Foreign Institutional Investment

Institute of Professional Education

and Research

Macro Economics
Assignment On
Foreign Institutional Investment
(FII)

Submitted To- Submitted By-

Dr. A.K. Sharan Nasir Jalal

Roll No. - 29

ABSTRACT

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Most of the under developed countries suffer from low level of income and capital
accumulation. Though, despite this shortage of investment, these countries have
developed a strong urge for industrialization and economic development. As we know
the need for Foreign capital arises due to shortage from domestic side and other
reasons. Indian economy has experienced the problem of capital in many instances.
While planning to start the steel companies under government control, due to shortage
of resources it has taken the aid of foreign countries. Likewise we have received aid
from Russia, Britain and Germany for establishing Bhiloy, Rourkela and Durgapur
steel plants. The present paper is a modest attempt to study the trends in Foreign
Institutional Investment into India. It is observed that the FIIs investment has shown
significant improvement in the liquidity of stock prices of both BSE and NSE.
However, there is a high degree of positive co-efficient of correlation between FIIs
investment and market capitalization, FIIs investment and BSE & NSE indices,
revealing that the liquidity and volatility was highly influenced by FIIs flows. Further,
it is also proved that FIIs investment was a significant factor for high liquidity and
volatility in the capital market prices. The present study is a modest attempt to know
the status of FIIs in Indian capital market.

The present study tries to examine the determinants of Foreign Institutional

Investments in India, which have crossed almost US$ 12 billions by the end of 2002.
Given the huge volume of these flows and its impact on the other domestic financial
markets understanding the behavior of these flows becomes very important at the time
of liberalizing capital account. In this study, by using monthly data, we found that FII
inflow depends on stock market returns, inflation rate (both domestic and foreign) and
ex-ante risk. In terms of magnitude, the impact of stock market returns and the ex-ante
risk turned out to be major determinants of FII inflow. This study did not find any
causation running from FII inflow to stock returns as it was found by some studies.
Stabilizing the stock market volatility and minimizing the ex-ante risk would help in
attracting more FII inflow that has positive impact on the real economy.

PREFACE

As a part of the reform process, the Government of India opened up the Indian capital
market to global competition and took measures to initiate structural reforms by
putting in place the requisite regulatory and supervisory structure in the form of SEBI.
In a move towards current account convertibility and to increase foreign exchange
inflows, Foreign Institutional Investors (FIIs) were permitted to invest in the tradable
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Indian securities such as shares, debentures, bonds, mutual fund units etc. through
primary and secondary markets as per guidelines issued by Government of India in
September 1992.Gurucharan Singh (2004) highlighted that the securities market in
India has come a long way in terms of infrastructure, adoption of best international
practices and introduction of competition. Today, there is a need to review stock
exchanges and improve the liquidity position of various scrips listed on them. A study
conducted by the World Bank (1997) reports that stock market liquidity improved in
those emerging economies that received higher foreign investments. Calvo, et al.,
(1999) suggest that foreign investors purse irrational trading strategies such as herding
and quick changes in sentiments that make the emerging stock markets volatile. They
argue that information disadvantage and diversified international portfolio investment
create incentives for rational herd behavior causing stock markets in emerging
economies to be volatile. Fitz Gerald (1999) observed that the large and sudden
reversals of foreign equity investments make them extremely volatile in character.
The securities markets in developing countries are typically narrow and shallow, and
therefore, participation of foreign portfolio investors may, a priori, induce
considerable instability in these markets.

Executive Summary
 
Foreign institutional investors have gained a significant role in Indian capital markets.
Availability of foreign capital depends on many firm specific factors other than
economic development of the country. In this context this paper examines the
contribution of foreign institutional investment particularly among companies
included in sensitivity index (Sensex) of Bombay Stock Exchange. Also examined is
the relationship between foreign institutional investment and firm specific

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characteristics in terms of ownership structure, financial performance and stock

performance. It is observed that foreign investors invested more in companies with a
higher volume of shares owned by the general public. The promoters’ holdings and
the foreign investments are inversely related. Foreign investors choose the companies
where family shareholding of promoters is not substantial. Among the financial
performance variables the share returns and earnings per share are significant factors
influencing their investment decision.
 

