The Hindu Business Line : Foreign Investment Flows

The Government is keen on foreign investments but it must monitor these flows carefully as they can upset the country's stock market. Citing the recent Thailand experience, R. VAIDYANATHAN advises vigilance in attracting FII funds.

The recent developments in the financial markets of Thailand have not been adequately covered in India. The baht had been appreciating throughout last year and it was nearly 17 per cent up against the dollar this year, hurting Thailand's export competitiveness. The exporters, much disturbed, were pressuring the Government and the central bank to do something. Bangkok was also worried about inflation.. The central bank decided to impose capital controls, which took the form of a 10 per cent withholding tax on the initial investment.

The international financial press used such terms as "draconian" "authoritarian" and "antediluvian" to describe this move. The press in emerging markets, such as India, faithfully repeated the terms. Foreign institutions followed up on the threat to pull out of the Thai stock market by withdrawing some half a billion dollars on a single day out of an estimated $50-billion worth of investments. Foreign institutions account for nearly 30 per cent of the market.

Fateful Monday

Thai shares tumbled by 19 per cent at one point to recover a bit and closed 15 per cent down on the fateful Monday (December 18) after the announcement of the curbs. The Thai Government was forced to back-track to announce that the curbs would not be applicable to the stocks but only to bonds and debt instruments. The markets recovered and no doubt global funds were smug that had made the Thai Government see "reason".

The Thai affair yet again illustrates the limitations of a sovereign state against global funds that have huge corpus and clout to bring down, or enhance volatility in, markets.

Are there lessons for India in this? The first is to understand the nature of FIIs and also periodically monitor their role in the market. It must be realised that some of them come in for very short term and some for long.

Also, the national interest may not always coincide with the FIIs' demand for quick gains; conflict situations can emerge.

The country must learn to deal with such conflicts without affecting its interests. Institutions are becoming larger and in many cases dwarf sovereign governments. Their ability to arm-twist central banks and finance ministries is well known. Hence, while encouraging foreign fund flows in the stock market, the policy-makers must be prepared for the worst.

As of December 2006 993 FIIs were registered with the Securities and Exchange Board of India. More important, FII is not one animal. It comes in many breeds and from several origins with differing perspectives and risk return profiles. In clubbing all these into one, we may be missing the trees for the woods.

The various types of FIIs are listed in Table 1. Entities eligible to invest in India via the FII route are:

As FIIs: Overseas pension funds, mutual funds, investment trust, asset management companies, nominee companies, banks, institutional portfolio managers, 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 (that is, fund having more than 20 investors with no single investor holding more than 10 per cent of the shares or units of the fund).

As sub-accounts: A sub-account is generally the underlying fund on whose behalf the FII invests. The following entities are eligible to be registered as sub-accounts: Partnership firms, private companies, public companies, pension funds, investment trusts, and individuals.

Domestic entity: A domestic portfolio manager or a domestic asset management company shall also be eligible to be registered as an FII to manage the funds of sub-accounts. FIIs can register with SEBI under the following categories:

Regular FIIs - those required to invest not less than 70 per cent of their investments in equity-related instruments and up to 30 per cent in non-equity instruments.

100 per cent debt-fund FIIs - permitted to invest only in debt instruments.

To quote the Dr Ashok Lahiri Committee report: "The Government guidelines for FII of 1992 allowed, inter alia, entities such as asset management companies, nominee companies and incorporated/institutional portfolio managers or their power of attorney holders (providing discretionary and non-discretionary portfolio management services) to be registered as FIIs. While the guidelines did not have a specific provision regarding clients, in the application form the details of clients on whose behalf investments were being made were sought.

While granting registration to the FII, permission was also granted for making investments in the names of such clients. Asset management companies/portfolio managers are basically in the business of managing funds and investing them on behalf of their funds/clients.

"Hence, the intention of the guidelines was to allow these categories of investors to invest funds in India on behalf of their `clients'. These `clients' later came to be known as sub-accounts. The broad strategy consisted of having a wide variety of clients, including individuals, intermediated through institutional investors, who would be registered as FIIs in India."

The main information available on FII pertains to the inflows and outflows (Table 2). Though meagre, the key information pertains to the current market value of investments and the share of the FIIs in the trading.

Of significance is the FIIs' share of the overall market turnover; this enables an assessment of the impact of the foreign institutions. The Economic Survey suggests that the FII turnover could be around 12-15 per cent of the total market turnover.

The Government is keen on FII inflows as that is thought to better value our markets as also speed up the process of integrating with developed markets. Good intentions no doubt but the Government must be alert about the funds particularly in the context of the large hedge funds that are not regulated in many territories.

SEBI and the Reserve Bank of India should set up a group of experts to monitor the FIIs and their activity in the market, especially if they have any hand in the volatility.

This is all the more important as rupee might start appreciating in the context of large foreign flows and the economy's growth prospects and there would be pressure from the domestic export lobby to mitigate the situation. Such a monitoring would go a long way in protecting the country's interests and hopefully will not be considered "draconian" or "oppressive" by the wise men of the West.

(The author, a Professor of Finance and Control, Indian Institute of Management-Bangalore, can be contacted at vaidya@iimb.ernet.in. The views are personal and do not reflect that of his organisation.)

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