FDI and FII Impact on Economy

A

Project report

On

FDI & FII IMPACT ON INDIAN ECONOMY

In partial fulfillment of the requirements of

the Summer Internship of

Master of Management studies

Through

Rizvi Institute of Management Studies & Research

Under the guidance of

Prof. Furquan shaikh

Submitted by

Salman Khan

MMS

Batch: 2011 – 2013.

Rizvi Institute of Management Studies & Research Khan Mohd Salman

CERTIFICATE

This is to certify that Mr. Salman Khan, a student a Rizvi Institute of Management

studies and research, of MMS III bearing Roll No. 87 and specializing in Finance has

successfully completed the project titled

FDI & FII IMPACT ON INDIAN ECONOMY

Under the guidance of Prof. Furquan shaikh in partial fulfillment of the requirement

of Master of Management studies by Rizvi Institute of Management studies and

research for the academic year 2011 – 2013.

_______________

Prof. Furquaan shaikh

Project Guide

________________ _________________

_____________

Prof Umar Farooq Dr Kalim Khan

Academic Coordinator Director


EXECUTIVE SUMMARY

Foreign Direct Investment (FDI) flows are usually preferred over other forms

of external finance because they are non-debt creating, non-volatile and their returns

depend on the performance of the projects financed by the investors. FDI also

facilitates international trade and transfer of knowledge, skills and technology. In a

world of increased competition and rapid technological change, their complimentary

and catalytic role can be very valuable.

Over the years, FDI inflow in the country is increasing. However, India has

tremendous potential for absorbing greater flow of FDI in the coming years. Serious

efforts are being made to attract greater inflow of FDI in the country by taking

several actions both on policy and implementation front. An essential requirement of

the foreign investing community in making their investment decision is availability of

timely and reliable information about the policies and procedures governing FDI in

India.

Foreign direct investment (FDI) in India has played an important role in the

development of the Indian economy. FDI in India has - in a lot of ways - enabled

India to achieve a certain degree of financial stability, growth and development. This

money has allowed India to focus on the areas that may have needed economic

Attention, and address the various problems that continue to challenge the country.

India has continually sought to attract FDI from the world’s major investors. In 1998

and 1999, the Indian national government announced a number of reforms designed to

encourage FDI and present a favorable scenario for investors. FDI investments are

permitted through financial collaborations, through private equity or preferential

allotments, by way of capital markets through Euro issues, and in joint ventures.


TABLE OF CONTENTS

Serial No. TITLE Page No.

1. Chapter – I : Introduction 1

1.1 Foreword 2-3

1.2 Research Problem 4

1.3 Literature Review 5-6

1.4 Research Methodology 7

1.5 Limitations 8

2. Chapter – II : FDI An Overview 9

2.1 Foreign Direct Investment-Introduction 10-11

2.2 A short history 11-12

2.3 The B.O.P. Crisis 13

2.4 Begining of a new Era 13-14

2.5 Types of F.D.I. 14-17

2.6 Advantages of F.D.I. 17-18

2.7 Disadvantages of F.D.I. 18-20

2.8 Determinants of F.D.I. 20-21

2.9 Global and regional F.D.I. Trends 22

2.10 F.D.I. flow by Region (2009-2011) 23

2.11 F.D.I according to type of Investment 24

2.12 T.N.C’s top prospective host Economies 25-26

2.13 F.D.I. Approval route 26-27

2.14 Sector specific conditions 27-29

2.15 F.D.I. in India in last 10 years 30


Serial No. TITLE Page No.

2.16 Sector’s attracting highest F.D.I. 31-38

2.17 Countrywise inflow of F.D.I 39-41

2.18 Top 10 F.D.I. Equity inflow cases 42

3. Chapter – III : Foreign Institutional Investment 43

3.1 Background and history of FII 44-45

3.2 Market design for FII in India 45-48

3.3 Reason’s for strong inflow of FII 48

3.4 Role of FII 48

3.5 Registration process and other conditions for FII 49-50

3.6 Investment conditions and restrictions for FII 50-51

3.6 Trends of FII 51-52

3.7 Net FII investment over years 52-53

3.8 Divergent views on FII 53-54

3.9 FII inflow and Sensex 54-56

3.10 FII inflow and Exchange rates 56-59

3.11 Co-relation between FII and Sensex 60

3.12 Co-relation between FII and Banking Index 60

3.13 Co-relation between FII and Capital goods 61

3.14 Co-relation between FII and Power Index 61

3.15 Issues concerning FII’s in India 62-67

4 Chapter – IV : Conclusion 68-69

4.1 Bibliography 70


CHAPTER – I

INTRODUCTION

FDI & FII Impact on Indian Economy 1


FOREWORD

The Government of India has recognized the key role of the foreign direct investment

(FDI) and foreign institutional investment (FII) in its process of economic

development, not only as an addition to its own domestic capital but also as an

important source of technology and other global trade practices. In order to attract the

required amount of FDI and FII, it has bought about a number of changes in its

economic policies and has put in its practice a liberal and more transparent FDI and

FII policy with a view to attract more foreign direct institutional investment inflows

into its economy. These changes have heralded the liberalization era of the foreign

investment policy regime into India and have brought about a structural breakthrough

in the volume of FDI and FII inflows in the economy.

Growth of Indian economy is playing hide and seek with the double digit growth

(Gross Domestic Product) mark. The latter is a key index, which the foreign investors

check before committing large sums of money for investment. Of its own, the Indian

economy will find it difficult to reach this target, except for an occasional burst of

activity; like the one in 2003. To sustain it, outside help is needed and domestic house

is to be placed under strict discipline.

Democracy is a great buzzword, if it translates into order and political stability. Labor

unrest, political opportunism and corporate irregularities are a few issues, which

tarnish democracy and discourage outside investors. But the current government in

both its terms has opened up the economy to welcome foreign investment to keep up

with the strong domestic demand for quality goods and services. This has attracted

unprecedented amount of foreign investment in the last decade, but of the two forms

of foreign investment – foreign portfolio investment (FPI) and foreign direct

investment (FDI), the former has reached our shores much more than the latter.

As FPI essentially interacts with the real economy via the stock market, the effect of

stock market on the country’s economic development will also be examined. Research

shows that the perceived benefits of foreign portfolio investment have not been

realized in India. It can be seen that the mainstream argument that the entry of foreign

portfolio investors will boost a country's stock market and consequently the economy,

does not seem be working in India.



The influx of FIIs has indeed influenced the secondary market segment of the Indian

stock market. But the supposed linkage effects with the real economy have not

worked in the way the mainstream model predicts. Instead there has been an increased

uncertainty and skepticism about the stock market in this country. On the other hand,

the surge in foreign portfolio investment in the Indian economy has introduced some

serious problems of macroeconomic management for the policymakers like inflation,

currency appreciation etc.

On the other hand FDI is what the government really needs to attract in various

sectors like infrastructure, education etc. it is much more stable than the foreign

institutional investment which comes via the stock market route, and has more

accountability and brings fundamental and tangible benefits to the economy.

The dependence on FPI is pushing many developing countries, including India,

towards a more stock market oriented financial system. This makes it imperative to

evaluate the relative merits and demerits of a stock market based financial system in a

developing country as compared to the Chinese model where conditions are

conducive to foreign investment in the real sector. The global recession in 2008

proved how volatile the money pumped in by the FIIs into the secondary segment of

the financial market is, leading to huge losses for the domestic investors who had to

bear the brunt even though the economy as such was insulated from the adverse

effects of the recession. Whereas the sectors where there was FDI didn’t experience

such knee-jerk reactions.

In this context, this report is going to analyze the trends and patterns of foreign direct

investment (FDI) and foreign institutional investment (FII) flows into India during the

post liberalization period.



RESEARCH PROBLEM

The opening up of the Indian economy served as a great boon for our country as the

foreign investors saw vast opportunities in it and started investing through the various

routes allowed by the government of India. It is important to keep record of all such

inflows to form strict regulatory procedures, search for areas or sectors that needs

more investment etc, which is what this research proposes to do i.e. collect data

regarding inflow of foreign direct investment and foreign institutional investment

from credible sources for a specified timeline and tabulate such data to perform trend

analysis of these investments to understand whether these investments fluctuate

rapidly or move in a fixed pattern and also what provides impetus to these

investments or what are the parameters that trigger a massive pull-out of them. As it is

seen that FII is a volatile investment as compared to FDI the factors affecting the

inflow of both types of investment are explored and their investment annually is

compared on the basis of certain common parameters.



LITERATURE REVIEW

1. Institutional investors have grown in importance in the mature economies in

recent years and come to supplant banks as the primary custodians of people's

savings.

- T .T Ram Mohan,

{Economic and Political Weekly, Vol. 40, No. 24 (Jun. 11-17, 2005)

2. It is time to realize that in spite of the impression given by the financial media,

the movements on the stock markets and the Sensex do not necessarily imply

any fundamental changes in the economy and these movements affect a very

small minority of the country's population.

- Parthapratim Pal

{Economic and Political Weekly, Vol. 40, No. 8 (Feb. 19-25, 2005)

3. The main emerging feature of India's equity market is its gradual integration

with the global market and its consequent problems due to the hot money

movement by Foreign Institutional Investors (FIIs).

- Kishore C. Samal

{Economic and Political Weekly, Vol. 32, No. 42 (Oct. 18-24, 1997)

4. One must prevent the inflow/outflow of speculative 'hot money'. That can be

achieved partially (though very successfully) by a reasonably high 'capital

gains' tax.

