PROJECT REPORT

ON

“IMPACT OF FII’S AND FDI’S ONINDIAN STOCK MARKET”

A Dissertation report submitted in partial fulfillment of the requirement for the MBA degree course of Bangalore

University

ByNITHYASHREE .T.

Reg. No. 03VWCM6067(2003-2005)

Under the guidance and support ofProf. R.Narayanaswamy

FacultyAlliance Business Academy

ALLIANCE BUSINESS ACADEMYBANGALORE – 560 076

2003-05

DECLARATION

 

I, NITHYASHREE.T. of MBA IV Semester, studying at Alliance Business

Academy, Bangalore, hereby declare that this project titled “Foreign Institutional

Investments and Influence of Foreign Institutional Investments on the Equity

Stock Market of India ” has been prepared by me in partial fulfillment of the

requirements of the Bangalore University MBA programme during 2003-2005.

I further declare that this project has not been submitted earlier in any other

university or institution for the award of any degree or diploma.

DATE:

PLACE: BANGALORE NITHYASHREE.T.

GUIDE CERTIFICATION

This is to certify that NITHYASHREE T. student of MBA IV

semester of our Institute has completed her DISSERTATION on

the topic “FII investments and its influence on Indian Stock

Market”, under my guidance, and that no part of this report has

been submitted for the award of any other Degree or Diploma to

any other Board or University by any one else.

Date:Place: Bangalore

Prof.R.Narayanaswamy

Faculty Alliance Business Academy

ACKNOWLEDGEMENT

The satiation and euphonies that accompany the success completion of a task would be

incomplete without a mention of people who made it possible. So, with immense gratitude, I

acknowledge all those, whose guidance and encouragement served as a beacon light and crowned

my effort with success.

I thank Mr. R.Narayanaswamy, Faculty of Alliance Business Academy and my project

guide for his valuable guidance and suggestions, which were vital inputs towards the

completion of the project.

I am indebted to Dr. Mihir Das, Faculty of Alliance Business Academy for his help in

analysing, interpreting the data and for the stimulating discussion which has greatly

added to the study.

Lastly, I would like to thank all those who have directly or indirectly helped me complete

the project successfully.

NITHYASHREE.T.

RESEARCH ABSTRACT

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

importance. In this paper we analyze these flows and their relationship with Indian equity

market. Foreign capital flows have come to be acknowledged as one of

the important sources of funds for economies that would like to grow

at a rate higher than what their domestic savings can support.

Foreign capital flows have particularly become prominent after the

advent of globalization that has led to widespread implementation of

liberalization

programmes and financial reforms in various countries across the

globe in 1990s. This resulted in the integration of global financial

markets. As a result, capital started flowing freely across national

borders seeking out the highest rate of return.

Foreign portfolio inflows through FIIs, in India, are important from the policy

perspective, especially when the country has emerged as one of the most attractive

investment destinations in Asia. This paper reveals if the FIIs influence the Indian Equity

Market.

CHAPTER 1

THEORETICAL BACKGROUND

Introduction

When people think about globalization, they often first think of the increasing volume

of trade in goods and services. Trade flows are indeed one of the most visible aspects

of globalization. But many analysts argue that international investment is a much

more powerful force in propelling the world toward closer economic integration.

Investment, often alters entire methods of production through transfers of know-how,

technology and management techniques, and thereby initiates much more significant

change than the simple trading of goods.

Over the past ten years, foreign investment has grown at a significantly more rapid

pace than either international trade or world economic production generally. From

1980 to 1998, international capital flows, a key indication of investment across

borders, grew by almost 25% annually, compared to the 5% growth rate of

international trade. This investment has been a powerful catalyst for economic

growth.

But as with many of the other aspects of globalisation, foreign investment is raising

many new questions about economic, cultural and political relationships around the

world. Flows of investment and the rules that govern or fail to govern it can have

profound impacts upon such diverse issues as economic development, environmental

protection, labour standards and economic stability.

Forms of Foreign Investment

International investment or capital flows fall into four principal categories:

Commercial loans: These primarily take the form of loans by banks to foreign

businesses or governments.

Official flows: This category refers generally to the forms of development assistance

given by developed countries to developing ones.

Foreign Direct Investment (FDI): This category refers to international investment in

which the investor obtains a lasting interest in an enterprise in another country. FDI is

calculated to include all kinds of capital contributions, such as the purchases of

stocks, as well as the reinvestment of earnings by a wholly owned company

incorporated abroad (subsidiary), and the lending of funds to a foreign subsidiary or

branch. The reinvestment of earnings and transfer of assets between a parent company

and its subsidiary often constitutes a significant part of FDI calculations. An investor's

earnings on FDI take the form of profits such as dividends, retained earnings,

management fees and royalty payments.

Foreign Portfolio Investment (FPI): FPI is a category of investment instruments

that are more easily traded, may be less permanent, and do not represent a controlling

stake in an enterprise. These include investments via equity instruments (stocks) or

debt (bonds) of a foreign enterprise which does not necessarily represent a long-term

interest. The returns that an investor acquires on FPI usually take the form of interest

payments or non-voting dividends. Investments in FPI that are made for less than one

year are distinguished as short-term portfolio flows.

Until the 1980s, commercial loans from banks were the largest source of foreign

investment in developing countries. However, since that time, the levels of lending

through commercial loans have remained relatively constant, while the levels of

global FDI and FPI have increased dramatically. Over the period 1991 - 1998, FDI

and FPI comprised 90% of the total capital flows to developing countries.

Similarly, when viewed against the tremendous and growing volume of FDI and FPI,

the funds provided in the past by governments through official development

assistance, or lending by commercial banks the World Bank or IMF, are diminishing

in importance with each passing year. When one talks about the recent phenomenon

of globalization therefore, one is referring in large part to the effects of FDI and FPI,

and these two instruments will therefore be the primary focus of this issue brief.

Calculating Investment:

Calculations of FDI and FPI are typically measured as either a "flow," referring to the

amount of investment made in one year, or as "stock," measuring the total

accumulated investment at the end of that year.

Differences Between Portfolio and Direct Investment

One of the most important distinctions between Portfolio and Direct investment to

have emerged from this young era of globalisation is that portfolio investment can be

much more volatile. Changes in the investment conditions in a country or region can

lead to dramatic swings in portfolio investment. For a country on the rise, FPI can

bring about rapid development, helping an emerging economy move quickly to take

advantage of economic opportunity, creating many new jobs and significant wealth.

However, when a country's economic situation takes a downturn, sometimes just by

failing to meet the expectations of international investors, the large flow of money

into a country can turn into a stampede away from it.

By contrast, because FDI implies a controlling stake in a business, and often connotes

ownership of physical assets such as a equipment, buildings and real estate, FDI is

more difficult to pull out or sell off. Consequently, direct investors may be more

committed to managing their international investments, and less likely to pull out at

the first sign of trouble.

This volatility has effects beyond the specific industries in which foreign investments

have been made. Because capital flows can also affect the exchange rate of a nation's

currency, a quick withdrawal of investment can lead to rapid decline in the purchasing

power of a currency, rapidly rising prices (inflation) and then panic buying to avoid

still higher prices. In short, such quick withdrawals can produce widespread economic

crisis. This was partly the case in the Asian Economic Crisis that began in 1997.

Although the economic turmoil began as a result of some broader shifts in

international economic policy and some serious problems within the banking and

financial sectors of the affected East Asian nations, the capital flight which ensued --

some compared it to the great financial panics which took place in the United States

during the 19th century -- significantly exacerbated the crisis.

Why Do Companies Invest Overseas?

Companies choose to invest in foreign markets for a number of reasons, often the

same reasons for expanding their operations within their home country. The

economist John Dunning has identified four primary reasons for corporate foreign

investments:

Market seeking - Firms may go overseas to find new buyers for goods and services.

Market-seeking may happen when producers have saturated sales in their home

market, or when they believe investments overseas will bring higher returns than

additional investments at home. This is often the case with high technology goods.

Resource seeking - Put simply, a company may find it cheaper to produce its product

in a foreign subsidiary- for the purpose of selling it either at home or in foreign

markets. The foreign facility may be able to obtain superior or less costly access to the

inputs of production (land, labor, capital and natural resources) than at home.

Strategic asset seeking - Firms may seek to invest in other companies abroad to help

build strategic assets, such as distribution networks or new technology. This may

involve the establishment of partnerships with other existing foreign firms that

specialize in certain aspects of production.

Efficiency seeking - Multinational companies may also seek to reorganize their

overseas holdings in response to broader economic changes. Fluctuations in exchange

rates may also change the profit calculations of a firm, leading the firm to shift the

allocation of its resources.

Foreign Investment Increased so Dramatically in recent Decades?

