Foreign Institutional Investments (FIIs) in India and the Related Laws by VANDANA BAKSHI on OCTOBER 1, 2011 In present era

of globalization no country or economy has been left untouched from international trade and commerce. More access to international capital markets and foreign investments has helped developing countries surmount their less developed capital markets. During the past few years, a flow of capital has been seen from the developed part of the world to the less developed economies which has led to decrease in the vulnerability of developing countries to financial crisis by reduction in their external debt burden from 39% of gross national income in 1995 to 26% in 2006 and increase in foreign exchange reserves to 92% of long term debt and 423% of more volatile short term debt in 2006. Over the years same scenario has been witnessed in the Indian economy also. And thus, today most of the market entities are interested in attracting foreign capital as it not only helps in creating liquidity for the firms stock and the stock market but also leads to lowering of the cost of the capital for the firms and allows them to compete more effectively in the global market place. Foreign Investment It has been defined as a transfer of funds or materials fro m one country (called capital exporting country) to another country (called host country) in return for a direct or indirect participation in the earnings of that enterprise. Foreign investments provide a channel through which one can have access to foreign capital and after the opening up of the Indian economy; these have grown in leaps and bounds. Basically foreign investment can be made through following routes:

Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI). Private Equity investments-Foreign venture capital investor(FVCI)

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

commonly made through foreign Institutional Investors (FIIs), non resident Indian (NRI) and persons of Indian origin (PIO). BACKGROUND In the late 1980s India suffered an acute financial crunch. At that time Indian foreign exchange stood at mere US $1.2 bn which could barely finance 3 weeks worth of imports. And India had to pledge its gold reserve with IMF to secure a loan of just US $457 mn. The gross fiscal deficit of the government rose from 9.0% of GDP in 1980-81 to 10.4 percent in 1985-86 and to 12.7% in 1990-91. Since these deficits had to be met by borrowings, the internal debt of the government accumulated rapidly, rising from 35% of GDP at the end of 1980-81 to 53% of GDP at the end of 1990-91. According to India Report, Astaire Research A Balance of Payments crisis in 1991 pushed the country to near bankruptcy. In return f or an IMF bailout, gold was transferred to London as collateral, the rupee devalued and economic reforms were forced upon India. That low point was the catalyst required to transform the economy through badly needed reforms to unshackle the economy. Controls started to be dismantled, tariffs, duties and taxes progressively lowered, state monopolies broken, the economy was opened to trade and investment,private sector enterprise and competition were encouraged and globalization was slowly embraced. The reforms process continues today and is accepted by all political parties, but the speed is often held hostage by coalition politics and vested interests. Thus it was decided to open up the economy, the economic policies were liberalized and private sector was given the freedom to participate in the Indian economy more effectively. The Indian market was integrated with the world economy and international investors were invited to participate in India. Consequently, the committee on the reforms of the financial system under the chairmanship of Mr M. Narsimham Rao was made which sought for reforms in the financial sector. One of its recommendation included developing an active government securities market and strengthening the open market operations as an instrument of monetary policy. And thus this reform paved way for foreign investments which were at that time the need of the hour. As a result of this, Indian stock market witnessed metamorphic changes and a transition-from a dull to a highly buoyant stock market. Improved market surveillance system, trading mechanism and introduction of new financial instruments made it a center of attraction for the international investors. FOREIGN INSTITUTIONAL INVESTORS

