CHAPTER II FOREIGN INSTITUTIONAL INVESTORS AND INVESTMENT...

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CHAPTER II

FOREIGN INSTITUTIONAL INVESTORS AND INVESTMENT: AN

OVERVIEW

2.1 INTRODUCTION

Indian stock market has grown steadily over the years alluring domestic

investors and foreign investors as a hotspot of investment. The major part of

investment in Indian stock market is attributed to institutional investors among whom

foreign investors are prominent in the post-liberalisation period. This chapter gives a

brief sketch on conceptual and functional framework of FIIs and their benefits. The

discussion on evolution of foreign institutional investment in Indian market and the

development policies initiated by the Indian government regarding foreign

institutional investors have been also described in this chapter.

2.2 EVOLUTION OF FOREIGN INSTITUTIONAL INVESTMENTS

Until the late 1980s, India’s economic development strategy was focused on

self-reliance and import substitution. 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. After the

launch of the liberalisation measures 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 evolution of FII policy in India has displayed a steady and

cautious approach to liberalisation of a system of quantitative restrictions (QRs). The

policy liberalisation has taken the form of:

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(i) relaxation of investment limits for FIIs;

(ii) relaxation of eligibility conditions;

(iii)Liberalisation of investment instruments accessible for FIIs.

The measures introduced by the government to liberalize provisions relating to

foreign investments in 1991 attracted investors from every corner of the world. Since

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

that were listed or were to be listed on the stock exchanges in India and in schemes

floated by domestic mutual funds. As a result foreign investment inflows into India

has increased manifold in the form of foreign direct investment (FDI) and foreign

institutional investment (FII).

2.3 FOREIGN INVESTMENTS: THE INDIAN PERSPECTIVE

Foreign investments in the country can take the form of investments in listed

companies (i.e., FII investments), investments in listed/unlisted companies other than

through stock exchanges (i.e., through the foreign direct investment or private

equity/foreign venture capital investment route), investments through American

Depository Receipts/Global Depository Receipts (ADR/GDR), or investments by

non-resident Indians (NRIs) and Persons of Indian Origin (PIOs) in various forms.

Chart 2.1 reveals these forms of foreign investments.


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Chart 2.1: Foreign Investments in India

Source: NSE

2.4 FOREIGN INSTITUTIONAL INVESTOR:

FII is defined as an institution organized outside of India for the purpose of

making investments into the Indian securities market under the regulations prescribed

by SEBI. The term Foreign Institutional Investor is defined by SEBI as “an institution

established or incorporated outside India which proposes to make investment in India

in securities, provided that a domestic asset management company or domestic

portfolio manager who manages funds raised or collected or brought from outside

India for investment in India on behalf of a sub-account, shall be deemed to be a

Foreign Institutional Investor.” ‘FII’ include “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


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outside India proposing to make proprietary investments or investments on behalf of a

broad-based fund.

2.4.1 Important Terms Related to FIIs:

1. Sub-account:

Sub-account includes those foreign corporations, foreign individuals, and

institutions, funds or portfolios established or incorporated outside India on whose

behalf investments are proposed to be made in India by a FII, and who is registered as

a sub-account under the SEBI (FII) Regulations, 1995.

2. Designated Bank:

Designated Bank means any bank in India which has been authorized by the

Reserve Bank of India to act as a banker to FII.

3. Domestic Custodian:

Domestic Custodian means any entity registered with SEBI to carry on the activity

of providing custodial services in respect of securities.

4. Broad Based Fund:

Broad Based Fund means a fund established or incorporated outside India, which

has at least twenty investors with no single individual investor holding more than 49%

shares or units of the fund. If the broad-based fund has institutional investor(s), then it

is not necessary for the fund to have 20 investors. Further, if the broad-based fund has

an institutional investor who holds more than 49% of the shares or units in the fund,

then the institutional investor must itself be a broad-based fund.


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5. Caution List

When the total holdings of FIIs under the scheme reach the limit of 2 percent

below the sectoral cap, the RBI issues a notice to all designated branches of the

Authorised Dealer (AD) Category-I banks cautioning that any further purchases of

shares of the particular Indian company will require prior approval of the RBI. The

RBI gives case-by-case approvals to FIIs for the purchase of shares of companies

included in the Caution List. This is done on a first-come, first-served basis.

6. Ban List

Once the shareholding by FIIs reaches the overall ceiling/sectoral

cap/statutory limit, the RBI places the company in the Ban List. Once a company is

placed on the Ban List, no FII or NRI can purchase the shares of the company under

the Portfolio Investment Scheme.

2.4.2 Eligibility for Registration as FII:

According to SEBI regulations, the following conditions have to be adhered to

for registration as FII.

i. An institution established or incorporated outside India as a pension fund, mutual

fund, investment trust, insurance company, or reinsurance company;

ii. An international or multilateral organization or an agency thereof, or a foreign

governmental agency, sovereign wealth fund, or a foreign central bank;

iii. An asset management company, investment manager or advisor, bank, or

institutional portfolio manager that is established or incorporated outside India and

proposes to make investments in India on behalf of broad-based funds and its

proprietary funds, if any;


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should establish separate accounts for detailing on a daily basis the investment

capital utilisation and securities held by each FII for which it is acting as

custodian. The custodian is supposed to report to the RBI and SEBI semi-annually

as part of its disclosure and reporting guidelines.

