Advantages

Enhanced flows of equity capital FIIs have a greater appetite for equity than debt in their asset structure. The opening up the economy to FIIs has been in line with the accepted preference for non-debt creating foreign inflows over foreign debt. Enhanced flow of equity capital helps improve capital structures and contributes towards building the investment gap. Managing uncertainty and controlling risks. FII inflows help in financial innovation and development of hedging instruments. Also, it not only enhances competition in financial markets, but also improves the alignment of asset prices to fundamentals. Improving capital markets. FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. Equity market development aids economic development. By increasing the availability of riskier long term capital for projects, and increasing firms incentives to provide more information about their operations, FIIs can help in the process of economic development. Improved corporate governance. FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms operations, improve corporate governance. Bad corporate governance makes equity finance a costly option. Also, institutionalization increases dividend payouts, and enhances productivity growth.

Disadvantages

Problems of 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. Problems for small investor: 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. 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. Hot Money: 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.

FIIs and the Indian Stock Market

A major development in our country post 1991 has been liberalization of the financial sector, especially that of capital markets. Our country today has one of the most prominent and followed stock exchanges in the world. Further, India has also been consistently gaining prominence in various international forums, though we still have a long way to go.

Before I actually begin with the crux of this article, let me give you a brief background. Developing countries like India are generally capital scarce. This is because levels of income are lower in comparison to other developed countries, which in turn means savings and investments are also lower. So how do developing nations get out of such a situation? Simple! They borrow money, like we all do when we need to buy a house or a car. Countries can thus invest this borrowed money in various social and physical infrastructure; earn a return on them which helps them pay off their debt, and simultaneously propel the country to a higher growth trajectory.

However, there is another way in which a country can attract foreign money. This is by way of Foreign Direct Investment (FDI) of Portfolio Investment (better known as Institutional Investment). The difference between the two is subtle. Lets look into FDI first. FDI is defined as investment made to acquire lasting interest in enterprises operating outside of the economy of the investor. Examples of FDI would include POSCO setting up a steel plant in Orissa (in-bound FDI), Tata buying Arcelor (outbound FDI) and so on.

On the other hand, FII is used to denote an investor, who invests money in the financial markets of a country different from the one in which that investor is incorporated. So, if you as an Indian decide to invest in the US stock markets, it is an out-bound foreign institutional investment. Similarly, suppose a rich American millionaire invests in the Indian stock markets, it would be termed as in-ward FII.

If you follow financial dailies, you are bound to see headlines such as FIIs remained net buyers. Net buyers implies that foreign investors poured more money into the stock market than they took out, which is generally seen as a positive development as far as our economy is concerned.

But are we obsessed with FIIs? Do we give them more attention than they deserve? Well, this is a very contentious issue, and addressing this is beyond the scope of this article. But we can debate on some basic issues regarding FII flows.

For instance, take a look at the chart. On the left axis, we have measured net FII flows (inflows minus outflows), in Rs. Crores. On the right axis, we have measured the Sensex. What does this show us? Well, for one, it shows the spectacular rise of the Sensex over the past few months! Secondly, we can see how volatile FII flows are. It is almost impossible to predict whether FIIs will be net sellers or net buyers tomorrow! What is more important is that there is no rigid relationship between the Sensex and FII flows. Statisticians use a measure known as the correlation coefficient, which is used to depict a relationship between two variables mathematically. This coefficient ranges from minus 1 to plus 1. So, if we consider two variables, and the coefficient is -1, it means that when one moves up, the other moves down in the same proportion. When it is 1, it means when one moves up or down, the other also moves in the same manner, and when it is zero, it means there is no correlation. So when one moves up (or down), theres no way to figure out how the other variable will behave.

So basically, one can compute the correlation coefficient between the Sensex and FII flows. I found it to be 0.13 over a 21 month period. This is a very weak correlation, though it cannot be ignored entirely. But if they are so weakly correlated, then why do they grab the headlines?

Well, thats because we need to look beyond the numbers! In any kind of market, financial or real, investor sentiment and psychology play a crucial role. This is something that just cannot be captured in a few numbers. Now an in-depth explanation of investor psychology is not possible here, but I can give a

few examples of it. For instance, when the stock markets rise, they just seem to be rising (as you may have observed recently)! Experts and academicians have studied the behavior of investors, and found that frenzy and greed drive investors during a bull run, and especially when a bull run is at its full momentum, investors tend to follow the band-wagon and overlook economic fundamentals while investing. In fact, stock market crashes too occur in similar ways. One major investor may begin selling his stocks suddenly. Looking at him, others may panic, and they too follow suit. Such panic spreads like wild fire in the markets, and ultimately leads to a major crash. This was similar to what happened during the times of Harshad Mehta and Ketan Parikh.

It is because of the volatile nature of investors sentiments that FIIs are tracked so closely. It would not be prudent to drive away foreign investors from investing in our country. I had mentioned the importance of foreign capital in the context of a developing economy, and that is precisely why the government has been so keen on liberalizing the external financial sector since 1991. If one foreign investor has had a good experience investing in our country, it builds up our reputation in the international community, and encourages more foreign investors to invest in our economy. However, a crisis of any kind will create panic among foreign investors as well, and regaining their trust and confidence in our economy will entail another mammoth task!