The destabilising foreign hand

Financial Express, June 6, 2006

Are Indian equity markets driven by FIIs? What is the share of FII

ownership in Indian companies? How to FII's choose which company to

invest in, and whether to stay invested in the company or leave? If we

are to understand, rather than fear, what Indian pink papers often

call "an FII driven market" we need to start with the facts. This was

the objective of a recent study (, Ajay Shah

and I did using data for all companies listed on BSE or NSE.

We found that evidence contradicts some widely held beliefs. For

example, it is believed that FIIs "dominate" the equity

market. However, the data suggests that their role is fairly

limited. Price formation today primarily takes place on the equity

derivatives market. The latest data shows that all institutional

investors - domestic plus FII - add up to roughly 8 percent of the turnover on

the equity derivatives market. To attribute domination to something

smaller than 8 percent would be like asking the tail to wag the dog. On the

equity spot market also, the share of FIIs in trading works out to a

value like 8 percent.

In a more rigourous econometic analysis examining causality, we

analyse daily data for net FIIs flows. Interestingly, we do not

find a clear causality where higher net FII flows lead to higher stock

prices, or vice versa. If anything, our analysis suggests a reverse

causality: that when Indian stock prices do well, FII inflows come in;

when Indian stock prices do badly, FII outflows take place. Our

evidence suggests that atleast so far, FIIs are followers, not

leaders. This may well change in the future, if FII participation on

the equity market goes from 8 percent to (say) 50 percent. But until then, the

widespread belief about the "domination" of FIIs needs to be


This result is supported by annecdotal evidence. As an example, in

the latest two weeks of a sharp drop in stock prices, the exit by FIIs

has been remarkably small. FIIs have been buying on the equity

derivatives and selling on the spot. If we add up, the total net sale

by FIIs works out to an average of roughly Rs.500 crore per day. This

is a small value considering that on most days, the total volume (NSE

plus BSE, spot plus derivatives) works out to roughly Rs.50,000 crore

per day.

How big is the share of FIIs in the ownership of individual firms?

Here we find that FII ownership is concentrated in a small number of

firms. In March 2005, there were only 332 companies where FII

ownership exceeded 5 percent. This is a tiny fraction of the 2600 companies

in India where a meaningful extent of equity market trading takes

place. In total FIIs own 11 percent of all companies. Their

share has risen from 8.5 percent in 2001 to 11.1 percent in 2005.

Sometimes, it is felt that FIIs are capricious and unpredictable. It

is felt that hedge funds weave from one company to another, making

huge money driving up stock prices, and damaging the cost of capital

when they choose to dump a company. What does the evidence say?

While there are only 332 companies with FII ownership exceeding 5

percent, these companies appear to have been selected for some

characteristics. FIIs seem to care about 3 things: size, liquidity and

corporate governance. In other words, if a company wants to attract

foreign shareholders, it needs to be big, it needs a liquid secondary

market for the stock, and the managers need to be very careful to not

steal from the shareholders. Once companies achieve FII investment,

this tends to stay. There is an 82 percent chance that a company with

over 5 percent FII investment will continue to have this, after a

period of one year. This makes FIIs looks more like a stable source of

equity capital than a capricious and unreliable bunch.

It is easy to be xenophobic about FIIs and slip into the stance of

Mahathir Mohammad, where white men are seen as another East India

Company. But it makes more sense for us to understand the rules of the

game and the forces at work in globalisation, and then set about

putting our house in order so as to exploit the benefits.


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