ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

A+| A| A-

Neither Dread Nor Encourage Them

Foreign institutional investor inflows into the Indian stock market have conferred several benefits - in terms of lower cost of equity, securities market reforms and corporate governance. However, more receipts are unlikely to increase these benefits, while the downside is the potential volatility in exchange rates arising from the fact that participatory notes constitute a large component. We are unsure about the origins of funds that go into participatory notes and we do not know whether they are permanent in nature. It is possible to derive the benefits of FII investment without having to put up with the uncertainties created by PNs. We do not need to dread FII flows, but neither is there any need to be fixated about raising them.

Neither Dread Nor Encourage Them

Foreign institutional investor inflows into the Indian stock market have conferred several benefits – in terms of lower cost of equity, securities market reforms and corporate governance. However, more receipts are unlikely to increase these benefits, while the downside is the potential volatility in exchange rates arising from the fact that participatory notes constitute a large component. We are unsure about the origins of funds that go into participatory notes and we do not know whether they are permanent in nature. It is possible to derive the benefits of FII investment without having to put up with the uncertainties created by PNs. We do not need to dread FII flows, but neither is there any need to be fixated about raising them.


spectre haunts some of the policymaking circles in the country, the spectre of a massive exodus of FII funds that might play havoc with the Indian economy. The ‘Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative Flows’, headed by Ashok Lahiri, attempts to lay this spectre to rest. Its central message, namely, FII flows have conferred several benefits and do not pose systemic risks, is hard to quarrel with. However, the report does seem to overstate the importance of FII flows to the Indian economy, particularly at the present juncture, while understating the problems they pose.

Net FII inflows have been increasing in recent years. In 2004-05, they amounted to $10.5 billion. This figure has already been exceeded in the current financial year. Cumulative FII investments were $39 billion in October 2005, larger than FDI investment in the same period and contributing nearly 28 per cent of the foreign exchange reserves at end-September 2005.

This is all to the good. The expert group (EG) seems to think more is better and FII flows should be “encouraged”– indeed finding ways to do so was part of the mandate of the EG. But the case for actively enticing FII flows in the present situation is by no means persuasive. We begin by examining the case for encouraging FII flows. Next, we examine the vulnerabilities that such flows might create. The last section concludes.

Do We Need to Encourage FII Flows?

Why do we need to encourage FII flows? The EG outlines the rationale for doing so in the following terms: (1) It can “supplement domestic savings and augment domestic investment without increasing the foreign debt of the country”. (2) “Capital inflows into the equity market give higher stock prices, lower cost of equity capital, and encourage investment by Indian firms.” (3) “Foreign investors often help spur domestic reforms aimed at improving the market design of the securities markets, and help strengthen corporate governance.”

To take up the first proposition, there is a conceptual problem with the EG’s

Economic and Political Weekly January 14, 2006 formulation. FII inflows do have some savings-like characteristics. For instance, an increase in FII flows would help lower interest rates. But, do they actually increase savings? Savings are income less consumption. Hence, lower the consumption, the higher the savings. If FII flows push up stock prices, they would stimulate consumption through the wealth effect and hence end up lowering savings in the economy.

Still less do FII flows partake of the character of investment. The EG cites the International Monetary Fund’s definition of foreign direct investment (FDI) as “that category of international investment that reflects the objective of obtaining a lasting interest by a resident entity in one economy in an enterprise resident in another economy”. The European Union interprets this “lasting interest” to mean any investment in a firm in excess of 10 per cent. Any foreign investment that exceeds this limit is FDI; anything below the limit is portfolio investment. Going by this definition, FII investment in several Indian firms deserves to be categorised as FDI. Who says India can’t attract FDI!

In terms of evaluating the economic impact of FII flows, it is more appropriate to think of investment as an increase in capital stock. FII flows only change the ownership of assets; they do not augment capital stock – at any rate, not in the first round. FII flows are transfers and they do not constitute savings and investment any more than overseas remittances do. There is no call to claim for FII flows macroeconomic benefits that do not exist.

Cost of Equity

Turn now to the second proposition, about FII flows lowering the cost of equity. It is important to distinguish between FII flows into the secondary market and those into the primary market (the omnibus term for the two together is “portfolio flows”). The lowering of the cost of equity for Indian firms has to do with the primary market. For the foreign investor for whom Indian equities are part of an internationally diversified portfolio, the expected rate of return on equity would be lower than for an Indian investor. Hence, FII investment in the primary market can be expected to reduce the cost of equity for Indian firms.