OBJECTIVES

The main objective of this assignment is to through light on FIIs into Indian economy
in the recent past. The other objectives are:

1. To examine the need for foreign capital.

2. To study the growth of registered number of Foreign Institutional Investors in
India.
3. To study the activities such as investments and sales by the FIIs in the recent
past.

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NEED OF THE FOREIGN INVESTMENT

The need of foreign investment/ foreign capital arises due to the following reasons:

Development of basic infrastructure:

The development of any economy depends on the available infrastructure in that
country. The infrastructure facilities such as Roads, Railways, sea ports, warehouses
banking services and insurance services are the prominent players. Due to long
gestation period naturally individuals will not come forward to invest in infrastructure
industries. Government of India could not able to raise necessary investments. To fill
the gap foreign capital is highly suitable.

Rapid industrialization:
The need for foreign capital arises due to the policy initiatives of the government to
intensify the process of industrialization. For instance the government of India is
gradually opening the sectors to foreign capital to expand the industrial sector.

To undertake the initial risk:

Many developing countries suffer from severe scarcity of private investors. The risk
problem can be diverted to the foreign capitalists by allowing them to invest. As we
know the Indians are comparatively risk averse. The same risk can be transferred to
foreign investors by allowing their investment where risk is more.

Global imperatives:
Globalization is the order of the day. The international agreements between countries
are also the reason for the foreign capital. The multinational companies are expanding
their presence to many countries; while they are entering into the foreign countries
they will bring their capital. The principles of WTO and other regional associations
are binding the member countries to allow foreign capital.

Comparative advantage:
The variations in the cost of capital like interest rate are also one of the important
factors which resulting in approaching foreign capital. For example; Interest rates are
high in India compared with developed economies. To reduce the cost of capital,
companies/organizations are now looking for foreign capital. In several countries the
interest rates are very low as 1% to 3%, where as in some countries the interest rates
are very high as 8% to 10% per annum.

To remove the technological gap:

The developing countries have very low level of technology compared to the
developed countries. However, these developing countries posses a strong urge for
industrialization to develop their economies and to wriggle out of the low level
equilibrium trap in which they are caught. This raises the necessity for importing
technology from the advanced countries. That technology usually comes with foreign
capital when it assumes the form of private foreign investment or foreign
collaboration.

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REGISTERED FII’S IN INDIA

The Indian capital market opened its doors to foreign investors in 1991. The new
industrial policy of the government has initiated many measures to attract foreign
capital. The following table highlights the registered FIIs in India during the period
from 2006 to 2010.

No of Registered FIIs in India:

Year No. of Registered FIIs

January 2006 833
January 2007 1059

January 2008 1279

January 2009 1609

January 2010 1697

From the above table it is clear that there is constant growth in the number of
registered FIIs in India. In the year 2006 (January, 2006), the number of registered
FIIs were 833 only. The same number has been increased to 1697 by the year 2010
(January 2010). The number has been increased by more than 100 %. In spite of the
global financial crisis the number of registered FIIs has shown a significant increase.
Irrespective of the situation in Indian stock markets these FIIs has earmarked their
presence. But the investment made by FIIs has experienced drastic decline in the
recent past. This is mainly because of the global economic meltdown. Though the
number of registered FIIs increased the net investments were not increased
proportionately.

Importance of the Topic:

To facilitate foreign private capital flows in the form of portfolio investments,

developing countries have been advised to develop their stock markets. It was
suggested that these investments would help the stock markets directly through
widening investor base and indirectly by compelling local authorities to improve the
trading systems. While the volatility associated with portfolio capital flows is well
known, there is also a concern that foreign institutional investors might introduce
distortions in the host country markets due to the pressure on them to secure capital
gains. In this context, this paper seeks to assess the importance of foreign portfolio
investments in India\ relative to other major forms and to study the relationship
between foreign portfolio investments and trends in the Indian stock market during
the past four years.

