FII flows into a country are associated with several advantages and disadvantages.
- Enhanced flows of equity capital
- FIIs have a greater appetite for equity than debt in their asset structure. The opening up the economy to FIIs has been in line with the accepted preference for non-debt creating foreign inflows over foreign debt. Enhanced flow of equity capital helps improve capital structures and contributes towards building the investment gap.
- Managing uncertainty and controlling risks.
- FII inflows help in financial innovation and development of hedging instruments. Also, it not only enhances competition in financial markets, but also improves the alignment of asset prices to fundamentals.
- Improving capital markets.
- FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets.
- Equity market development aids economic development.
- By increasing the availability of riskier long term capital for projects, and increasing firms’ incentives to provide more information about their operations, FIIs can help in the process of economic development.
- Improved corporate governance.
- FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms’ operations, improve corporate governance. Bad corporate governance makes equity finance a costly option. Also, institutionalization increases dividend payouts, and enhances productivity growth.
- Problems of Inflation: Huge amounts 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.
- Problems for small investor: The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high then they can bring in huge amounts of funds in the country’s 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. This creates problems for the small retail investor, whose fortunes get driven by the actions of the large FIIs.
- Adverse impact on Exports: FII flows leading to appreciation of the currency may lead to the exports industry becoming uncompetitive due to the appreciation of the rupee.
- Hot Money: “Hot money” refers to funds that are controlled by investors who actively seek short-term returns. These investors scan the market for short-term, high interest rate investment opportunities. “Hot money” can have economic and financial repercussions on countries and banks. When money is injected into a country, the exchange rate for the country gaining the money strengthens, while the exchange rate for the country losing the money weakens. If money is withdrawn on short notice, the banking institution will experience a shortage of funds.