- Arun Ghosh

{Economic and Political Weekly, Vol. 30, No. 21 (May 27, 1995)

5. The combination of trading driven substantially by conditions in other markets

and large price pressures from the trading of foreigner’s raises the possibility

that foreign trading can be destabilizing in emerging markets.

- Anthony Richards

{The Journal of Financial and Quantitative Analysis, Vol. 40, (Mar 2005)



6. Thus the impact of the reforms in India on the policy environment for Foreign

Direct Investment presents a mixed picture. The industrial reforms have gone

far, though they need to be supplemented by more infrastructure reforms,

which are a critical missing link.

- Kulwinder Singh

{Centre for Civil Society, New Delhi Research Internship Programme, 2005}

7. If at all, it would seem that foreign firms have greater credibility amongst

consumers for offering quality products and providing customer satisfaction.

- S. Ganesh

{Economic and Political Weekly, Vol. 32, No. 22 (May 31 - Jun. 6, 1997)

8. For a country that quarantined its economy from the rest of the world for much

of the last 60 years, India has increasingly relied on foreign investment in

recent years. It has helped bridge the gap between domestic savings and the

growing capital needs of the private sector and the government, which is

borrowing money to pay for welfare programs and subsidies.

- Vikas Bajaj

{The New York Times; India Finds Itself Awash in Foreign Investment}

9. Foreign Direct Investment (FDI) flows have increased substantially in the past

two decades. These developments have motivated the appearance of a large

number of empirical papers that test the expected benefits that FDI inflows are

assumed to bring to the host countries. We survey the recent theoretical and

empirical literature, but restrict our attention to the productivity changes that

are induced by increased FDI inflows. We review both the aggregate

productivity effects, as well as the spillover effects of FDI on local firms.

- Hugo Rojas-Romagosa



RESEARCH METHODOLOGY

The research has been carried out by collection of secondary data with the use of

primarily the internet, books on banking and finance, various business magazines,

journals, newspapers. No primary data has been used here like face to face interviews

or telephonic interviews, questionnaires etc.

For FDI The study takes into account a sample of top 10 investing countries e.g.

Mauritius, Singapore, USA etc. and top 10 sectors e.g. service sector, computer

hardware and software, telecommunications etc. which had attracted larger inflow of

FDI from different countries.

For FII Correlation tool has been used to determine whether two ranges of data move

together — that is, how the Sensex, Foreign exchange reserves and exchange rates are

related to the FII which may be positive relation, negative relation or no relation.

For the purpose of comparison between FDI and FII the raw data has been arranged

into a table for better observation and then this numerical data has been incorporated

into bar charts and line charts. These are statistical tools used to read their pattern and

conduct trend analysis.



LIMITATIONS

Limitations are conditions that restrict the scope of the study period or may affect the

results of the research. It cannot be controlled by the researchers and can even affect

the analysis of research adversely.

One of the limiting factors of my project was that I have taken only three variables for

a time period of about seven to ten years for analysis due to time constraints. Since

the sample size is small so the results can be different from actual facts and may not

give an appropriate judgement.

Also all the data have been collected from secondary sources. Information collected

first hand from professionals and scholars through interviews would have given the

report a larger perspective.



CHAPTER – II

FOREIGN DIRECT INVESTMENT

– AN OVERVIEW



INTRODUCTION

Foreign direct investment (FDI) plays an extraordinary and growing role in global

business. It can provide a firm with new markets and marketing channels, cheaper

production facilities, access to new technology, products, skills and financing. For a host

country or the foreign firm which receives the investment, it can provide a source of new

technologies, capital, processes, products, organizational technologies and management

skills, and as such can provide a strong impetus to economic development.

Foreign direct investment, in its classic definition, is defined as a company from one

country making a physical investment into building a factory in another country. The

direct investment in buildings, machinery and equipment is in contrast with making a

portfolio investment, which is considered an indirect investment. In recent years, given

rapid growth and change in global investment patterns, the definition has been broadened

to include the acquisition of a lasting management interest in a company or enterprise

outside the investing firm’s home country. As such, it may take many forms, such as a

direct acquisition of a foreign firm, construction of a facility, or investment in a joint

venture or strategic alliance with a local firm with attendant input of technology, licensing

of intellectual property, In the past decade, FDI has come to play a major role in the

internationalization of business.

Reacting to changes in technology, growing liberalization of the national regulatory

framework governing investment in enterprises, and changes in capital markets profound

changes have occurred in the size, scope and methods of FDI. New information

technology systems, decline in global communication costs have made management of

foreign investments far easier than in the past. The sea change in trade and investment

policies and the regulatory environment globally in the past decade, including trade policy

and tariff liberalization, easing of restrictions on foreign investment and acquisition in

many nations, and the deregulation and privatization of many industries, has probably

been the most significant catalyst for FDI’s expanded role.

One of the most striking developments during the last two decades is the spectacular

growth of FDI in the global economic landscape. This unprecedented growth of global

FDI in 1990 around the world make FDI an important and vital component of

development strategy in both developed and developing nations and policies are designed



in order to stimulate inward flows. Infact, FDI provides a win – win situation to the host

and the home countries. Both countries are directly interested in inviting FDI, because they

benefit a lot from such type of investment. The ‘home’ countries want to take the

advantage of the vast markets opened by industrial growth. On the other hand the ‘host’

countries want to acquire technological and managerial skills and supplement domestic

savings and foreign exchange. Moreover, the paucity of all types of resources viz.

financial, capital, entrepreneurship, technological know- how, skills and practices, access

to markets- abroad- in their economic development, developing nations accepted FDI as a

sole visible panacea for all their scarcities. Further, the integration of global financial

markets paves ways to this explosive growth of FDI around the globe.

A SHORT HISTORY

After getting independence in 1947, the government of India envisioned a socialist

approach to developing the countries economy – broadly based on the USSR system.

The government decided to adopt an economic agenda that would follow five year

plans. Each five year plan was focused on certain sectors of the economy that the

government felt needed to be developed for the countries progress. The government

followed an interventionist policy and dictated most of the norms of running a

business by favoring certain sectors and ignoring others.

Until 1991, India was primarily a closed economy. The industrial environment in

India was highly regulated and a license system – known as “licence raj” - was in

place to ensure compliance with the government regulations and directives. Under the

Industries Development and Regulations act (1951) starting and operating any

industry required approval - in the form of a licence - from the government. Any

change in production capacity or change in the product mix also called for obtaining

government approval. This led to the development of increasingly complex and

opaque procedures for obtaining a licence and led to a burgeoning bureaucracy. The

licence system thus shifted lot of power and perverse incentives in the hands of file

pushing bureaucrats (or “Babus”). This directly led to increased corruption as the

procedure for obtaining a licence was vaguely defined and left open to individual

interpretations. In addition, there was no monitoring system in place to ensure speedy



disposal of licence applications. Also, the labor markets were highly regulated and the

government did not allow the companies to lay off its workers. This meant that even

in severe downturns the companies kept bleeding but could not rationalize its

workforce. Eventually these companies - majority of them public sector companies –

would become chronically sick and the government kept subsidizing them at huge

costs to the taxpayer.

One draconian measure was the introduction of the Foreign Exchange Regulation act

(FERA) of 1973 which curtailed foreign investment to 40% in Indian companies. in

1973. Foreign companies also came under the Monopolies and Restrictive Policy

(MRTP), 1969 Act during this period. MRTP (1969) Act restricted companies on the

size of operation and the pricing of products and services. The Reserve Bank of India

geared itself to implement the above act. As a result, many companies that did not

want to increase equity participation of Indians as per section (2) of FERA, 1973

decided to cease their operations in India. As many as 54 companies applied to wind

up their operations by 1977-78 since the implementation of the above Act in 1974 and

9 companies applied to wind up their operations in 1980-81

(Annual Reports, Reserve Bank of India 1977, 1978, 1981).

This had a very adverse impact and companies such as Coca-Cola and IBM exited

the country. The government also adopted a policy of import substitution and the idea

was to help the domestic industry improve in a safe environment until the local

industries could compete internationally. This was implemented by levying extremely

high tariffs or completely banning imported goods. Due to the government’s

protection most of the industries failed to catch up with the technological innovations

taking place around the world. As they were shielded from imports due to extremely

high import tariffs the industries had no incentive to improve their operations. This

led to a vicious circular logic where the tariffs were not reduced since domestic

companies could not compete and the high tariffs prevented industries from

innovating. Corruption and opaqueness of the system added to the difficulties and the

situation became extremely complex.



THE BOP CRISIS

Gulf war broke out in 1990 and the resulting oil shock was enough to trigger a serious

balance of payment (BoP) crisis for India in 1991. The cost of oil imports went up to

10,820 crores from the estimated 6,400 crores. Traditionally, India received lot of

remittances from the expatriates working in the Gulf countries and this source also

dried up as the migrant Indian workers were forced to return home due to the war.

The problem was compounded due to an extremely high inflation of about 16% and a

fiscal deficit of about 8.5%. The situation was so severe that India had foreign

reserves of only around $1 Billion - barely enough to cover two weeks of its payment

obligations. India’s credit rating was downgraded as its debt servicing capability was

critically impaired and the government had to pledge its gold reserves to soothe

creditors. Ostensibly, the trigger for the BoP crisis was the oil shock but the deeper

issue was that the government’s heavy hand in trying to regulate businesses and to

move the country towards economic progress had failed to produce results and drastic

measures were now called for.