15. The RBI should make available to the designated bank branches a list of

companies where no investment will be allowed on the basis of the upper

prescribed ceiling of 30% having been reached under the portfolio investment

scheme.

16. Reserve Bank of India may at any time request by an order a registered FII to

submit information regarding the records of utilisation of the inward remittances

of investment capital and the statement of securities transactions. Reserve Bank of

India and/or SEBI may also at any time conduct a direct inspection of the records

and accounting books of a registered FII.

17. FIIs investing under this scheme will benefit from a concessional tax regime of a

flat rate tax of 20% on dividend and interest income and a tax rate of 10% on long

term (one year or more) capital gains.

2.4.5 General Obligations and Responsibilities of FIIs:

General Obligations and Responsibilities laid down by the FII Regulations

1995 are as follows:

1) Appointment of domestic custodians: A Foreign Institutional Investor or a global

custodian acting on behalf of the Foreign Institutional Investor, should enter into an

agreement with a domestic custodian to act as custodian of securities for the Foreign


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Institutional Investor. The Foreign Institutional Investor should ensure that the

domestic custodian takes steps for -

monitoring of investments of the Foreign Institutional Investor in India;

reporting to SEBI on a daily basis the transactions entered into by the

Foreign Institutional Investor;

preservation for five years of records relating to his activities as a Foreign

Institutional Investor; and

furnishing such information to SEBI as may be called for by SEBI with

regard to the activities of the Foreign Institutional Investor and as may be

relevant for the purpose of this regulation.

A Foreign Institutional Investor may appoint more than one domestic

custodian with prior approval of SEBI, but only one custodian may be appointed for a

single subaccount of a Foreign Institutional Investor.

2) Appointment of designated bank: A Foreign Institutional Investor should appoint

a branch of a bank approved by the Reserve Bank of India for opening of foreign

currency denominated accounts and special non-resident rupee accounts.

3) Investment advice in publicly accessible media: A foreign institutional investor

or any of his employees should not render directly or indirectly any investment advice

about any security in the publicly accessible media whether real-time or non real-

time, unless a disclosure of his interest including long or short position in the said

security has been made, while rendering such advice. In case of an employee of the

foreign institutional investor is rendering such advice, he should also disclose the

interest of his dependent family members and the employer including their long or

short position in the said security, while rendering such advice.


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4) Maintenance of proper books of accounts, records, etc: Every Foreign

Institutional Investor should keep or maintain, as the case may be, the following

books of accounts, records and documents, namely:

a) true and fair accounts relating to remittance of initial corpus for buying,

selling and realising capital gains of investment made from the corpus;

b) accounts of remittances to India for investments in India and realising capital

gains on investments made from such remittances;

c) bank statement of accounts

d) contract notes relating to purchase and sale of securities; and

e) communication from and to the domestic custodian regarding investments in

securities.

The FII is suppose to intimate SEBI in writing the place where such books,

records and documents will be kept or maintained.

5) Preservation of books of accounts, records, etc: Every Foreign Institutional

Investor should preserve the books of accounts, records and documents mentioned

above.

6) Appointment of compliance officer: Every FII should appoint a compliance

officer who would be responsible for monitoring the compliance of the Act, rules and

regulations, notifications, guidelines, instructions, etc, issued by the SEBI or the

central government. The compliance office officer has to immediately and

independently report to the SEBI any non-compliance observed by him.

7) Information to SEBI: Every Foreign Institutional Investor is required to submit to

SEBI or the Reserve Bank of India, as the case may be, any information, record or

documents in relation to his activities as a Foreign Institutional Investor as SEBI or as


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the Reserve Bank of India may require. Further, the FII should disclose information

concerning the terms of and parties to off-shore derivative instruments such as

Participatory notes, Equity Linked Notes or any other such instruments, by whatever

names they are called, entered into by it or its sub-accounts or affiliates relating to any

securities listed or proposed to be listed in any stock exchange in India as and when

and in such form as SEBI may require.

2.4.6 Code of Conduct for FIIs:

The codes of conduct given by SEBI are:

1. A FII and its key personnel are required to observe high standards of integrity,

fairness and professionalism in all dealings in the Indian Securities market

with intermediaries, regulatory and other Government authorities.

2. A FII should at all times render high standards of service, exercise due

diligence and independent professional judgement.

3. A FII should ensure and maintain confidentiality in respect of trades done on

its own behalf and/or on behalf of its sub-accounts/clients.

4. A FII should ensure the following:

a. clear segregation of its own money/securities and sub-accounts

money/securities.

b. arms length relationship between its business of fund

management/investment and its other business.

5. A FII should maintain an appropriate level of knowledge and competency and

abide by the provisions of the Act, regulations made there under and the

circular and guidelines, which may be applicable and relevant to the activities


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carried on by it. Every FII should also comply with the award of the

Ombudsman and decision of SEBI under SEBI (Ombudsman) Regulations

2003.

6. A FII should not make any untrue statement or suppress any material fact in

any documents, reports or information furnished to SEBI.

7. A FII should ensure that good corporate policies and corporate governance are

observed by it.

8. A FII should ensure that it does not engage in fraudulent and manipulative

transactions in the securities listed in any stock exchange in India.

