FII Flows to India

7/28/2019 FII Flows to India

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FII Flows to India:Nature and Causes

RAJESH CHAKRABARTI*

AbstractSince the beginning of liberalisation FII flows to India have steadily

grown in importance. In this paper we analyse these flows and their relation-

ship with other economic variables and arrive at the following major conclu-

sions: (a) While the flows are highly correlated with equity returns in India,

they are more likely to be the effect than the cause of these returns; (b) The

FIIs do not seem to be at an informational disadvantage in India compared to

the local investors; (c) The Asian Crisis marked a regime shift in the determi-

nants of FII flows to India with the domestic equity returns becoming the sole

driver of these flows since the crisis. Given the thinness of the Indian market

and its susceptibility to manipulations, FII flows can aggravate the equity

market bubbles, though they do not actually start them.

I. IntroductionPortfolio investment flows from industrial countries have

become increasingly important for developing countries in recent years.

The Indian situation has been no different. In the year 2000-01,

portfolio investments in India accounted for over 37 per cent of totalforeign investment in the country and 47 per cent of the current account

deficit. The corresponding figures in the previous year were 59 per cent

and 64 per cent respectively. A significant part of these portfolio flows

to India comes in the form of Foreign Institutional Investors (FIIs)

investments, mostly in equities. Ever since the opening up of the Indian

equity markets to foreigners, FII investments have steadily grown from

about Rs. 2,600 crore in 1993 to over Rs.11,000 crore in the first half

of 2001 alone. Their share in total portfolio flows to India grew from

47 per cent in 1993-94 to over 70 per cent in 1999-2000.1 The nature of

the foreign investors decision-making process that lies at the heart ofthe portfolio flows is briefly outlined in Box 1.

While it is generally held that portfolio flows benefit the

economies of recipient countries2, policy-makers world-wide have been

more than a little uneasy about such investments. Portfolio flowsoften

* I am grateful to Anupam Gupta and Mihir Rakshit for helpful com-ments. All remaining errors and shortcomings are my sole responsibility.

1 RBI Bulletin, October 2000.2 see Errunza (1999)

While it is generally

held that portfolio

flows benefit the

economies of

recipient countries,

policy-makers

world-wide have

been more than a

little uneasy about

such investments.

Portfolio flows

often referred to as

hot moneyare

notoriously volatile

compared to otherforms of capital

flows.


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referred to as hot moneyare notoriously volatile compared to other

forms of capital flows. Investors are known to pull back portfolioinvestments at the slightest hint of trouble in the host country often

leading to disastrous consequences to its economy. They have been

blamed for exacerbating small economic problems in a country by

making large and concerted withdrawals at the first sign of economic

weakness. They have also been held responsible for spreading financial

crisescausing contagion in international financial markets. In the

wake of the Asian crisis, prominent economists3 have, for these rea-

Box 1: The International Portfolio Investors decision-making problem

International portfolio flows, as opposed to foreign direct investment (FDI) flows,refer to capital flows made by individuals or investors seeking to create an interna-tionally diversified portfolio rather than to acquire management control over foreigncompanies.

Diversifying internationally has long been known as a way to reduce the overallportfolio risk and even earn higher returns. Investors in developed countries caneffectively enhance their portfolio performance by adding foreign stocks, particularlythose from emerging market countries where stock markets have relatively low cor-relations with those in developed countries. For instance, according to Morgan StanleyCapital Internationals estimates, between 1985 and 1990, an investor holding an all-US portfolio could improve her returns by over 25 per cent by holding the MSCIworld index instead and at the same time, reduce her risk by about 2 per cent*.

The portfolio investors problem may be thought of as deciding upon appropriatecountry weights in the portfolio so as to maximise portfolio returns subject to a riskconstraint, or in the absence of a pre-specified risk level, to reach the optimum

portfolio, that which has the highest Sharpe ratio, S, where the Sharpe ratio is theratio of expected excess return (excess over the risk-free rate) to the dispersion(standard deviation) of the return. The problem, therefore, is as follows:

P

fP

x

rrESMax

i

=

)(

}{

where {xi}refers to the portfolio weights for different countries and E(r

P) and

Prefer

to the expected return and standard deviation of the return for the entire portfoliorespectively.