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Foreign investment in India is of two types:

Investment by foreign institutional investors (FII) and foreign direct
investment (FDI). Foreign investment can be in the form of investment in
secondary financial markets or as direct investment in companies (FDI).
Foreign investment is a major source of capital for many industries. In
developing countries, not enough capital is readily available for expansion
or setting up new projects. Foreign investment in the form of portfolio
investment adds depth and liquidity to secondary markets.
Further in developing economies there is a great demand for foreign
exchange within the economy exceeds the supply. Inflows of foreign capital
bridge the gap. In fact in India the reserves will now be used for
infrastructural development.
In India, there seems to be a very strong correlation between the
unprecedented Bull Run that started in May 2003 when the BSE Sensex was
at 3000 and the surge in inflow of foreign capital through foreign
institutional investors. We find that FII investment in India had shown some
upswings and downswings from around 1993-94 till about 2002- 2003, but
thereafter there has been an upsurge in FII investment with it averaging
around $9599 million a year during 2003-05. This figure is around 5 times
the average annual inflows witnessed from 1993-94 to 1997-98 and from
1999 to 2002 and more than 20 times the average annual inflows during
1997-99 and 2002-03. Also while cumulative net FII inflows into India from
early 1990s to end of March 2003 amounted to $15,804 million, in the
period thereafter till about December 2005, the addition to this value was of
$25,267 million.
At the same time we see that the Sensex which had fallen to about 3000
crossed 4000 and 5000 respectively by August and November 2003. It
broke through the 6000 level by January 2004 before crossing the 7000
mark in June 2005. After that the rise of the sensex quickened further over
the year. It crossed 8000 in September and 9000 in November of 2005. And
from then on it has been quickening the pace of its rise crossing 10,000 in
February 2006 and 15,000 in July 2007.
One cannot expect the FIIs to take an active interest in the developmental
concerns of the emerging economies. If there is any benefit that accrues to
the emerging economies it will only be incidental. The main driving force
behind the actions of these institutional investors is profit. FIIs tend to invest
selectively in companies that achieve good results or show potential for
future profitability. The share prices of such companies have risen
substantially. This then can have a compounding effect on the size and
nature of the firm in that the firm can now acquire other firms and hence
grow even more. What might ensue is also a healthy competition among
firms vying for foreign investment or foreign ownership in terms of
shareholders. In order to attract foreign investment these firms could
possibly employ greater transparency and improve corporate governance.

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In terms of the macroeconomic impact of FII investments in India we also

need to consider the effect of the enormous inflows of foreign exchange that
occur as a result of these capital inflows. This inflow of foreign exchange
exerts an upward pressure on the Rupee. The appreciation of the Rupee
would mean that imports into India become cheaper and exports become
more expensive. As imports become cheaper and exports become more
expensive, importers stand to gain from cheaper imports and on the whole
those industries that use imported raw materials will face lower costs. This
in turn will lead to lower prices and have a welcome deflationary effect. The
appreciation of the Rupee also simultaneously makes Indian exports less
competitive in the global economy, thus forcing organizations to be more
productive and focus on quality.
Foreign institutional investors have played significant roles in other
emerging economies too. In OECD countries for instance, institutional
investors have been major players in the development of their financial
markets and in the overall economic growth. In China too, with the
introduction of the Qualified Foreign Institutional Investor (QFII) scheme
which took effect in 2003, the domestic markets were being opened up to
foreign investment. Taiwan too had implemented this strategy of QFIIs to
prevent rapid inflow and outflow of currency which was perceived as a
threat to the economic stability of the economy. In Mexico, significant
economic, political and social advances have occurred simultaneously with
its transition into a preferred investment destination.
On the flip side though, we find that FII investment in a country would
bring in a lot more volatility than what may have been experienced before in
the financial markets. A large outflow of funds due to FII activities can
leave behind a crisis situation in the domestic economy which threatens to
spill over to the rest of the world. This was what happened in the East Asian
Crisis of 1998. Before the crisis period the East Asian economies attracted a
large proportion of the total capital inflows to the developing countries.
However, this situation changed around 1997-98 when capital flows
reversed, and capital started flowing out of these economies. The crisis
affected not only the currencies but also the stock markets and other asset
prices. The effects of this crisis were felt not only within the East Asian
region but also in countries like Russia and the U.S.A.
In India too, by opening the economy to short term capital flows, we run the
risk of becoming more vulnerable to any sudden capital outflows from the
economy. Even when there are no such sudden outflows, the large inflows
of funds can create problems by making Indian exports less competitive. In
India, in 2004-05, (figures in brackets indicate the value of exports as a
percentage of total exports for the year) the major commodities of export
were gems and jewellery (17%), chemical and related products (15.7%),
engineering goods (18.11%) and textiles (14.9%) among others. When the
Rupee appreciates because of the large capital inflows, these sectors would
become less competitive. Thus, these sectors could possibly experience a
slowdown in growth. Whereas earlier, exports would have contributed to the
growth of these sectors, now with a possible fall in exports, the overall
growth rates in the sector may be lower. Thus, there is a possibility of

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layoffs and slower growth rates in sectors like textiles in India.