9. A FII or any of its directors or managers should not either through its/his own

account or through any associate or family members, relatives or friends

indulge in any insider trading.

10. A FII should not be a party to or instrumental for –

a) creation of false market in securities listed or proposed to be listed in

any stock exchange in India;

b) price rigging or manipulation of prices of securities listed or proposed

to be listed in any stock exchange in India;

c) passing of price sensitive information to any person or intermediary in

the securities market.

2.4.7 Prohibitions on Investments:

FIIs are not permitted to invest in equity issued by an Asset Reconstruction

Company. FIIs are also not allowed to invest in any company which is engaged or

proposes to engage in the following activities:


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1) Business of chit fund or

2) Nidhi Company or

3) Agricultural or plantation activities or

4) 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).

5) Trading in Transferable Development Rights (TDRs)

2.4.8 FII POLICY - TIMELINE OF DEVELOPMENTS

The historical evolution of the FII policy is summarized in the Table2.4.1. The

objective of these policy changes was to increase the participation by FIIs, to allow

operational flexibility, and also to give access to domestic asset management

capability.

Table 2.4.1: Timeline of FII Policy Developments

Year Policy changes

1992 FIIs are allowed to invest by the government guidelines in all securities in

primary and secondary markets as well as in schemes floated by mutual

funds. Single FIIs to invest 5 percent and all FIIs are allowed to invest 24

percent of a company’s issued capital. Broad-based funds shall have 50

investors with no one holding more than 5 percent.

1997

The aggregated limit for all FIIs increased to 30 percent, subject to

special procedure and resolution.

1998 FIIs permitted to invest in dated government securities subject to a ceiling

of US $ 1 billion. The aggregate portfolio investment limit of FIIs was


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enhanced from 5 percent to 10 percent, and the ceilings made mutually

exclusive.

2000 Foreign firms and high net worth individuals permitted to invest as sub-

accounts of FIIs. Domestic portfolio manager were allowed to be

registered as FIIs to manage the funds of subaccounts.

2001 FII ceiling under special procedure was enhanced to 49 percent to

increase FII participation. FII ceiling under special procedure was also

raised in sectoral cap.

2003 The FII dual approval process of the SEBI and the RBI changed to a

single approval process of the SEBI to streamline the registration process.

2006 FII investment up to 23% permitted in market infrastructure institutions

in the securities markets, such as stock exchanges, depositories, and

clearing corporations.

2007 FIIs were allowed to invest US $ 3.2 billion in government securities.

2008 Government increased the cumulative debt investment limits from US $ 3

billion to US $ 6 billion for FII investments in corporate debt. The

restriction of investment at a ratio of 70:30 in equity and debt was

removed. The restrictions on Overseas Derivatives Instruments (ODIs)

were removed.

2009

FIIs lending shares abroad was disapproved and E-bids platform for FIIs

were introduced. FIIs are allowed to participate in interest rate futures.

2010 FIIs are allowed to offer domestic government securities and foreign

sovereign securities with AAA rating as collateral (in addition to cash) to

recognized stock exchanges in India for their transactions in the cash


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segment of the market. The Investment caps for FIIs were increased by

US $ 5 billion each in government securities and corporate bonds to US $

10 billion.

2011 The limit of US $ 5 billion in corporate bonds issued by companies in the

infrastructure sector with a residual maturity of over five years increased

by an additional limit of US $ 20 billion, taking the total limit to US $ 25

billion.

2.4.9 Mauritius Route of Foreign Investment

Double Taxation Avoidance Agreement (DTAA) with Mauritius was signed

by India in August 1982. The treaty specified that capital gains made on the sale of

shares of Indian companies by investors resident in Mauritius would be taxed only in

Mauritius and not in India. In 1992, Mauritius passed the Offshore Business Activities

Act which allowed foreign companies to register in the island nation for investing

abroad. As a result, the benefits are quick incorporation of a company in Mauritius,

total exemption from capital- gains tax, total business secrecy and a completely

convertible currency. The DTAA has helped Mauritius in the development of its

Financial Services sector; India has on the other hand benefitted in terms of foreign

investments. Many Indian and foreign-based companies have set up subsidiaries in

Mauritius only to avail themselves of tax exemptions. Some of its salient features are:

Capital gains earned by the Fund (organized in Mauritius) registered as a sub-

account of an FII from its investments in Indian Companies would be tax

exempt subject to the condition that it does not have a permanent

establishment in India.


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Interest income earned by the Fund (organized in Mauritius) registered as a

subaccount of an FII from India from debt (whether listed or unlisted) incurred

in foreign currency would be taxed at the rate of 20%.


subaccount of an FII from all investments in listed debt securities of Indian

Companies (whether or not incurred in foreign currency) would be taxed at the

rate of 20%.


subaccount of an FII other than that mentioned above would be taxed at the

rate of 35% under the India-Mauritius tax treaty.

Dividends earned by the Fund would not be subject to any withholding tax in

India.

2.4.10 Tax Provisions for FIIs

According to Income-tax Act, 1961; tax provisions for FIIs are summarised as

follows:

a. Interest earned by an entity (registered as an FII or sub-account of a registered

FII) from India from its investments in listed debt securities of Indian

Companies (whether or not incurred in foreign currency) will be taxed at the

rate of 20% under section 115AD of the Income-tax Act, 1961 (the “ITA”).

b. Interest income of an entity (registered as an FII or sub-account of a registered

FII) from debt (whether listed or unlisted) incurred in foreign currency would

be taxed at the rate of 20% under section 115A of the ITA.