The term FII is used to denote an investor, mostly in the form of an institution or entity which invests money in the financial markets of a country different from the one where in the institution or the entity is originally incorporated. According to Securities and Exchange Board of India (SEBI) it is an institution that is a legal entity established or incorporated outside India proposing to make investments in India only in securities. These can invest their own funds or invest funds on behalf of their overseas clients registered with SEBI. The client accounts are known as sub-accounts. A domestic portfolio manager can also register as FII to manage the funds of the sub-accounts. From the early 1990s, India has developed a framework through which foreign investors participate in the Indian capital market. A foreign investor can either come into India as a FII or as a sub-account. In December 2005, the number of FII and sub-accounts stood at 823 and 2273 respectively. Basically FIIs have a huge financial strength and invest for the purpose of income and capital appreciation. They are no interested in taking control of a company. Some of the big American mutual funds are fidelity, vanguard, Merrill lynch, capital research etc. They are permitted to trade in securities in primary as well as secondary markets and can trade also in dated government securities, listed equity shares, listed non convertible debentures/bonds issued by Indian company and schemes of mutual funds but the sale should be only through recognized stock exchange. These also include domestic asset management companies or domestic portfolio managers who manage funds raised or collected or bought from outside India for the purpose of making investment in India on behalf of foreign corporate or foreign individuals. In the Indian context, foreign institutional investors (FIIs) and their sub-accounts mostly use these instruments for facilitating the participation of their overseas clients, who are not interested in participating directly in the Indian stock market. Why are FIIs required? FIIs contribute to the foreign exchange inflow as the funds from multilateral finance institutions and FDI are insufficient.

It lowers cost of capital, access to cheap global credit. It supplements domestic savings and investments. It leads to higher asset prices in the Indian market. And has also led to considerable amount of reforms in capital market and financial sector.

Investments by FIIs A FII may invest through 2 routes:

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

Equity Investment route: In case of Equity route the FIIs can invest in the following instruments: A. Securities in the primary and secondary market including shares which are unlisted, listed or to be listed on a recognized stock exchange in India. B. Units of schemes floated by the Unit Trust of India and other domestic mutual funds, whether listed or not. C. Warrants 100% Debt route: In case of Debt Route the FIIs can invest in the following instruments: A. Debentures (Non Convertible Debentures, Partly Convertible Debentures etc.) B. Bonds C. Dated government securities D. Treasury Bills E. Other Debt Market Instruments It should be noted that foreign companies and individuals are not be eligible to invest through the 100% debt route. LIBERALIZATION OF LAWS: 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. Initially, only pension funds, mutual funds, investments trusts, asset management companies, nominee companies and incorporated/institutional portfolio managers were permitted to invest directly in the Indian stock markets. In 1996-97, the group was expanded to include banks, 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 investments on behalf of a broad-based fund. When India opened investment into listed equities through the FII framework: Not all foreign investors were eligible to register with the Indian securities regulator (SEBI). No FII was permitted to own more than 5% of a firm and there were restrictions on ownership by all FIIs taken together. Foreign investors faced many difficulties in accomplishing transactions in the Indian equity market. For example in 1993, the settlement system which was based on physical paper share certificates found it difficult to handle the settlement volume of foreign investors. Similarly, foreign investors who sent orders to open outcry trading floor of the Bombay stock exchange found an array of problems including high transactions costs and low probability of order execution. Thus from 1993 to 2003, the Ministry of Finance and SEBI led a strong reforms aiming at a fundamental transformation of the equity market. Presently the ceiling for overall investment for FIIs is 24% of the paid up capital of the Indian company. The limit is 20% of the paid up capital in the case of public sector banks, including the State Bank of India. The ceiling can be raised upto sectoral cap/statutory ceiling, subject to the approval of the board and the general body of the company passing a special resolution to that effect.

Procedure for Registration: The Procedure for registration of FII has been given by SEBI regulations. It states- no person shall buy, sell or otherwise deal in securities as a Foreign Institutional Investor unless he holds a certificate granted by the Board under these regulations. An application for grant of registration has to be made in Form A, the format of which is provided in the SEBI (FII) Regulations, 1995. The Eligibility criteria for applicant seeking FII registration is as follows: Good track record, professional competence and financial soundness.

Regulated by appropriate foreign regulatory authority in the same capacity/category where registration is sought from SEBI. Permission under the provisions of the Foreign Exchange Management Act, 1999 (FEMA) from the RBI. Legally permitted to invest in securities outside country of its incorporation/establishment. The applicant must be a fit and proper person. Local custodian and designated bank to route its transactions.