However, this is subject to several caveats. First, for Indian firms that can access equity in the international markets, FII flows into India would not be relevant at all. Such firms can lower the cost of equity on their own regardless of FII investment in the Indian market.

Secondly, FIIs would not be the sole investors in primary issues of Indian firms. There would be domestic institutional and retail investors as well. If the latter are the dominant investors in a given primary issue, then, at the margin, the cost of equity would be determined by their return expectations and not by those of FIIs. Hence, the presumed benefits of FII investment in terms of lowering the cost of equity would be small or non-existent.

Thirdly, the cost of equity is the expected rate of return on equity (and is provided by the capital asset pricing model) as distinct from the actual rate of return that investors might derive from the secondary market. So “higher stock prices” (through FII investment in the secondary market) do not necessarily translate into lower cost of equity. (They would in the Gordon growth model, but only on the assumption that lower dividend yields do not reflect higher growth opportunities.) Besides, as the report itself points out, it is not even clear that FII flows cause higher stock prices in the first place – there is ambiguity in the literature as to whether it is FII flows that cause higher returns or vice versa.

Higher FII flows into the secondary market would contribute to lowering the cost of equity in a quite different way. By enhancing liquidity in the economy, they would cause the risk-free rate in the economy to decline. But, in this respect, FII flows are no different from several other inflows on the foreign exchange account and are dwarfed in importance by, say, remittances.

The importance of FII flows into the secondary market can be exaggerated. You need a secondary market in order to provide an exit to those who have invested in the primary market. In principle, a modest amount of FII flows into the secondary market would suffice for the purpose. In short, it is not clear why the objective of lowering the cost of equity for Indian firms would require higher and higher levels of FII flows into the secondary market and we should, therefore, “encourage” such flows.

There are practical limitations as well. Indian corporates’ access to FII capital will be constrained by the owners’ need to maintain control through high levels of equity holding. That is, perhaps, part of the reason why the revival in the primary market we have seen in recent years has been driven by public sector firms rather than by private sector firms.

From the standpoint of the Indian corporate sector as a whole, it is the public sector, therefore, that stands to reap the benefits of lower cost of equity by placing equity with FIIs. This is something that will clearly be constrained by the pace of disinvestment. Disinvestment has its own rationale; it cannot be driven by considerations of accessing FII funds.

To sum up, for the many reasons spelt out above, the prospect of any substantial lowering of equity by Indian firms through access to higher levels of FII capital is largely notional in the present situation. And, in any case, such lowering of the cost of equity has very little to do with enhanced FII flows into the secondary market.

Reform of Securities Market

The third reason the EG report cites for encouraging FII inflows is that it makes for reform of the securities market and improved governance. This is unexceptionable. But, again, one could argue that the incremental benefits from FII inflows at this point would be small. The stock market infrastructure and governance have been overhauled and we do hear people say that the Indian market today compares with the best. It is not clear what raising FII inflows from $10 billion to, say, $20 billion might accomplish in this respect.

As for improving corporate governance, yes, disclosure has changed beyond recognition ever since FIIs came into the Indian market. The whole culture of analysts putting corporate results and corporate news under the scanner has caught on in a big way. This has contributed to better governance.

But the big change in governance that one might have hoped for, which is institutional activism dislodging inept management, is a no-no in the Indian context. Perhaps it has do with the fact that FII

Table: Estimate of PN-Related Flows as Proportion of Net FII Flows
1 2 3 4 5
Value of Securities Underlying PNs ($ bn) Values of Securities PN Flows in 2004-05 Underlying PNs ($ bn) ($ bn) Net FII Flows in 2004-05 ($ bn) PN Flows/ FII Flows 3/4
(April 2004)6.95 (March 2005) 11.87 (2-1) 4.93 10.2 48.30 Per cent

Source: EG report.

Economic and Political Weekly January 14, 2006

exposure to India is still quite small in relation to the total volume of institutional funds. Perhaps, there is fear of a backlash from entrenched management and a political backlash as well. Whatever the reason, FIIs have kept a low profile where governance is concerned.