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c. Other interest income earned by an entity (registered as an FII or sub-account

of a registered FII) from unlisted debt not incurred in foreign currency would

be taxed at the rate of 48%.

d. Long-term capital gains earned by an entity (registered as an FII or sub-

account of a registered FII) from sale of listed debt securities of Indian

Companies would be taxed at the rate of 10% and short-term capital gains

would be taxed at 30% in terms of section 115AD of the ITA.

e. Long-term capital gains earned by an entity (registered as an FII or sub-

account of a registered FII) from sale of unlisted securities of Indian

Companies would be taxed at the rate of 20% and short-term capital gains

would be taxed at 48% under the ITA.

f. Dividends earned by an entity (registered as an FII or sub-account of a

registered FII) would not be subject to any withholding tax in India.

2.5 TRENDS IN FOREIGN INVESTMENT IN INDIA

The measures introduced by the government to liberalize provisions relating to

foreign investments in 1991 lured investors from every corner of the world. As a

result foreign investment inflows to India has increased manifold as the foreign direct

investment (FDI) and foreign institutional investment (FII). The data in the given

Table2.5.1 provides the trend foreign investment flows into India classified as Foreign

Direct Investment (FDI) and Portfolio Investments (FII). Foreign direct

investment (FDI) refers to the net inflows of investment to acquire a lasting

management interest (10 percent or more of voting stock) in an enterprise operating in

an economy other than that of the investor. Foreign Institutional Investment (FII)


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refers to outside companies investing in the financial markets of India. International

institutional investors must register with the Securities and Exchange Board of India

to participate in the Indian markets.

Table: 2.5.1Trend of Foreign Investments in India

Year A. Direct

investment B. Portfolio investment Total Investment (A+B)

Rs. Crore Rs. Crore Rs. Crore 1990-91 174 11 185

1991-92 316 10 326

1992-93 965 748 1,713

1993-94 1,838 11,188 13,026

1994-95 4,126 12,007 16,133

1995-96 7,172 9,192 16,364

1996-97 10,015 11,758 21,773

1997-98 13,220 6,794 20,014

1998-99 10,358 -257 10,101

1999-00 9,338 13,112 22,450

2000-01 18,406 12,609 31,015

2001-02 29,235 9,639 38,874

2002-03 24,367 4,738 29,105

2003-04 19,860 52,279 72,139

2004-05 27,188 41,854 69,042

2005-06 39,674 55,307 94,981

2006-07 103,367 31,713 135,080

2007-08 140,180 109,741 249,921

2008-09 173,741 -63,618 110,123

2009-10 179,059 153,516 332,575

2010-11 138,462 143,435 281,897

Source: SEBI


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The distinction between FDI and FII is that FDI have lasting interest in

management of the firm while FII are “fair weather friends” who are concerned about

safety of their investment. The Table 2.5.1 reveals the investments made in FDI and

FII ever since 1990-91 in India. It can be noticed that FDI has shown a steady growth

of Rs.174 crores in 1990-91 to Rs. 179,059 crores 2009-2010. There has been sharp

increase of FDI in the year 2006-07 from Rs. 103,367 crores from the previous year

of Rs. 39,674crores. In contrast portfolio investments indicate periods of up trends

and down trends since 1990-91. There have been more capital outflows than inflows

during the years 1998-99 and 2008-2009 as far as portfolio investments are

concerned.

2.5.1 Registered FIIs in India:

The Table2.5.2 highlights the number of FIIs registered in India since

initiation of foreign investments in India. With liberalisation of Indian economy, there

has been a steady increase in registration of FIIs in India from 1993. The number of

registered FIIs in 1995 was 156 which has rose to 1765 in 2011. Some prominent FIIs

registered in India are: California Public Employees’ Retirement System (CalPERS),

United Nations for and on behalf of the United Nations Joint Staff Pension Fund,

Public School Retirement System of Missouri, Commonwealth of Massachusetts

Pension Reserves Investment Trust, Treasurer of the State North Carolina Equity

Investment Fund Pooled Trust, the Growth Fund of America, and AIM Funds

Management Inc (Department of Economic Affairs, Ministry of Finance).


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Table: 2.5.2 Number of Registered FIIs

Financial Year Number of FIIs registered with SEBI

1993 0

1994 3

1995 156

1996 353

1997 439

1998 496

1999 450

2000 506

2001 527

2002 490

2003 502

2004 540

2005 685

2006 882

2007 997

2008 1319

2009 1635

2010 1722

2011 1765

Source: NSE


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Registered FIIs in India have various countries of origin. 42% of FIIs are from

US, followed by UK (20%) and Europe (17%) as indicated in Chart2.5.1. The

diversity of FIIs has been increasing with the number of registered FIIs in India

steadily rising over the years.

Chart: 2.5.1 Sources of FIIs in India

Source: SEBI

The Chart2.5.2 shows a constant growth of registered FIIs in India irrespective

of the stock market performance in India. It also shows that net investment made by

FIIs have not proportionately increased as the number of registered FIIs.