Faced with these insurmountable problems, the Indian government turned to the IMF

and thus began a series of far reaching reforms in the India economy which

envisioned transforming the country’s economy from an interventionist and overly-

regulated economy to a more market oriented one.

THE BEGINING OF A NEW ERA

The year 1991 marks a new growth phase of FDI in India with an all time high flow

of FDI. Following the Industrial Policy (1991) , a large number of foreign companies

from different parts of the world rushed into India. In this period, in addition to

thousands of foreign collaborations in India, as many as 145 foreign companies

registered in India within a span of 10 years from 1991-2000. Companies like General

Motors, Ford Motors, and IBM that divested from India in the 1950s and 1970s

reentered India during this period. A large number of Asian companies like Daewoo

Motors, Hyundai Motors and LG Electronics from S. Korea, Matsushita Television

and Honda Motors from Japan invested in India during this period.



With the legislation of the Industrial Licensing Policy, 1991, industrial licensing was

abolished except for 18 industries. FDI up to 51% equity was allowed in 34 formerly

high priority industries and the concept of phased manufacturing requirement on

foreign companies was removed. Further, the tariffs on imports have been steadily

reduced in every budget since 1991. Subsequently, GOI replaced FERA, 1973 that

regulated all foreign exchange transactions with Foreign Exchange Management Act

(FEMA), 1999. The objectives of FEMA have been to facilitate external trade and

payments and to promote orderly development and maintenance of foreign exchange

market. The total number of foreign collaborations increased from 976 in the year

1991 to 2144 in the year 2000.

WHAT IS FOREIGN DIRECT INVESTMENT?

Is the process whereby residents of one country (the source country) acquire

ownership of assets for the purpose of controlling the production, distribution, and

other activities of a firm in another country (the host country). The international

monetary fund’s balance of payment manual defines FDI as an investment that is

made to acquire a lasting interest in an enterprise operating in an economy other than

that of the investor. The investors purpose being to have an effective voice in the

management of the enterprise. The united nations 1999 world investment report

defines FDI as ‘an investment involving a long term relationship and reflecting a

lasting interest and control of a resident entity in one economy (foreign direct investor

or parent enterprise) in an enterprise resident in an economy other than that of the

foreign direct investor ( FDI enterprise, affiliate enterprise or foreign affiliate).



TYPES OF FDI

A)BY DIRECTION

Inward FDIs:

Inward FDI for an economy can be defined as the capital provided from a foreign

direct investor (i.e. the coca cola company) residing in a country, to that economy,

which is residing in another country. (I.e. India's economy).

EXAMPLE: General Motors decides to open a factory in India. They are going to

need some capital. That capital is inward FDI for India.

Different economic factors encourage inward FDIs. These include interest

loans, tax breaks , grants, subsidies, and the removal of restrictions and limitations.

Outward FDIs:

A business strategy where a domestic firm expands its operations to a foreign country

either via a Green field investment, merger/acquisition and/or expansion of an

existing foreign facility. Employing outward direct investment is a natural progression

for firms as better business opportunities will be available in foreign countries when

domestic markets become too saturated.

In recent years, emerging market economies (EMEs) are increasingly becoming a

source of foreign investment for rest of the world. It is not only a sign of their

increasing participation in the global economy but also of their increasing

competence. More importantly, a growing impetus for change today is coming from


http://www.economywatch.com/foreign-direct-investment/


developing countries and economies in transition, where a number of private as well

as state-owned enterprises are increasingly undertaking outward expansion through

foreign direct investments (FDI). Companies are expanding their business operations

by investing overseas with a view to acquiring a regional and global reach.

B) BY TARGET

Greenfield investment:

A form of foreign direct investment where a parent company starts a new venture in a

foreign country by constructing new operational facilities from the ground up. In

addition to building new facilities, most parent companies also create new long-term

jobs in the foreign country by hiring new employees.

Green field investments occur when multinational corporations enter into developing

countries to build new factories and/or stores. Developing countries often offer

prospective companies tax-breaks, subsidies and other types of incentives to set up

green field investments. Governments often see that losing corporate tax revenue is a

small price to pay if jobs are created and knowledge and technology is gained to boost

the country's human capital.

Horizontal FDI:

Horizontal FDI arises when a firm duplicates its home country-based activities at the

same value chain stage in a host country through FDI. For example, Ford assembles

cars in the United States. Through horizontal FDI, it does the same thing in different

host countries such as the United Kingdom (UK), France, Taiwan, Saudi Arabia, and

India. Horizontal FDI therefore refers to producing the same products or offering the

same services in a host country as firms do at home.

Vertical FDI:

Vertical Foreign Direct Investment takes two forms:

1. Backward vertical FDI: where an industry abroad provides inputs for a firm's domestic production process like exploiting the available raw materials in the host country.



2. Forward vertical FDI: in which an industry abroad sells the outputs of a firm's domestic production i.e to be nearer to the consumers through the aquisition of distribution outlets.

C) BY MOTIVE

Resource seeking:

Investments which seek to acquire factors of production that is more efficient than

those obtainable in the home economy of the firm. In some cases, these resources may

not be available in the home economy at all (e.g. natural resources,naturally occurring

materials such as coal, fertile land, etc., that can be used by man, and cheap labor).

This characterizes Foreign Direct Investment into developing countries, for example

seeking cheap labor in India and China, or natural resources in the Middle East and

Africa.

Market seeking:

Market seeking FDI is driven by access to local or regional markets. Investing locally

can be driven by regulations or to save on operational costs such as transportation.

General Motors’ investment in China is market seeking because the cars built in

China are sold in China, the size and growth of host country markets are among the

most important FDI determinants.

Efficiency seeking:

Investments which firms hope will increase their efficiency by exploiting the benefits

of economies of scale and scope, and also those of common ownership. It is suggested

that this kind of Foreign Direct Investment comes after either resource or market

seeking investments have been realized, with the expectation that it further increases

the profitability of the firm.

Efficiency seeking FDI is commonly described as off shoring, or investing in foreign

markets to take advantage of a lower cost structure. A credit card company opening a

call center in India to serve U.S. customers is a form of efficiency seeking FDI.



ADVANTAGES OF FDI

1. Raising the Level of Investment : Foreign investment can fill the gap between

desired investment and locally mobilized savings. Local capital markets are often

not well developed. Thus, they cannot meet the capital requirements for large

investment projects. Besides, access to the hard currency needed to purchase

investment goods not available locally can be difficult. FDI solves both these

problems at once as it is a direct source of external capital. It can fill the gap

between desired foreign exchange requirements and those derived from net export

earnings.

2. Up gradation of Technology : Foreign investment brings with it technological

knowledge while transferring machinery and equipment to developing countries.

Production units in developing countries use out-dated equipment and techniques

that can reduce the productivity of workers and lead to the production of goods of

a lower standard.

3. Improvement in Export Competitiveness : FDI can help the host country

improve its export performance. By raising the level of efficiency and the

standards of product quality, FDI makes a positive impact on the host country’s

export competitiveness. Further, because of the international linkages of MNCs,

FDI provides to the host country better access to foreign markets. Enhanced

export possibility contributes to the growth of the host economies by relaxing

demand side constraints on growth. This is important for those countries which

have a small domestic market and must increase exports vigorously to maintain

their tempo of economic growth.

4. Employment Generation/Development : Foreign investment can create

employment in the modern sectors of developing countries. Recipients of FDI

gain training of employees in the course of operating new enterprises, which

contributes to human capital formation in the host country.



5. Benefits to Consumers : Consumers in developing countries stand to gain from

FDI through new products, and improved quality of goods at competitive prices.

6. Revenue to Government : Profits generated by FDI contribute to corporate tax

revenues in the host country.

DISADVANTAGES OF FDI

FDI is not an unmixed blessing. Governments in developing countries have to be very

careful while deciding the magnitude, pattern and conditions of private foreign

investment. Possible adverse implications of foreign investment are the following:

1. When foreign investment is competitive with home investment, profits in

domestic industries fall, leading to fall in domestic savings.

2. Contribution of foreign firms to public revenue through corporate taxes is

comparatively less because of liberal tax concessions, investment allowances,

disguised public subsidies and tariff protection provided by the host government.

3. Foreign firms reinforce dualistic socio-economic structure and increase income

inequalities. They create a small number of highly paid modern sector executives.

They divert resources away from priority sectors to the manufacture of

sophisticated products for the consumption of the local elite. As they are located

in urban areas, they create imbalances between rural and urban opportunities,

accelerating flow of rural population to urban areas.

4. Foreign firms stimulate inappropriate consumption patterns through excessive

advertising and monopolistic market power. The products made by multinationals

for the domestic market are not necessarily low in price and high in quality. Their

technology is generally capital-intensive which does not suit the needs of a labour-

surplus economy.



5. Foreign firms able to extract sizeable economic and political concessions from

competing governments of developing countries. Consequently, private profits of

these companies may exceed social benefits.

6. Profit distribution, investment ratios are not fixed: Continual outflow of

profits is too large in many cases, putting pressure on foreign exchange reserves.

Foreign investors are very particular about profit repatriation facilities.

