The government had announced in this year's budget that it would allow overseas individuals to invest in equity schemes of Indian mutual funds as part of a move to diversify the class of foreign investors in the local equities market.

Securities market regulator, Sebi, the Reserve Bank of India and the finance ministry have been in talks to operationalise a scheme for this and the central bank has suggested that as a prudential measure, a ceiling on investment by these foreign investors should be fixed to start with, two senior officials ent said. 

The way the scheme will operate is that a foreign investor will have to open a dematerialisation or paperless trading account and a bank account here for which the Know Your Customer norms will be done by a local bank or intermediary registered with regulators here. Once this is done, foreign investors can buy into over 400 equity schemes. 

Foreign funds and non-resident Indians who are registered with Sebi are allowed to invest in equity mutual funds but there has hardly been any investment except in select exchange traded funds. 

In the Indian equities market, there are no fetters on foreign funds in terms of investment except a limit of 10% on a single foreign investor buying into a company's capital. For investments in Indian corporate and government debt too, there are restrictions. "We need a framework for both capital inflows and outflows and we thought that it would not only be prudent but also provide clarity upfront if we say that there would be a ceiling on investment," a senior official said. This official declined to be identified. 

What could be of concern to the central bank is a possible surge in volatile capital inflows later which could put pressure on currency and inflation management. When foreign capital flows are robust, the Reserve Bank will have to mop up these flows which in turn results in boosting liquidity in the local markets. To check this excess liquidity, the RBI sells securities or bonds to banks and institutions to drain it out – a process known as sterilisation. This however comes at a cost to the government – which has to service the interest cost on these bonds. 

Right now, such worries are overblown because excess inflows if any are being used to finance India's current account deficit – the excess of goods and services imports over exports. In FY11, foreign portfolio investors bought stocks and bonds of over $31 billion. In the year to date, foreign funds have been net sellers at $490 million. Sebi has worked out a scheme for foreign investors to buy into local mutual funds which is being vetted by the government and the Reserve Bank of India. One of the challenges in getting the scheme going is in ensuring KYC or due diligence of the foreign investor. Only some of the depository participants such as banks which have a wide global network may be in a position to carry this out. Indian institutions may either to forge tie-ups with foreign partners or open offices abroad if they want to woo greater foreign portfolio investment. If the scheme takes off as policy makers are hoping it would – it will boost India's mutual fund industry which manages assets of over Rs 7,00,000 crore and is now weighed down by the problem of lack of interest on the part of distributors to sell mutual funds. They have been loath to push mutual fund products after the regulator banned fund houses from charging investors an entry fees or load. 

India's policy-makers are considering putting a cap or ceiling of between $5 and $10 billion on investment by foreign investors in Indian mutual funds to possibly limit the impact of any surge in inflows once this route is opened up soon.