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Chart: 2.5.2 Number of FIIs and Net Foreign Institutional Investment

Source: NSE

2.5.2 Sensex movements and FII

According to information given by SEBI, the net investment made by FIIs was

highest in the year 2010-2011. A negative trend was noticed in the year 1999 and

2009 due to East-Asian crisis and Global financial crisis respectively. According to

financial press, FIIs are facing a cash crunch in their home markets and shrinking

profit margins of Indian investments attributes to decline in amount of net investments

made by FIIs.

Chart: 2.5.3 FII and Sensex Behaviour

Source: SEBI


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Since the beginning of liberalisation, FII flows to India have steadily grown in

volume and importance. Over the same time, Sensex, the benchmark index measuring

the stock market performance, has also shown remarkable growth. India, with the

world’s second highest growth rate, has been an attractive market for foreign

investors. Since 2001, FIIs have invested huge money into the Indian equity market

which is one of the major reasons for the significant jump in Sensex over the last

decade. Despite the economic slowdown, FIIs have continued to pump in money in

India. DIIs too have been investing in the Indian stock market; however, the level of

investments and their investment strategy differs from FIIs, as shown in chart 2.5.4.

Chart: 2.5.4 Institutional Investments and Sensex

Source: BSE

2.5.3 Composition of Foreign Institutional Investment in India

Foreign Institutional Investments in Indian stock market may take the form of

equity or debt. The amount invested by FIIs is more in equity compared to debt


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investments and hence total investments of FIIs are depends heavily upon equity

investments. Table 2.5.3 depicts that FIIs have been investing in equity instruments

since 1993 but started investing in the debt instruments only from 1997.

Table: 2.5.3 Investments by FIIs in Equity and Debt

Financial Year Net investment by FIIs(Rs crore)

Equity Debt Total

1993 13 0 13

1994 5,127 0 5,127

1995 4,796 0 4,796

1996 6,942 0 6,942

1997 8,546 29 8,575

1998 5,267 691 5,958

1999 -717 -867 -1,584

2000 9,670 453 10,122

2001 10,207 -273 9,933

2002 8,072 690 8,763

2003 2,527 162 2,689

2004 39,960 5,805 45,765

2005 44,123 1,759 45,881

2006 48,801 -7,334 41,467

2007 25,236 5,605 30,840

2008 53,404 12,775 66,179

2009 -47,706 1,895 -45,811

2010 1,10,221 32,438 1,42,658

2011 1,10,121 36,317 1,46,438

2012 43,738 49,988 93,726

2013 1,40,033 28,334 1,68,367

Total 6,28,377 1,68,467 7,96,844

Source: SEBI


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In terms of net cumulative investments by FIIs, US-based FIIs dominate with

45 percent of the net cumulative FII investments in India, followed by UK at 18 per

cent. Chart2.5.5. Also a significant number belonged to Europe and Japan FIIs that

registered with SEBI in recent years. These developments have helped improving the

diversity of the set of FIIs operating in India (Department of Economic Affairs,

Ministry of Finance).

Chart: 2.5.5 Country Wise Share of Net FII in India

Source: SEBI

Table 2.5.4 indicates FII turnover in the Indian stock markets from the year

2001 to the year 2012. Purchases by FIIs have been more than the sales through the

study period except in the 2009.


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Table: 2.5.4 Trends in FII turnover

Year Gross Purchases (INR crore)

Gross sales (INR crore)

Net Investment (INR crore)

2001 74051 64118 9933

2002 50071 41308 8763

2003 47062 44372 2689

2004 144855 99091 45764

2005 216951 171071 45880

2006 346976 305509 41467

2007 520506 489665 30841

2008 948018 881839 66179

2009 614576 660386 -45811

2010 846433 703776 142658

2011 992596 846158 146438

2012 921285 827562 93725

Source: SEBI

2.5.4 FII Ownership in NSE-Listed Companies

The FII ownership of shares in the various sectors of NSE-listed companies is

depicted in Table 2.5.5. FIIs held the highest stake of 18.41 % in the Banking sector

followed by Finance and Media & Entertainment of 18.18 % and 15.20 %

respectively. At the end of March 2013, FIIs held the highest stake of 16.9 percent in

the banking sector, followed by FMCG and finance (9.2 percent and 8.8 percent,

respectively). The total percentage of shares held by FIIs across different sectors was

6 percent of the total shares of the companies listed on the NSE as at the end of March

2013 which has decreased from 10.78 percent at the end of March 2007.


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Table 2.5.5 : Sectoral Composition of FII in NSE