As stated earlier in this brief, international investment levels have exploded in recent

decades. These increases in the flows of foreign investment have themselves marked a

new and distinct phenomenon in the era of globalisation. Several factors have helped

drive this growth:

1) Technology. Telecommunications and transportation advances have simply made

it easier to do business across large distances. As former President Clinton once

pointed out, in the 1960s, transatlantic telephone lines could only accommodate 80

simultaneous calls between Europe and the United States. Today, satellites and other

telecommunications infrastructure can handle one million calls at one time.

Fax machines, email and the drop in the cost of air travel have also contributed

significantly to the growth of FDI. As you can imagine, a business owner might think

twice about trying to run an affiliate in a foreign country if communication with that

office were not both easy and cheap. Changes in practices tend to be driven by

changes in capabilities, and these new methods to communicate have unquestionably

helped drive much of the subsequent desire to promote economic integration.

2) The lure of higher profits. Many countries in East Asia had built their

phenomenal growth on a foundation based on greater integration into the international

economy, particularly emphasizing export-led growth. Investors from around the

world realized that access to East Asian markets and their trading partners might help

them attain much higher returns on their investments than they could obtain at home.

3) Financial liberalization. Prior many countries imposed strict limits on the rights

of companies and individuals to invest overseas, to purchase foreign securities, or

even to hold foreign currencies. Many of these restrictions were put in place following

the Great Depression of the 1930's, which had produced volatile movements of

capital, triggering financial panics in some cases. Financial liberalization has been the

most direct, and probably the single biggest, factor accounting for the growth of

international investment flows over the past several decades.

Factors Influencing Foreign Investment Decisions

Now that you understand the basic economic reasons why companies choose to invest

in foreign markets, and what forms that investment may take, it is important to

understand the other factors that influence where and why companies decide to invest

overseas. These other factors relate not only to the overall economic outlook for a

country, but also to economic policy decisions taken by foreign governments, aspects

that can be very political and controversial.

The policy frameworks relating to FDI and FPI are relatively similar, although there

are a few differences.

The determinants of FPI are somewhat complex because portfolio investment

earnings are more likely to be tied to the broader macroeconomic indicators of a

country, such as overall market capitalization of an economy, they can be more

sensitive to factors such as:

high national economic growth rates

exchange rate stability

general macroeconomic stability

levels of foreign exchange reserves held by the central bank

general health of the foreign banking system

liquidity of the stock and bond market

interest rates

In addition to these general economic indicators, portfolio investors also look at the

economic policy environment as well, and especially at factors such as:

the ease of repatriating dividends and capital

taxes on capital gains

regulation of the stock and bond markets

the quality of domestic accounting and disclosure systems

the speed and reliability of dispute settlement systems

the degree of protection of investor's rights

SURVEY OF LITERATURE:

Balance of Payments is a statistical record of ALL of a country's int'l transactions

with the rest of the world, over a certain time period (quarter or year), using double-

entry bookkeeping. (private transactions and government transactions).

Examples of International Transactions in BALANCE OF PAYMENT:

1. Imports (M) and Exports (X) of a) goods/merchandise and b) services

2. Cross-border Financial flows (investments in foreign stocks and bonds, real

estate, interest/DIV income, business investment, FDI, etc.)

3. Foreign Aid

BALANCE OF PAYMENT ACCOUNTS

1. CURRENT ACCOUNT

Exports (X) / Imports (M) of: a) Merchandise, b) Services, c) Factor income and d)

Unilateral (one way) government transfers.

Balance on Current Account (CA) = X + M + Net Transfer

2. CAPITAL ACCOUNT

Record of the Sales of Indian Assets (Stocks, bonds, real estate, businesses) to

foreigners, X of assets, resulting in a capital inflow, or a Credit (cash inflow); and the

Purchases of Foreign assets by Indians, M of assets, capital outflow, Debit (cash

outflow).

Specifically:

a. Foreign Direct Investment (FDI)

Refers to international investment in which the investor obtains a lasting interest in an

enterprise in another country. Most concretely, it may take the form of buying or

constructing a factory in a foreign country or adding improvements to such a facility,

in the form of property, plants or equipment.

b. Portfolio Investment:

Purchases/sales of stocks, bonds, notes, mutual funds, money market securities,

options, etc., in foreign capital markets not involving controlling interest.

International portfolio investments have increased significantly recently due to a)

relaxation/deregulation of capital controls (increased capital mobility) and b) a desire

for International portfolio diversification (most security returns have a low correlation

among countries, resulting in risk reduction).  

3. OTHER ACCOUNTS

HOME BIAS IN PORTFOLIO HOLDINGS

Despite significant and obvious gains from International portfolio diversification,

investors demonstrate a "home bias" and allocate a disproportionate share of funds to

domestic securities. 

Excessive transactions costs:

1. Information costs, language barriers

2. Possible unfavorable tax treatment

3. Legal barriers to foreign investment

4. Currency, inflation risk

FII flows and contemporaneous stock returns are strongly correlated in India. The

correlation coefficients between different measures of FII flows and market returns on

the Bombay Stock Exchange during different sample periods.

Positive correlations have often been held as evidence of FII actions determining

Indian equity market returns. However, correlation itself does not imply causality.

A positive relationship between portfolio inflows and stock returns is consistent with

at least four distinct theories:

1) the “omitted variables” hypothesis;

2) the “downward sloping demand curve” view;

3) the “base-broadening” theory; and

4) the “positive feedback strategy” view.

The “omitted variables” view is the classic case of spurious correlation – that the

correlated variables, in fact, have no causal relationship between them but are both

affected by one or more other variables missed out in the analysis.

The “downward sloping demand curve” view contends that foreign investment creates

a buying pressure for stocks in the emerging market in question and causes stock

prices to rise much in the same way as suddenly higher demand for a commodity

would cause its price to rise.

The ‘base-broadening’ argument contends that once foreigners begin to invest in a

country, the financial markets in that country are now no longer moved by national

economic factors alone but rather begin to be affected by foreign market movements

as well. As the market itself is now affected by more factors than before, its exposure

to domestic shocks decline. Consequently the ‘risk’ of the market itself falls, people

demand a lower risk premium to buy stocks, and stock prices rise to higher levels.

Finally the ‘positive feedback view’ asserts that if investors ‘chase’ returns in the

immediate past (like the previous day or week) then aggregating their fund flows over

the month can lead to a positive relationship in the contemporaneous monthly data.

In the present context, both directions of causation are equally plausible.

The positive relationship between market return and FII flows, however, serves only

as a first-pass in understanding the nature of such flows and their implications for the

Indian markets. Since the FII flows essentially serve to diversify the portfolio of

foreign investors, it is only normal to expect that several factors – both domestic as

well as external to India – are likely to affect them along with the expected stock

returns in India. The declining world interest rates have been among the important

“push” factors for international portfolio flows in the early 90’s. The “usual suspects”

in the literature include:

US and world equity returns, changes in interest rates, stock market volatility, some

measure of the country risk and the exchange rate. Other factors that may affect FII

flows Country risk measures, that incorporate political and other risks in addition to

the usual economic and financial variables, may be expected to have an impact on

portfolio flows to India though they are likely to matter more in the case of FDI flows.

CHAPTER 2

DESIGN OF THE STUDY

TITLE OF THE STUDY

“FOREIGN INSTUTIONAL INVESTMENTS AND THE INFLUENCE OF

FOREIGN INSTITUTIONAL INVESTMENTS ON EQUITY STOCK MARKET IN

INDIA”.

STATEMENT OF THE PROBLEM

In this research an effort has been made to develop an understanding of the influence

of the FIIs in the Indian equity market. The Foreign Institutional Investors (FIIs) have

emerged as important players in the Indian equity market in the recent past. This

paper makes an attempt to understand whether there exists a relationship between FII

and Equity Market returns in India.

OBJECTIVES OF THE STUDY

Analyse the trends of Foreign Investment flows and Foreign Institutional Inflows.

Analyse the Yearly trends of FII purchases, FII sales and Net Investment.

Analyse the reason for the major decline of Net Investment in the year 1998-99.

Examine whether FIIs have any influence on Equity Stock Market.

SCOPE OF THE STUDY

The report examines The Influence of Foreign Institutional Investments on Equity

Stock Market in India. The scope of the research comprises of information derived

from secondary data from various websites. The various information and statistics

were derived from the websites of BSE, NSE, Money Control, RBI and SEBI. Sensex

and Nifty was a natural choice for inclusion in the study, as it is the most popular

market indicies and widely used by market participants for benchmarking.

REFERENCE PERIOD

The study period covered under this is for the financial year : 1st April 2004 to 31st

March 2005.

RESEARCH DESIGN:

TYPE OF RESEARCH:

SOURCES OF DATA

The main source of obtaining necessary data for the study was Secondary Data. This

study is empirical in nature and hence secondary data is used to conduct the research.

