Foreign Institutional Investors

Abstract

The finances provided by foreign institutional investors (FII) can be viewed as one of the catalysts that can contribute to capital formation and economic progress. Such finances may also result in stock market gains unrelated to the underlying real economy fundamentals. In either case, there will be some gains to domestic investors. However, there are risks involved in attracting such financial flows. For, depending upon the economic conditions in their own country or opportunities as they arise elsewhere, the FII may withdraw prematurely. Gains to domestic investors will then be reduced. Regulatory regimes have the role of maximizing the share of benefits to domestic investors in the process of risk sharing. The present study conceptualizes this process in a modified principal agent model. Firstly, it will be shown that regulatory diligence and the maximum share of benefits to domestic investors depend on the degree of difficulty and costs involved in making regulatory adjustments in response to the perceived risks and risk aversion of domestic investors. Secondly, we modify the results taking into account the costs of absorbing the investments into the domestic productive system. It can be shown that a greater degree of regulatory diligence will be necessary to make sure that the expected share increase is commensurate with these costs. Thirdly, the effect of FII investments being withdrawn earlier than expected can be shown to depend on the speed with which the domestic economy can convert the financial gains to real returns. In particular, domestic investors may agree to a lower maximum share if the rate of absorption is high. Fourthly, the regulators allowing investments of FII may be sequential. That is, they may allow a low level of investment to begin with and increase the volumes only when the propensity to withdraw is not damaging to the domestic economy. This aspect will also be examined. Fifthly, we investigate the risk-spreading nature of these investments even when risks are shared within an efficient regulatory regime. Surely, all the practical details of implementing the regulatory measures cannot be fully incorporated in the present framework. Similarly, not all aspects of the distinction between purely financial (capital gains-related) returns and real returns can be captured. More work along these lines is warranted.

Based on content from “Foreign Institutional Investors, Risk Sharing and Regulatory Diligence”, in O.P. Gupta and K. Gupta (eds.) first published in the edited volume Indian Capital Markets: Emerging Issues (Hyderabad: ICFAI University Press), 2010, pp. 3–22. Content reproduced here with permission from ICFAI University Press.