Sectors

Percentage Share of Foreign institutional Investors at the end of

Mar-07 Mar-08 Mar-09 Mar-10

Mar-11

Mar-12

Mar-13

Banks 18.41 19.15 14.27 16.02 17.62 15.9 16.9

Engineering 11.45 10.63 7.34 8.28 9.36 5.1 4.6

Finance 18.18 17.44 13.01 16.53 23.35 8.4 8.8

FMCG 11.91 14.07 12.72 14.09 16.34 9.4 9.2

Information Technology 14.53 16 12.44 11.68 21.16 7.3 7.2

Infrastructure 7.15 8.86 7.31 8.9 7.87 5.9 6.3

Manufacturing 9.57 9.46 7.28 8.79 9.41 4.8 4.6

Media & Entertainment 15.2 11.7 11.42 7.06 10.97 5.8 6.1

Petrochemicals 5.85 14.73 4.77 6.08 6.52 4.5 5.1

Pharmaceuticals 11.17 10.69 7.88 8.78 10.19 6.2 6.8

Services 13.09 10.7 8.39 8.05 7.41 5.4 5.2

Telecommunication 11.17 9.12 6.85 8.64 8.44 5.7 5.6

Miscellaneous 8.9 9.3 8.39 8.1 13.65 6.1 5.8

Total stake of FIIs in all the Sectors 10.78 10.62 8.4 9.58 10.32 6 6

Source : NSE


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2.6 DEVELOPED VS EMERGING MARKETS – INVESTMENT

PERSPECTIVE

The term “emerging economies” was coined in the early 1980s. Its members

were typically the fast growing economies with low to medium per-capita income

levels that have sustained tremendous economic development in long term,

implemented significant structural reforms, and have “emerged‟ as significant players

in the global economy. Another term known as “Emerging Markets” emerged to

signify a potential market for the future. According to Sharpe (2005), in general, these

countries have in common a relatively low (compared with Western countries) level

of per capita gross domestic product (GDP), improving political and economic

stability, a currency convertible into Western countries’ currencies and most

important, securities available for investment by foreigners. Investing in emerging

stock markets have proven attractive to a number of foreign individual and

institutional investors who in many cases have invested directly in those securities or

when that is not possible, through countries funds. Because their stock markets are not

highly developed and therefore are less efficient, there are considerable opportunities

for relatively high returns from emerging market investment. Also there is a relatively

high level of risk involved as witnessed by the meltdown of several Asian emerging

stock markets in 1997, 1998, 2007 and 2008 according to Sharpe (2005). Domestic

debt levels in these markets are low coupled with higher savings rate as shown in

Chart2.6.1 provides a platform for credit growth which in turn will boast domestic

spending thus driving demand leading to economic expansion in emerging economies.


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Chart 2.6.1: Saving Rate Projections for DM and EM

Source: World Bank

2.6.1 Comparison of Emerging vs. Developed Markets Risk

Typically risks associated with emerging equity markets are higher than that

of developed markets. Also, Betas of EMs are higher than developed markets which

means that EMs are more volatile. The Chart2.6.2 indicates the 3-year rolling

volatility of emerging market and developed market equities. Emerging equity

volatility has been consistently higher.

Chart 2.6.2: Comparing 3-year rolling volatility between DM and EM

Source: MSCI Barra


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2.6.2 Return on Equity (RoE)

Emerging markets offer better RoE as compared to developed markets as

shown in Chart2.6.3.In future also emerging markets are poised at an advantage due

to structural reforms in various sectors, increase in FDI limit, ease of labour and

capital, better transport infrastructure.

Chart 2.6.3: Comparing RoE between DM and EM

Source: MSCI

2.6.3 Price to earnings ratio (P/E)

Since early 2000s, Emerging markets are trading at a discount relative to

developed markets and their own long term average which means that they are

relative cheap as compared to investing in developed markets. The roles of the

emerging economies have now become a key consideration for all investors it

contributes to more than 50% of the global corporate growth as depicted in Chart

2.6.4. Over a long period of time both the markets will converge.


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Chart 2.6.4: Comparing Price to earnings ratio between DM and EM

Source: MSCI

2.6.4 Market capitalization to GDP ratio

Economic development is reflected in the proportion of the economy that is

reflected in the stock market. This dimension is reflected by the ratio of country

market capitalization to GDP. As shown in Chart2.6.5, advanced financial markets

tend to have market capitalization/GDP ratios that are closer to 100%. In contrast,

stock markets in China, India, and Russia capture only a small portion of the

economy. Emerging market companies make of up 26% of global equity market cap

while emerging markets represent 36% of global GDP indicating a lot of gap still

exists between GDP and equity market capitalization.


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Chart 2.6.5: Comparing Market capitalization to GDP ratio of select countries

Source: IMF and MSCI

2.6.5 Sharpe Ratio

Though Emerging markets have been an excellent long-term buy and hold

investment, they have not always compensated for their higher risk. The Sharpe ratio

of the investment is fairly volatile and prone to extreme swings as shown in

Chart2.6.6. Since 2002, the risk-adjusted return of investing in emerging markets has

been consistently higher.


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Chart 2.6.6: Comparing Sharpe Ratio between DM and EM

Source: MSCI

The statistics compared between developed markets and emerging markets are

in support of the fact that the emerging markets are going to reshape a new world

order in the future. The emergence of the emerging markets as the favoured place for

investor’s post the global and the EU crises offering better equity risk premium has

been established however there are still many issues which cast shadow on the

sustainability of these markets as a dream destination. The central bank’s and the

policymakers in the emerging markets face real challenge in protecting their

economies from reversal of capital flows, the FIIs which are very high due to the high

interest rate differentials. High proportion of capital inflows in equity markets expose

these markets to global shocks in the world market and could magnify domestic

policy conundrums.

2.6.6 Investments in BRIC Countries

The Private Equity (PE) investments gained momentum in the late nineties

with the growth of Indian IT companies and with the simultaneous global dot-com

boom. Following the global IT boom, the Indian IT sector was viewed as a prominent


54

funding opportunity, and consequently, saw a lot of venture capital coming into the

country.

