It seems clear that the government has begun to get worried about the extent of portfolio investments flowing into the country; not because anything is wrong with such investment but because of the imbalances that result.

First came the speech by the Reserve Bank governor, where he debated what could/should be done about FII flows, in the manner of exploring options.

Then came the government's decision to allow (if not mandate) private provident funds to invest 5 per cent of their inflows in the stock market.

Now comes the decision to ask the Employees Provident Fund Organisation to raise interest rates on its balances, without additional government support.

The EPFO can raise the money to pay this only if it switches more of its money into the equity market.

In other words, the government is trying to push more domestic institutional players into the stock market, and my guess is that this is to provide a foil to the foreign institutional investors.

It is a role that Unit Trust of India used to play, till it went belly up.

The mantle then fell on Life Insurance Corporation, but even LIC [Get Quote] can do only so much. So now it is the PFs. (This is risky, given their zero ability to make the right investment calls, but that's another issue.)

The general provocation for these steps, if you look for one, must be the overweening role that the FIIs have come to play -- not just in the stock market (where they have been the swing factor for some time) but in companies as well.

FIIs are now the largest shareholders in 77 Indian companies (up from 24 companies two years ago); these companies account for 44 per cent of the Indian equity market's total capitalisation.

And I suspect that the government, unwilling to discourage the FII inflows, wants to make sure nevertheless that the corporate sector does not become as FII-dependent as the stock market has already become.

If you look at the macro-economic numbers, though, the problem could be analysed differently. If something like 85 per cent of the foreign inflows is going into the stock market, ask yourself where the domestic money is going and the answer is immediately obvious: it is going to the government.

The combined fiscal deficit of the central and state governments is about 10 per cent of GDP; and it so happens that household financial savings are about 11 per cent of GDP.

In other words, the government is pre-empting domestic savings by offering rates (like 9.5 per cent on EPF money) and a complete risk guarantee, which makes it impossible for risk-averse middle class savers to think of the stock market as an alternative; the stock market simply does not offer the returns that would make worthwhile the transition to risk instruments.

So Indians take their money and give it to the government, while foreigners buy up Indian companies to the extent of 2.5 per cent of GDP every year!

The paradox is that while the Indian market is desperately thin, the Indian corporate sector offers many good examples of the perfect trinity: reasonable valuations, assured performance, and high corporate governance standards.

It is a combination that is not commonly found elsewhere and explains why, although India has only a 5.5 per cent weighting in the Morgan Stanley emerging markets index, it has been getting for the past two years more than 23 per cent of the total FII flows into emerging markets.

Bear in mind that the total market capitalisation in India is roughly 50 per cent of GDP. If FIIs already own a good chunk of that as well as buy more to the extent of 2.5 per cent of GDP every year, soon they will own much of what is worth owning on the market.

Already, we are not far from that situation. In other words, something has to give.

Either domestic institutions have to start buying stock in a more concerted way, or individual investors have to start trusting mutual funds with much more of their money, or more depth has to be added to the market by listing more public sector giants -- or the FIIs will have to be reined in if they don't lose interest in India first.

If nothing else changes for the next couple of years, keep your eye on North Block.