The destabilising foreign hand: spectre or fact?

Are Indian equity markets driven by FIIs? What is the share of FII ownership in Indian companies? How do 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 (http://tinyurl.com/o8nk3) 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% of the turnover on the equity derivatives market. To attribute domination to something smaller than 8% would be like asking the tail to wag the dog. On the equity spot market, too, the share of FIIs in trading works out to a value close to 8%.

In a more rigorous econometric 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 at least so far, FIIs are followers, not leaders. This may well change in the future, if FII participation on the equity market goes from 8% to (say) 50%. But until then, the widespread belief about the ?domination? of FIIs needs to be questioned.

This result is supported by anecdotal 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 a 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 a 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%.

This is a tiny fraction of the 2,600 companies in India where a meaningful extent of equity market trading takes place. In total, FIIs own 11% of all companies. Their share has risen from 8.5% in 2001 to 11.1% 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%, these companies appear to have been selected for some characteristics. FIIs seem to care about three 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% chance that a company with over 5% 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.