The data was collected from the Internet by exploring the Secondary sources available

on websites.

Secondary Data: The secondary data constitutes of daily FII flows data which was

collected from Money Control and Equity Master, the daily returns of SENSEX and

NIFTY from BSE and NSE websites respectively. The trends in FII flows from the

RBI website and information on FII from SEBI.

PLAN OF ANALYSIS

The data gathered from various sources were primarily studied and necessary data

was sorted out sequentially keeping in mind the procedure of the study. The analysis

has been made by, correlating the FII purchases, sales and net investment with equity

market returns to identify whether a relation exists between them. Findings are

included which transmits the important points, which were gathered from the study.

METHODOLOGY

1. Form a testable hypothesis

2. Collect relevant data to test hypothesis

3. Perform statistical analysis.

4. Interpret the results.

HYPOTHESIS

Null Hypothesis (Ho): There is no influence of FIIs on the Stock indexes.

Alternative Hypothesis (Ha): There is an influence of FIIs on Stock indexes.

If we reject the Ho, then we accept the Ha, setting the significance level to 5% and

1% at Degree of Freedom = n-2.

LIMITATIONS OF THE STUDY

As the time available is limited and the subject is very vast the study is mainly

focused on identifying whether there does exist a relationship between FIIs and Indian

Equity Stock Market.

The study is general.

It is mainly based on the data available in various websites;

The inferences made is purely from the past year’s performance;

There is no particular format for the study;

Sufficient time is not available to conduct an in-depth study;

OPERATIONAL DEFINITIONS

Exchange rate of a nation's currency- Currency like other commodities, rises or

falls in "price" with demand. When investors leave, they sell their holdings in a

country's currency and as demand falls, the "price" of that currency will also fall

Gold standard-When a country is said to be on the Gold Standard, the value of its

currency and the quantity of its currency in circulation is tied the nation's reserve of

gold. Such a system tends to restrict the country's monetary supply.

OECD-The Organization for Economic Cooperation and Development (OECD) is a

descendant of the U.S.-European cooperation required to execute the Marshall Plan

and rebuild Europe after World War II. A tribute to the success of that effort is the

fact that the 30 or so members of the OECD now include Japan and Korea as well, are

thought of as the wealthy nations of the world.

Economies of Scale-Produces are often able to enjoy considerable production cost

savings by buying inputs in bulk, mass-producing or retailing their end product. These

lower costs achieved through expanded production are called Economies of Scale.

Debt/equity ratio-The debt/equity ratio measures the extent to which a firm's capital

is provided by lenders (through debt instruments such as fixed-return bonds) or

owners (through variable-return stocks). A greater reliance on financing through debt

can mean greater profitability for shareholders, but also greater risk in the event things

go sour.

International Monetary Fund-The IMF is an international organization of 183

member countries, established in 1947 to promote international monetary cooperation,

exchange stability, and orderly exchange arrangements; to foster economic growth

and high levels of employment; and to provide temporary financial assistance to

countries to help ease balance of payments adjustment.

Institutional Investor- An organization whose primary purpose is to invest its own

assets or those held in trust by it for others. includes pension funds, investment

companies, insurance companies, universities and banks.

Interest rates-Interest rates have a powerful effect on the volume of a nation's money

supply. By raising interest rates, i.e., making the cost of borrowing money more

expensive, governments or banks can decrease the money supply. A decrease in the

money supply tends to be counter-inflationary, which makes a currency more valuable

compared to other currencies.

Foreign Direct Investment (FDI)-This category refers to international investment in

which the investor obtains a lasting interest in an enterprise in another country. Most

concretely, it may take the form of buying or constructing a factory in a foreign

country or adding improvements to such a facility, in the form of property, plants or

equipment.

Foreign Portfolio Investment (FPI)-FPI is a category of investment instruments that

are more easily traded, may be less permanent, and do not represent a controlling

stake in an enterprise. These include investments via equity instruments (stocks) or

debt (bonds) of a foreign enterprise that does not necessarily represent a long-term

interest.

Most Favored Nation Treatment-The phrase "most favored nation" refers to the

obligation of the country receiving the investment to give that investment the same

treatment as it gives to investments from its "most favored" trading partner.

Balance of payments-The Balance of Payments (BOP) is a statistical statement that

summarizes, for a specific period (typically a year or quarter), the economic

transactions of an economy with the rest of the world. It covers:

All the goods, services, factor income and current transfers an economy

receives from or provides to the rest of the world

Capital transfers and changes in an economy's external financial claims and

liabilities

Portfolio investment – covers the acquisition and disposal of equity and debt

securities that cannot be classified under direct investment or reserve asset

transactions. These securities are tradable in organised financial markets.

FDI Flows and Stocks – Through direct investment flows the investors builds up a

direct investment stock (position), making part of the investor’s balance sheet. The

FDI stock (position) normally differs from accumulated flows because of revaluation

(changes in prices or exchange rates) and other adjustments like rescheduling or

cancellation of loans, debt forgiveness or debt-equity swaps with different values.

Multinational Companies (MNCs) – are incorporated or unincorporated enterprises

comprising parent enterprises and their foreign affiliates.

Foreign Direct Investor – A foreign direct investor is an individual, an incorporated

or unincorporated public or private enterprise, a government, a group of related

individuals, or a group of related incorporated and/or unincorporated enterprises

which have a direct investment enterprise that is a subsidiary, associate or branch –

operating in a country other than the country or countries of residence of the direct

investor or investors.

Host Economy – is the country that receives FDI or FPI from the foreign investor(s).

Home Economy – is the country of origin/residence of the company that invests in

the foreign economy/host economy.

Subsidiary – is an incorporated enterprise in the host country in which the foreign

investor owns more than 50 per cent of the shareholder’s voting power or has the right

to appoint or remove a majority of the members of this enterprise’s administrative,

management or supervisory body.

Equity capital – comprises of equity in branches and ordinary shares in subsidiaries

and associates.

Reinvested earnings – consist of the direct investor’s share of earnings not

distributed as dividends by subsidiaries or associates and earnings of branches not

remitted to the direct investor.

Other capital – covers inter-company debt (including short-term loans such as trade

credits) between direct investors and subsidiaries, branches and associates.

WTO – World Trade Organisation.

Correlation coefficient - measures the degree of co-movement between two

variables, simple measure of statistical association.

Coefficient of Determination (R2) - ranges from 0 - 1, is always part of the standard

regression output, the most important measure of goodness of fit. R2 = correlation

coefficient (r) squared, since the range of r is from -1 to +1, squaring r forces R2 to

fall between 0 and 1.

CHAPTER 3

OVERVIEW OF CHAPTER SCHEME

CHAPTER 1 – Theoretical Background

This chapter deals with the theoretical background of the study throwing light on the

introduction, forms of Foreign Investment, Differences between Portfolio and Direct

Investment, factors influencing Foreign Investment decisions and a Survey of

Literature.

CHAPTER 2 – Design of the Study

This chapter states the problem of the study; the objectives of the study, the scope,

methodology, tools for collecting data, a plan of analysis, hypothesis and the

limitations of the study. The chapter also includes the operational definitions of the

terms commonly used in the study, along with which the chapter scheme is included.

CHAPTER 3 –Overview of Chapter Scheme

CHAPTER 4- Industry Profile

This chapter gives information on the Foreign Investment flows in India, Foreign

portfolio flows in India, Milestones of FII in India, Acts and Rules relating to FII, a

brief profile of SEBI, RBI, BSE and NSE.

CHAPTER 5 – Analysis and Interpretation of Data

This chapter deals with analysis and interpretation of the data collected. The purpose

of this chapter is to draw inferences, based on the calculations and statistics. Graphs

are also included to give a clear view of the data analysed.

CHAPTER 6 – Findings, Recommendations and Conclusion.

This chapter is the concluding chapter dealing with findings, recommendations and

conclusion which are drawn after the study on Influence of FIIs in Equity Stock

Market.

CHAPTER 4

INDUSTRY PROFILE

INVESTMENT IN INDIAN MARKET

India is believed to be a good investment despite political uncertainty, bureaucratic

hassles, shortages of power and infrastructure deficiencies. India presents a vast

potential for overseas investment and is actively encouraging the entrance of foreign

players into the market. No company, of any size, aspiring to be a global player can,

for long ignore this country, which is expected to become one of the top three

emerging economies.

Success in India

Success in India will depend on the correct estimation of the country's potential;

underestimation of its complexity or overestimation of its possibilities can lead to

failure. While calculating, due consideration should be given to the factor of the

inherent difficulties and uncertainties of functioning in the Indian system. Entering

India's marketplace requires a well-designed plan backed by serious thought and

careful research. For those who take the time and look to India as an opportunity for

long-term growth, not short-term profit- the trip will be well worth the effort.