7. Political Lobbying: Foreign firms may influence political decisions in developing

countries. In view of their large size and power, national sovereignty and control

over economic policies may be jeopardized. In extreme cases, foreign firms may

bribe public officials at the highest levels to secure undue favours. Similarly, they

may contribute to friendly political parties and subvert the political process of the

host country.

DETERMINANTS OF FDI

To understand the scale and direction of FDI flows, it is necessary to identify their

major determinants. The relative importance of FDI determinants varies not only

between countries but also between different types of FDI. Traditionally, the

determinants of FDI include the following.

1. Size of the Market : Large developing countries provide substantial markets

where the consumers demand for certain goods far exceed the available supplies.

This demand potential is a big draw for many foreign-owned enterprises. In many

cases, the establishment of a low cost marketing operation represents the first step

by a multinational into the market of the country. This establishes a presence in

the market and provides important insights into the ways of doing business and

possible opportunities in the country.

2. Political stability : In many countries, the institutions of government are still

evolving and there are unsettled political questions. Companies are unwilling to

contribute large amounts of capital into an environment where some of the basics

political questions have not yet been resolved.



3. Macro-economic Environment : Instability in the level of prices and exchange

rate enhance the level of uncertainty, making business planning difficult. This

increases the perceived risk of making investments and therefore adversely

affects the inflow of FDI.

4. Legal and Regulatory Framework : The transition to a market economy entails

the establishment of a legal and regulatory framework that is compatible with

private sector activities and the operation of foreign owned companies. The

relevant areas in this field include protection of property rights, ability to

repatriate profits, and a free market for currency exchange. It is important that

these rules and their administrative procedures are transparent and easily

comprehensive.

5. Access to Basic Inputs : Many developing countries have large reserves of

skilled and semi-skilled workers that available for employment at wages

significantly lower than in developed countries. This provides an opportunity for

foreign firms to make investments in these countries to cater to the export market.

Availability of natural resources such as oil and gas, minerals and forestry

products also determine the extent of FDI.

The determinants of FDI differ among countries and across economic sectors. These

factors include the policy framework, economic determinants and the extent of

business facilitation such as macro-economic fundamentals and availability of

infrastructure.

Recent global and regional FDI trends



The rise of FDI flows in 2011 was widespread in all three major groups – developed,

developing and transition economies. Developing economies continued to absorb

nearly half of global FDI and transition economies another 6 per cent.

This graph gives a pretty good indicator of how relative FDI inflows have changed

since 2002 we can see that right from the year 2002 there has been an increase in FDI

investments in the developing economies. The increase in the GDP growth or the bull

phase which most of the developing economies experienced from 2003-2008 could be

attributed to the increased FDI.

FDI flows, by region, 2009–2011



Amount in billions of dollarsSource: UNCTAD

In 2011, FDI inflows increased in all major economic groups − developed, developing

and transition economies. Developing countries accounted for 45 per cent of global

FDI inflows in 2011. The increase was driven by East and South-East Asia and Latin

America. East and South-East Asia still accounted for almost half of FDI in

developing economies. Inflows to the transition economies of South-East Europe, the

Commonwealth of Independent States (CIS) and Georgia accounted for another 6 per

cent of the global total.

FII ACCORDING TO TYPE OF INVESTMENT



Source:UNCTADCross-border mergers and acquisitions are rising, but Greenfield investment still

dominates, as the following graph shows.

Greenfield investment and M&A differ in their impacts on host economies, especially

in the initial stages of investment. In the short run, M&A’s clearly do not bring the

same development benefits as Greenfield investment projects, in terms of the creation

of new productive capacity, additional value added, employment and so forth. The

effect of M&As on, for example, host-country employment can even be negative, in

cases of restructuring to achieve synergies.

TNCs’ top prospective host economies for 2012–2014

The importance of developing regions to TNCs as locations for international

production is also evident in the economies they selected as the most likely



destinations for their FDI in the medium term. Among the top five, four are

developing economies .Indonesia rose into the top five in this year’s survey,

displacing Brazil in fourth place. South Africa entered the list of top prospective

economies, ranking 14th with the Netherlands and Poland. Among developed

countries, Australia and the United Kingdom moved up from their positions in last

year’s survey, while Germany maintained its position.

Source: UNCTAD survey 2011

If we analyze the above survey it can be said that the global capital which is not

providing good returns in the developed economies is moving rapidly towards

developing economies.

Major developing economies like India,China,Brazil etc have emerged as the top

destinations for FDI worldwide because the potential impact of the economic crisis

enforce the shifting of geographical focus to developing and transition economies

because of their much better economic performance than the developed

countries .Factors such as weaker economic growth in developed countries and

abnormal functioning of the world credit are putting pressures on the pace of recovery

of FDI flows towards developed economies.

FDI Approval Route

Foreign direct investments in India are approved through two routes–



1. Automatic approval by RBI –

The Reserve Bank of India accords automatic approval within a period of two weeks

(subject to compliance of norms) to all proposals and permits foreign equity up to

24%; 50%; 51%; 74% and 100% is allowed depending on the category of industries

and the sectoral caps applicable. The lists are comprehensive and cover most

industries of interest to foreign companies. Investments in high priority industries or

for trading companies primarily engaged in exporting are given almost automatic

approval by the RBI.

2. The FIPB Route – Processing of non-automatic approval cases –

FDI in activities not covered under the automatic route requires prior approval of the

Government which are considered by the Foreign Investment Promotion Board

(FIPB), Department of Economic Affairs, Ministry of Finance. Indian companies

having foreign investment approval through FIPB route do not require any further

clearance from the Reserve Bank of India for receiving inward remittance and for

the issue of shares to the non-resident investors.



SECTOR SPECIFIC CONDITIONS ON FDI

PROHIBITED SECTORS.

1. Retail Trading (except single brand product retailing)

2. Lottery Business including Government /private lottery, online lotteries, etc.

3. Gambling and Betting including casinos etc.

4. Chit funds

5. Nidhi company

6. Trading in Transferable Development Rights (TDRs)

7. Real Estate Business or Construction of Farm Houses

8. Manufacturing of Cigars, cheroots, cigarillos and cigarettes substitutes

9. Activities / sectors not open to private sector investment e.g. Atomic Energy

10. Railway Transport (other than Mass Rapid Transport System

PERMITTED SECTORS

In the following sectors/activities, FDI up to the limit indicated against each

sector/activity is allowed, subject to applicable laws/ regulations; security and other

conditionality. In sectors/activities not listed below, FDI is permitted upto 100% on

the automatic route, subject to applicable laws/ regulations; security and other

conditions.

Sr.

No.

Sector/Activity FDI cap/Equity Entry/Route

1. Hotel & Tourism 100% Automatic

2. NBFC 49% Automatic

3. Insurance 26% Automatic

4. Telecommunication:

cellular, value added services 49%

Automatic



ISPs with gateways, radio-paging

Electronic Mail & Voice Mail 74%

100%

Above 49% need

Govt. licence

5. Trading companies:

primarily export activities

bulk imports, cash and carry

wholesale trading

51%

100%

Automatic

Automatic

6. Power(other than atomic reactor

power plants)100% Automatic

7. Drugs & Pharmaceuticals 100% Automatic

8. Roads, Highways, Ports and Harbors 100% Automatic

9. Pollution Control and Management 100% Automatic

10 Call Centers 100% Automatic

11. BPO 100% Automatic

13. Airports:

Greenfield projects

Existing projects

100%

100%

Automatic

Beyond 74% FIPB

14 Assets reconstruction company 49% FIPB

15. Cigars and cigarettes 100% FIPB

16. Courier services 100% FIPB

17. Investing companies in infrastructure

(other than telecom sector)

49% FIPB



Foreign Direct Investment in India in the last 10 Years

It can be seen that the flow of FDI has consistent and gradually increasing over the

years. There has been an increase of 129% i.e. Rs. 13851 Crores from the year 2000-

01 to 2005-06 while the increase from 2005-06 to 2011-12 has been a phenomenal

607% i.e. from Rs. 24584 Cr to Rs. 173947 Cr which can be attributed to relaxation of

foreign investment rules. Despite the global financial credit squeeze brought by the



recession India continues to be an attractive destination for investment as there is

tremendous potential for growth in the vast and diverse markets of our country.

The bars from 2000-01 to 2004-05 have been almost hovering the same levels but

importantly haven’t gone down which is because the foreign investors saw immense

potential but were not getting enough incentives to enter with huge business

propositions. The breakout came from the year 2005-06 when the investment nearly

doubled as compared to 2000-01, after which there was no looking back as consistent

economic growth, de-regulation, liberal investment rules, and operational flexibility

helped increase the inflow of Foreign Direct Investment or FDI. So much so that even

during the year 2008-09 when the recession had taken its toll on the western countries

there was no indication of falling investment via the FDI route as can be seen from the

chart. In fact during 2008-09 the chart shows that FDI breached the Rs. 1 lakh crore

marks. In percentage terms FDI inflow increased by 28% from 2007-08 to 2008-09.

SECTORS ATTRACTING HIGHEST FDI EQUITY INFLOWS:

DIFFERENT SECTORS ATTRACTING HIGHEST FDI EQUITY INFLOWS:


http://www.economywatch.com/foreign-direct-investment


Note: Cumulative Sector- wise FDI equity inflows (from April 2000 to January 2012)

Source: Department of Industrial Policy & Promotion

DIFFERENT SECT O RS ATTRACTING HIG H EST FDI EQUITY INFLOW S


http://dipp.nic.in/


ANALYSIS

The sectors receiving the largest shares of total FDI inflows up to January 2012 were

the services sector, Telecommunications each accounting for 20% and 8%

respectively. These were followed by the Computer software and Hardware, real

estate, construction and Drugs and Pharma sectors.