Eligible Securities: A FII can make investments only in the following types of securities:

Securities in the primary and secondary markets including shares, debentures and warrants of unlisted, to- be-listed companies or companies listed on a recognized stock exchange. Units of schemes floated by domestic mutual funds including Unit Trust of India, whether listed on a recognized stock exchange or not, and units of scheme floated by a Collective Investment Scheme. Government Securities Derivatives traded on a recognized stock exchange like futures and options. FIIs can now invest in interest rate futures that were launched at the National Stock Exchange (NSE) on 31st August, 2009. Commercial paper. Security receipts

FII Regulations: Investment by FIIs is regulated under SEBI (FII) Regulations, 1995. Following are some of important regulations by SEBI and RBI: 1. A Foreign Institutional Investor may invest only in the instruments mentioned earlier. 2. The total investments in equity and equity related instruments (including fully convertible debentures, convertible portion of partially convertible debentures and tradable warrants) made by a FII in India, whether on his own account or on account of his sub- accounts, should

be at least 70% of the aggregate of all the investments of the FII in India, made on his own account and through his sub-accounts. 3. The cumulative debt investment limit for FII investments in Corporate Debt is US $15 billion. The amount was increased from US $6 billion to USD 15 billion in March 2009. 4. US $8 billion will be allocated to the FIIs and Sub-Accounts through an open bidding platform while the remaining amount is allocated on a first come first served basis subject to a ceiling of Rs.249 cr. per registered entity. 5. The debt investment limit for FIIs in government debt is currently capped at $5 billion and cumulative investments under 2% of the outstanding stock and no single entity can be allocated more than Rs. 1000 crores of the government debt limits. Further, in 2008 amendments were made to attract more foreign investors to register with SEBI, these amendments are: 1. The definition of broad based fund under the regulations was substantially widened allowing several more sub accounts and FIIs to register with SEBI. 2. Several new categories of registration viz. sovereign wealth funds, foreign individual, foreign corporate etc. were introduced, 3. Registration once granted to foreign investors was made permanent without a need to apply for renewal from time to time thereby substantially reducing the administrative burden, 4. Also the application fee for foreign investors applying for registration has recently been reduced by 50% for FIIs and sub accounts 5. Also, institutional investors including FIIs and their sub-accounts have been allowed to undertake short-selling, lending and borrowing of Indian securities from February 1, 2008. 6. Also the rigid criteria of requiring FIIs and sub-account to register as a 70:30 FII/ subaccount or 100% debt FII/sub-account has recently been done away with(as has been discussed above in the essay). EFFECTS ON INDIAN ECONOMY The various reforms introduced by Indian government to encourage FIIs to invest in Indian market have been effective to such an extent that in November 2010 FIIs stood at 5426 whereas it stood at 1713 in early 1990s. The changes have led to increase in liquidity, reduce risk, improve disclosure and thus FIIs have become the corner stone in the phenomenal rise

of the Indian stock market. It has led to shift of focus of foreign investors away from Indian securities traded at London or New York, and the primary markets for India- related equities trading has become the NSE and BSE in Bombay. From the table below it becomes apparent that from just Rs 4 crores of net investment in 1992-93, the investment rose to Rs 5445 the next financial year when the economic changes were introduced and further today in 2010-11 it stands at Rs 133,049. YEAR 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 Net Investments by FIIs (rs cr.) 4 5445 4777 6721 7386 5908 -729 9765 9682 8273 2669 44000 41416 47,602 36,396.60 71,952 -53,796

