Of direct interest to FIIs is the condition of the capital market in a country.

Even though there is the suspicion that a chunk of FII funds into India may not be authentic, it would help to know the factors that influence the genuine FII flows into any country.

An IOSCO report that studied the behaviour of institutional investors in emerging countries throws up some insights. Incidentally, India did not participate in this survey.

Factors at play

Of the macro economic and political factors that affect FII flows, economic growth features high on the list. Since higher GDP growth leads to better corporate earnings and lower credit risk in bonds, improvement in economic growth results in better FII flows and vice versa.

Inflation is another factor that wards off these investors. Interest rate differential does not have much impact since many emerging countries impose restrictions on foreign investment in debt.

Political stability, whether the country is going through a financial crisis, privatisation and ownership rights and the regulatory and judicial system in the country are other influencing factors.

Of direct interest to FIIs is the condition of the capital market in a country. Let us examine where the Indian equity market stands on these parameters.

Lack of depth and liquidity in capital market can be a clear no-no for institutional investors. Indian market is fairly well positioned on this parameter. Of the 25 jurisdictions surveyed by IOSCO, 17 had less than 500 public listed companies.

But the Bombay Stock Exchange with more than 5,000 listed companies and the National Stock Exchange with over 1,600 listed entities offer a wide array of choice to investors.

There is a problem, however, with cash volumes. About 50 per cent of cash volume on the NSE is concentrated in the Nifty stocks.

A highly traded stock such as Reliance Industries averaged turnover of Rs 377 crore in the first quarter of this year while a small-cap stock such as Ramky Infra recorded an average daily turnover of just Rs 43 lakh — i.e., the distribution of volume is not even in our market and concentrated in a handful of counters, leading to high impact cost.

Restriction on price movement of securities by imposing price bands is also viewed unfavourably since market efficiency is compromised by these bands.

Further it makes exit difficult in less liquid stocks. Both BSE and NSE have market wide circuit filter as well as filters for individual stocks.

IOSCO recommends that these trading bands should be widened and gradually removed to attract greater FII flows.

Lack of liquidity in corporate bond market is another common issue in emerging markets. Risk aversion of investors who prefer government bonds to corporate bonds, buy and hold strategy of institutional investors and limited supply is a problem in India as well as other emerging markets.

Despite this, FIIs have shown an enormous appetite for bonds, buying $4.7 billion in debt so far in 2012.

Foreign investors prefer markets that provide adequate means to hedge their positions. Many emerging markets do not have a developed derivative market. Many markets also restrict trading activity of institutional investors.

India allows FIIs unrestricted participation in the derivative segment and this has worked in our market’s favour. Trading by FIIs accounts for about one-third of the derivative trading volumes on NSE.

Transaction costs that consist of commissions, fees and taxes, including stamp duty, also impact FII interest. The Indian market has among the highest transaction costs globally on equity transactions. While financial transaction tax (Securities Transaction Tax in India) is common on delivery based cash transactions it is very rare in derivatives. India is the only country besides the UK and Taiwan to tax derivative transactions.

It is also among the few countries that impose both stamp duty as well as STT on equity transactions. Reduction of these taxes can be done with little loss to the exchequer since the growth in volumes by this move can compensate for the reduction in revenue.

Exchange Controls and Capital Account Restrictions too limit overseas flows.

Some EMs require foreign investors to get approval before repatriating funds in and out of the country, others have quotas for FIIs and minimum holding period before funds are repatriated.

India has limits for FII holdings in companies and there are limits on FII investment in bonds and government securities. But the RBI does not restrain inflow and outflow of FII funds from the country.

Lack of transparency, inequality in tax treatment of FIIs and domestic institutions, restrictions on accessibility to asset classes, lack of sound court and legal system are other deterrents to foreign investors. But India is not too badly positioned on these parameters.

(This article was published on August 18, 2012)
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