Since the variability of the portfolio return (

P) depends on the correlation matrix ofthe country level returns, emerging markets with their lower correlation with devel-oped markets help to reduce the overall risk of the investor. Thus, emerging marketslike India are naturally attractive to international portfolio investors as investmentdestinations. Beginning in the mid-80s several of these markets that were previouslyclosed to foreign investors, began to liberalise making portfolio investments possi-ble and portfolio investments poured into them in the 90s till the Asian crisis.

* See Tesar (1999).

3 See, for instance, Bhagwati (1998), Krugman (1998) and Stiglitz (1998)


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sons, expressed doubts about the wisdom of the IMF view of promoting

free capital mobility among countries.

International capital flows and capital controls have emerged

as important policy issues in the Indian context as well.4 The danger of

Mexico-style abrupt and sudden outflows inherent with FII flows and

their destabilising effects on equity and foreign exchange markets have

been stressed. Some authors have argued that FII flows have, in fact,

had no significant benefits for the economy at large.

While these concerns are all well placed, comparatively less

attention has been paid so far to analysing the FII flows data and

understanding their key features. A proper understanding of the nature

and determinants of these flows, however, is essential for a meaningful

debate about their effects as well as for predicting the chances of their

sudden reversals. In an attempt to address this lacuna, this paper

undertakes an empirical analysis of FII investment flows to India.

The broad objective of the present paper is to gain a better

understanding of the nature and determinants of FII flows. Towards this

end we first take a look at the FII investment flows data to bring out the

key features of these flows. Next we study the relationship between FII

flows and the stock market returns in India with a close look at the

issue of causality. Finally we study the impact of other factors identified

in the portfolio flows literature on the FII flows to India. In all of these

investigations we make a distinction between the pre-Asian crisis period

and the post-Asian crisis period to check if there was a regime shift in

the relationships owing to the Asian crisis.

The paper is arranged as follows. The next section sketches a

brief review of the recent literature in the area. The third section

provides an overview of the nature and sources of portfolio flows in

India, pointing out their main characteristics. The fourth section probes

into the possible determinants of FII flows to India. The fifth and final

section concludes with a summary of the major findings and their

policy implications.

II. What we know about International Portfolio FlowsInternational portfolio flows are, as opposed to foreign direct

investment, liquid in nature and are motivated by international portfo-

lio diversification benefits for individual and institutional investors in

industrial countries. They are usually undertaken by institutionalinvestors like pension funds and mutual funds. Such flows are, there-

fore, largely determined by the performance of the stock markets of the

host countries relative to world markets. With the opening of stock

markets in various emerging economies to foreign investors, investors

in industrial countries have increasingly sought to realise the potential

for portfolio diversification that these markets present. While the

4 See Samal (1997), Pal (1998) and Rangarajan (2000) for instance.

While the Mexican

crisis of 1994, the

subsequent Tequila

effect, and the

widespread Asian

crisis have had

temporary

dampening effects

on international

portfolio flows, they

have failed to

counter the long-

term momentum of

these flows.


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Mexican crisis of 1994, the subsequent Tequila effect, and the wide-

spread Asian crisis have had temporary dampening effects on interna-

tional portfolio flows, they have failed to counter the long-term mo-

mentum of these flows. Indeed, several researchers5 have found evi-

dence of persistent home bias in the portfolios of investors in indus-

trial countries in the nineties. This home biasthe tendency to hold

disproportionate amounts of stock from the home countrysuggests

substantial potential for further portfolio flows as global market

integration increases over time.