Market potential

India is the fifth largest economy in the world (ranking above France, Italy, the United

Kingdom, and Russia) and has the third largest GDP in the entire continent of Asia. It

is also the second largest among emerging nations. (These indicators are based on

purchasing power parity). India is also one of the few markets in the world, which

offers high prospects for growth and earning potential in practically all areas of

business. Despite the practically unlimited possibilities in India for overseas

businesses, the world's most populous democracy has, until fairly recently, failed to

get the kind of enthusiastic attention generated by other emerging economies such as

China.

Lack of enthusiasm among investors

The reason being, after independence from Britain 50 years ago, India developed a

highly protected, semi-socialist autarkic economy. Structural and bureaucratic

impediments were vigorously fostered, along with a distrust of foreign business. Even

as today the climate in India has seen a sea change, smashing barriers and actively

seeking foreign investment, many companies still see it as a difficult market. India is

rightfully quoted to be an incomparable country and is both frustrating and

challenging at the same time. Foreign investors should be prepared to take India as it

is with all of its difficulties, contradictions and challenges.

Developing a basic understanding or potential of the Indian market

Envisaging and developing a Market Entry Strategy and implementing these strategies

when actually entering the market are three basic steps to make a successful entry into

India. The Indian middle class is large and growing; wages are low; many workers are

well educated and speak English; investors are optimistic and local stocks are up;

despite political turmoil, the country presses on with economic reforms. But there is

still cause for worries- Infrastructure hassles.

The rapid economic growth of the last few years has put heavy stress on India's

infrastructure facilities. The projections of further expansion in key areas could snap

the already strained lines of transportation unless massive programs of expansion and

modernization are put in place. Problems include power demand shortfall, port traffic

capacity mismatch, poor road conditions (only half of the country's roads are

surfaced) and low telephone penetration.

Indian Bureaucracy

Although the Indian government is well aware of the need for reform and is pushing

ahead in this area, business still has to deal with an inefficient and sometimes still

slow-moving bureaucracy.

Diverse Market

The Indian market is widely diverse. The country has 17 official languages, 6 major

religions, and ethnic diversity as wide as all of Europe. Thus, tastes and preferences

differ greatly among sections of consumers. Therefore, it is advisable to develop a

good understanding of the Indian market and overall economy before taking the

plunge.

INTERNATIONAL PORTFOLIO FLOWS:

International portfolio flows, as opposed to foreign direct investment (FDI) flows,

refer to capital flows made by individuals or investors seeking to create an

internationally diversified portfolio rather than to acquire management control over

foreign companies. Diversifying internationally has long been known as a way to

reduce the overall portfolio risk and even earn higher returns. Investors in developed

countries can effectively enhance their portfolio performance by adding foreign stocks

particularly those from emerging market countries where stock markets have

relatively low correlations with those in developed countries.

International portfolio flows are largely determined by the performance of the stock

markets of the host countries relative to world markets. With the opening of stock

markets in various emerging economies to foreign investors, investors in industrial

countries have increasingly sought to realize the potential for portfolio diversification

that these markets present.

It is likely that for quite a few years to come, FII flows would increase with global

integration. The main question is whether capital flew in to these countries primarily

as a result of changes in global (largely US) factors or in response to events and

indicators in the recipient countries like its credit rating and domestic stock market

return. The answer is mixed – both global and country-specific factors seem to matter,

with the latter being particularly important in the case of Asian countries and for debt

flows rather than equity flows.

FOREIGN INVESTMENT FLOWS IN INDIA:

One of the most important distinctions between Portfolio and Direct investment to

have emerged from this young era of globalisation is that portfolio investment can be

much more volatile.

TABLE: Foreign Investment Flows in India

Year A. Direct Investment B. Portfolio Investment Total (A + B)(US $ million) (US $ million) (US $ million)

1990-91 97 6 1031991-92 129 4 1331992-93 315 244 5591993-94 586 3567 41531994-95 1314 3824 51381995-96 2144 2748 48921996-97 2821 3312 61331997-98 3557 1828 53851998-99 2462 61 25231999-00 2155 3026 51812000-01 4029 2760 67892001-02 6131 2021 81522002-03 4660 979 56392003-04 4675 11377 16052

From a net foreign investment inflow of US $ 5.3 billion in 1997-98, such inflows

declined to US $ 2.4 billion in 1998-99. This is because of the lower portfolio inflows,

as a result of which the net investment has dropped. The changes in the investment

conditions in a country or region can lead to dramatic swings in portfolio investment.

For a country on the rise, in other words for developing countries, FPI can bring about

rapid development, helping an emerging economy move quickly to take advantage of

economic opportunity, creating many new jobs and significant wealth. However,

when a country's economic situation takes a downturn, sometimes just by failing to

meet the expectations of international investors, the large flow of money into a

country can turn into a stampede away from it.

CHART: FOREIGN INVESTMENT FLOWS

FOREIGN PORTFOLIO FLOWS TO INDIA

Foreign portfolio investments have been allowed in India on the basis of the

recommendations of the Narasimham committee which stated:

The committee would also suggest that the capital markets should be gradually

opened up to foreign portfolio investments and simultaneously efforts should be

initiated to improve the depth of the market by facilitating the issue of new types of

equities and innovative debt instruments.’ (Narasimham committee report)

Prior to 1992, only non-resident Indians (NRIs) and Overseas corporate bodies

(OCBs) were allowed to undertake portfolio investment in India. Only on September

14, 1992 the Government of India issued guidelines on FII investments in India which

was followed by a notification by Securities and Exchange Board of India (SEBI)

three years later in November 1995.

FOREIGN INSTITUTIONAL INVESTMENT IN INDIA: MILESTONES

India embarked on a programme of economic reforms in the early 1990s to tie over

its balance of payment crisis and also as a step towards globalisation.

An important milestone in the history of Indian economic reforms happened on

September 14, 1992, when the FIIs (Foreign Institutional Investors) were allowed 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 the stock exchanges in India and in the schemes floated by domestic mutual

funds.

Initially, the holding of a single FII and of all FIIs, NRIs (Non-Resident Indians)

and OCBs (Overseas Corporate Bodies) in any company were subject to a limit of 5%

and 24% of the company's total issued capital respectively.

In order to broad base the FII investment and to ensure that such an investment

would not become a camouflage for individual investment in the nature of FDI

(Foreign Direct Investment), a condition was laid down that the funds invested by FIIs

had to have at least 50 participants with no one holding more than 5%. Ever since this

day, the regulations on FII investment have gone through enormous changes and have

become more liberal over time.

From November 1996, FIIs were allowed to make 100% investment in debt

securities subject to specific approval from SEBI as a separate category of FIIs or sub-

accounts as 100% debt funds. Such investments were, of course, subjected to the

fund-specific ceiling prescribed by SEBI and had to be within an overall ceiling of US

$ 1.5 billion. The investments were, however, restricted to the debt instruments of

companies listed or to be listed on the stock exchanges.

* In 1997, the aggregate limit on investment by all FIIs was allowed to be raised from

24% to 30% by the Board of Directors of individual companies by passing a

resolution in their meeting and by a special resolution to that effect in the company's

General Body meeting.

From the year 1998, the FII investments were also allowed in the dated government

securities, treasury bills and money market instruments.

In 2000, the foreign corporates and high net worth individuals were also allowed to

invest as sub-accounts of SEBI-registered FIIs. FIIs were also permitted to seek SEBI

registration in respect of sub-accounts. This was made more liberal to include the

domestic portfolio managers or domestic asset management companies.

40% became the ceiling on aggregate FII portfolio investment in March 2000.

This was subsequently raised to 49% on March 8, 2001 and to the specific sectoral

cap in September 2001.

As a move towards further liberalization a committee was set up on March 13, 2002

to identify the sectors in which FIIs portfolio investments will not be subject to the

sectoral limits for FDI.

Later, on December 27, 2002 the committee was reconstituted and came out with

recommendations in June 2004. The committee had proposed that, 'In general, FII

investment ceilings, if any, may be reckoned over and above prescribed FDI sectoral

caps. The 24 per cent limit on FII investment imposed in 1992 when allowing FII

inflows was exclusive of the FDI limit. The suggested measure will be in conformity

with this original stipulation.' The committee also has recommended that the special

procedure for raising FII investments beyond 24 per cent up to the FDI limit in a

company may be dispensed with by amending the relevant regulations.

Meanwhile, the increase in investment ceiling for FIIs in debt funds from US $ 1

billion to US $ 1.75 billion has been notified in 2004. The SEBI also has reduced the

turnaround time for processing of FII applications for registrations from 13 working

days to 7 working days except in the case of banks and subsidiaries.

All these are indications for the country's continuous efforts to mobilize more foreign

investment through portfolio investment by FIIs. The FII portfolio flows have also

been on the rise since September 1992. Their investments have always been net

positive, but for 1998-99, when their sales were more than their purchase

ACTS AND RULES

FII registration and investment are mainly governed by SEBI (FII) Regulations,

1995.

