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This article is written by Shivangi Ghosh, currently pursuing BA LLB from Amity Law School, Delhi. The article is an exhaustive overview of the legality of Foreign Institutional Investments in India.

Introduction

Foreign Capital can be accessed in two ways one which is Foreign Direct Investment(FDI) and the other is Foreign Portfolio Investment(FPI) which is by way of Foreign Institutional Investment(FII). 

A foreign institutional investor (FII) is an investor or pool of investors that invest in a fund in a country that is outside their own country outside where it is registered or headquartered. In India, the entities investing in the nation’s financial institution markets are called the Foreign Institutional Investor(FII).

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What is the difference between Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII)

  • Management of control

In FDI investors enjoy higher control of the company and hence are involved in managerial decisions and help steer the company. On the contrary, FII allows funds investment in the foreign financial market with no managerial hold on the institutions.

  • Regulations on entry and exit criteria

FII has liberal regulations as compared to FDI regulations. For example, the nuclear energy sector does not allow Foreign Direct Investment (FDI). The exit criteria for FII are also liberal as whenever the economy is unstable and investors feel threatened about the funds invested in the market. They can immediately pull-out the funds without having to bear the loss.

  • Allows transfer of resources

The only transfers that happen in FII are funds but not in the case of FDI as it helps in transferring a lot of skilled resources like new and improved technologies, Research and Development(R&D), Capital, strategies, policies, management, etc. FII funds do not help to improve the economy of the country as FDI can. The more inflow can also mean it can become inflationary and not beneficial, so to create a balance, RBI takes charge to balance.

  • Capital

FDI is a long-term capital inflow, whereas for FII it can be both long and short depending on the economy of the host country. For Example, if the economy is unstable due to any reason the investors might want to pull back their funds as there is no such bar to drawing their funds back.

Important provisions of the Institutional Investors Regulation

  • Eligibility of types of Investments under the Regulation

FIIs including mutual funds, pension funds, investment trust, banks, asset management companies, Nominee Company, incorporated/institutional portfolio managers, or their power of attorney holder (providing discretionary and non-discretionary portfolio management services) is permitted under the Foreign Institutional Investors guidelines. Investment in all securities traded on the primary and secondary markets which include equity and other securities of companies that are listed or about to be listed on the stock exchanges in India.

  • Prior Approval to be granted by Securities Exchange Board of India (SEBI)

A foreign institutional investor is required to take prior approval from the SEBI before entering the market and a proper registration process is carried out so that he can engage in financial activities in the country.

  • Permission to be granted by the Reserve Bank Of India (RBI)

A Foreign Institutional Investor shall have to take various permissions under the Foreign Exchange Regulation Act, 1973 issued by the Reserve Bank of India apart from taking the SEBI registration. It is important to note, both the authorities’ approval is necessary for FII.

  • Registration and Renewal of the Foreign Institutional Investors (FII)

SEBI holds their registration for the maximum period of five years along with the RBI permission under the Foreign Exchange Regulations Act that shall be valid for five years. Which should be renewed every after five periods in the future.

  • Capability to Move, purchase, and speculate foreign Ventures in the Market After taking Prior approval from the authorities

The Foreign institutional investors will have the capacity to move, purchase, and acknowledge capital gains on speculations on ventures made through the first corpus exchanged to India under the FERA consent. 

What is the legal framework governing FII in India

The Foreign Institutional Investors are regulated by the Securities and Exchange Board of India (SEBI) through the SEBI (Foreign Institutional Investors) Regulations, 1995 along with the Reserve Bank of India through Regulation 5(2) of the Foreign Exchange Management Act (FEMA), 1999.

The FIIs have to comply with such special focus regulations and obtain approval from both the authorities SEBI and RBI to operate which shall enable them to engage in buying and selling of securities, open foreign currency, remit, repatriate funds, etc.

What are the legal limitations of foreign institutional investments

There are various legal precedents and restrictions on Foreign Institutional Investors(FII)

  1. FIIs are generally limited to a maximum investment of 24% of the paid-up capital of the Indian company receiving the investment. However, FIIs can invest more than 24% if the investment is approved by the company’s board and a special resolution is passed. The ceiling on FIIs’ investments in Indian public-sector banks is only 20% of the banks’ paid-up capital. Although the 24% limit may be raised to 30% in the case of individual companies who have obtained shareholder approval for the same but not more.
  2. Any FII or sub-account of an FII has been permitted to invest up to 10% of the equity of any one company, subject to the overall limit of 24% on investments by all FIIs, NRIs, and OCBs
  3. While permitting investment, SEBI set prescribed conditions which may be compulsory concerning the maximum amount which can be invested in the debt securities by foreign institutional investors on their account and sub-account. An investment made in securities which are issued by the assets reconstruction companies or those companies who are under the Security and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
  4. The Reserve Bank of India monitors compliance with these limits daily by implementing cutoff points 2% below the maximum investment. This gives it a chance to caution the Indian company receiving the investment before allowing the final 2% to be purchased.
  5. RBI and SEBI are two authorities to regulate FII but due to different provision an entirely separate body which comes under RBI and SEBI should be created to monitor effectively these capital Funds to be created to monitor compliance to both the regulations given under (Foreign Institutional Investors) Regulations,1995 and  Foreign Exchange Management Act (FEMA), 1999.