2009-2010 2010-2011

84,269 133,049

In 1993 the first and only FII to invest in India was Pictet Umbrella Trust Emerging Markets Fund, an institutional investor from Switzerland but today Indian growth story has attracted global majors like CLSA, HSBC, Citigroup, Merrill Lynch, Crown Capital, Fidelity, Goldman Sachs and Morgan Stanley, among others to enter the Indian financial market. Goldman Sachs and Macquarie have acquired a 20% stake each in PTC India Financial services Ltd. Temasek Holdings, Investment Corporation of Dubai, Goldman Sachs, Macquarie, AIF Capital, Citigroup and India Equity Partners (IEP) have picked a combined stake of 10% in Bharti Infratel. Also an entity of Merrill Lynch has picked up 49% stake in seven residential projects of real estate major, DLF. This boost, though good for Indian economy has led to a number of negative consequences. Let us study the positive and the negative side of this rise of investments by FIIs one by one. Positive impact: It has been emphasized upon the fact that the capital market reforms like improved market transparency, automation, dematerialization and regulations on reporting and disclosure standards were initiated because of the presence of the FIIs. But FII flows can be considered both as the cause and the effect of the capital market reforms. The market reforms were initiated because of the presence of them and this in turn has led to increased flows. A. Enhanced flows of equity capital: FIIs are well known for a greater appetite for equity than debt in their asset structure. For example, pension funds in the United Kingdom and United States had 68 per cent and 64 per cent, respectively, of their portfolios in equity in 1998. Not only it can help in supplementing the domestic savings for the purpose of development projects like building economic and social infrastructure but can also help in growth of rate of investment, it boosts the production, employment and income of the host country. B. Managing uncertainty and controlling risks: FIIs promote financial innovation and development of hedging instruments. These because of their interest in hedging risks, are known to have contributed to the development of zero-coupon bonds and index futures. FIIs not only enhance competition in financial markets, but also improve the alignment of asset prices to fundamentals. FIIs in particular are known to have good information and low transaction costs. By aligning asset prices closer to fundamentals, they stabilize markets. In addition, a variety of FIIs with a variety of risk-return preferences also help in dampening volatility.

C. Improving capital markets: FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. By increasing the availability of riskier long term capital for projects, and increasing firms incentives to supply more information about them, the FIIs can help in the process of economic development. D. Improved corporate governance: Good corporate governance is essential to overcome the principal-agent problem between share-holders and management. Information asymmetries and incomplete contracts between share-holders and management are at the root of the agency costs. Bad corporate governance makes equity finance a costly option. With boards often captured by managers or passive, ensuring the rights of shareholders is a problem that needs to be addressed efficiently in any economy. Incentives for shareholders to monitor firms and enforce their legal rights are limited and individuals with small share-holdings often do not address the issue since others can free-ride on their endeavor. FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms operations, improve corporate governance. Among the four models of corporate control - takeover or market control via equity, leveraged control or market control via debt, direct control via equity, and direct control via debt or relationship bankingthe third model, which is known as corporate governance movement, has institutional investors at its core. In this third model, board representation is supplemented by direct contacts by institutional investors. Negative impact: If we see the market trends of past few recent years it is quite evident that Indian equity markets have become slaves of FIIs inflow and are dancing to their tune. And this dependence has to a great extent caused a lot of trouble for the Indian economy. Some of the factors are: A. Potential capital outflows: Hot money refers to funds that are controlled by investors who actively seek short-term returns. These investors scan the market for short-term, high interest rate investment opportunities. Hot money can have economic and financial repercussions on countries and banks. When money is injected into a country, the exchange rate for the country gaining the money strengthens, while the exchange rate for the country losing the money weakens. If money is withdrawn on short notice, the banking institution will experience a shortage of funds. B. Inflation: Huge amounts of FII fund inflow into the country creates a lot of demand for rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created. This situation leads to excess liquidity thereby leading to inflation where too much money chases too few goods.

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

market. And also attempts should be made to encourage small domestic investors to participate in the equity market.

World Development Indicators and Global Development Finance data files. Encyclopaedia Of Public International Law (vol.8, p.246) http://www.ukibc.com/ukindia2/files/India60.pdf Government of India. Report on the committee on the financial system, New Delhi, November 1991, p-45 SEBI(foreign institutional investors) Regulations 6, 1995 Board-based fund is one which has more than 20 investors with no single investor holding more than 10% of the shares or units of the fund. (GOI,2005) The above report is compiled on the basis of reports submitted to SEBI by custodians and constitutes trades conducted by FIIs RBI, handbook of statistics on Indian economy Michael and Menkhoff, 2003;mody et al 2001