Service sector



The services sector covers a wide range of activities from the most sophisticated

information technology (IT) to simple services provided by the unorganized sector,

such as the services of the barber and plumber. National Account classification of the

services sector incorporate trade, hotels, and restaurants; transport, storage and

communication; financing, insurance, real estate, and business services. In World

Trade Organization (WTO) and Reserve Bank of India RBI classifications,

construction is also included.

Source: Economic review 2011-2012

The services sector has been a major and vital force steadily driving growth in the

Indian economy for more than a decade. The economy has successfully navigated

The turbulent years of the recent global economic crisis because of the vitality of this

Sector in the domestic economy and its prominent role in India’s external economic

Interactions.

In 2010, the share of services in the US$63 trillion world gross domestic product

(GDP) was nearly 68 per cent, as in 2001. India’s performance in terms of this

indicator is not only above that of other emerging developing economies, but also

very close to that of the top developed countries. Among the top 12 countries with

highest overall GDP in



2010, India ranks 8 and 11 in overall GDP and services GDP respectively. While

countries like the UK, USA, and France have the highest share of services in GDP at

above 78 per cent, India’s share of 57 per cent is much above that of China at 41.8

Per cent. In 2010 compared to 2001, India is the topmost country in terms of increase

in its services share in GDP

If we look at the above graph it is clearly seen that the service sector GDP growth

clearly outperforms the overall GDP growth by a considerable margin so the growth

in service sector GDP can be attributed to the continued inflow of FDI in that sector.



TELECOM SECTOR

FDI policy for the Telecom Sector is as under:

Sr. No. Sector/Activity FDI Cap/Equity Entry route

1. Basic and cellular,

Unified Access Services,

National/International

Long Distance, and other

value added telecom

services

74% (including FDI,

FII, NRI, FCCBs,

ADRs, GDRs,

convertible preference

shares, and

proportionate foreign

equity in Indian

promoters /Investing

Company)

Automatic upto 49%.

FIPB beyond 49%

2. ISP with gateways,

radio-paging, end-to-end

bandwidth.

74% Automatic upto 49%

FIPB beyond 49%

3. a) ISP without gateway.

b) Infrastructure provider

providing dark fibre,

right of way, duct space,

tower.

c) Electronic mail and

voice mail

100% Automatic up to 49%

FIPB beyond 49%

4. Manufacture of telecom

equipments

100% Automatic

India is one of the world's fastest growing telecom markets, and this has acted as the

primary driver for foreign and domestic telecommunication companies investing into

the sector. Massive investments have been made in the telecom sector of India, both

by the private and government sector.

The telecom industry has witnessed significant growth in subscriber base over the last

decade, with increasing network coverage and a competition-induced decline in tariffs

acting as catalysts for the growth in subscriber base. The growth story and the



potential have also served to attract newer players in the industry, with the result that

the intensity of competition has kept increasing.

The market share of the telecom companies reflects the fragmented nature of the

industry, with as many as 15 players. As of January 31, 2012, Bharti telecom led the

market with 19.6 per cent share, Reliance (16.7 per cent), Vodafone (16.4 per cent),

Idea (11.9 per cent), BSNL (10.8 per cent), Tata (9.3 per cent), Aircel (6.9 per cent),

with the remaining share being held by other smaller operators, according to Telecom

Regulatory Authority of India (TRAI) database.

Telecom Sector FDI Equity Inflows (US $ Million)

Note: FDI inflow for 2011-12 only uptil January 2012

Source: Department of Industrial Policy & Promotion



Teledensity in India

Source: DOT

Telecom sector FDI inflows increased by more than 100 % since 2007-2008.we can

see robust FDI inflows in the two succeeding years from 2007-08 and that has

contributed significantly to the rise of the telecom sector in India. Some of the biggest

FDI inflows into the country relate to this sector viz. The NTT DOCOMO-Tata

Teleservices joint venture worth $2.70 billion, the Vodafone deal which was worth

US$ 11.1 billion, according to its chairman Mr. Analjit Singh Vodafone has invested

USD 26 billion in India from the time they came in 2007 till now. They have

contributed USD 6 billion to the exchequer.

The FDI investments in the sector went down considerably since 2010-11mainly due

to the 2g scam and various other policy related matters. Even though the investments

have gone down but the base for telecom revolution in India was created by the

investments done prior to 2010-11 and that can be seen in the increase in the

increased teledensity in India. Total numbers of telephone connections have grown

from 98 million in 2005 to 846 million in 2011 i.e. a whopping increase of more than

760% in 6 years.



Pharma Sector

The DIPP data suggests that the drugs and pharmaceuticals sector has attracted an

impressive level of FDI worth US$ 1,882.76 million during April 2000 to March

2011. Industrial licenses are not required in India for most of the drugs and

pharmaceutical products. Manufacturers are free to produce any drug duly approved

by the Drug Control Authority.

Since 2006, as many as six big Indian pharma companies have been taken over by

foreign firms. About $4.73 billion or 50 percent of the recorded FDI in the sector

since the year 2000 has been in the form of mergers and acquisitions. In the year

2006, Matrix Lab was sold to the US-based company Mylan. In 2008, Dabur Pharma

was bought by Singapore-based Fresenius Kabi. Again in the same year, Ranbaxy was

taken over by the Japanese company, Diachii Sankyo. The year 2009 witnessed two

major deals in which Shantha Biotech was taken over by the French major Sanofi

Aventis and the US-based company Hospira took over Orchid Chemicals. The latest

example is of Piramal Healthcare, which was bought in the year 2010 by the US

multinational, Abbot Laboratories.



COUNTRY-WISE INFLOW OF FDI

DIFFERENT COUNTRIES ATTRACTING HIG H EST FDI EQUITY

INFLOW S :



DIFFERENT COUNTRIES ATTRACTING HIG H EST FDI EQUITY

INFLOW S :

India’s 83% of cumulative FDI is contributed by eight countries while remaining 17%

by the rest of the world. India’s perception abroad has been changing steadily over the

years. This is reflected in the ever growing list of countries that are showing interest

to invest in India. Mauritius emerged as the most dominant source of FDI contributing

39% of the total investment in the country since 2000. Singapore was the second

dominant source of FDI inflows with 10% of the total inflows. However, USA slipped

to fourth position by contributing 6% of the total inflows. Japan moved to third with

investments of 8%

FDI from Mauritius to India is the highest in comparison with all the other countries

that invest in India. FDI from Mauritius to India is the highest due to the special

treatment of tax given in India to the investments that come through Mauritius. The

India-Mauritius Double Taxation Avoidance Agreement (DTAA) was signed in 1982

and has played an important role in facilitating foreign investment in India via

Mauritius. It has emerged as the largest source of foreign direct investment (FDI) in

India, accounting for 39 per cent of inflows between April 2000 and February 2011. A



large number of foreign institutional investors (FIIs) who trade on the Indian stock

markets operate from Mauritius

A large number of Foreign Institutional Investors who trade on the Indian stock

markets operate from Mauritius. According to the tax treaty between India and

Mauritius, Capital Gains arising from the sale of shares is taxable in the country of

residence of the shareholder and not in the country of residence of the Company

whose shares have been sold. Therefore, a company resident in Mauritius selling

shares of an Indian company will not pay tax in India. Since there is no Capital gains

tax in Mauritius, the gain will escape tax altogether.

For instance, a company from the UK may desire to invest in India. It may initiate,

conduct and conclude all negotiations and agreements from the UK. But before the

actual investment, it may purchase a shell company in a tax haven, say, Mauritius, and

route its investment through that Mauritian company.

Since technically or artificially the investment is made from out of a Mauritian

company, it may seek to claim the Indo-Mauritian DTAA rather than the Indo-UK

DTAA and, as such, would capitalize on the tax-effectiveness of the former treaty.

This way, either India or the UK may be deprived of their share of higher revenue

available to them under the Indo-UK DTAA. Since such investing company `shop’

around treaties artificially (rather than DTAA to which they are naturally subject), it is

graphically described `treaty shopping’.



TOP 10 FDI EQUITY IN FLOW CASES

(APRIL 2000 TO JANUARY 2012)



CHAPTER – III

FOREIGN INSTITUTIONAL INVESTMENT



FOREIGN INSTITUTIONAL INVESTMENT (FII)

Background

Indian Markets have been one of the most attractive investment places for the FII's.

India being a developing nation attracts the foreign flows looking at the growth

potential in the Indian Economy. The FII's contribute a major chunk of volumes on

the Indian bourses and this in turn impacts the market moves. In case of recession in

the world economies, the foreign investors look for saver bets and India with a rising

GDP where other nations GDP / Growth is shrinking has always offered greater

investment avenues. Indian Markets have been the clear outperformers vis-a-vis the

global markets in the past years.

HISTORY OF FOREIGN INSTITUTIONAL INVESTORS

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, Foreign Institutional Investors 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.


http://www.mbaknol.com/managerial-economics/an-overview-of-foreign-direct-investment-fdi-in-india/


Foreign Institutional Investment—

As defined by the European Union Foreign Institutional Investment is an investment

in a foreign stock market by the specialized financial intermediaries managing savings

collectively

on behalf of investors, especially small investors, towards specific objectives in term

of risk, return and maturity of claims.

