This article has been written by Krishna Bajpai pursuing Diploma in M&A, Institutional Finance and Investment Laws and has been edited by Oishika Banerji (Team Lawsikho). This article aims to review the regulatory framework governing foreign portfolio investment in Indian securities.

This article has been published by Sneha Mahawar.​​ 

Introduction 

Foreign Portfolio Investment (FPI) has emerged as a significant source of capital for Indian companies in recent years. In 2021, FPIs have invested more than $26 billion in Indian equities and $14 billion in debt instruments. The Reserve Bank of India (RBI) has taken several steps to liberalise FPI regulations in India to attract more foreign capital. In this article, we will review the regulatory framework governing FPI in India, including the Foreign Exchange Management Act, 1999, SEBI’s regulations on foreign institutional investors (FIIs) and qualified foreign investors (QFIs).

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Foreign portfolio investment routes in India

Foreign portfolio investments in India can be made through various routes. The three main routes for FPIs are:

  1. Foreign Portfolio Investors (FPIs): FPIs are registered with SEBI and can invest in Indian securities as per the regulations prescribed by SEBI. FPIs include various categories such as Category I, Category II, and Category III FPIs.
  2. Qualified Foreign Investors (QFIs): QFIs are individuals, groups, or associations who are not resident in India and can invest in Indian mutual fund schemes. QFIs were introduced in 2012 to provide a route for small investors to invest in Indian markets.
  3. Foreign Venture Capital Investors (FVCIs): FVCIs are registered with SEBI and can invest in Indian companies engaged in specific sectors. FVCIs are subject to various restrictions and regulations as per SEBI guidelines.

Foreign portfolio investment limits in India

SEBI has prescribed certain limits on the investment that can be made by FPIs in Indian securities. The limits are based on the type of security and the category of the FPI. For instance, FPIs are allowed to invest up to 20% of the paid-up capital of an Indian company. However, FPIs are subject to lower limits in certain sectors such as banking and insurance. SEBI has also prescribed a limit on the overall investment that can be made by FPIs in Indian securities. The limit is reviewed periodically and is currently set at USD 600 billion.

Challenges faced by foreign portfolio investors in India

It is ideal to note that the complex Indian legal system burdens the functioning courts. Alongside this, procedural compliances that need to be followed are also to be adhered to by the establishments. Many times, investors are surrounded by legal issues even after the operation has begun. These issues range from property to that of general operations. When it comes to foreign enterprises, therefore, it becomes a herculean task for them to be subjected to and overcome the same. The prime reason behind so many hurdles is the ever-changing bureaucracy following corruption involvement. Although it is correct to state that foreign companies generally avoid communication with government authorities to solve their roadblocks, one cannot deny that compliance adherence is a must for them. Initial risk in the foreign company can be avoided by means of collaboration with local business partners at legal, technical and financial levels, which in turn can responsibly reduce the amount of possessed risk for the companies. Money and time of the companies, which amount to the strongest resources, are also saved in this process. The possible challenges that can arise to foreign investors have been listed hereunder: 

  1. Foreign portfolio investors face several challenges when investing in India. One of the major challenges is the complex regulatory framework governing FPI investments. The regulations are subject to frequent changes, which can create uncertainty and make it difficult for investors to plan their investments.
  2. Another challenge faced by FPIs is the taxation regime in India. FPIs are subject to different tax rates depending on the type of security and the category of the FPI. The complex tax regime can discourage foreign investors from investing in India.

Impact of foreign portfolio investments on the Indian economy

Foreign portfolio investments have played a significant role in the growth of the Indian economy. FPIs have invested heavily in Indian equities and debt securities, providing much-needed capital to Indian companies. FPI investments have also helped to boost the Indian stock market, which has a positive impact on the overall economy. However, FPI investments can also create volatility in the markets, as FPIs tend to pull out their investments in times of uncertainty. The Indian government and regulatory authorities need to ensure that the FPI regulations are stable and predictable to provide a conducive environment for foreign capital. 

What effect can FPI sell-off have on the Indian economy

FPI sell-off can have effect at different levels of the Indian economy. The same have been briefly provided hereunder:

  1. Effect on local currency: Local currency is said to be taking a beating when FPIs are sold back to their home markets. This makes the investors sell rupees in exchange for their home currency, owing to the decline in rupee value with rising supply in the market. 
  2. Effect on exports and imports: It needs to be duly noted that a weaker rupee vis-à-vis a dollar results in expensive imports of crude oil, which India remains to be largest importer of. Cost-driven inflationary push will be a common sight for sectors that remain sensitive with respect to changes in crude oil prices.
  3. Effect on stocks and equity mutual fund investments: This effect is directly related to sell off as the higher the inflation, the more detrimental it is for the market. 
  4. Effect on India’s foreign exchange reserves: It has been estimated that India’s foreign exchange reserves have fallen from USD 46 billion in the last nine months to that of USD 596.45 billion. This is majorly due to withdrawals of FPI and the appreciation of the dollar. 

All you need to know about Foreign Exchange Management Act, 1999 (FEMA)

FEMA is the primary legislation governing FPI in India. It replaced the Foreign Exchange Regulation Act (FERA), 1973, which was considered archaic and restrictive. FEMA provides a legal framework for foreign exchange transactions, capital account transactions, and external commercial borrowing. FEMA has been amended several times to liberalise FPI regulations in India.

