What are the sources of foreign capital?

Answer 1

All About Foreign Capital - FDI/FII

It's difficult for any developing nation to grow without foreign capital post globalization. Attracting foreign capital to one's country is one of the most important tasks of finance ministry and central banks. Foreign capital not only increases the growth rate of economy but also brings new ideas and technology which empowers the local industries. So, what are the sources of foreign capital and how are they classified? If there are different classifications, then which one is the most important with respect to growth perspective? What are the rules and regulations which govern the foreign capital and how will it affect common investors like us? Let's try to find answers to these crucial questions from India's perspective through this article.

What is Foreign Capital and how is it classified?

Any capital which is invested in India from foreign sources (Like Foreign Investors, Companies, NRI's, PIO's, etc) is considered as foreign capital.

Classification of foreign capital:

Classification of foreign capital is primarily based on the source of capital. Broadly, it's classified into four categories:

1. Foreign Direct Investment (FDI)

2. Foreign Institutional Investment (FII)

3. Non Resident Indian i.e. NRI investment

4. Person of Indian Origin i.e. PIO Investment

Category three and four are self explanatory, so we will focus on category one and two as a lot of confusion prevails in investors minds regarding FDI and FII.

What are FDI and FII?

Foreign Direct Investment (FDI):

FDI stands for Foreign Direct Investment and it's a part of country's financial accounts. FDI basically comprises of investment by foreign individuals or entities into Indian companies. FDI's have ownership and controlling interest in the company and are treated as promoter group shareholders. A foreign company buying a majority stake in an Indian company is an example of foreign direct investment. FDI does not include foreign investment into the stock markets.

Foreign Institutional Investment (FII):

Foreign institutional Investment is the investment by foreign companies into Indian financial market. Its mandatory for FII's to register with the Securities and Exchange Board of India (SEBI) to participate in the financial market. Normally the FII's do not have ownership interest in Indian companies and their share holding can be compared to public share holding in a company. According to SEBI, foreign pension funds, mutual funds, charitable/endowment/university funds etc are treated as FII.

To remove the ambiguity related to FDI and FII, Finance Minister Mr P Chidambaram has proposed that India will follow global practices to define foreign institutional investors (FIIs) and foreign direct investment (FDI) based on their share holdings in domestic firms. According to international practice, when an investor has a stake of 10% or less in a company, it is treated as FII and, when an investor has a stake of more than 10%, it is treated as FDI.

Which is more reliable - FDI or FII?

FDI is of long term in nature as the foreign investors have ownership interest. Exit route is relatively tough as FDI is a planned investment and most of the investment goes to physical assets. As a lot of future planning is involved, FDI is not speculative in nature. Compared to FDI, FII is short term in nature as most of the investment is done through secondary market. Entry and exit, both are relatively easy and hence the investments have speculative element in them.

Using FDI/FII data as common investors

As we can see that FDI is long term in nature and FII is short term in nature, investors and traders can map their style of investing with FDI and FII data. If you are a trader (short term time horizon) you should be more concerned about the FII data. Historically, it has been observed that stock index follows the FII cycle. When there is increase in FII flow Stock Market rises and when there is fall in FII activity stock market falls. Simply following the FII activity can be hugely beneficial for traders.

If you follow long term investing style, you should be more concerned about FDI data. Track the sectors and companies which are attracting heavy FDI inflow. Tracking the government policies can provide a great insight into FDI inflow data. Planning your investment in accordance with the FDI data can create great fortune for you in long run.