FII Flows to Indian Capital Market: A Cause and Effect Study

Abstract

This study investigates the cause and effects of foreign institutional investors' investment in Indian by finding the relationship between the foreign institutional investment and financial and real economy variables over the period from January 2007 to March 2014. Johansen’s co-integration and vector error correction model have been applied to explore the long-run equilibrium relationship between FII flows and macroeconomic and financial variables. The analysis reveals that the FII’s investment in India & variables under the study are co-integrated and, hence, a long-run equilibrium relationship exists between them. It is observed from the VECM that in the long-run, the relationship between the FII investment in India and wholesale price index, index of industrial production and exchange rate are positive. In the Granger causality sense, FII’s investment in India causes WIP, Exchange Rate causes FII’s investment and there is bidirectional causality exists between FII’s investment and index of industrial production. While the findings show the evidence of causality from FII flow to wholesale price index in both long-run and short run but not other way around. Furthermore, it is observed from the findings that FII flow causes exchange rate in long run only. Exchange rate also decides the FII flows in short run.

Keywords: FII, Causality Test, Co-integration Test, VECM

JEL Classification: C22, E02, F21, G28, O10