Can this help control market volatility?

Tue, 3 Jan Pre-Open

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2011 is over. The year witnessed a very disappointing performance from Indian stock markets. The benchmark index, BSE-Sensex lost nearly 25% of its value during the year. In fact, Indian stock markets were among the worst performers in Asia.

This volatile performance of 2011 has prompted the government into opening the Indian stock markets to foreign nationals. As per them, this would add to the stability of the markets by introducing breadth in them. The government of India has allowed foreign individual investors, pension funds and trusts to directly invest in equities. The new category of investors is termed as qualified foreign investors (QFIs). This scheme would come into operation from 15th January, 2012. As per the scheme, QFIs can own up to 5% of Indian companies while their cumulative investments are capped at 10%.

It is not like these categories of investors were not in the market earlier. They used to invest in the Indian stock markets either through opening accounts with Security And Exchange Board Of Indian (SEBI) registered foreign Institutional Investors (FIIs) or they had to come through participatory notes (PNs or P-Notes) route. (Just for reference, participatory note is an instrument that derives its value from an underlying financial instrument such as an equity share. It is used by foreign investors which are not registered with SEBI). In addition to this, QFIs were permitted to take the mutual fund route at the start of the year 2011.

However, all these methods of participation in the Indian stock markets by the investors require financial intermediaries. In addition to the usual hassles involved in using intermediaries, these methods also involve cost implications. Such nuisances were a deterrent to foreign investors from investing in the Indian stock markets. As a result, the new step taken by the Indian government is definitely a welcome move. It would not only help the foreign investors but also is expected to provide much needed stability in the Indian stock markets. The aim is to widen the investor class and attract more foreign funds which would help to deepen the Indian capital market.

This new step would also help the India government counter the increasing perception of policy paralysis. If everything goes well, it would also help the Indian government to curb the widening current account deficit. It would boost the investors' confidence and sentiments in the stock market as well. However there is a catch. After all, this is again a type of hot money. Because foreign investors can move out of the market as quickly as they move in. This would mean that each time there is a vibration in the global markets; Indian markets too would react sharply. As the foreign investors would scurry out. The fall can be even sharper than that in other markets due to the additional perceived risk attached to investing in a foreign market.