Under FEMA, FPIs are classified into two categories: 

  1. Foreign portfolio investors (FPIs) and 
  2. Non-resident Indians (NRIs). 

FPIs are further classified into three subcategories: 

  1. Category I: FPIs are government agencies, central banks, and sovereign wealth funds.
  2. Category II: FPIs are all other entities not covered under Category I or Category III.
  3. Category III: FPIs are those who take positions in the derivatives segment only.

FEMA allows FPIs to invest in Indian securities such as equities, bonds, debentures, and mutual funds. FPIs can also invest in Indian companies through the primary and secondary markets. However, FPIs are not allowed to invest in Indian companies engaged in the agricultural sector or plantation activities.

FEMA also provides guidelines for the repatriation of funds by FPIs. FPIs can freely repatriate their investments, subject to compliance with certain regulations. FPIs can repatriate the sale proceeds of their investments, dividends, and interest income. FEMA also allows FPIs to open and maintain a non-resident rupee account (NRE) and a non-resident ordinary account (NRO) with Indian banks.

SEBI Regulations on FPIs

The Securities and Exchange Board of India (SEBI) is the regulatory body responsible for regulating FPIs in India. SEBI has issued several guidelines and circulars to regulate FPIs in India. SEBI regulations on FPIs are in line with FEMA guidelines.

Under SEBI regulations, FPIs are classified into two categories, namely, foreign portfolio investors (FPIs) and eligible foreign investors (EFIs). FPIs are those who have been registered with SEBI under the SEBI (Foreign Portfolio Investors) Regulations, 2019. EFIs are those who invest in India through the International Financial Services Centre (IFSC).

SEBI has also prescribed the investment limits for FPIs in Indian securities. The investment limits vary depending on the type of security and the category of the FPI. SEBI has also prescribed sectoral caps for FPIs in Indian companies. For instance, FPIs are not allowed to invest more than 24% of the paid-up capital of an Indian company engaged in the defence sector.

SEBI regulations also provide for the KYC (Know Your Customer) norms for FPIs. FPIs are required to submit their KYC documents to SEBI and comply with the anti-money laundering (AML) guidelines. SEBI has also prescribed the guidelines for the transfer of securities by FPIs in India.

SEBI has also issued circulars to simplify the registration process for FPIs in India. The circulars have reduced the time and cost required for FPI registration. SEBI has also allowed FPIs to invest in unlisted debt securities issued by Indian companies.

SEBI regulations also provide for the monitoring of FPI investments in India. SEBI requires FPIs to report their investments and divestments in Indian securities on a daily basis. SEBI also monitors the concentration of FPI investments in Indian companies to ensure that no single FPI holds a significant stake in an Indian company.

Qualified Foreign Investors (QFIs)

Apart from FPIs, SEBI also allows qualified foreign investors (QFIs) to invest in Indian securities. QFIs are individuals and entities who are not residents in India but are eligible to invest in Indian securities. QFIs were introduced in 2011 to widen the investor base for Indian securities. Under SEBI regulations, QFIs can invest in Indian mutual funds and directly invest in Indian equities. QFIs are required to open a demat account with a SEBI-registered depository participant (DP) to invest in Indian securities. QFIs are also required to comply with the KYC norms prescribed by SEBI.

SEBI has prescribed the investment limits for QFIs in Indian securities. The investment limits vary depending on the type of security and the category of the QFI. SEBI has also prescribed the guidelines for the transfer of securities by QFIs in India.

SEBI has also allowed QFIs to invest in Indian debt securities. QFIs can invest in Indian debt securities issued by Indian companies and government securities. The investment limits for QFIs in Indian debt securities are also prescribed by SEBI.

Taxation of foreign portfolio investments in India

One of the major challenges faced by foreign portfolio investors (FPIs) in India is the complex tax regime. FPIs are subject to different tax rates depending on the type of security and the category of the FPI. For instance, FPIs are subject to a higher tax rate on short-term capital gains than on long-term capital gains. The Government of India has taken steps to simplify the tax regime for FPIs in India, but more needs to be done to make it more investor-friendly.

Recent developments in FPI Regulations

The SEBI has been making continuous efforts to simplify and streamline the FPI regulations in India. In 2021, SEBI introduced several amendments to the FPI regulations to provide more flexibility to FPIs. For instance, SEBI allowed FPIs to participate in the offer for sale (OFS) mechanism and permitted them to invest in unlisted debt securities issued by Indian companies.

Impact of FPI investments on Indian markets

Foreign portfolio investments have played a significant role in the growth of Indian markets. FPIs have invested heavily in Indian equities and debt securities, providing much-needed capital to Indian companies. However, FPI investments can also create volatility in the markets, as FPIs tend to pull out their investments in times of uncertainty. The Indian government and regulatory authorities need to ensure that the FPI regulations are stable and predictable to provide a conducive environment for foreign capital.

Conclusion

Foreign portfolio investments have played a significant role in the growth of Indian markets. The regulatory framework governing FPI in India has evolved over the years to attract more foreign capital. The Foreign Exchange Management Act, 1999, and SEBI regulations provide a legal framework for foreign exchange transactions and FPI investments in India. However, there are still some challenges faced by FPIs in India, such as the complex tax regime. The regulatory authorities in India need to ensure that the FPI regulations are stable and predictable to provide a conducive environment for foreign capital.

 References

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