Factors Influencing Foreign Portfolio Investments (FPI)

Swetha Dhinesh

16 May, 2023

Foreign Portfolio Investment has been viewed as a way to allow a wide range of different types of investors access to the global markets. The term “foreign portfolio investment” (FPI) describes how investors want to make investments abroad and who buy and hold a diverse range of foreign financial assets. A variety of investment vehicles, including equities, bonds, mutual funds, derivatives, fixed deposits, etc., are available to foreign portfolio holders. 

These investment opportunities are created with the idea that comparatively high risk comes with potentially significant gains. This feature is available to individual investors and businesses, organisations, and governments of a country. FPI investors run a higher risk as a result of the increased share price volatility they experience (this varies depending on the nation of investing). They, therefore, anticipate and aim for bigger gains from FPI endeavours.

Despite the higher risk associated with FPI, there are several factors to consider when balancing the upside potential against the negative. These variables include a nation’s capacity to buy and sell FPIs with relative ease, access to foreign financing, variations in currency exchange rates, level of development and political stability, among others.

Foreign Portfolio Investment (FPI)

Investing in the financial assets of a foreign nation, such as stocks or bonds listed on an exchange, is known as foreign portfolio investment (FPI). Because portfolio investments can be easily sold off and are occasionally perceived as short-term attempts to make money rather than long-term investments in the economy, this sort of investment is sometimes viewed less favourably than direct investment.

How is FPI differentiated from FDI?

The ownership component is what distinguishes an FPI from an FDI. In foreign direct investment, you invest to gain control over a foreign company or other entity’s operations. FDI is an investment where you seek ownership, whereas FPI is a type of investment where you buy stocks or bonds from a foreign company. It provides no ownership of the entity since it offers no means of controlling the entity.

FPI categories

The three types of FPI in India are as follows based on the risk profile of investments: 

1. Category I or Low Risk: It includes financial resources that the Indian government supports. Government bonds, any fund owned by the Indian government, a sovereign wealth fund, etc., are all included. 
2. Category II or Moderate Risk: Regulatory broad-based funds, such as mutual funds, pension funds, insurance policies, bank deposits, etc., are included in this category.
3. Category III or High Risk: All FPIs that fall into Category III are those that are not qualified for the first two categories. It consists of charitable trusts, endowments, benevolent foundations, etc.

Why is investing in foreign portfolios important?

Investing in a foreign portfolio is crucial since it allows investors the chance to diversify their portfolio’s assets internationally, which can help them earn higher returns after adjusting for risk. Additionally, this implies that a portfolio with companies spread throughout several different nations will have less volatility overall.

Factors Influencing Foreign Portfolio Investment

These are the following factors that influence foreign portfolio investment: 

Growth Prospects

1. The economy of a nation is important to foreign investment. Investors like to invest in a country’s financial assets if its economy is strong and expanding. In contrast, investors tend to reduce or abandon their investments if there is financial instability or a recession. 
2. For example, Foreign Portfolio Investment is crucial to India’s continued economic expansion. India’s economy has grown to be the sixth-largest in the world as a result of the significant increase in foreign portfolio investors. 
3. The increase in FPI enabled the country’s economy to expand and recover more quickly. Similar to foreign direct investment, foreign portfolio investment also plays a significant role in emerging nations like India. An FPI serves to diversify outside funding sources, foster regional market growth, and reduce capital costs.
4. Hence, with the help of these elements Indian economy is expanding globally. And the investor’s sight is turning to India for investments. This is in every nation where the investors find that the economy is robust and growing; they will invest accordingly. 

Interest rates

1. A high return on investment is what every investor seeks. As a result, investors seek out nations with high-interest rates. 
2. Generally speaking, a higher currency rate increases the value of the currency in the country. Higher interest rates frequently draw foreign investment, which raises both demand for and the value of the host nation’s currency.
3. Conversely, lower interest rates typically make a currency less valuable relative to other currencies and are less appealing to foreign investment.

Tax rates

1. Capital gains are subject to taxes, and a higher tax rate might result in a lower overall return on investment. As a result, investors favour making investments in nations with lower tax rates. 
2. The tax rate in one country may considerably impact an investor’s decision when other criteria, such as infrastructure, economic stability etc., are more or less equal. 
3. It may depend on the tax instrument used by the government authorities, the characteristics of the multinational corporation^[1], and the relationships between the tax systems in the country of origin and the recipient country.
4. The lower tax rate will improve foreign investors’ investment in the country, which will reflect economic development. 

Investing Ideas for Foreign Portfolios

Foreign portfolio investment is inherently risky. Thus, financial markets must be strictly regulated to manage the risk successfully. In order to allocate foreign or domestic capital flows prudently and effectively, the financial system must also be able to recognise and mitigate risks.

The effective use of credit and sound financial intermediation are key factors in enabling economic growth and development. Financial systems can keep themselves in good shape by identifying and controlling business risks. Additionally, the financial system must be resilient to shocks from the economy.

Foreign portfolio investment has a number of other facets. Such investments that come in steadily point to a healthy stock market. Global analysts carefully monitor these trends since they reflect a nation’s present economic situation.

Last but not least, FPIs give investors the option to diversify their investments globally. Exchange rate variations can also be profitable for a portfolio investor. As a result, an investor from a nation with a struggling economy can make significant returns by making large investments in a foreign nation with a strong currency.

Conclusion

The regulatory environment for FPIs has been dynamic. The legislative bodies seek to create the whole regulatory environment in a way that permits FPI to make a total contribution to the Indian financial markets. FPI is one of the key sources of capital inflows into many emerging markets, and it significantly contributes to the growth of the economy.

Read our Article: Tax Implications of Foreign Venture Capital Investments in India