SEBI’s Definition of FIIs presently includes foreign pension funds, mutual funds,

charitable/endowment/university funds, asset management companies and other

money managers operating on their behalf in a foreign stock market. Foreign

institutional investment is liquid nature investment, which is motivated by

international portfolio diversification benefits for individuals and institutional

investors in industrial country.

Explanation

It refers to the purchase of stocks, bonds, debentures or other securities by an FII. FIIs

include pension funds, mutual funds, investment trusts, asset management companies,

nominee companies and incorporated/institutional portfolio managers.

In contrast to FDI, FIIs do not invest with the intention of gaining controlling interest

in a company. They typically make short-term investments. These investments are

made-to- book profits. Compared to FDI, a portfolio investor can enter and exit

countries with relative ease. This is a major contributing factor to the increasing

volatility and instability of the global financial system. Because of the very nature of

such investment, FII money is also called ‘hot money’. The rapid outflow of ‘hot

money’, in the recent past, has created exchange-rate problems in Argentina and in

Southeast Asia. Since FIIs are very sensitive, a mere change in perception about an

economy can prompt them to pull out investments from a country.

Market design in India for foreign institutional investors in India –

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 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.

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. A domestic portfolio manager or a domestic asset

management company shall also be eligible to be registered as FII to manage the

funds of sub-accounts.

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 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 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.

Who can be registered as an FII?

The applicant should be any of the following categories:

1. Pension funds

2. Mutual funds

3. Investment trust

4. Insurance or reinsurance companies

5. Endowment funds

6. University funds

7. Foundations or charitable trusts or charitable societies who propose to invest on

their own behalf and

a) Asset management companies

b) Nominee companies

c) Institutional portfolio managers

d) Trustees

e) Power of attorney holders

f) Bank

Who propose to invest their proprietary funds or on behalf of “broad based” funds or

on of foreign corporate and individuals.

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)

Reasons for strong flow of FIIs in India

FIIs attracted by the fast growing economy of India and strong performance of Indian

companies have been attracted towards India to an extent that India has gone on to

become the preferred investment destination.

The primary reasons for India being a preferred destination for FIIs are:

Global liquidity into the equity markets.

Improved performance and competitiveness of Indian firms.

Opening up of Indian economy.

Cheap labor and other factors of production.

Highly developed stock market and high degree of vigilance over it.

Tax Incentives.

Regulation and Trading Efficiencies

F and O Segment

Role of FIIs:

The Indian stock market has come of age and has substantially aligned itself

with the international order.

Market has also witnessed a growing trend of 'institutionalization' that may be

considered as a consequence of globalization.

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.

FII which based the pressure on the rupee from the balance of payments

position and lowered the cost of capital to Indian business.

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.

Rolling settlement was introduced at the insistence of FIIs as they were

uncomfortable with the badla system.



The FIIs are playing an important role in bringing in funds needed by the

equity market.

The increase in the volume of activity on stock exchanges with the advent of

on screen trading coupled with operational inefficiencies of the former

settlement and clearing system led to the emergence of a new system called

the depository System.

Flow of money into Indian economy via FIIs has been increasing at a rapid

rate. This has forced economist and policy makers to consider impacts of this

inflow on the macro economic factors as well. This has resulted in deeper

analysis of factors like Interest Rate, Inflation Rate, GDP and Exchange Rate

etc. both in short term as well as long term

Registration Process of FIIs

FIIs are required to obtain a certificate by SEBI for dealing in securities. SEBI grants the certificate SEBI by taking into account the following criteria:

i) The applicant's track record, professional competence, financial soundness,

experience, general reputation of fairness and integrity.

ii) Whether the applicant is regulated by an appropriate foreign regulatory authority.

iii) Whether the applicant has been granted permission under the provisions of the

Foreign Exchange Regulation Act, 1973 (46 of 1973) by the Reserve Bank of India

for making investments in India as a Foreign Institutional Investor.

iv) Whether the applicant is a) an institution established or incorporated outside India

as a pension fund, mutual fund, investment trust, insurance company or reinsurance

company. b) an International or Multilateral Organization or an agency thereof or a

Foreign Governmental Agency or a Foreign Central Bank. c) an asset management

company, investment manager or advisor, nominee company, bank or institutional

portfolio manager, established or incorporated outside India and proposing to make

investments in India on behalf of broad based funds and its proprietary funds in if any

or d) university fund, endowments, foundations or charitable trusts or charitable

societies.



v) Whether the grant of certificate to the applicant is in the interest of the

development of the securities market.

vi) Whether the applicant is a fit and proper person.

The SEBIs initial registration is valid for a period of three years from the date of its

grant of renewal.

Investment Conditions and Restrictions for FIIs:

1. A Foreign Institutional Investor may invest only in the following:-

(a) Securities in the primary and secondary markets including shares, debentures

and warrants of companies, unlisted, listed or to be listed on a recognized stock

exchange in India.

(b) Units of schemes floated by domestic mutual funds including Unit Trust of

India, whether listed or not listed in a recognized stock exchange

(c) Dated Government securities.

(d) Derivatives traded on a recognized stock exchange.

(e) Commercial paper.

(f) Security receipts

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 Foreign Institutional Investor in India, whether on his

own account or on account of his sub- accounts, should not be less than seventy per

cent of the aggregate of all the investments of the Foreign Institutional Investor in

India, made on his own account and on account of his sub-accounts. However, this is

not applicable to any investment of the foreign institutional investor either on its own

account or on behalf of its sub-accounts in debt securities which are unlisted or listed

or to be listed on any stock exchange if the prior approval of the SEBI has been

obtained for such investments. Further, SEBI while granting approval for the

investments may impose conditions as are necessary with respect to the maximum

amount which can be invested in the debt securities by the foreign institutional

investor on its own account or through its sub-accounts. A foreign corporate or

individual is not eligible to invest through the hundred percent debt route.



Even investments made by FIIs in security receipts issued by securitization companies

or asset reconstruction companies under the Securitization and Reconstruction of

Financial Assets and Enforcement of Security Interest Act, 2002 are not eligible for

the investment limits mentioned above. No foreign institutional investor should invest

in security receipts on behalf of its sub-account.

Increasing Trend of FIIs

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. It can be observed from the table below

that India is one of the preferred investment destinations for FIIs over the years.

SEBI Registered FIIs

Year Number of FIIs

2001-02 490

2002-03 502

2003-04 540

2004-05 685

2005-06 882

2006-07 996

2007-08 1219

2008-09 1334

2009-10 1729

2010-11 1767

2011-12 1758

Source: www.sebi.gov.in 2011-12 data till June 2012



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

steadily rising over the years. The names of some prominent FIIs registered are:

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

Public School Retirement System of Missouri, Treasurer of the State North Carolina

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

Management Inc, etc.

NET FII INVESTMENTS OVER THE YEAR’S

Divergent views on FII

FIIs inducing instability to Stock Markets

Many experts consider FIIs to be "Fair Weather Friends", who come in bulk when

there is money to be made and leave abruptly at the first sign of impending trouble in

the host country, thereby inducing undesirable risk and uncertainty into markets. A

good recent example is evident from FII behavior in last eighteen months itself. Better

fundamentals of Indian economy as compared to the western economies, attracted and

prompted FIIs to invest aggressively here, raising the total to a astronomical figure of

$ 20 billion. This almost single handily took the Sensex to touch the 20,000 mark

again. However, come November 2010, few local factors like inflation, lower IIP and


FII Activity for previous years

YearGross Purchase Gross Net

(Cr) Sale Investment(Cr) (Cr)

2012 277,696.30 235,201.50 42,494.702011 611,055.60 613,770.80 -2,714.202010 766,283.20 633,017.10 133,266.802009 624,239.70 540,814.70 83,424.202008 721,607.00 774,594.30 -52,987.402007 814,877.90 743,392.00 71,486.302006 475,624.90 439,084.10 36,540.202005 286,021.40 238,840.90 47,181.902004 185,672.00 146,706.80 38,965.802003 94,412.00 63,953.50 30,459.002002 46,479.10 42,849.80 3,629.60

SOURCE:INDIA INFOLINEData for 2012 upto may 2012.


internal political drama, resulted in major square off of FII positions in no time,

thereby pushing the market into a sluggish and corrective mode.

There are other disturbing instances when the FIIs became the agents triggering a

blood bath at Dalal Street. On 16th Oct, 2007 Finance Minister Mr. P. Chidambaram

made a statement expressing his apprehensions over the usage offshore derivative

instrument: P-notes, through which the FIIs made about 60% of their investment in

India. Little did the market analysts or the Finance Minister knew that this seemingly

ordinary statement would have the potential to inflict a deadly free fall of the market

indices. The markets crashed by a staggering 9% within few hours, registering one of

the biggest absolute fall in Indian stock market history. The consequences were so

severe that the markets had to be closed down for an hour and Mr. Chidambaram had

to call a press conference to rephrase his statements. It was yet another alarming call

to the domestic investors that woke them up to the rising dominance and influence of

the FIIs on Indian Stock Markets.

The Alternate View

There is another set of experts who believe that FIIs are life blood for an emerging

economy like India. They augment domestic saving without increasing foreign debt,

provide vital liquidity to Indian companies to sustain road to growth, reduce cost of

equity capital and help reduce deficit of Balance of payments (BOP). Also these

experts believe that FIIs, like any other investors buy or sell according to prevailing

sentiments in the market, rather than creating any sentiments that drive the markets.