It is important to note that global financial integration, how-

ever, can have two distinct and in some ways conflicting effects on this

home bias. As more and more countriesparticularly the emerging

marketsopen up their markets for foreign investment, investors in

developed countries will have a greater opportunity to hold foreign

assets. However, these flows themselves, along with greater trade flows

will tend to cause different national markets to increasingly become

parts of a more unified global market, reducing their diversification

benefits. Which of these two effects will dominate is, of course, an

empirical issue, but given the extent of the home bias it is likely that

for quite a few years to come, FII flows would increase with global

integration.

In recent years, international portfolio flows to developing

countries have received the attention of scholars in the areas of finance

and international economics alike. In the 1990s several papers have

explored the causes and effects of cross-border portfolio investment.

While papers in the finance tradition have focused on the nature and

determinants of portfolio flows from the perspective of the diversifying

investors, those from the international macroeconomics perspective

have focused on the recipient countrys situation and appropriate policy

response to such flows. For the present purposes, we shall focus only on

papers that address the issue of portfolio flows exclusively.6

Previous research has also attempted to identify the factors

behind these capital flows.7 The main question is whether capital flew

into these countries primarily as a result of changes in global (largely

US) factors or in response to events and indicators in the recipient

countries like their credit rating and domestic stock market return. The

question is particularly important for policy makers in order to get a

better understanding of the reliability and stability of such flows.The answer is mixedboth global and country-specific factors seem to

matter, with the latter being particularly important in the case of Asian

countries and for debt flows rather than equity flows.

5 Including French and Poterba (1991), Cooper and Kaplanis (1994) andTesar and Werner (1995a).

6 For the related literature on international capital flows in general(comprising both FDI and portfolio flows) see Calvo et al (1993), World Bank(1997), and Feldstein (1999).

7 See Chuhan et al (1998)

The main question

is whether capital

flew into these

countries primarily

as a result of

changes in global

(largely US) factors

or in response to

events and

indicators in the

recipient countries

like their credit

rating and domestic

stock market return.


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As for the motivation of US equity investment in foreign

markets, recent research8 suggests that US portfolio managers investing

abroad seem to be chasing returns in foreign markets rather than sim-

ply diversifying to reduce overall portfolio risk. The findings include

the well-documented home bias in OECD investments, high turnover

in foreign market investments and that, in general, the patterns of

foreign equity investment were far from what an international portfolio

diversification model would recommend. The share of investments

going to emerging markets has been roughly proportional to the share

of these markets in global market capitalisation but the volatility of US

transactions was even higher in emerging markets than in other OECD

countries. Furthermore, there was no relation between the volume of US

transactions in these markets and their stock market volatility.

The Mexican and Asian crises and the widespread outcry

against international portfolio investors in both cases have prompted

analyses of short-term movements in international portfolio investment

flows. The question of feedback trading has received considerable

attention. This refers to investors reaction to recent changes in equity

prices. If a gain in equity values tends to bring in more portfolio

inflows, it is an instance of positive feedback trading while a decline

in flows following a rise in equity values is termed negative feedback

trading. Between 1989 and 1996 unexpectedequity flows from abroad

raised stock prices in Mexico at the rate of 13 percentage points for

every 1 per cent rise in the flows.9 There has been, however, no evi-

dence of feedback trading among foreign investors in Mexico. In the

period leading to the Asian crisis, on the other hand, Korea witnessed

positive feedback trading and significant herding among foreign

investors.10 Nevertheless, contrary to the belief in some segments, these

tendencies actually diminished markedly in the crisis period and there

has been no evidence of any destabilising role of foreign equity

investors in the Korean crisis. While FII flows to the Asian Crisis

countries dropped sharply in 1997 and 1998 from their pre-crisis levels,

it is generally held that the flows reacted to the crisis (possibly exacer-

bating it) rather than causing it.

More recent studies11 find that the effect of regional factors as

determinants of portfolio flows has been increasing in importance over

time. In other words portfolio flows to different countries in a region

tend to be highly correlated. Also the flows are more persistent thanreturns in the domestic markets. Feedback trading or return-chasing

behaviour is also more pronounced. The flows appear to affect contem-

poraneous and future stock returns positively, particularly in the case of

8 See Bohn and Tesar (1996) and Tesar and Werner (1995a) for studies offlows to OECD countries and Tesar and Werner (1995b) for a study of US portfolioflows to emerging markets.