ELIGIBILITY FOR REGISTRATION AS FII: Following entities / funds are

eligible to get registered as FII:

1. Pension Funds

2. Mutual Funds

3. Insurance Companies

4. Investment Trusts

5. Banks

6. University Fund s

7. Endowments

8. Foundations

9. Charitable Trusts / Charitable Societies

Further, following entities proposing to invest on behalf of broad based funds(a fund

established or incorporated outside India, which has at least twenty investors with no

single individual investor holding more than 10% shares or units of the fund) , are

also eligible to be registered as FIIs:

1. Asset Management Companies

2. Institutional Portfolio Managers

3. Trustees

4. Power of Attorney Holders

INVESTMENT OPPORTUNITIES FOR FIIs

The following financial instruments are available for FII investments

a) Securities in 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 mutual funds;

c) Dated Government Securities;

d) Derivatives traded on a recognized stock exchange ;

e) Commercial papers.

Investment limits on equity investments

a) FII, on its own behalf, shall not invest in equity more than 10% of total issued

capital of an Indian company.

b) Investment on behalf of each sub-account shall not exceed 10% of total issued

capital of an India company.

c) For the sub-account registered under Foreign Companies/Individual category, the

investment limit is fixed at 5% of issued capital.

These limits are within overall limit of 24% / 49 % / or the sectoral caps a prescribed

by Government of India / Reserve Bank of India.

Investment limits on debt investments

The FII investments in debt securities are governed by the policy if the Government

of India. Currently following limits are in effect:

For FII investments in Government debt, currently following limits are

applicable:

For corporate debt the investment limit is fixed at US $ 500 million.

TAXATION

The taxation norms available to a FII is shown in the table below.

Nature of Income Tax Rate

Long-term capital gains 10%

Short-term capital gains 30%

Dividend Income Nil

Interest Income 20%

Long term capital gain: Capital gain on sale of securities held for a period of more

than one year.

Short term capital gain: Capital gain on sale of securities held for a period of less than

one year.

BRIEF PROFILE OF IMPORTANT INSTITUTIONS:

A brief profile of important institutions included in the study is given below.

RESERVE BANK OF INDIA

India's Central Bank - the RBI - was established on 1 April 1935 and was nationalized

on 1 January 1949. Some of its main objectives are regulating the issue of bank notes,

managing India's foreign exchange reserves, operating India's currency and credit

system with a view to securing monetary stability and developing India's financial

structure in line with national socio-economic objectives and policies.

The RBI acts as a banker to Central/State governments, commercial banks, state

cooperative banks and some financial institutions. It formulates and administers

monetary policy with a view to promoting stability of prices while encouraging higher

production through appropriate deployment of credit. The RBI plays an important role

in maintaining the exchange value of the Rupee and acts as an agent of the

government in respect of India's membership of IMF. The RBI also performs a variety

of developmental and promotional functions.

The first concern of a central bank is the maintenance of a soundly based commercial

banking structure. While this concern has grown to comprehend the operations of all

financial institutions, including the several groups of non-bank financial

intermediaries, the commercial banks remain the core of the banking system. A

central bank must also cooperate closely with the national government. Indeed, most

governments and central banks have become intimately associated in the formulation

of policy.

They are often responsible for formulating and implementing monetary and credit

policies, usually in cooperation with the government. they have been established

specifically to lead or regulate the banking system.

SECURITUIES AND EXCHANGE BOARD OF INDIA

In 1988 the Securities and Exchange Board of India (SEBI) was established by the

Government of India through an executive resolution, and was subsequently upgraded

as a fully autonomous body (a statutory Board) in the year 1992 with the passing of

the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In

place of Government Control, a statutory and autonomous regulatory board with

defined responsibilities, to cover both development & regulation of the market, and

independent powers have been set up.

The basic objectives of the Board were identified as:

to protect the interests of investors in securities;

to promote the development of Securities Market;

to regulate the securities market and

for matters connected therewith or incidental thereto.

Since its inception SEBI has been working targetting the securities and is attending to

the fulfillment of its objectives with commendable zeal and dexterity. The

improvements in the securities markets like capitalization requirements, margining,

establishment of clearing corporations etc. reduced the risk of credit and also reduced

the market.

SEBI has introduced the comprehensive regulatory measures, prescribed registration

norms, the eligibility criteria, the code of obligations and the code of conduct for

different intermediaries like, bankers to issue, merchant bankers, brokers and sub-

brokers, registrars, portfolio managers, credit rating agencies, underwriters and others.

It has framed bye-laws, risk identification and risk management systems for Clearing

houses of stock exchanges, surveillance system etc. which has made dealing in

securities both safe and transparent to the end investor.

Another significant event is the approval of trading in stock indices (like S&P CNX

Nifty & Sensex) in 2000. A market Index is a convenient and effective product

because of the following reasons:

It acts as a barometer for market behavior;

It is used to benchmark portfolio performance;

It is used in derivative instruments like index futures and index options;

It can be used for passive fund management as in case of Index Funds.

Two broad approaches of SEBI is to integrate the securities market at the national

level, and also to diversify the trading products, so that there is an increase in number

of traders including banks, financial institutions, insurance companies, mutual funds,

primary dealers etc. to transact through the Exchanges. In this context the introduction

of derivatives trading through Indian Stock Exchanges permitted by SEBI in 2000 AD

is a real landmark.

BOMBAY STOCK EXCHANGE:

Of the 22 stock exchanges in the country, Mumbai's (earlier known as Bombay),

Bombay Stock Exchange is the largest, with over 6,000 stocks listed. The BSE

accounts for over two thirds of the total trading volume in the country. Established in

1875, the exchange is also the oldest in Asia. Among the twenty-two Stock

Exchanges recognised by the Government of India under the Securities Contracts

(Regulation) Act, 1956, it was the first one to be recognised and it is the only one that

had the privilege of getting permanent recognition ab-initio.

Approximately 70,000 deals are executed on a daily basis, giving it one of the highest

per hour rates of trading in the world. There are around 3,500 companies in the

country which are listed and have a serious trading volume. The market capitalization

of the BSE is Rs.5 trillion. The BSE `Sensex' is a widely used market index for the

BSE.

The main aims and objectives of the BSE is to provide a market place for the purchase

and sale of security evidencing the ownership of business property or of a public or

business debt. It aims to promote, develop and maintain a well-regulated market for

dealing in securities and to safeguard the interest of members and the investing public

having dealings on the Exchange. It helps industrial development of the country

through efficient resource mobilization. To establish and promote honourable and just

practices in securities transactions

BSE Sensex

The BSE Sensex is a value-weighted index composed of 30 companies with the base

April 1979 = 100. It has grown by more than four times from January 1990 till date.

The set of companies in the index is essentially fixed. These companies account for

around one-fifth of the market capitalization of the BSE.

NATIONAL STOCK EXCHANGE OF INDIA

The National Stock Exchange of India Limited has genesis in the report of the High

Powered Study Group on Establishment of New Stock Exchanges, which

recommended promotion of a National Stock Exchange by financial institutions (FIs)

to provide access to investors from all across the country on an equal footing. Based

on the recommendations, NSE was promoted by leading Financial Institutions at the

behest of the Government of India and was incorporated in November 1992 as a tax-

paying company unlike other stock exchanges in the country.

On its recognition as a stock exchange under the Securities Contracts (Regulation)

Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market

(WDM) segment in June 1994. The Capital Market (Equities) segment commenced

operations in November 1994 and operations in Derivatives segment commenced in

June 2000.

S&P CNX Nifty

S&P CNX Nifty is a well-diversified 50 stock index accounting for 23 sectors of the

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

index based derivatives and index funds.

S&P CNX Nifty is owned and managed by India Index Services and Products Ltd.

(IISL), which is a joint venture between NSE and CRISIL. IISL is India's first

specialised company focused upon the index as a core product. IISL have a consulting

and licensing agreement with Standard & Poor's (S&P), who are world leaders in

index services.

The average total traded value for the last six months of all Nifty stocks is

approximately 58% of the traded value of all stocks on the NSE

Nifty stocks represent about 60% of the total market capitalization as on

March 31, 2005.

Impact cost of the S&P CNX Nifty for a portfolio size of Rs.5 million is

0.07%

S&P CNX Nifty is professionally maintained and is ideal for derivatives

trading

CHAPTER 4

ANALYSIS AND INTERPRETATION

Portfolio flows – often referred to as “hot money” – are notoriously volatile compared

to other forms of capital flows. Investors are known to pull back portfolio investments

at the slightest hint of trouble in the host country often leading to disastrous

consequences to its economy. They have been blamed for exacerbating small

economic problems in a country by making large and concerted withdrawals at the

first sign of economic weakness.