Hence there lies a conflict between the pros and cons of FIIs and the all important

question regarding the role of FIIs in deciding the fate of our stock markets

Relationship between FII inflow and Sensex


YEAR NET FII INVESTMENTS

BSE SENSEX CLOSING

2005 47181.9 9397.93

2006 36540.2 13786.91

2007 71486.3 20286.99

2008 -52987.4 9647.31

2009 83424.2 17464.81

2010 133266.8 20509.1

2011 2714.2 15454.9

2012 42263.3 16950


Source:BSE & SEBI

From the above charts it is clear that net FII investments at BSE show a similar

pattern to the Yearly average closings. The blue bars denoting the net FII can be

called a volatile from the chart as there are sudden sharp drops and sharp rises. It has

no fixed pattern. The net FII started declining from 2007-08 till the middle of 2008-09

which caused a sharp fall in Sensex also which went below the 10000 level in 2007-

08 falling by almost 52% as compared to the previous year. But the FIIs started

pouring in again from the end of 2009 after the governments abroad started providing

bail-out packages, sops and various other incentives to the ailing companies. The

Sensex also rises sharply from 2008-09 after the FIIs turned into net buyers and hence

a similar pattern can be found between these two.



Conclusion & Recommendations

The study conducted for the time frame from 2005 to 2012, supports the “FII inducing

volatility and driving the market indices” theory to a substantial level. Compared to

security markets in developed economies, Indian markets being narrower and

shallower, allows foreign investors with access to significant funds, to become the

dominant player in determining the course of markets. Because of their over sensitive

investment behavior and herding nature, FIIs are capable of causing severe capital out

flight abruptly, tumbling share prices in no time and making stock markets unstable

and unpredictable. In the process, more often than not, the domestic individual

investors are on the receiving end, losing their precious savings in such outrageous

speculative trading.

India as an emerging economic power cannot afford to be intimidated down by the

FIIs every now and then. We need formidable Domestic Investors which can pump in

liquidity even during cash crunch circumstances thereby fuelling the development.

With savings to the tune of roughly 35% of GDP, India can use this to its strength by

formulating policies which ensure that domestic funds like Pension Funds, Provident

Funds & other Large Corpus Funds have a greater exposure to the equity market. The

foreign investment in India should be encouraged, but only from a strategic long term

perspective. Derivative instruments which facilitate long term foreign investment with

specified lock in periods should be introduced. Sustained long term foreign

investments would not only contribute to India's growth but also help in curbing

volatility, maintaining currency stability and creating environment for inclusive

economic development.

FII’s IMPACT ON EXCHANGE RATES

To understand the implications of FII on the exchange rates we have to understand

how the value of one currency goes up (appreciates) or goes down against the other

currency. The simple way of understanding is through Demand and Supply. If say US

imports from India it is creating a demand for Rupee thus the Indian rupee appreciates

w.r.t the dollar. If India imports then the dollar appreciates w.r.t the Indian rupee.



Now considering FII’s for every dollar that they bring into the country, there is a

demand for rupee created and the RBI has to print and release the money in the

country. Since the FII’s are creating a demand for rupee, it appreciates w.r.t the dollar.

Thus if for e.g. if prior to the demand the exchange rate was 1 USD = Rs 40, it could

become 1 USD = Rs 39 after they invets. Similarly when FII withdraw the capital

from the markets, they need to earn back the U.S Dollar so that leads to a demand for

dollars the rupee depreciates. 1 USD goes back to Rs. 40. Thus FII inflows make the

currency of the country invested in appreciate and their selling and disinvestment may

lead to depreciation.

Depreciating currency not favorable to the FII’s: considering a simple hypothetical

example. I invested 1 USD in India at an exchange rate of 1 USD = Rs. 40. If rupee

appreciates the exchange rates become 1 USD = Rs. 20. Now if I disinvest I get 2

dollars, whereas I invested only 1 USD thereby a gain of 1 USD. (Though in real

terms the purchasing power of my dollar might decrease as my import cost would

increase, and cost of living back home may increase, but when I do consider practical

examples there is always a gain for FII whenever the currency of the country invested

in appreciates w.r.t the home currency)

Similarly when rupee depreciates w.r.t US Dollar and exchange rate becomes 1 USD

= Rs. 80 I get only 0.5 Dollar and I lose 0.5 of the 1 USD invested. Thus we observe

that for the FII’s to gain investing in India the rupee should appreciate w.r.t the dollar.



Source:SEBI & Moneycontrol

The above diagram brings to light a very important occurrence regarding Net FII and

the Foreign Exchange Rate. It can be seen that whenever the red line (foreign

exchange rate) goes up the blue line (Net FII) goes down. If we look at the graph for

the last 5 years we find that during the recession of 2008 when the FIIs pulled out

money from nearly every emerging economy including India, we see that there is an

appreciation in the value of rupee from 39 to around 48, Similar relation can be

concluded from the year 2010 and 2011.




Here also we can clearly see that when the FIIs were net purchasers in the month of

January and February the $ rates came down from 49.68 to 48.94 and similarly the

rupee started appreciating from the month of April when the FIIs turned net sellers.

The fall in April started after the passing of the union budget which leads us to

conclude that the fall in the value was majorly the implications of GAAR provisions

which speaks about retrospective taxation and also due to the worsening condition in

the Euro zone.




This data is presented for a very short run period from May 28 to June 28.the value of

the rupee appreciated from 55.1846 on 28 may to 57.0147 on 25 June, this can be

considered to be a very big rise in less than a month and on may 28 the US dollar

settled at INR 56.8554.The reason for this is that FIIs have been net sellers for the

major part of june from the dates for which the data has been collected they have sold

worth Rs 2212 Cr and purchased worth Rs 1077.Now the appreciation in the rupee in

the last few days that is on 29th June can be attributed to the government giving a

clarification on GAAR which is related to the FIIs coming to India via Mauritius and

also to the European Union leaders’ sensible decision to create a single supervisory

body for Euro zone banks with active involvement of the European Central bank by

the end 2012.



Level of co - relation between FII and SensexCorrelations

fiiinvestment sensexfiiinvestmentPearson Correlation1 .734*

Sig. (2-tailed) .038N 8 8

sensex Pearson Correlation.734* 1Sig. (2-tailed) .038N 8 8

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

It has been found by Pearson Correlation that the BSE Sensex and foreign

institutional investment has followed a close relationship. The Pearson correlation

values indicate positive correlation between the foreign institutional investments and

the movement of Sensex

(Pearson correlation value is (0.734).

Level of co-relation between FII and Banking IndexCorrelations

FIIinvestment Bankex

FIIinvestment Pearson Correlation 1 .707*

Sig. (2-tailed) .050

N 8 8

Bankex Pearson Correlation .707* 1


N 8 8

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

It has been founded by the study that BSE Banking Index and foreign institutional

investment has followed a close relationship. The Pearson correlation values indicate

positive correlation between the foreign institutional investments and the movement

of Banking Index.

(pearson’ correlation value is (0.707).



Level of co-relation between FII and Capital goods.Correlations

FIIinvestment Capitalgoodsindex

FIIinvestment Pearson Correlation 1 .679


N 8 8

Capitalgoodsindex Pearson Correlation .679 1


N 8 8

It has been found by Pearson Correlation that the Capital goods Index and foreign



the movement of Capital goods index


Level of co-relation between FII and Power Index

Correlations

Powerindex FIIinvestment

Powerindex Pearson Correlation 1 .553


N 8 8

FIIinvestment Pearson Correlation .553 1


N 8 8

It has been found by Pearson Correlation that the BSE Power Index and foreign



the movement of Power Index




Issues concerning FII’s in India

Participatory Notes

Participatory Notes commonly known as P-Notes or PNs are instruments issued by

registered foreign institutional investors to overseas investors, who wish to invest in

the Indian stock markets without registering themselves with the market regulator, the

Securities and Exchange Board of India (SEBI).Indian-based brokerages buy India-

based securities on behalf of these unregistered overseas investors and then issue

participatory notes to foreign investors. Any dividends or capital gains collected from

the underlying securities go back to the investors.SEBI permitted FIIs to register and

participate in the Indian stock market in 1992.Investing through P-Notes is very simple

and hence very popular amongst FII’s.

Participatory notes have attracted significant market attention recently because of huge

inflow of foreign funds into Indian stock markets through this route. Since the ultimate

beneficiary of transactions carried out using participatory notes is not known to the

market regulator and the tax authorities, there is scope for misuse and tax avoidance.

Also, since participatory notes do not attract the attention of the market regulators of

the countries in which they are issued, the entities holding participatory notes virtually

go unregulated.

As per the latest data available with market regulator SEBI, the total value of PNs in

Indian markets stood at about Rs 1,30,012 crore (about USD 25 billion) at the end of

April 2012, down from Rs 1,83,151 crore at the end of February and Rs 1,65,832 crore

as on March 31, 2012.

Participatory Notes Crisis of 2007

On the 16th of October, 2007, SEBI (Securities & Exchange Board of India) proposed

curbs on participatory notes which accounted for roughly 50% of FII investment in

2007. SEBI was not happy with P-Notes because it is not possible to know who owns

the underlying securities and hedge funds acting through PNs might therefore cause

volatility in the Indian markets.



