Foreign Portfolio Investment

Impact of foreign portfolio investment (FPIs) on domestic capital markets

A key component of ensuring the growth and success of the economy is creating a solid and stable financial market. Different players who dominate the domestic market and markets abroad are to blame for stock market fluctuations. One of these elements is a capital market investment in the form of a foreign portfolio.

After the liberalisation process, foreign portfolio investment became more significant in the Indian stock market because these institutions’ investments in India were only authorised after the 1992 economic reforms.

Foreign institutions that invest fall under the category of more experienced, knowledgeable investors because of their involvement in a wider variety of assets. Foreign Portfolio Investment does have a significant impact, particularly in the Indian capital market, where they hold a large number of securities. Consequently, they have emerged as one of the key factors influencing India’s economic growth.

Foreign Portfolio Investment (FPI)

A Foreign Portfolio Investment (FPI) entails the investor’s acquisition of overseas financial assets. It involves a variety of financial assets, including mutual funds, stocks, and fixed deposit accounts. Investors who make investments in overseas portfolios are known as Foreign Portfolio Investors.

The Securities and Exchange Board of India (SEBI)^[1] oversees foreign portfolio investment in India. In India, FPI refers to investment groups or “foreign institutional investors” (FIIs) and “qualified foreign investors” (QFIs).

Capital Market

A capital market is a financial marketplace for the purchase and sale of assets backed by long-term debt or equity. Suppliers are individuals or groups with the financial resources to lend or invest. Common examples are banks and investors. The Securities Exchange Board of India governs the Indian capital market.

The capital markets or share markets of India make up a sizeable percentage of the global economy because of India’s fair share of the global economy. The financial system depends on the capital market.

Structure of the Indian Capital Market

Two types of markets are:  

Primary Market: The initial public offering (IPO) market, often known as the primary market, is where businesses first issue shares. The company’s shares are listed on the stock exchange after getting the IPO successfully. Money is raised for the primary market through prospectus, rights offerings, and private placements. The funds are raised to help the business develop and grow.

Secondary Market: A secondary market is where listed shares and other securities are traded. The market area for buying and selling securities is typically a stock exchange. The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are India’s two leading stock exchanges, accounting for most equities trading and investments. NSE and BSE are perfect examples of secondary markets.

Foreign Portfolio Investment in Capital Market

Depending on the volatility of the market where the investment is made, FPI consists of securities and other foreign financial assets held by the foreign investor; it does not give investors direct ownership of financial assets. FPI enables investors to diversify their portfolios with a global advantage. It can be made by individuals, businesses, or even governments in other nations. 

In 1991, when India’s economy opened up, it unlocked better and greater opportunities to attract foreign investment in the Indian capital market. It was a game-changer when the RBI decided to allow SEBI-registered FIIs, NRIs, PIOs, and OCBs to invest in the Indian stock market through the portfolio investment plan. Asset management firms, pension funds, mutual funds, banks, investment trusts, nominee businesses, and institutional portfolios are examples of organisations that may register as FIIs. One of the main forces behind the growth of the Indian stock market has been foreign portfolio investors (FPIs) and foreign institutional investors (FIIs). 

Impact of FPIs on Domestic Capital Markets

Expanding the local capital market 

• Foreign portfolio investors could help domestic capital markets by bringing more advanced portfolio management tools and technologies. Local markets could play this function more widely with the support of rising demand, improving risk management options for both domestic and foreign investors.
• Returns in the domestic capital market positively and considerably impact the FPI. Foreign investors are drawn to countries with higher stock market returns.
• With the help of FPI, the local market is expanding with the inflow of investment from foreign and domestic investors because of the substantial profit or return from the investment. 

Promotes the development of equity markets

• Foreign portfolio investments can support the expansion of equity markets and shareholders’ involvement in corporate governance.
• As businesses compete for investment, the market will reward greater performance, better prospects, and more robust corporate governance.
• Equity prices will become value-relevant for investors as the market’s functioning and liquidity grow, ultimately.