TRENDS IN FII INVESTMENT IN INDIA

TABLE : Trends in FII investment

Year FII PURCHASE FII SALES FII NET FII NET CUM FII NET

  in crores in crores in crores US$ million US$ million

1993-94 5593 466 5126 1634 16381994-95 7631 2835 4796 1528 31671995-96 9694 2752 6942 2036 52021996-97 15554 6979 8575 2432 76341997-98 18695 12737 5958 1649 92841998-99 16115 17699 -1584 -386 88981999-00 56856 46734 10122 2339 112372000-01 74051 64116 9934 2160 133962001-02 49920 41165 8755 1846 152422002-03 47060 44371 2689 562 158042003-04 144858 99094 45765 9949 25754

Source: Reserve Bank of India Annual Report 2004

INFERENCE: The investments by FIIs have been registering a steady growth since

the opening of the Indian capital markets in September 1992. Their investments have

always been net positive, but for 1998-99, when their sales were more than their

purchases.

It can be observed from the above table that the portfolio investment inflows have

always been on the increase. But the years 2001-02 and 2002-03 saw some reversal in

the trend. From a net inflow of US $ 2.1 billion in 2000-01, such inflows declined to

US $ 1.8 billion in 2001-02, and further dropped to US $ 0.562 billion in 2002-03.

The decline is because of the lower portfolio inflows, as a result of which the net

investment has dropped in these years. However, this decline witnessed a sharp

reversal in the year 2003-04. FIIs have made a net investment of Rs. 45,764 crores

during this year registering a growth of 1602% over the previous year, creating a

record in the history of FII investment in India. Gross purchases in this year amounted

to Rs.144,857 crores, a growth rate of 208% compared to the year before. This trend

continued in April 2004, only to suffer reversal again during May and June 2004,

when the net investment became negative. Fortunately, the year from July 2004 has

been seeing a net positive portfolio flows by FIIs. As of September 2004, the net FII

portfolio investment stands at US $ 27,637 million. If it is so, then increasing the FII

investment cap per se will not be helpful. The country has to work on specific

measures to encourage more FII investments. The analysis of data indicates that there

has been substantial divestment by the FIIs during the year 1998-99. The maximum

outflow was during the months of May and June 1998 (almost US$430 millions).

CHART : Sources of FII in India

Source: Sebi website

INFERENCE: The sources of these FII flows are varied. The FIIs registered with

SEBI come from as many as 28 countries. US-based institutions accounted for

slightly over 41%, those from the UK constitute about 20% with other Western

European countries hosting another 17% of the FIIs). It is, however, instructive to

bear in mind that these national affiliations do not necessarily mean that the actual

investor funds come from these particular countries. Given the significant financial

flows among the industrial countries, national affiliations are very rough indicators of

the ‘home’ of the FII investments. In particular institutions operating from

Luxembourg, Cayman Islands or Channel Islands, or even those based at Singapore or

Hong Kong are likely to be investing funds largely on behalf of residents in other

countries. Nevertheless, the regional breakdown of the FIIs does provide an idea of

the relative importance of different regions of the world in the FII flows.

CHART : GROWTH OF FII INVESTMENTS IN INDIA

INFERENCE: The trickle of FII flows to India that began in January 1993 has

gradually expanded to an average monthly inflow of close to Rs. 1900 crores during

the first six months of 2001. By June 2001, over 500 FIIs were registered with SEBI.

The total amount of FII investment in India had accumulated to a formidable sum of

over Rs.50,000 crores during this time. In terms of market capitalization too, the share

of FIIs has steadily climbed to about 9% of the total market capitalization of BSE

(which, in turn, accounts for over 90% of the total market capitalization in India).

CHART: TRENDS IN YEARLY GROSS PURCHASES

INFERENCE: On observation of the above chart of trends in yearly Gross

Purchases, the Gross Purchases of FIIs in India registered a record of Rs.144,857

crores in the year 2003-04, a a growth rate of 208% compared to the previous year

2002-03. This trend continued in April 2004, only to suffer reversal again during May

and June 2004, when the net investment became negative.

CHART: TRENDS IN YEARLY GROSS SALES

INFERENCE

In the above chart we can see that during the year 2003-04 FIIs Gross Sales amounted

an increase Rs.99094 crores when compared to Rs. 44371 crores. The FIIs Gross

Sales shows an upward trend with reference to the base year of 1993-94 when the

Gross Sales where only Rs. 466 crores.

CHART: TRENDS IN YEARLY NET INVESTMENT

INFERENCE: From a net inflow of US $ 2.1 billion in 2000-01, such inflows

declined to US $ 1.8 billion in 2001-02, and further dropped to US $ 0.562 billion in

2002-03. The decline is because of the lower portfolio inflows, as a result of which

the net investment has dropped in these years. However, this decline witnessed a

sharp reversal in the year 2003-04. The country has to work on specific measures to

encourage more FII investments.

If one looks at the trend of portfolio equity investment in the Indian stock market

since 2002-03, it shows that there has been a very sharp increase in the net FII

investment in India since April 2003. For the financial year 2003-04, FIIs have

invested more than Rs 44,000 crore of portfolio capital in the Indian stock market. To

put this figure into perspective, for the period 1992-93 to 2002-03, the maximum

annual net investment by FIIs in India was in the year 1999-2000 and for that year,

total net FII investment in India was Rs 9,765 crores. This rising trend of portfolio

investment continued in 2004 also. In fact, in March 2004, a record Rs 8.800 crores of

net foreign portfolio investment came into the Indian equity market. This trend

continued till the end of April and more than Rs 4,200 crores of portfolio investment

was made in the Indian stock market in that month. However, for the month of May,

FIIs turned net sellers in the Indian equity markets. Between 30 th April 2004 and 31st

May 2004, net FII investment was negative. During this period, FIIs withdrew more

than Rs 3,500 crores from the Indian equity market. In June, net FII investment turned

positive, however, net FII investment for the month of June was only Rs 516 crores

which is much lower than the average

The analysis of data indicates that there has been substantial divestment by the FIIs

during the year 1998-99. The maximum outflow was during the months of May and

June 1998 (almost US$430 millions).

TABLE : Monthly Trends of FIIs for the Year 1998-99

Month Purchases Sales Net Net  (Rs mn) (Rs mn) (Rs mn) (US$ mn)

Apr-98 11422 11756 -335 -8.4May-98 8253 13284 -5031 -124.3Jun-98 8023 16072 -8049 -190.5Jul-98 13098 12154 944 22.2Aug-98 7932 11783 -3851 -90.1Sep-98 14381 12458 1923 45.2Oct-98 10737 16470 -5733 -135.4Nov-98 10391 9845 546 12.9Dec-98 11089 8789 2300 104.8Jan-99 16355 11894 4462 104.8Feb-99 16477 13084 3393 79.8Mar-99 25207 23973 1233 29

A major factor which led to continuous outflow of funds during the middle and end of

the year 1998 was the worsening outlook on the emerging markets. Credit worthiness

of almost all the South-east Asian nations was severely damaged by the crises which

started in July 1997. As a result, the FIIs were facing heavy redemption pressures

from the Emerging Markets Funds. The stock markets in all these countries fell

continuously from March 1998 till about September 1998. The integration of the

Indian capital markets with the international markets thus spilled over to Indian

markets as well. However, the net outflow from the Indian markets was much lower

than the other Asian countries. A further indication of the integration of the Indian

markets can be seen from the upsurge in the valuations and funds inflows during the

first quarter of 1999, when all the other Asian countries have also seen rising trend in

stocks indices.

The sluggishness in investment in the emerging markets was exacerbated by the fact

that throughout 1998-99, US and European markets showed historically high

valuations, and the expectations of further rise because of the strong economic

indicators there which led to reduced allocations elsewhere.

INFLUENCE OF FII ON THE EQUITY INDEXES OF INDIA

We are interested in testing a hypothesis about the influence of FII in Equity Stock

Market by correlating Gross Purchases, Gross Sales and Net Investment with Nifty

and Sensex.  T-test is conducted at 1% and 5% significance. Statistical significance is

way to measure the likelihood that chance explains the results.

FORMULATING A HYPOTHESIS:

Null Hypothesis (Ho): there is no influence of FIIs on the Stock indexes.

Alternative Hypothesis (Ha): there is an influence of FIIs on Stock indexes.

If we reject the Ho, then we accept the Ha. Setting the significance level to 5% and

1%, the null hypothesis would be rejected only when the maximum number of months

show positive correlation.

T-Statistic:

Using T-test is calculated using the following formula:

When,

-the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level.

-if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated

Conclusion: At the 1% level of stat sig we find that there is an influence of FIIs on

Stock Market Indexes of India.

