The Impact of Fii Regulations in India: A Time-Series Intervention Analysis of Equity Flows

Abstract

This paper examines the impact of reforms of the foreign institutional investors' (FIIs) investment policy, on FII portfolio flows to the Indian stock markets, an aspect, studies on determinants of FII flows to India so far have not taken into consideration. FIIs have been allowed to invest in the domestic financial market since 1992; the decision to open up the Indian financial market to FII portfolio flows was influenced by several factors such as the disarray in India's external finances in 1991 and a disorder in the country's capital market. Aimed primarily at ensuring non-debt creating capital inflows at a time of an extreme balance of payment crisis and at developing and disciplining the nascent capital market, foreign investment funds were welcomed to the country. FII inflow to India grew manifold from US $0.18 million (net, monthly) in January 1993 to about US $400 million within a year's time. Given the volatile nature of capital flows to emerging markets seen in the early 1990s and the nature and growth of such flows to India, FII investment in India, obviously called for special regulatory attention. Investment by FIIs in India is jointly regulated by Securities and Exchange Board of India (SEBI) through the SEBI (Foreign Institutional Investors) Regulations, 1995 and by the Reserve Bank of India through Regulation 5(2) of the Foreign Exchange Management Act (FEMA), 1999.

The promulgation of legislation pertaining to foreign investment by SEBI, in 1995 marked a watershed for FII flows to India, as this paper shows that it led to a significant increase in the level of FII equity inflows in the pre-Asian crisis period. Our analysis also helps to evaluate the impact of liberalization policies as well as measures for strengthening of policy framework for FII flows, in the post-Asian crisis period. The SEBI FII Regulations and RBI policies are amended and modified from time to time in response to the gradual maturing of the Indian financial market and changes taking place in the global economic scenario. We try to assess the impact on FII flows of several of these policy revisions during the period January 1999 to January 2004, through a multivariate GARCH regression model. Using techniques of time series intervention analyses we incorporate the effect of each individual policy intervention in a model, which includes the two most important covariates of FII, flows to India, namely stock market (BSE) returns and past FII flows. The range of policies considered encompasses liberalization policies as well as restrictive ones taken to assure stability of flows. The results strongly suggest that the liberalization policies that expand the membership of FII categories and their scope of investment in the Indian market, enhance sectoral and individual caps, provide for hedging of risks of investing in the Indian stock markets by allowing FIIs to enter the foreign exchange and derivatives market and policies that bring about procedural simplifications and fees reduction, seem to have significant expansionary effect on net inflows. Each of the liberlization policies have either increased the mean level of FII inflows and/or the sensitivity of these flows to a change in BSE return and/or the inertia of these flows. Measures to improve SEBI/RBI's control over the FII investments like banning of NRIs/OCBs and mandating stricter disclosure norms also do not show any significant negative impact on the net inflows; on the whole, it is found that these policies mostly render FII investments more sensitive to the domestic market returns and raise the inertia of the FII flows to the Indian stock market.

Keywords: Foreign institutional investment, FII portfolio capital flows, regulatory infrastructure, impact of regulation changes, GARCH(1,1) model of stock market returns and FII flows, time-series intervention analysis

JEL Classification: C22, G18