However on the whole, it may not be wrong to say that in India, the FIIs
have been instrumental in capital formation in a significant way. Some
might even attribute the buoyancy in the market and steady inflow of dollars
into the economy to this upsurge in FII activity in India. The resultant
appreciation of the Rupee has also had its own implications for the Indian
economy. However on the downside there are some severe implications in
terms of increased volatility in financial markets. This volatility majorly
impacts the small local investors in these markets. Another significant
development has been that the Indian markets are now no longer insulated
from the world markets not only through the international flow of goods and
services but also due to this international flow of capital. The jury is still out
on the impact of FII investment in India whether positive or negative.

THEORETICAL MODEL FOR FOREIGN INSTITUTIONAL

INVESTMENT

To build the theoretical model, well-known “uncovered interest parity”

(UIP) and “purchasing power parity” (PPP) conditions have been combined.
To bring the model closer to reality, the assumption of equal riskiness in
domestic and foreign assets (made under UIP) is relaxed. When there is both
perfect capital mobility and equal risk of both home and foreign bonds, then
home and foreign bonds are said to be perfect substitutes. Perfect
substitutability of domestic and foreign bonds implies that the uncovered
interest parity condition will hold on a continuous basis.

Let the rate of return to foreign investor by investing in domestic stock

market be id and return in the same market if. By investing in the domestic
market the foreign investor makes two investments, one being in the Indian
stock market and the other in the Indian rupee. Accordingly, the overall
return to the investor can be divided into a return on the stock and a return
on the investment in the rupee. If the foreign investor subsequently sells the
rupee at the end of the period, the return o the foreign currency would be ic
and this can be presented as if = id + ic. If we consider the nominal
exchange rate as rupees per U.S. dollar, e, initially only expectations can be
formed with regard to the exchange rate movement,
hence
if = id − E(˙e / e),

Where E (˙e / e) is the expected rate of change in value of the rupee against
the dollar. This equation represents the uncovered interest parity condition.
Uncovered interest parity dictates that the expected rate of depreciation of
the rupee-dollar exchange rate is equal to the interest rate differential
between Indian and U.S. stocks. Now we incorporate the PPP condition,
according to which the real exchange rate that is defined as the ratio of the
two countries’ price level, expressed in a common currency, should be
equated to unity for all pairs of countries and at all times. This can be
expressed as e = Q Pd / Pf ; where e is the nominal exchange rate, Q is the

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real exchange rate, Pd is the domestic price level, and Pf is the foreign price
level. PPP theory also asserts that Q can be taken as exogenously
determined (Q =Q¯). Hence, e =Q¯ Pd / Pf implying that over a period of
time the exchange rate moves in proportion to movements in the ratio of
price level, pd / pf. Taking log and differentiating with respect to time, we
get ˙e / e = p˙d / pd − p˙f / pf. Hence, the changes in the exchange rate and
E(˙e / e) would depend on the inflation rate differentials Putting
this result in the uncovered interest parity condition, we have

id = if + πd − π f, (1)

Where π is the inflation rate in respective countries.

Now, to be more realistic, we relax the assumption of equal risk for
domestic and foreign assets under UIP. By dropping this assumption we
have
id − if = E(˙e / e) + ρ,

Where ρ is risk premium. In other words, a large interest rate differential

implies a market expectation of large exchange rate depreciation or currency
risk. Risk averse investors expect higher returns for investing in relatively
riskier assets and therefore the risk premium represents compensation to the
investor for assuming risk. The above equation is modeled as

id − if = E(˙e / e) + σd − σf,

Where σ is a measure of dispersion (standard deviation) representing risk in

respective countries. Hence, the return differentials depend on the inflation
rate differentials and the risk premium. This can be represented as

id − if = πd − π f + σd − σf,

Where we have drawn three domestic and three foreign variables affecting
FII. In a functional form, it can be represented as

FII = f(id, if, πd, π f, σd, σf).