If FII shareholding in Indian companies were to go up further, one would expect FIIs to become more demanding. In which case one should expect resistance to FII flows. Is the political system equipped to override such resistance? Which way would government-owned financial institutions vote if there was a confrontation between FIIs and management? It makes little sense to talk of “encouraging” FII flows without coming to grips with the attendant issues of political economy.

In any case, the EG report is not very eloquent on what “encouraging” FII flows means in practice. It has only two suggestions to make: the cap on FII investment must be over and above the FDI cap; more good quality securities must become available and disinvestment is a means of ensuring this. Perhaps the EG recommendation is better understood to mean that nothing should be done to discourage FII flows.

Vulnerability to FII Flows

We understand the potential upside to FII flows. What about the downside? In theory, FII flows could render the capital markets as also the larger macroeconomy vulnerable. The EG contends that, by and large, this not so in actuality. The perception that FII flows are “hot money” and are inherently destabilising is not borne out by experience elsewhere or in India.

This is indeed true. The two major episodes in which portfolio flows are widely believed to have been destabilising are the ERM crisis of 1992 and the east Asian crisis of 1997. The EG report correctly points out in both these episodes, the focus of speculative attacks was the exchange rate regime rather than the equity market itself. In point of fact, it was large outflows of debt as well as of domestic capital that destabilised the east Asian markets, not the exodus of portfolio funds.

In India, there have been four major episodes of vulnerability: the east Asian crisis of 1997, the Pokhran nuclear explosion (1998), the stock market scam of 2001 and Black Monday (May 17, 2004). The EG report makes the point in none of the episodes did the outflow of FII funds touch one billion dollars a month – or around Rs 170 crore a day which is a small proportion of daily trading volume. The annual trading turnover in 2004 was Rs 88 lakh crore; FIIs’ trading turnover was a mere Rs 5 lakh crore.

But the fact remains that FII flows impact significantly on prices. This may not be on account of the trading they do themselves; it could be that FII investment decisions tend to get magnified by influencing decisions of domestic investors and lead to overshooting in the market. In May 2004, FII sales in the Indian market did cause prices to plummet sharply. There are times when even the mention of a decrease in net FII inflows has caused stock prices to fall.

The salient point is not that FII flows do not cause price volatility. It is that such volatility does not pose any systemic threat to the stock market or to the economy at large. Thus, in May 2004, the stock markets’ risk management systems were robust enough to withstand an eight sigma volatility whereas such systems generally have the capacity only to deal with three-six sigma events. The danger of a stock market collapse brought on by bankruptcies among market participants must thus be rated low.

The macroeconomic impact of volatility in stock prices caused by FII flows is also limited on many counts. The primary market is not a significant source of funds for the corporate sector, so fluctuations in stock prices do not affect investment in a big way. The wealth effect of market portfolios on consumption, which is small even in industrial countries, may be expected to be even smaller in India. Hence national income is unlikely to suffer major swings through the consumption effect.

Bank exposure to the stock market is tightly regulated, so bank failure on account of a fall in stock prices is not something we need to fear. In April-September 2005, FII flows accounted for only $ 5 billion out of the total flows on the capital account of $ 19 billion that financed the current account deficit of $ 13 billion. So the balance of payments effects of FII flows too are not a cause for concern either.

The principal vulnerability created by FII flows today relates to management of exchange rates – and this is the reason for the RBI’s discomfort with the thrust of the EG report which is in favour of “encouraging” FII flows. The sharp rise in FII inflows in the last three years is a factor underlying the appreciation of the rupee for most of the recent period.

As the RBI is not sure about the stability of FII flows, it has been containing appreciation of the rupee through intervention in the forex market. The resultant money supply expansion is contained through sterilisation operations. Such operations impose a cost on the economy as interest rates are higher than they would be in the absence of sterilisation.

The RBI is particularly uncomfortable with the large and growing share of participatory notes in FII inflows. As the EG report states, “PNs are instruments used by foreign funds, not registered in the country, for trading in the domestic market. They are a derivative instrument issued against an underlying security which permits the holder to share in the capital appreciation/income from the underlying security.” PNs are issued by FIIs to overseas clients who may not be eligible to invest in the Indian stock market.