However the proposals of SEBI were not clear and this led to a knee-jerk crash when

the markets opened on the following day (October 17, 2007). Within a minute of

opening trade, the Sensex crashed by 1744 points or about 9% of its value - the

biggest intra-day fall in Indian stock-markets in absolute terms. This led to automatic

suspension of trade for 1 hour. Finance Minister P.Chidambaram issued clarifications,

in the meantime, that the government was not against FIIs and was not immediately

banning PNs. After the markets opened at 10:55 am, they staged a remarkable

comeback and ended the day at 18715.82, down just 336.04 from Tuesday’s close

after tumbling to a day’s low of 17307.90.

This was, however not the end of the volatility. The next day (October 18, 2007), the

Sensex tumbled by 717.43 points — 3.83 per cent — to 17998.39, its second biggest

fall. The slide continued the next day when the Sensex fell 438.41 points to settle at

17559.98 at the end of the week, after touching the lowest level of that week at

17226.18 during the day.

The SEBI chief, M.Damodaran held an hour long conference on the 22nd of October

to clear the air on the proposals to curb PNs where he announced that funds investing

through PNs were most welcome to register as FIIs, whose registration process would

be made faster and more streamlined. The markets welcomed the clarifications with

an 879-point gain — its biggest single-day surge — on October23, thus signaling the

end of the PN crisis. SEBI issued the fresh rules regarding PNs on the 25th of

October, 2007 which said that FIIs cannot issue fresh P-Notes and existing exposures

were to be wound up within 18 months. The Sensex gave thumbs up the next day -

Friday, 26 October by re-crossing the 19,000 barrier with a 428 point surge. The

coming Monday (October 29, 2007) history was created when the Sensex leaped

734.5 points to cross the hallowed 20,000 mark.

GAAR

GAAR originally proposed in the Direct Taxes Code, is targeted at arrangements or

transactions made specifically to avoid taxes. The government had decided to advance

the introduction of GAAR and implement it from the current financial year itself.

More than 30 countries have introduced GAAR provisions in their respective tax

codes to check evasion.



GAAR allows tax authorities to call a business arrangement or a transaction

'impermissible avoidance arrangement' if they feel it has been primarily entered into

to avoid taxes. Once an arrangement is ruled 'impermissible' then the tax authorities

can deny tax benefits. Most aggressive tax avoidance arrangements would be under

the risk of being termed impermissible. The rule can apply on domestic as well as

overseas transactions. It is a very broad based provision and can easily be applied to

most tax-saving arrangements. Many experts feel that the provision would give

unbridled powers to tax officers, allowing them to question any tax saving deal.

Foreign institutional investors are worried that their investments routed through

Mauritius could be denied tax benefits enjoyed by them under the Indo-Mauritius tax

treaty. The proposal has hit the stock market as FII inflows dropped on concerns, and

the rupee hit an all time low to the dollar.

The Indian law taxes gains derived from the sale of shares irrespective of whether the

shareholder is a resident or nonresident. Under India's tax treaty with Mauritius, gains

derived by a resident of Mauritius from the sale of shares in an Indian company are

taxable only in Mauritius and as it does not tax capital gains, the transaction escapes

tax in both countries. Foreign investors have been using the Mauritius holding

company structure to make investments in India right from the early 1990s. Following

the liberalization of the Indian economy, the Indo-Mauritius DTAA, was "discovered"

as an effective mechanism to avoid capital gains tax on sale of shares in Indian

companies. A Foreign enterprise can set up a subsidiary in Mauritius, and use it to

derive capital gains from acquisition and sale of shares. Although India follows the

source rule for taxation of non-residents, which makes this transaction taxable under

the Income Tax Act, 1961, Article 13(4) of the DTAA gives Mauritius the right to tax

this transaction. Since such gains are exempt from tax in Mauritius, the transaction

becomes completely tax exempt, resulting in double non-taxation. As a result, much

of the Mauritian investment into India is actually round tripping by Indian companies

setting up a Mauritian entity to avoid capital gains tax in India.



Source:SEBI

The above figure illustrates daily movement of FII flows in India from 16 th March,

2012 when the Finance Minister announced the implementation of GAAR. It can be

observed there has been an outflow of dollars to the effect of $ 1 bn during this

period. This has also had an impact on the exchange rate which has depreciated from

Rs 50.31 on March 16th, 2012 to Rs 51.16 on March-end and further to Rs 52.51 and

Rs 53.72 on April end and May 4th, 2012 respectively. This was notwithstanding the

fact that forex reserves had remained largely stable, increasing from $294.8 bn on

March 16th to $ 295.4 bn on April 27th.Clearly the sentiment was affected which

drove the rupee down further.

Response of the Government

GAAR will now be applicable from April 1st, 2013. Further this rule would only be

invoked when there are specific complaints and it will not be easy for assessing tax

officers to invoke GAAR. The onus to prove that an arrangement is 'impermissible'

will lie with the tax department. Also to provide greater clarity and certainty in the

matters relating to GAAR, a Committee has been constituted under the chairmanship

of Director General of Income Tax to give recommendations for formulating the rules

and guideline for implementation of GAAR provision and to suggest safeguards so

that the provisions are not applied indiscriminately.



HOT MONEY

Hot money is a term that is most commonly used in financial markets to refer to the

flow of funds (or capital) from one country to another in order to earn a short-term

profit on interest rate differences and/or anticipated exchange rate shifts. These

speculative capital flows are called "hot money" because they can move very quickly

in and out of markets, potentially leading to market instability

large and sudden inflows of capital with short term investment horizon have negative

macroeconomic effects, including rapid monetary expansion, inflationary pressures,

real exchange rate appreciation and widening current account deficits. Especially,

when capital flows in volume into small and shallow local financial markets, the

exchange rate tends to appreciate, asset prices to rally and local commodity prices to

boom. These favorable asset price movements improve national fiscal indicators and

encourage domestic credit expansion. These, in turn, exacerbate structural weakness

in the domestic bank sector. When global investors' sentiment on emerging markets

shift, the flows reverse and asset prices give back their gains, often forcing a painful

adjustment on the economy

The following are the details of the dangers that hot money presents to the receiving

country's economy:

Inflow of massive capital with short investment horizon (hot money) could

cause asset price to rally and inflation to rise. The sudden inflow of large

amounts of foreign money would increase the monetary base of the receiving

country (if the central bank is pegging the currency), which would help create

credit boom. This, in turn, would result in such a situation in which "too much

money chase too few goods". Consequences of this would be inflation.

Furthermore, hot money could lead to exchange rate appreciation or even

cause exchange rate overshooting. And if this exchange rate appreciation

persists, it would hurt the competitiveness of respective country's export sector

by making the country's exports more expensive compared to similar foreign

goods and services.



Sudden outflow of hot money, which would always certainly happen, would

deflate asset prices and could cause the collapse value of the currency of

respective country. This is especially so in countries with relatively scarce

internationally liquid assets. There is growing agreement that this was the case

in the 1997 East Asian Financial Crisis. In the run-up to the crises, firms and

private firms in South Korea, Thailand and Indonesia accumulated large

amounts of short term foreign debt (a type of hot money). The three countries

shared a common characteristic of having large ratio of short term foreign debt

to international reserves. When the capital starts to flow out, it caused a

collapse in asset prices and exchange rates. The financial panic fed on itself

causing foreign creditors to call in loans and depositors withdraw funds from

banks, all of these magnified the illiquidity of the domestic financial system

and forced yet another round of costly asset liquidations and price deflation. In

all of the three countries, the domestic financial institutions came to the brink

of default on their external short term obligations.



CHAPTER – IV

CONCLUSION



What does India Need - FDI or FII

FDI usually is associated with export growth. It comes only when all the criteria to

set up an export industry are met. That includes, reduced taxes, favorable labor law,

freedom to move money in and out of country, government assistance to acquire land,

full grown infrastructure, reduced bureaucratic involvement etc. IT, BPO, Auto Parts,

Pharmaceuticals, unexplored service sectors including accounting; drug testing,

medical care etc are key sectors for foreign investment. Manufacturing is a brick and

mortar investment. It is permanent and stays in the country for a very long time. Huge

investments are needed to set this industry. It provides employment potential to semi

skilled and skilled labor. On the other hand the service sector requires fewer but

highly skilled workers. Both are needed in India. If India plays its cards right India

may be the hub for the service sector. Still high end manufacturing in auto parts and

pharmaceuticals should be India’s target.

The FII (Foreign Institutional Investor) is monies, which chases the stocks in the

market place. It is not exactly brick and mortar money, but in the long run it may

translate into brick and mortar. Sudden influx of this drives the stock market up as too

much money chases too little stock. Where FDI is a bit of a permanent nature, the FII

flies away at the shortest political or economical disturbance. The Global Recession

of 2008 is a key example of the latter. Once this money leaves, it leaves ruined

economy and ruined lives behind. Hence FII is to be welcomed with strict political

and economical discipline.



BIBLIOGRAPHY

www.dipp.nic.in

www.sebi.gov.in

www.bseindia.com

www.rbi.org.in

www.unctad.org

www.indiainfoline.com

www.thehindu.com


http://www.thehindu.com/

http://www.rbi.org.in/

http://www.bseindia.com/

http://www.sebi.gov.in/

http://www.dipp.nic.in/

FDI and FII Impact on Economy

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