Basic Features of Foreign Institutional Investment
The term foreign institutional investment denotes all those investors or investment
companies that are not located within the territory of the country in which they are
investing. 
These are actually the outsiders in the financial markets of the particular company.
Foreign institutional investment is a common term in the financial sector of India. 

The types of institutions that are involved in the foreign institutional investment
are as follows: 
Mutual Funds
Hedge Funds
Pension Funds
Insurance

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Companies

The economies like India, which are growing very rapidly, are becoming hot favorite
investment destinations for the foreign institutional investors. These markets have the
potential to grow in the near future. This is the prime reason behind the growing
interests of the foreign investors. The promise of rapid growth of the investable fund
is tempting the investors and so they are coming in huge numbers to these countries.
The money, which is coming through the foreign institutional investment, is referred
as 'hot money' because the money can be taken out from the market at anytime by
these investors. 
The foreign investment market was not so developed in the past. But once the
globalization took the whole world in its grip, the diversified global market became
united. Because of this the investment sector became very strong and at the same time
allowed the foreigners to enter the national financial market. 
At the same time the developing countries understood the value of foreign investment
and allowed the foreign direct investment and foreign institutional investment in their
financial markets. Although the foreign direct investments are long term investments
but the foreign institutional investments are unpredictable. The Securities and
Exchange Board of India looks after the foreign institutional investments in India.
SEBI has imposed several rules and regulations on these investments.

FOREIGN INSTITUTIONAL INVESTMENT IN INDIA

India opened its stock market to foreign investors in September 1992 and since then
has received portfolio investment from foreigners in the form of foreign institutional
investment in equities. This has become one of the main channels of FII in India. In
order to trade in the Indian equity market, foreign corporations need to register with
the Securities and Exchange Board of India (SEBI) as foreign institutional investors.
India allows only authorized foreign investors to invest in pension funds, investment
trusts, asset management companies, university funds, endowments, foundations,
charitable interests and charitable societies that have a track record of five years and
which are registered with a statutory authority in their own country of incorporation
or settlement. It is possible for foreigners to trade in Indian securities without
registering as an FII but such cases require approval from the Reserve Bank of India
(RBI) or the Foreign Investment Promotion Board (FIPB). Foreign institutional
investors generally concentrate on the secondary market. The total amount of foreign
institutional investment in India has accumulated to the formidable sum of over U.S.
$12 billion as of January 2003. 

Some important facts about the Foreign Institutional Investment:

 The number of registered foreign institutional investors on June 2007 has

reached 1042 from 813 in 2006
 US $6 billion has been invested in equities by these investors
 The total amount of these investments in the Indian financial market till June
2007 has been estimated at US $53.06 billion
 The foreign institutional investors are preferring the construction sector,
banking sector and the IT companies for the investments

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 Most active foreign institutional investors in India are HSBC, Merrill Lynch,
Citigroup, CLSA

The increase in the volume of foreign institutional investment (FII) inflows in recent
years has led to concerns regarding the volatility of these flows, threat of capital
flight, its impact on the stock markets and influence of changes in regulatory regimes.
The determinants and destinations of these flows and how are they influencing
economic development in the country have also been debated. This paper examines
the role of various factors relating to individual firm-level characteristics and
macroeconomic-level conditions influencing FII investment. The regulatory
environment of the host country has an important impact on FII inflows. As the pace
of foreign investment began to accelerate, regulatory policies have changed to keep
up with changed domestic scenarios. The paper also provides a review of these
changes.

