How FIIs changed Indian capital markets

Author: | Published: 30 Nov 2012
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The Indian securities regulator’s scheme aimed at foreign trades was a key step in liberalising the country’s capital markets, explains Ajay Vaidya, chief legal and compliance officer of Kotak Mahindra Capital

To understand India's capital markets, you must know how the rules have developed over the years: the timeline of government notifications can extend back to even the 1950s. However, until India started liberalising in 1992, it was a very closed market.

Once liberalisation began, there was great demand for foreign money to enter the stock market. However, Indian promoters were worried that foreign investors with enormous amounts of capital would take over and destabilise their companies.

In 1995 the Securities and Exchange Board of India (Sebi) established the Foreign Institutional Investor (FII) scheme. This primarily allowed the entrance of portfolio investors such as mutual funds, pension funds, sovereign funds, asset-management companies and their managed funds that aimed to be traders rather than strategic investors.

When the FII rules were announced in 1995, FII holdings in a company were capped at five percent. At present, one FII can have 10% of outstanding capital in a company and altogether FIIs can hold 24%. If FIIs want to increase their shareholdings in a company past 24%, the company is able to pass a shareholder resolution allowing them to do so, up to permissible foreign investment limits.

The FII route has also developed the participatory Notes (P Notes) investment route, where regulated investors get indirect access to the Indian stock market. Under this route, a FII first buys the security, and then swaps its returns with the P Note buyer. FIIs are also big investors in Indian IPOs. With the opening of Indian markets to new products, FII now have significant investments in exchange traded derivatives, mutual funds, and debt securities.

When speaking with FIIs, I often ask about their management style. In India, domestic investors have not been activists, but FIIs vote with their feet. If a company isn't run well – if it doesn't deliver on its promises or if it isn't run efficiently – investors will sell their shares.

This has resulted in the improvement of corporate governance standards. Some FIIs have been very active in engaging with companies about their expectations, which helps retail investors by enhancing minority shareholder rights.

Now FIIs are very influential. When Sebi makes regulations, it realises that retail investors piggyback on FII investment. For example, FIIs cannot withdraw their bids on IPOs; as when retail investors see a large number of FIIs in a book, they come in. If FIIs suddenly withdraw, it is seen as harmful for the retail investors.

In the last 17 years, FIIs have been very helpful for expanding India's markets. The government recognises their input, and has even added one more category for foreign investors: the qualified institutional buyer.

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