Advantages and disadvantages of the legal clauses

Advantages

  • Enhanced flow of capital

The growth rate of the country is enhanced as the funds are inflowing which can help boost the production as well as the rate of employment in the host country.

  • A competitive spirit is encouraged

It promotes a healthy environment for competition and growth of both the parties which are involved in the transaction that can help strengthen the bond. It can prove to be beneficial to invest in certain countries because of their economies.

  • Improved Business 

The foreign institutional investors build professionals and they are planted in various countries for investment purposes which increases and improves corporate governance when they solve the firm’s operation which helps achieve desired goals.  

Disadvantages

  • Shortage of Funds

In case of a bad economy in any country, the withdrawal of funds by the investors can cause a sudden outflow from the market which can prove to be a turbulent hard to handle for the host country.

  • Inflation

The huge inflow of foreign institutional investors funds creates a high demand for the rupee and thereby pumping a huge amount of money by the RBI into the market. This creates excess liquidity creating inflation.

  • Adverse impact on exports

Foreign institutional investors inflows leading to an appreciation of the currency, exports become expensive which ultimately leads to lower demand and hence a shortfall in the export of goods and reduces competitiveness.

Issues and challenges 

There are various challenges faced in the due process

  1. The quality of capital needs to improve.
  2. There are more inflows in the form of FII and not FDI which can help boost the economy and the state of the country which cannot be achieved by the FIIs. FDI will bring in resources to the host country and help create a better financial market standing too.
  3. Need for Better regulation to monitor and supervise these flows. It is also pertinent to note that there are no bad types of funds but the focus is to make money but secondarily the aim is to provide a stronger economy in return.
  4. RBI does not have enough government bonds left to balance the market. These interjectory funds will lead to the creation of additional liquidity which will prove to be inflationary.
  5. These markets can be really shallow and volatile in nature which can prove to be bad for investors as the price may have a sharper increase just because the Influential entities many other companies exit and they cause manipulation in the market. Due to this high degree of volatility is caused as there are many companies that suffer wrongful losses due to influential investing entities.
  6. RBI will not be able to regulate capital flows and not be able to continue the exchange rate policy. No country follows three policies that consist of a capital account policy, a currency policy, and monetary policy. For example, China has decided that it requires external capital flows for employment and economic growth and has decided to have a fixed exchange rate, and almost no monetary policy, Other developed countries do not engage in all three types of policies like India does which makes it tough to regulate but RBI steers through.

                    

Critical analysis

The influencers in the market have a negative impact on the market as it is to be noted that there are more than 4800 companies listed on the stock market but BSE Sensex only incorporates 30 which goes out to show that only influential people have standing in these markets. This shows that the Financial market is a bit narrow. This shallowness would also mean that the effects of FII activity would be augmented only if they can influence and start to create a herd-like mentality to follow the FIIs when making their investment decisions.

Indian stock markets induce a high degree of variety of trading prices over a period of time

  1. Due to correction, it can lead to FII pull-out which can cause an immediate decline in prices.
  2. An increase in investment by FIIs triggers a sharp price increase, it would provide additional incentives for FII investment which would increase the purchases
  3. Exchange rate Conversion can also prove to be volatile as When FIIs are attracted to the market by expectations of a price increase that tend to be automatically realized, the inflow of foreign capital can result in an appreciation of the rupee to the dollar ratio. This increases the return earned in foreign exchange when rupee assets are converted into dollars. As a result, the investments turn even more attractive which would encourage an investment that would imply a sharper fall.
  4. The growing realization of how shallow these markets can be and speculation is done for choosing the right moment to exit this can also cause manipulation in the market and a high degree of volatility is caused as there are many companies that suffer wrongful losses due to influential investing entities.

Conclusion 

Foreign institutional investors(FII) main aim is to propose investment in India which must register with the SEBI) along with the Reserve Bank of India (RBI) to function in the market. They are generally investing in Indian companies in stock and debenture under the rules and regulations of different companies. FII pull-out can cause serious problems to the Financial sector of the Country. As it can be seen the FDI inflow has reduced, there is hope that one day FDI will be equal to FII by reforming policies and not being fixed to all three policies of the Exchange rate, Capital Rate Policy, and Current Rate Policy which can help RBI to regulate and monitor all kinds of Capital inflows.

References

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