FII affecting Exchange Rates, Stock Markets, Inflation and Exports

Foreign Institutional investors: Mutual funds, insurance companies, pension funds, university funds, investment trusts, endowment funds and charitable trusts incorporated outside India but investing in equity and debt securities in the country are known as FIIs. They collect money from individuals and corporate (primarily from countries belonging to the European and American continents), and invest it in financial instruments worldwide, with India being one of the targeted markets. FII who want to invest in the Indian Markets have to register with the SEBI (Security and Exchange Bureau of India) and also from the RBI to maintain a foreign currency account to bring in and take out the funds and also a rupee bank account to make the transactions.

FII’s In Stock Markets: The FII’s profit from investing in emerging financial stock markets, say the Indian stock Exchange. If the cap on FII is high then they can bring in lot of funds in the countries stock markets and thus have great influence on the way the stock markets behaves, going up or down. The FII buying pushes the stocks up and their selling shows the stock market the downward path. So this is how influencing FII can be, as is seen in the present downtrend of the stock markets in India courtesy heavy FII selling.

FII affecting the Exchange Rates: As pointed out in the first paragraph, FII need to maintain an account with the RBI for all the transactions.

 To understand the implications of FII on the exchange rates we have to understand how the value of one currency goes up (appreciates) or goes down against the other currency. The simple way of understanding is through Demand and Supply. If say US imports from India it is creating a demand for Rupee thus the Indian rupee appreciates w.r.t the dollar. If India imports then the dollar appreciates w.r.t the Indian rupee.

Now considering FII’s for every dollar that they bring into the country, there is a demand for rupee created and the RBI has to print and release the money in the country. Since the FII’s are creating a demand for rupee, it appreciates w.r.t the dollar. Thus if for e.g. if prior to the demand the exchange rate was 1 USD = Rs 40, it could become 1 USD = Rs 39 after they invets. Similarly when FII withdraw the capital from the markets, they need to earn back the green buck (USD) so that leads to a demand for dollars the rupee depreciates. 1 USD goes back to Rs. 40. Thus FII inflows make the currency of the country invested in appreciate (e.g. FII investing in India may lead to Rupee appreciating w.r.t several other currencies) and their selling and disinvestment may lead to depreciation.

Depreciating currency not favorable to the FII’s: considering a simple hypothetical example. I invested 1 USD in India at an exchange rate of 1 USD = Rs. 40. If rupee appreciates the exchange rates become 1 USD = Rs. 20. Now if I disinvest I get 2 dollars, whereas I invested only 1 USD thereby a gain of 1 USD. (Though in real terms the purchasing power of my dollar might decrease as my import cost would increase, and cost of living back home may increase, but when I do consider practical examples there is always a gain for FII whenever the currency of the country invested in appreciates w.r.t the home currency)

Similarly when rupee depreciates w.r.t US Dollar and exchange rate becomes 1 USD = Rs. 80 I get only 0.5 Dollar and I lose 0.5 of the 1 USD invested.

Thus we observe that for the FII’s to gain investing in India the rupee should appreciate w.r.t the dollar.

*Recently the rupee has depreciated with respect to the dollar due to FII selling, and due to the selling it has been depreciating even further.

FII and Inflation: The huge amount of FII fund inflow into the country creates a lot of demand for rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created by the FII’s. This situation could lead to excess liquidity (amount of excess cash floating in the market) thereby leading to Inflation, where too much money chases too few goods (perfect example of demand-pull inflation). Thus there should be a limit to the FII inflow in the country.

FII and Local companies: FII bring lot of funds to the country’ markets leading to free availability of funds for the local companies in need of funds to carry on expansion in their production capacities or starting new ventures.

FII and Exports: However because the FII lead to appreciation of the currency, they lead to the exports industry becoming uncompetitive due to the appreciation of the rupee. For e.g. if 1 USD = Rs.40 and a soap costs 1 USD. Now when the rupee appreciates 1 USD = Rs. 20, I will have to sell the same soap to the US for 2 US Dollars in order to sustain the same income that I have been making i.e. Rs.40. Thus excess FII fund inflow in the country can also make a negative impact on the economy of the country.

Thus the FII bring in a lot of funds to the country which could be used by the companies to achieve rapid growth but there should also be a mechanism to keep them in check so that they do not affect the economy of the country negatively. FII are always compared with FDI (Foreign Direct Investment). It is believed that large FII inflows reflect the openness and Reliability of country’ markets. Thus it has to be seen which model perfectly suits a country’ growth