Foreign Institutional Investment in the Indian Equity Market: An Analysis of Daily Flows During January 1999-May 2002

Abstract

The performances of the emerging equity markets vis a vis their matured counterparts in the developed world have shown repeated reversals in recent times; in the pre-Mexican crisis period (1990-1994), most of the emerging markets performed much better compared to the matured markets in terms of both return and associated risk, while the pattern reversed during 1995-2001 (a period affected by the Asian crisis). In the recent past emerging markets (those of Asia and Latin America, in particular) have shown a remarkable recovery, in terms of both the level of return and risk, while the matured markets have experienced drop in return and rise in risk. Such reversals of market performances make foreign equity investment extremely volatile and may have a destabilizing effect on the domestic economy of the recipient country. It is therefore prudent to evolve appropriate built-in mechanisms in these economies such that destabilization and damages can be minimized in case foreign investors suddenly withdraw from the equity market. It is in this context that a careful examination of the nature of foreign institutional investment (FII) flow into an economy may help identify, the strength of various factors likely to affect such flows, and also, the possible impact of such flows on the performance of the equity market concerned.

Over the past decade India has gradually emerged as an important destination of global investors' investment in emerging equity markets. In this paper we explore the relationship of foreign institutional investment (FII) flows to the Indian equity market with its possible covariates based on a time series of daily data for the period January, 1999 to May, 2002. Here we try to identify the relevant covariates of FII flows into and out of the Indian equity market and also to determine the nature of causality between the relevant variables. We incorporate into the analysis variables that appear, a priori, to be the primary determinants of global investors' demand/supply for/of stocks in the Indian market. The set of possible covariates considered comprises two types of variables. The first type includes variables reflecting daily market return and its volatility (representing risk) in domestic and international equity markets, based on the BSE Sensex, S&P 500 and the MSCI WI, as well as measures of co-movement of returns in these markets (the relevant betas). The second type of variables, on the other hand, are essentially macroeconomic ones like daily returns on the Rupee-Dollar exchange rate, short run interest rate and index of industrial production (IIP); variables that are likely to affect foreign investors' expectation about returns in the Indian equity market. The data set embodies day to day variations and hence, is better suited for examination of various interrelationships, including Granger causality for equity market operations that are typically short run issues. Also, we relate daily FII flows first to the variables mentioned above (distinguishing between three kinds of flows, namely, FII flows into the country or FII purchases, FII flows out of the country or FII sales and the net FII inflows into the country or FII net) and later modify the model specification to include a short past history of the variables over different time frames, like a week or fortnight.

Our results show that, though there is a general perception that FII activities exert a strong demonstration effect and thus drive the domestic stock market in India, evidence from causality tests suggests that FII flows to and from the Indian market tend to be caused by return in the domestic equity market and not the other way round. The regression analysis, in various stages, reveals that returns in the Indian equity market is indeed an important (and perhaps the single most important) factor that influences FII flows into the country. While, the dependence of net FII flows on daily return in the domestic equity market (at a lag, to be more specific) is suggestive of foreign investors' return-chasing behaviour, the recent history of market return and its volatility in international and domestic stock markets have some significant effect as well. However, while FII sale (and FII net inflow) is significantly affected by the performance of the Indian equity market, FII purchase is not responsive to this market performance. Looking at the role of the beta's of the Indian market with respect to the S&P 500 and MSCI indices it is concluded that foreign institutional investors do not seem to use the Indian equity market for the purpose of diversification of their investments. It is also seen that return from exchange rate variation and fundamentals of the Indian economy may have some influence on FII decisions, but such influence does not seem to be strong, and finally, daily FII flows are highly autocorrelated and this autocorrelation can not be accounted for by all or some of the covariates considered in our study.

Policy implications that emerge are that a move towards a more liberalised regime, in the emerging market economies like India, should be accompanied by further improvements in the regulatory system of the financial sector. To fully reap the benefits of capital market integration, in India (and other countries having thin and shallow equity markets) the prime focus should be on regaining investors' confidence in the equity market so as to strengthen the domestic investor base of the market, which in turn could act as a built-in cushion against possible destabilizing effects of sudden reversal of foreign inflows.

Note: This is a description of the paper and not the actual abstract.

Keywords: Keywords: emerging equity markets, foreign portfolio investment, foreign institutional investors, international capital flows, determinants of FII flows, determinants of portfolio flows, stock market returns

JEL Classification: G15, F32, E44