Foreign Investment refers to investments made by the residents of a country in the

financial assets and production processes of another country. After the opening up of
the borders for capital movement, these investments have grown
in leaps and bounds. The effect of foreign investment, however, varies from country
to country. It can affect the factor productivity of the recipient country and can also
affect the balance of payments. In developing countries there has been a great need
for foreign capital, not only to increase the productivity of labor but also because
foreign capital helps to build up the foreign exchange reserves needed to meet trade
deficits. Foreign investment provides a channel through which developing countries
can gain access to foreign capital. It can come in two forms: foreign direct investment
(FDI) and foreign institutional investment (FII). Foreign direct investment involves in
direct production activities and is also of a medium- to long-term nature. But foreign
institutional investment is a short-term investment, mostly in the financial markets.
FII, given its short-term nature, can have bidirectional causation with the returns of
other domestic financial markets such as money markets, stock markets, and foreign
exchange markets. Hence, understanding the determinants of FII is very important for
any emerging economy as FII exerts a larger impact on the domestic financial markets
in the short run and a real impact in the long run. The present study examines the
determinants of foreign institutional investment in India, a country that opened its
economy to foreign capital following a foreign exchange crisis.
India, being a capital scarce country, has taken many measures to attract foreign
investment since the beginning of reforms in 1991. Up to the end of January 2003,
India succeeded in attracting a total foreign investment of around U.S.$48 billion out
of which U.S.$12 billion was in the form of FII. These figures show the importance of
FII in the overall foreign investment program. India is in the process of liberalizing its
capital account, and this has a significant impact on foreign investment and
particularly on FII, which affects short-term stability in the financial markets. Hence,
there is a need to determine the push and pull factors behind any change in the FII, so
that we can frame our policies to influence the variables that attract foreign
investment. Also, FII has been the subject of intense discussion, as it is held to be
responsible for having intensified the currency crises of the 1990s in East Asia and
elsewhere in the world. The present study aims to examine the determinants of FII in
the Indian context. We attempt to analyze the effect of return, risk, and inflation,
which in the literature are considered to be the major determinants of FII. The
proposed relationship among the factors (discussed in detail later) is that inflation and

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risk in the domestic country and return in the foreign country adversely affect the FII
flowing to the domestic country, whereas inflation and risk in the foreign country and
return in the domestic country have a favorable effect on the flow of FII. In the next
section we will briefly consider the existing studies of this topic.

What is FII & how it is permitted

 
An investor or investment fund that is from or registered in a country outside of the
one in which it is currently investing. Institutional investors include hedge funds,
insurance companies, pension funds and mutual funds.
The term is used most commonly in India to refer to outside companies investing in
the financial markets of India. International institutional investors must register with
the Securities and Exchange Board of India to participate in the market. One of the
major market regulations pertaining to FIIs involves placing limits on FII ownership
in Indian companies.
 
 Foreign Direct Investment in India is permitted as under the following forms
of investments:
 Through financial collaborations.
 Through joint ventures and technical collaborations.
 Through capital markets via Euro issues.
 Through private placements or preferential allotments.

FDI is not permitted in the following industrial sectors:

 Arms and ammunition.
 Atomic Energy.
 Railway Transport.
 Coal and lignite.
 Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds,
copper, zinc.                                     
 
Factors contributed significantly to the FII flows to India:
 
Regulation and Trading Efficiencies: Indian stock markets have been well regulated
by the stock exchanges, SEBI and RBI leading to high levels of efficiency in trading,
settlements and transparent dealings enhancing the confidence level of FIIs in
increasing allocations to India.
 
New Issuance: We have witnessed extremely high quality issuance during the year
from companies such as NTPC, ONGC and TCS leading to strong FII participation
with successful new issuance of over $ nine billion, yet another record for the year.
 
Attractive Markets: Indian equity markets continue to be attractive to foreign
investors with expected earnings growth of over 13 per cent compared with negative
growth expected among competing countries in the region such as Taiwan and Korea.
Indian blue chips are seen to have high quality of balance sheets with net debt to
equity of the top 30 companies being negative, with net cash on the balance sheets.
However earnings growth is expected to be lower than last year and upside in stock
prices will be subject to sentiments in the global markets and foreign flows to

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emerging markets. However high quality new issuance from PSUs and other large
corporate will continue to see good demand from FII. However domestic mutual
funds have been net sellers of equities during 2004 with risk aversion still prevalent
among local investors after seeing several short periods of high volatility. With the
booming stock markets presently catching the headlines in local press, this trend will
hopefully reverse during 2005.
 
Outsourcing: 
The rhetoric over outsourcing of jobs to India has died down after the US elections
and demand will soar for Indian BPO and software services companies. However
Indian software companies will need to enhance margins by going up the value chain
to high level consulting and scaling up the project sizes. Significant outsourcing
opportunities will also open up in textiles and drugs with dismantling of quotas for
textiles and introduction of product patent regime for pharmaceuticals.
 