The Table2.6.1 indicates the PE investments of BRIC countries from 2001 to

2011. India and China were found to attract maximum investments. According to a

report by Emerging Markets Private Equity Association (EMPEA) there has been a

decline in the investment to BRIC countries in 2009. Among BRIC countries there is

strong competition between China and India for foreign equity investments. It can be

noticed from the Table2.6 that amount of investments in China and India is very high

compared to Brazil and Russia. All BRIC countries faced a downtrend in investments

during the year 2009.

Table: 2.6.1: Private Equity Investments in BRIC Countries

Year Brazil in US $ mn Russia in US $ mn India in US $ mn China in US $ mn

2001 281 77 320 1575

2002 261 127 40 126

2003 321 113 456 1667

2004 120 240 1272 1389

2005 474 240 1377 2991

2006 1342 402 5687 8200

2007 5285 805 9905 9458

2008 3020 2647 7483 8994

2009 989 217 4011 6288

2010 4604 1516 6222 9190

2011 2461 1579 6172 10529

Source: NSE


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2.6.7 Geographical breakdown of FPIs in India

According to IMF statistics, equity investments form a major chunk of the

Foreign Portfolio Investments in India. Table 2.6.2 indicates USA and Mauritius are

found to be the largest investors in the Indian markets. Many European and Asian

countries have also found to be significant in FPI in India.

Table 2.6.2: Foreign Portfolio Investments in India as on December 2012

Source: IMF

USA is the largest investor in India upto the year 2012 with 75,686 US$

million in equity followed by Mauritius with 72, 831 US$ million. Total investments

made by all countries in India was 3, 13,253 US$ million with 2, 49,737 US$ million

in equity instruments.

Country Equity investments (US$ million) FPI (US$ million)

Australia 2,901 3,115 Canada 4,560 4,657 Denmark 1,542 1,579 France 4,266 4,650 Ireland 3,673 4,084 Japan 3,813 5,195 Korea 1,902 2,025 Luxembourg 28,694 31,180 Mauritius 72,831 78,228 Netherland 5,424 5,841 Norway 2,935 4,260 Singapore 17,875 47,822 Spain 2,743 2,755 Switzerland 1,066 1,944 UK 13,834 22,024 USA 75,686 78,846 Others 5,992 15,050

Total 2,49,737 3,13,253


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2.7 SELECTED VARIABLES FOR THE STUDY

This study includes data on FIIs as dependent variable and select stock indices

and selected macroeconomic variables as independent variables for the study. Data on

purchases, sales and net investments made by FII is considered as explained variable.

Monthly data on select stock indices and selected macroeconomic variables is taken

as explanatory variables for the study.

2.7.1 Selected Stock Indices

NSE and BSE indices are broad-market indices, consisting of the large, liquid

stocks listed on the Exchange are mainly in the study. They serve as a benchmark for

measuring the performance of the stocks or portfolios.

S&P CNX Nifty

The CNX Nifty is a well diversified 50 stock index accounting for 22 sectors

of the economy. It is used for a variety of purposes such as benchmarking fund

portfolios, index based derivatives and index funds. The CNX Nifty Index represents

about 70.14% of the free float market capitalization of the stocks listed on NSE as

on March 31, 2014.

S&P CNX 100

CNX 100 is a diversified 100 stock index accounting for 38 sectors of the

economy. The CNX 100 Index represents about 81.57% of the free float market

capitalization of the stocks listed on NSE as on March 31, 2014. The total traded

value for the last six months ending March 2014 of all index constituents is

approximately 72.53% of the traded value of all stocks on the NSE.


57

S&P CNX 500

The CNX 500 is India’s first broad based benchmark of the Indian capital

market. The CNX 500 Index represents about 97.00% of the free float market

capitalization of the stocks listed on NSE as on March 31, 2014. The total traded

value for the last six months ending March 2014, of all Index constituents is

approximately 97.08% of the traded value of all stocks on NSE. The CNX 500

companies are disaggregated into72 industry indices viz. CNX Industry Indices.

Industry weightages in the index reflect the industry weightages in the market. For

e.g. if the banking sector has a 5% weightage in the universe of stocks traded on NSE,

banking stocks in the index would also have an approx. representation of 5% in the

index.

BSE SENSEX

S&P BSE SENSEX, first compiled in 1986, was calculated on a "Market

Capitalization-Weighted" methodology of 30 component stocks representing large,

well-established and financially sound companies across key sectors. It is considered

as- The Barometer of Indian Capital Markets. The base year of S&P BSE

SENSEX was taken as 1978-79. S&P BSE SENSEX today is widely reported in both

domestic and international markets through print as well as electronic media. It is

scientifically designed and is based on globally accepted construction and review

methodology. Since September 1, 2003, S&P BSE SENSEX is being calculated on a

free-float market capitalization methodology. The "free-float market capitalization-

weighted" methodology is a widely followed index construction methodology on

which majority of global equity indices are based; all major index providers like

MSCI, FTSE, STOXX, and Dow Jones use the free-float methodology.