Increases the liquidity and market efficiency

• The liquidity of domestic capital markets is increased by foreign portfolio investment, which also improves market efficiency. Start-up businesses will gain the most from this.
• A greater range of investments can be financed as markets go deeper, broader, and more liquid. Start-up businesses will gain the most from this. Savings can be invested in with the knowledge that if they require access to their money, they will be able to manage their portfolio or rapidly sell their financial securities.

Increases the value of the currency

• An increase in FPIs results in a greater influx of foreign currencies into the country, favouring the country’s balance of payments. The position with the balance of payments is strengthened by having more cash in the forex reserve.
• The availability of money in the economy prevents the rupee from falling further and raises its value relative to other currencies.
• The country’s import cover is strengthened by the existence of foreign reserves in a surplus position, which is critical for an import-dependent nation like India. A stronger rupee or an appreciating currency eases the burden of paying for imports.

Unstable volatility

• The unpredictable nature of such investments would result in a continual shift between markets over short intervals for the nation receiving FPI. There is considerable volatility as a result of this.
• One of the key concerns for investors before making a stock market investment is volatility. Volatility is the degree of price fluctuation over a specific period; the risk attached to an investment determines the expected return.
• Investors move their money to less hazardous assets due to a rise in stock market volatility because they perceive it as an increase in the risk associated with equity investments. 
• As a result, stock prices are pushed lower, allowing higher expected future gains to offset the additional risk. One of the essential factors in all investment decisions, including portfolio development, asset and derivative pricing, devising hedging strategies, evaluating capital sufficiency and margin requirements, along with other risk management tools, is volatility. 

Capital flow

• Increased foreign portfolio investment inflow would help the Indian capital market grow. Equity prices will increasingly represent the companies’ intrinsic values as market functionality and liquidity increase, facilitating the more effective deployment of capital flows.
• Foreign portfolio investors benefit from domestic capital markets by developing more sophisticated portfolio management tools.

Balance of Payment:

• Foreign portfolio investment has both positive and negative effects on the balance of payment. FPIs have a barrier-free entry and exit method, which makes them highly volatile and causes fluctuations in the Indian market.
• Growing import costs and a drop in foreign investment cause an outflow of money in the economy, which could endanger the balance of payments.
• Portfolio investment will highly impact the balance of payment of a country. It is helpful for a country like India, and the balance of payment specifies whether the country has a shortage or excess funds. It indicates whether the country’s export is more than its import or vice versa.

Impact of Indian secondary market by FPI

• When foreign portfolio investors invest money in the Indian stock market, the price of shares rises, pushing secondary market liquidity as a result. It lowers the cost of issuing shares, enhancing the issue of more equity as it increases both domestic and international demand due to better access. 
• As a result, it promotes additional participants and boosts market efficiency by increasing supply, demand, and liquidity. The country’s exchange rate, foreign reserves, monetary policy, and saving and investing habits are all impacted by the total inflow of foreign capital.
• Because it offers investors a variety of assets with varying levels of risk, return, and liquidity, a thriving stock market impacts demand by increasing the choice of assets and giving savers more options and liquidity, which leads to increased savings. All of this promotes more domestic savings, increases the rate of domestic savings, and enhances capital formation.

Exchange rate

• The exchange rate volatility is anticipated to impact host countries’ capital inflows negatively. A higher volatility means a higher degree of uncertainty or risk in returns earned by foreign investors.
• The exchange rate is taken as the effectiveness of macroeconomic policies in the host country. Stability in the exchange rate is expected to be observed by foreign investors, especially portfolio investors, to earn higher returns.
• Foreign portfolio investment will decrease when the exchange rate is lower and riskier for foreign investors. They are knowledgeable investment experts who will tackle the situation before it occurs.

Conclusion

FPIs are often higher in developing nations with large growth potential. FPI is significant since it fuels the stock markets and increases the liquidity of the host nation’s capital markets. FPIs in India will also benefit the investor and the expansion of the Indian economy. The efficiency of the stock market and economic growth will increase as the FPIs rise. From the above discussion, we can conclude foreign portfolio investment is crucial in India.

Read our Article:Factors Influencing Foreign Portfolio Investments (FPI)