Some of the concerns about PNs are:

  • a big chunk of these is merely the money of wealthy Indians disguised as FII investment.
  • some of the funds may be associated with activities such as smuggling or the drugs trade.
  • to the extent that it is individuals with short-term horizons rather than institutions that are using these, PNs may enhance volatility in the market.
  • Since February 2004, FIIs are allowed to issue PNs only to regulated entities and further trading can be only with regulated entities. The EG is of the view that this is adequate safeguard against misuse of PNs. The RBI does not think so.

    As Appendix III of the EG report shows, the importance of PNs has grown sharply in the last two years. What accounts for the rise? Who are the regulated entities that would not qualify for investing in India through the FII route? What prevents individuals from parking funds in regulated entities to which FIIs issue PNs? The EG might have shed light on these issues.

    The EG report gives the ratio of PNs to net FII investment for each month since September 2003. As we are concerned primarily with flows, it would have been more instructive had the EG provided the figures for PN-related flows in absolute terms and as a ratio of net FII flows each month.

    Assuming that PN-related flows in a given period would simply be the difference in the value of underlying security for the initial and last months, we have attempted to compute the ratio of PN to FII flows for 2004-05, one year for which the complete picture of both PN and FII flows is available in the EG report (see the table). It turns out that PNs accounted for

    Economic and Political Weekly January 14, 2006 nearly 48 per cent of the FII inflows in 2004-05. The ratio would be even higher in 2005-06 looking at the trends in the data in the period up to August 2005.

    Volatility of Participatory Notes

    There are three ways to deal with the problem of volatility posed by the high proportion of PNs in FII flows. One, phase these out. This is the RBI’s stated preference in its dissenting note to the EG report. The BoP implications of doing so are not great.

    In April-September of 2005-06, as mentioned, portfolio flows amounted to $ 5 billion. If PNs were phased out, this figure would have been around $ 2.5 billion. Forex reserves rose by $ 6 billion in the period; instead they would have risen by $ 3.5 billion. In BoP terms at least, this is the right moment for grasping the PN nettle. But, if net FII inflows were to decline, stock prices might fall. Since successive governments have decreed that stock price movements in India must be unidirectional, it is understandable that the government does not have the stomach for outlawing PNs.

    A second option is to muddle through until the stability of PNs is established or until FII flows become insignificant in overall capital flows. But this clearly means that the economy will continue to have to bear the costs of sterilisation in the medium term.

    The third option, which the EG report mentions, is to introduce price-based controls such as the Tobin tax or the Chilean approach of requiring that a certain proportion of inflows be invested in oneyear government securities. The RBI would like the whole question of vulnerability to FII flows to be considered by another committee.


    FII flows into the Indian stock market have conferred several benefits on the economy. They helped augment capital flows at a time when the BoP situation was not comfortable. They allowed Indian firms to access overseas capital at a cost that was lower than the domestic cost of capital.

    They ushered in major reforms in the working of securities markets and in corporate governance.

    However, no matter how successful a policy may have been, it needs to be revisited when the context changes. We need to examine the importance of FIIs in relation to the present needs of the Indian economy and the Indian corporate sector as well as the possible risks posed by FII flows.

    It would be incorrect to suppose that more FII flows would mean more benefits. More FII flows are unlikely to increase the benefits – in terms of lower cost of equity, securities market reforms and corporate governance – already realised or available at the existing level of FII flows. At the macroeconomic level, the BoP situation is sufficiently comfortable for us not to worry about having to attract higher FII flows.

    Volatility in FII flows does not pose systemic risks. The downside to FII flows is principally the potential volatility in exchange rates arising from fact that PNs constitute a large component of FII flows

    Economic and Political Weekly January 14, 2006

    today. We are unsure about the origins of funds that go into PNs and we do not know whether these are permanent in nature.

    It is possible to derive the benefits of FII flows without having to put up with the uncertainties created by the PN component. Eliminating the uncertainties that go with PNs will also help reduce or eliminate the costsof sterilisation incurred in the process of having to deal with potentially volatile FII flows. We do not need to dread FII flows. But neither is there any need to be fixated about raising the level of FII flows or even maintaining the existing level.



    Economic and Political Weekly January 14, 2006

    To read the full text Login

    Get instant access

    New 3 Month Subscription
    to Digital Archives at

    ₹826for India

    $50for overseas users


    (-) Hide

    EPW looks forward to your comments. Please note that comments are moderated as per our comments policy. They may take some time to appear. A comment, if suitable, may be selected for publication in the Letters pages of EPW.

    Back to Top