58

BSE 100 Index

S&P BSE 100 Index is a broad based Index. This Index has 1983-84 as the

base year and was launched in 1989. In line with the shift of the S&P BSE Indices to

the globally accepted Free-Float methodology, S&P BSE 100 was shifted to Free-

Float methodology effective from April 5, 2004. The method of computation of Free-

Float index and determination of free-float factors is similar to the methodology for

S&P BSE SENSEX

BSE 500 Index

S&P BSE-500, consisting of 500 scrips is calculated from August 9, 1999.

The changing pattern of the economy and that of the market were kept in mind while

constructing this index. S&P BSE 500 index represents nearly 93% of the total market

capitalization on BSE. S&P BSE 500 covers all 20 major industries of the economy.

In line with other S&P BSE indices, effective August 16, 2005 calculation

methodology was shifted to the free-float methodology.

Sectoral Indices

Sector-based index are designed to provide a single value for the aggregate

performance of a number of companies representing a group of related industries or

within a sector of the economy. Select NSE and BSE sectoral indices are used in the

study

2.7.2 Selected Macroeconomic Variables

Call Money Rate (CMR)

Call money refers to short term finance repayable on demand, with maturity

period of one day to fifteen days, used for inter bank transactions. Commercial banks


59

have to maintain a minimum cash balance known as cash reserve ratio. The Reserve

Bank of India changes the cash ratio from time to time which in turn affects the

amount of funds available to be given as loans by commercial banks. Call money is a

method by which banks lend from each other to be able to maintain the cash reserve

ratio. The interest rate paid on call money is known as call rate. Portfolio flows to

developing countries are extremely sensitive to interest differentials. Money tends to

flow to countries with high interest rates because of the differences between the

current interest rates in international markets. If the interest rate is high, FII invest to

get capital gains high growth rate.

Exchange Rate(ER)

The next macroeconomic variable used in this study has been the exchange

rate or forex rate. It is regarded as the value of one country’s currency in terms of

another currency.US Dollar ($) has been taken to be the foreign currency against

which the Indian Rupee exchange rate is considered. Sudden and unexpected changes

in exchange rates affect international investors’ returns in their own currencies. If the

risk of such changes in the exchange rate is high, foreign investors would expect a

similarly high rate of return to reward them for the additional risk emanating from

changes in the exchange rate. This, in turn, reduces the number of investment

opportunities offering high enough rates of return. For this reason, sharply fluctuating

exchange rates, or sudden revaluations or devaluations in fixed exchange rates, pose

an obstacle to foreign investment.

Foreign-Exchange Reserves (FER)

Foreign-exchange reserves or forex reserves are assets held by central banks

and monetary authorities, usually in different reserve currencies, used to back its


60

liabilities. Holding the currencies of other countries as assets allow governments to

keep their currencies stable and reduce the effect of economic shocks. When there is a

deficit BOP condition, FIIs avoid investing in those countries.

Index of Industrial Production (IIP)

Industrial Production Index is used as proxy to measure the growth rate in real

sector. Industrial production presents a measure of overall economic activity in the

economy and it is a key economic indicator that measures real output from the

manufacturing, mining, and utilities industries. An increase in industrial production

index is positively related to stock price and Portfolio investments are expected to

decline in low return period of stock markets. However, portfolio investments are

expected to increase in high return period of stock markets.

Wholesale Price Index (WPI)

Wholesale Price Index represents the price of goods at a wholesale stage i.e.

goods that are sold in bulk and traded between organizations instead of consumers.

WPI is used as a measure of inflation in India. Adequate money supply and stable

inflation rate attract FII

MSCI Emerging Market Index (MSCI_EM)

Morgan Stanley Capital International Index (MSCI) is used as to proxy the

effects of the state of the global equity markets. MSCI indexes are widely used as the

benchmark indexes by which the performances of global equity portfolios are

measured. The MSCI Emerging Markets Index is a free float-adjusted market

capitalization index that is designed to measure equity market performance in the

global emerging markets launched in 1988. Since then, emerging markets have

become an important and integrated part of a global equity portfolio allocation. The


61

MSCI Emerging Markets Index covers over 800 securities across 23 markets and

represents approximately 13% of world market cap.

REFERENCES

Sharpe, William F., Gordon J. Alexander and Jeffery V. Bailey (2003), Investments,

6 ed., Prentice Hall of India Private Limited, New Delhi.

Bhole, L.M.(2004), Financial Institution and Markets: Structure, Growth and

Innovations, Tata McGraw Hill Publishing Company Limited, New Delhi.

Khan, M.Y. (2004), ‘Indian Financial System’, Tata McGraw Hill Publishing

Company Limited, New Delhi, 2004.

Salomons, Roelof and Grootveld, Henk, The Equity Risk Premium: Emerging versus

Developed Markets (August 7, 2002).

NSE: Indian Securities Market: A Review, Volume IV, 2001, National Stock

Exchange, Mumbai.

RBI: Handbook of Statistics on Indian Economy, Reserve Bank of India, Mumbai,

various issues.

SEBI: Annual Report, Various Issues, Securities and Exchange Board of India,

Mumbai.

SEBI: SEBI BULLETIN, Various Issues, Securities and Exchange Board of India,

Mumbai.

http://www.world-exchanges.org/statistics/monthly-reports

http://www.msci.com/products/indices/size/standard/index_review.html

http://www.world- exchanges.org/files/statistics

www.imf.org

www.msci.org

www.sebi.in

www.nse.com

http://epfr.com/


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