TABLE: CORRELATION OF FII WITH NIFTY

MONTH GROSS PURCHASES GROSS SALES NET INVESTMENTAPRIL -0.308891015 -0.486299015 -0.122510317MAY -0.203839618 -0.226174846 0.127555673JUNE 0.40719847 0.013881057 0.556762421JULY 0.231397721 -0.008199745 0.352195939AUGUST -0.296292834 -0.009987101 -0.288696993SEPTEMBER 0.631541276 0.478957403 0.377141924OCTOBER -0.107835133 -0.303940405 0.118451125NOVEMBER 0.103856902 0.232269601 -0.020576251DECEMBER -0.689594568 -0.692805116 -0.496878284JANUARY -0.02034654 -0.57330261 0.64885866FEBRUARY 0.124176605 -0.056354197 0.233709555MARCH 0.419911809 -0.255570154 0.483718703

FII flows and contemporaneous stock returns are strongly correlated in India. The

correlation coefficients between different measures of FII flows and market returns on

the Bombay Stock Exchange during different sample periods are shown in Table

above. While the correlations are quite high throughout the sample period, they

exhibit a significant rise since the beginning of the 1999-00. The calculations show

that there exists a relationship between FIIs and Nifty since 6 out of 12 months show

positive correlation in the case of Gross Purchass and 8 out of 12 months indicate a

positive correlation in the case of Net FII Investment and Nifty.

TABLE : CORRELATION OF FII WITH SENSEX

MONTH GROSS PURCHASES GROSS SALES NET INVESTMENTAPRIL -0.267580403 -0.509025858 -0.076211493MAY -0.184653959 -0.224809346 0.1484205JUNE 0.405635894 -0.004710378 0.575995013JULY 0.291205286 0.045396684 0.353391901AUGUST -0.315900375 -0.033391574 -0.301709231SEPTEMBER 0.661834837 0.506184274 0.389776394OCTOBER -0.067640059 -0.311421901 0.18995454NOVEMBER 0.083505749 0.244942636 -0.057919794DECEMBER -0.666663184 -0.688620778 -0.46494095JANUARY 0.02201209 -0.551509386 0.679227006FEBRUARY 0.00689661 -0.170243004 0.149373722MARCH 0.417854257 -0.250893125 0.479619465

The behaviour of the foreign portfolio investors matched the behaviour of Sensex

during this period. Net FII investment in the Indian capital markets started fluctuating

sharply during April and it turned negative. Net FII investment in the Indian stock

market was positive from May to July. During this period, the Sensex and net FII

investment showed very high degree of correlation. For the month of June showed a

correlation as high as 0.60. The months of September, October, November and

December shows a declining trend, the FII investment reversed from that day. On the

whole, there exists a relationship between FIIs and Sensex since 7 out of 12 months

show positive correlation in the case of Gross Purchases and 8 out of 12 months

indicate a positive correlation in the case of Net FII Investment and Sensex.

TABLE : COEFFECIENT OF DETERMINATION OF FII WITH NIFTY

MONTH GROSS PURCHASES GROSS SALES NET INVESTMENTAPRIL 0.095413659 0.236486732 0.015009MAY 0.04155059 0.051155061 0.01627JUNE 0.165810594 0.000192684 0.309984JULY 0.053544905 6.72358E-05 0.124042

AUGUST 0.087789444 9.97422E-05 0.083346SEPTEMBER 0.398844383 0.229400194 0.142236OCTOBER 0.011628416 0.09237977 0.014031NOVEMBER 0.010786256 0.053949168 0.000423DECEMBER 0.475540669 0.479978929 0.246888JANUARY 0.000413982 0.328675883 0.421018FEBRUARY 0.015419829 0.003175796 0.05462MARCH 0.176325927 0.065316104 0.233984

Coefficient of Determination (R2), ranges from 0 - 1, is always part of the standard

regression output, the important measure of goodness of fit. R2 = correlation

coefficient (r) squared, since the range of r is from -1 to +1, squaring r forces R2 to

fall between 0 and 1. R2 in the above table gives the percentage (%) of the total

variation in Nifty that is explained by the regression equation, or explained by FIIs.

During the month of January the total variation in Nifty explained by FII amounted to

42% and the remaining 58% is explained by other factors which influence Nifty.

TABLE : COEFFECIENT OF DETERMINATION OF FII WITH SENSEX

MONTH GROSS PURCHASES GROSS SALES NET INVESTMENTAPRIL 0.071599272 0.259107325 0.005808MAY 0.034097085 0.050539242 0.022029JUNE 0.164540479 2.21877E-05 0.33177JULY 0.084800519 0.002060859 0.124886AUGUST 0.099793047 0.001114997 0.091028SEPTEMBER 0.438025352 0.256222519 0.151926OCTOBER 0.004575178 0.0969836 0.036083NOVEMBER 0.00697321 0.059996895 0.003355DECEMBER 0.444439801 0.474198576 0.21617JANUARY 0.000484532 0.304162603 0.461349FEBRUARY 4.75632E-05 0.028982681 0.022313MARCH 0.17460218 0.06294736 0.230035

Similarly, in the case of FII and Sensex we have R2 = .46, indicating that variation in

FII explains about 46% of the variation in Sensex. 54% of the variation in Sensex is

unexplained by FII, explainable by other factors, omitted variables, random variation,

etc. We shouldn't put too much emphasis on R2, t-stat are more important. However,

R2, or some other measure of goodness of fit is expected in reported empirical results.

TABLE: T-statistics- FII and Nifty

MONTH Purchases Sales Net FII t(0.01) t(0.05)

April -1.339074452 -2.29467 -0.50896 2.567 1.74

May -0.907571397 -1.0121 0.560581 2.539 1.729

June 1.993833093 0.062084 2.997474 2.528 1.725

July 1.063712023 -0.03667 1.682898 2.528 1.725

August -1.38735818 -0.04467 -1.34851 2.528 1.725

September 3.642698972 2.440043 1.821109 2.528 1.725

October -0.460189184 -1.35354 0.506109 2.552 1.734

November 0.443023275 1.013144 -0.08732 2.552 1.734

December -4.363626504 -4.40261 -2.62379 2.518 1.721

January -0.083908304 -2.88498 3.515943 2.567 1.74

February 0.53094617 -0.23947 1.019787 2.552 1.734

March 2.069166259 -1.1822 2.471661 2.528 1.725

Comparing the t-stat to the critical value at the 1% level (one-tailed test) at degree of

Freedom, D.F. = N –2;

-the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level.

-if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated

We accept the Null Hypothesis since the maximum number of months show that FII

and Nifty are uncorrelated.

TABLE: T-statistics- FII and Sensex

MONTH Purchases Sales Net FII t(0.01) t(0.05)April -1.145014609 -2.4383 -0.31514 2.567 1.74

May -0.818971306 -1.00566 0.654196 2.539 1.729

June 1.984671667 -0.02107 3.151163 2.528 1.725July 1.361307913 0.20323 1.689426 2.528 1.725

August -1.488997461 -0.14941 -1.41523 2.528 1.725September 3.948264684 2.624836 1.892839 2.528 1.725

October -0.287631201 -1.39039 0.820854 2.552 1.734

November 0.355526636 1.071855 -0.24615 2.552 1.734December -4.098741766 -4.3519 -2.40656 2.518 1.721

January 0.09078017 -2.72599 3.815802 2.567 1.74February 0.029260533 -0.73298 0.64093 2.552 1.734

March 2.056876281 -1.1591 2.444422 2.528 1.725

Comparing the t-stat to the critical value at the 1% level (one-tailed test) at degree of

Freedom, D.F. = N –2;

-the calculated t>t(0.05,0.01) for (n-2) d.f., variable is significant at 5% level.

-if t<t(0.05) the data are consistent with the hypothesis of an uncorrelated

We accept the Null Hypothesis since the maximum number of months show that FII -

Nifty and FII-Sensex are uncorrelated.

F-STATISTIC:

Testing the Hypothesis

Null Hypothesis (Ho): There is no influence of FIIs on the Stock indexes.

Alternative Hypothesis (Ha): There is an influence of FIIs on Stock indexes.

If we reject the Ho, then we accept the Ha. Setting the significance level to 1%, the

null hypothesis would be rejected only when the entire year of 2004-05 shows

positive correlation.

Formula For F Test

Formula For T Test

TABLE: YEARLY CORRELATION AND F-TEST AT 1% SIGNIFICANCE

  PARTICULARS NIFTY SENSEX

PURCHASES Pearson Correlation 0.440552215 0.440403204

  Sig. (1-tailed) 1.04808E-13 1.07029E-13

  N 252 252

SALES Pearson Correlation 0.260429215 0.263882768

  Sig. (1-tailed) 1.41899E-05 1.0996E-05

  N 252 252

NET INVESTMENT Pearson Correlation 0.309072081 0.306581522

  Sig. (1-tailed) 2.79231E-07 3.4768E-07

  N 252 252

FII flows and contemporaneous stock returns are strongly correlated in India. The

correlation coefficients between different measures of FII flows and market returns on

the Bombay Stock Exchange during the year 2004-05 are shown in the Table. While

the correlations are high being 0.44 between FII purchases and Nifty, 0.44 between

FII Purchases and Sensex, 0.26 between FII Sales and Nifty, 0.26 between Gross

Sales and Sensex, 0.31 between Net FII and Nifty, 0.31 between Net FII and Sensex.

