual funds from owning more than 5 per cent of company’s stock.

According to the International

Monetary Fund’s Balance of Payments Manual 5, FDI was that category of international investment that reflects the objective of obtaining lasting interest by resident entity into one economy into enterprise resident into another economy. The lasting interest implies the existence of longterm relationship between

the direct investor & the

enterprise & significant degree of influence by the investor into the management of the enterprise. According to EU law, foreign investment was labeled direct investment when the investor buys more than 10 per cent of the investment target, & portfolio investment when the acquired stake was less than 10 percent. Institutional investors onto the other hand were specialized financial intermediaries managing savings collectively onto behalf of investors, especially small investors, towards

specific objectives into terms of

risk, returns, & maturity of claims. All take-overs were governed by SEBI (Substantial Acquisition of Shares & Takeovers) Regulations, 1997, & sub-accounts of FIIs were deemed to be “persons acting

into concert” with other

persons into the same category unless the contrary was established.

B. Potential capital outflows

FII inflows were popularly

described as “hot money”, because of the herding behavior & potential for large capital outflows. Herding behavior, with all the FIIs trying to either only buy or only sell at the same time, particularly at times of market stress, can be rational. With performance-related fees for fund managers, & performance judged onto the basis of how other funds were doing, there was great incentive to

suffer the

consequences of being wrong when everyone was wrong, rather than taking the

risk of being wrong when some

others were right. The incentive structure highlights the danger of contrarian bet going wrong & makes it much more severe than performing badly along with most others into the market. It not only leads to reliance onto the same information as others but also reduces the planning horizon to relatively short one.

Value at Risk models followed by

FIIs may destabilize markets by leading to

See

Bikhchandani, S & S. Sharma (2000): “Herd Behavior into Financial Markets”, Working Paper No.

WP/00/48,

International Monetary Fund, Washington DC, 2000.

15

simultaneous sale by various FIIs, as observed into Russia & Long Term Capital

Management 1998 (LTCM) crisis.

Extrapolative expectations or trend chasing rather than focusing onto fundamentals can lead to destabilization. Movements into the weightage

attached to country by

indices such as Morgan Stanley Country Index (MSCI) or International Finance Corporation (W) (IFC) also leads to en masse shift into FII portfolios. . Another source of concern were hedge funds, who, unlike pension funds, life insurance companies & mutual funds, engage into short-term trading, take short positions

&

borrow more aggressively, & numbered about 6,000 with $500 billion of assets under control into 1998. 50. Some of these issues had been relevant right from 1992, when FII investments were allowed in. The issues, which continue to be relevant even today, are: (i) benchmarking with the best practices into other developing countries that compete with

India for similar investments; (ii) if management

control was what was to be protected, was there reason to put restriction onto the maximum amount of shares that can be held by foreign investor rather than the maximum that can be held by all foreigners put together; & (iii) whether the limit of 24 per cent onto FII investment will be over & above the 51

per cent limit onto FDI. There were some

other issues such as whether the existing ceiling onto the ratio between equities & debentures into FII portfolio of 70:30 should continue

or not, but this was beyond the

terms of reference of the Committee To conclude Foreign Institutional Investment refers to investments made by residents of country into financial assets & production process of another country. After the

opening up of the borders for capital movement these investments had grown into leaps & bounds. But it had varied effects across the countries. It can affect the factor productivity of the recipient country & can also affect the balance of payments. Into developing countries there was great need of foreign capital, not only to increase their productivity of labor but also helps to build the foreign exchange reserves to meet the trade deficit. Foreign investment provides channel through which these countries can had access to foreign capital. It can come into two forms: foreign direct investment (FDI) & foreign portfolio investment (FPI). Foreign direct investment involves into the direct production activity & also of medium to long-term nature. But the foreign portfolio investment was short-term investment mostly into the financial markets & it consists of Foreign Institutional Investment (FII). The FII, given its short-term nature, might had bi-directional causation with the returns of other domestic financial markets like money market, stock market, foreign exchange market, etc. Hence, unde