Infrastructure: 
Woefully inadequate infrastructure is the biggest bottleneck for the growth and
profitability of Indian corporations. The administration needs to move much faster in
privatization of Projects in the areas of power, transportation, ports, airports and other
urban infrastructure to enhance competitiveness. This is particularly relevant due to
the fact that competing countries in Asia Pacific and China have moved at a much
faster pace during the last five years and have in place a first world  infrastructure.
 
Capex Cycle: 
With strong balance sheets, high liquidity in the banking system, supportive capital
markets and growing demand for goods and services we expect to see a strong wave
of capital expenditure cycle during the year leading to tremendous opportunities for
Indian equities.

Dollar Weakness: 
Analysts continue to look for a weak US dollar with the US twin deficits (budget and
trade deficits) unlikely to be resolved anytime soon. Studies have shown that flows
into emerging markets rise significantly during times of dollar weakness and India
will continue to be a beneficiary of this trend. Indian Rupee is expected to strengthen
further during 2005 which will be particularly favorable for domestic demand
oriented businesses such as banks and automobiles.
 
Rising Commodity Prices: 
Demand supply dynamics in both crude and metals call for higher prices during 2005
with increasing Chinese demand and economic recovery in Japan. This has
inflationary implications for India going forward, though it will be a boon for
commodity counters.
 
Consolidation: 
FII activity has been focused on large cap companies due to liquidity reasons, and
hence several high quality mid cap companies trade at a valuation discount due to lack
of investor demand. We expect to see significant merger activity among mid caps
which will enable them to gain better valuations under the institutional radar screen,
in addition to consolidation efficiencies. While China attracts significantly higher
FDI, India with its highly developed capital markets will be a beneficiary of FII flows

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at increasing pace each year. To summarize, Indian markets have successfully

absorbed the gains seen during 2003 and consolidated well during 2004 with a modest
gain and look set to outperform the global financial markets during 2005.

FII Investment is increasing in India:

 
Nearly half of the Rs 70,000 crore offshore investments that have come into Indian
bourses this fiscal, till October 2009, are from alleged tax havens such as Mauritius,
Hong Kong and Luxembourg—the three together contributing almost Rs 25,000 crore
of the net inflow from foreign institutional investors (FIIs).

Significant omissions from this list are FIIs of Singapore and Switzerland, the two
countries that had figured among the top five with the highest investments in Indian
equities during the economic slowdown of 2008. FIIs from the two countries had put
in over Rs 15,000 crore last year. The government has said there is no cause of
concern on the strong FII flow into stock markets with finance minister Pranab
Mukherjee stating that regulators were keeping a close watch on the money flow and
would act if it was alarming.
       
Till October 2009, FII held equities totaled more than $160 billion. According to a
finance ministry statement, the highest investments have come from US-based FIIs, to
the tune of Rs 21,344 crore till November 10. Second on the list is Luxembourg with
Rs 12,275 crore. France, Mauritius, the UK, UAE, Hong Kong, Australia, Norway
and Canada are the other countries in the top 10, in that order.

Investments from Mauritian FIIs have been Rs 9,400 crore, ahead of the UK (Rs
4,900 crore), UAE (Rs 4,800 crore) and Hong Kong (Rs 3,438 crore). What can be of
concern for the government is the rising share of participatory notes (PNs) in the total
FII flow into stock markets. Since the identity of PN investors is not known, the
government had put a tight leash last year on such investments after it feared that
some dirty money may have entered the market riding on P-notes. The story was
similar in 2006 when Luxembourg topped all other countries with maximum
investment of Rs 12,600 crore. The top four that year included Singapore, Hong Kong
and UAE—the US was a distant fifth with Rs 3,300 crore FII investments
 
One-third of investments made via PNs:

Poor market conditions towards the end of 2008 had forced the government to remove
restrictions on participatory notes (PNs), but it had asked FIIs to register in India
rather than investing through PNs. It is estimated that of net FII inflows of Rs 44,000
crore during September-October 2009, nearly a third, or Rs 14,000, crore investment
was on account of PNs.
 

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Foreign Institutional Investment

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