At the 1% significance level the null hypothesis is rejected with a view that FIIs flows

and market Purchases of have a high correlation. Hence the FIIs have significant

influence on Equity Indexes Nifty and Sensex.

The positive relationship between market return and FII flows, however, serves only

as a first-pass in understanding the nature of such flows and their implications for the

Indian markets. Since the FII flows essentially serve to diversify the portfolio of

foreign investors, it is only normal to expect that several factors – both domestic as

well as external to India – are likely to affect them along with the expected stock

returns in India.

CHAPTER 5

SUMMARY OF FINDINGS, RECOMMENDATIONS AND CONCLUSION

FINDINGS:

It is an accepted fact now that FIIs have significant influence on the movements of

the stock market indexes in India. If one looks at the total FII trade in equity in

India and its relationship with the stock market major indexes like Sensex and

Nifty, it shows a steadily growing influence of FIIs in the domestic stock market.

FIIs and the movements of Sensex are quite closely correlated in India and FIIs

wield significant influence on the movement of Sensex. NSE also observes that in

the Indian stock markets FIIs have a disproportionately high level of influence on

the market sentiments and price trends. This is so because other market

participants perceive the FIIs to be infallible in their assessment of the market and

tend to follow the decisions taken by FIIs. This ‘herd instinct’ displayed by other

market participants amplifies the importance of FIIs in the domestic stock market

in India.

Results of this study show that not only the FIIs are the major players in the

domestic stock market in India, but their influence on the domestic markets is also

growing. Data on trading activity of FIIs and domestic stock market turnover

suggest that FII’s are becoming more important at the margin as an increasingly

higher share of stock market turnover is accounted for by FII trading. Moreover,

the findings of this study also indicate that Foreign Institutional Investors have

emerged as the most dominant investor group in the domestic stock market in

India. Particularly, in the companies that constitute the Bombay Stock Market

Sensitivity Index (Sensex) and NSE Nifty, their level of control is very high.

Dominant position of FIIs in the Sensex companies, it is not surprising that FIIs

are in a position to influence the movement of Sensex and Nifty in a significant

way.

Since FIIs are dominating the Indian Market, individual investors are forced to

accept the dictates of major FIIs and hence join the group by entering the Mutual

Fund group. Many Mutual Funds floated specific funds for the sectors favoured

by the FIIs. An implication of MFs gaining strength in the Indian stock market

could be that unlike individual investors, whose monies they manage, MFs can

create market trends whereas the small individual investors can only follow the

trends. The situation becomes quite difficult if the funds gain a vested interest in

certain sectors by floating sector specific funds. One can even venture to say that

the behaviour of MFs in India has turned the very logic that mutual funds invest

wisely on the basis of well-researched strategies and individual investors do not

have the time and resources to study and monitor corporate performance, upside

down. Thus, the entry of FIIs has not resulted in greater depth in Indian stock

market; instead it led to focussing on only a few sectors. Ultimately to provide a

level playing field, even the domestic investors had to be offered lower rates of

capital gains tax.

While it can be expected that foreign affiliated mutual funds would follow the

investment pattern of FIIs, it is important to note that many domestic ones also

followed FIIs. The sectors favoured by FIIs account for a substantial portion of the

net assets under control of many Mutual Funds. The Mutual funds are gaining

prominence in the Indian Stock market and that the share of foreign affiliated MFs

is growing, a number of Indian funds are following the investment strategies of

the foreign ones.

On the other hand if FII investments constitute a large share of the equity capital

of a financial entity, an FII pullout, even if driven by development outside the

country can have significant implications for the financial health of what is an

important institution in the financial sector of this country.

Similarly, if any set of developments encourages an unusually high outflow of FII

capital from the market, it can impact adversely on the value of the rupee and set

of speculation in the currency that can in special circumstances result in a

currency crisis. There are now too many instances of such effects worldwide for it

be dismissed on the ground that India's reserves are adequate to manage the

situation.

FII investments, seem to have influenced the Indian stock market to a

considerable extent. FIIs are interested in the Indian stock market increases its

vulnerability to fluctuations. Analysis suggested a strong influence of FII

investment on the Sensex and Nifty index. This finding takes quite further the

general understanding that net FII investments influences stock prices in India as

it traces the relationship

The ‘home bias’ portfolios of investors in industrial countries – the tendency to hold

disproportionate amounts of stock from the ‘home’ country – suggests substantial

potential for further portfolio flows as global market integration increases over time.

It is important to note that global financial integration, however, can have two distinct

and in some ways conflicting effects on this ‘home bias’. As more and more countries

– particularly the emerging markets – open up their markets for foreign investment,

investors in developed countries will have a greater opportunity to hold foreign assets.

However, these flows themselves, along with greater trade flows will tend to cause

different national markets to increasingly become parts of a more unified ‘global’

market, reducing their diversification benefits. Which of these two effects will

dominate is, of course, an empirical issue, but given the extent of the ‘home bias’ it is

likely that for quite a few years to come, FII flows would increase with global

integration.

RECOMMENDATIONS:

Some of the steps that can be taken to help influence the choices made by foreign

institutional investors include:

The Government should cut its fiscal deficits, which would result in strengthening

the economy as a whole.

Creating infrastructure and other facilities to attract foreign investment. As

described earlier, an array of services can help promote foreign institutional

investment in India, ranging from basic services such as the provision of electricity

and clean water, to fair and effective dispute resolution systems.

The ability of governments to prevent or reduce financial crises also has a great

impact on the growth of capital flows. Steps to address these crises include

strengthening banking supervision, requiring more transparency in international

financial transactions and ensuring adequate supervision and regulation of financial

markets.

An attempt should be made to bring down the inflation level to attract more

foreign institutional investments into India.

The Banking system needs to be strengthened which could be achieved by

reducing the number of Non Performing Assets.

The FIIs investments, though shown an increasing trend over time, are still far

below the permissible limits. One such measure in this line could be the newly

announced INDONEXT, the platform for trading the small and mid-cap companies,

which might bring some focus on these companies and hopefully add some liquidity

and volume to their trading, which may attract some further investments in them by

FIIs.

The fact is that developing country like India has its own compulsions arising out

of the very state of their social, political and economic development. To attract

portfolio investments and retain their confidence, the host countries have to follow

stable macro-economic policies,

The provision for clear procedures must be followed in the event of disputes

between investors and host governments, to ensure that rules are adhered to and that

arbitration may be established by mutual consent.

Countries may impose these kinds of measures like expropriation, domestic

content requirements, restrictions on capital outflows of short term investments, etc

with the intention of protecting domestic industries from international competition

and promoting their economic development, but this usually leads to misallocation of

resources away from the natural economic capabilities of nations.

There has been a significant shift in the character of global capital flows to the

developing countries in recent years in that the predominance of private account

capital transfer and especially portfolio investments (FPI) increased considerably. In

order to attract portfolio investments which prefer liquidity, it has been advocated to

develop stock markets.

The general perception about the foreign portfolio investments is that, not only do

they expand the demand base of the stock market, but they can also stabilise the

market through investor diversification.

Obstacles to investment prevent countries from making optimal use of their own and

other countries' resources. Countless billions of dollars of potential wealth - for

investors in the form of profits, for workers in the form of wages, and for consumers

in the form of lower prices - are lost every year due to barriers to trade and

investment. Certain policy decisions of potential target countries of investment

receive close scrutiny from international investors. Consequently, a number of

international agreements have been written to specifically address those concerns.

CONCLUSION

This paper provides a preliminary analysis of FII flows to India and their influence on

the prices of stocks in the Indian stock market. A more detailed study using daily data

of equity returns for a longer period or, better still, disaggregated data showing the

transactions of individual FIIs at the stock level can help address questions regarding

the extent of herding or return-chasing behavior among FIIs which now account for a

significant part of the capital account balance in our balance of payments. The extent

to which FII participation in Indian markets has helped lower cost of capital to Indian

industries is also an important issue to investigate.

Broader and more long-term issues involving foreign portfolio investment in India

and their economy-wide implications have not been addressed in this paper. Such

issues would invariably require an estimation of the societal costs of the volatility and

uncertainty associated with FII flows. A detailed understanding of the nature and

determinants of FII flows to India would help us address such questions in a more

informed manner and allow us to better evaluate the risks and benefits of foreign

portfolio investment in India.