9 See Clark and Berko (1997)10 See Choe et al (1999)11 See, for instance, Froot et al (2001)

As for the

motivation of US

equity investment in

foreign markets,

recent research

suggests that US

portfolio managers

investing abroad

seem to be chasing

returns in foreign

markets rather than

sim-ply diversifying

to reduce overall

portfolio risk.


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emerging markets. Finally stock prices seem to behave on the assump-

tion of persistent portfolio inflows.

It is commonly argued that local investors possess greater

knowledge about a countrys financial markets than foreign investors

and that this asymmetry lies at the heart of the observed home bias

among investors in industrialised countries. A key implication of recent

theoretical work in this area12 is that in the presence of such informa-

tion asymmetry, portfolio flows to a country would be related to returns

in both recipient and source countries. In the absence of such asymme-

try, only the recipient countrys returns should affect these flows.

III. Foreign Institutional Investment in India: An OverviewIndia opened its stock markets to foreign investors in Septem-

ber 1992 and has, since 1993, received considerable amount of portfo-

lio investment from foreigners in the form of Foreign Institutional

Investors (FII) investment in equities. This has become one of the main

channels of international portfolio investment in India for foreigners.13

In order to trade in Indian equity markets, foreign corporations need to

register with the Securities and Exchange Board of India (SEBI) as

FIIs.14 The SEBI definition of FIIs presently includes foreign pension

funds, mutual funds, charitable/endowment/university funds etc. as well

as asset management companies and other money managers operating

on their behalf.

The trickle of FII flows to India that began in January 1993 has

gradually expanded to an average monthly inflow of close to Rs. 1,900

crore during the first six months of 2001. By June 2001, over 500 FIIs

were registered with SEBI. The total amount of FII investment in India

had accumulated to a formidable sum of over Rs. 50,000 crore during

this time (see Chart 1). In terms of market capitalisation too, the share

of FIIs has steadily climbed to about 9 per cent of the total market

capitalisation of BSE (which, in turn, accounts for over 90 per cent of

the total market capitalisation in India).

The sources of these FII flows are varied. The FIIs registered

with SEBI come from as many as 28 countries (including money

management companies operating in India on behalf of foreign inves-

tors). US-based institutions accounted for slightly over 41 per cent,

those from the UK constitute about 20 per cent with other Western

European countries hosting another 17 per cent of the FIIs (see Chart 2).

12 See Brennan and Cao (1997)13 The closed-end country fund, The India Fund launched in June 1986

provided a channel for portfolio investment in India before the stock marketliberalisation in 1992. Global Depository Receipts, American Depository Receipts,Foreign Currency Convertible Bonds and Foreign Currency Bonds issued by Indiancompanies and traded in foreign exchanges provide other routes for portfolioinvestment in India by foreign investors.

14 It is also possible for foreigners to trade in Indian securities withoutregistering as an FII; but such cases require approval from the RBI or the ForeignInvestment Promotion Board.

The effect of

regional factors as

determinants of

portfolio flows has

been increasing in

importance over

time. In other words

portfolio flows to

different countries in

a region tend to be

highly correlated.


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0

100

200

300

400

500

600

Months

0

10000

20000

30000

40000

50000

60000

Number of registered .IIs

Cumulative Investment

USA42%

UK20%

WEurope17%

Hong Kong

6%Singapore

4%Australia

4%

MiddleEast

1%

Canada2%

Japan1%

India1%

Others2%

CHART 1Growth of FII Investment in India

CHART 2Sources of FII Investment in India

Source: SEBI website


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Box 2: Some descriptive statistics of FII flows to India

The histogram and descriptive statistics for net FII flows between January 1993 andDecember 1999, the sample period selected for our analysis, are given in Panel A ofFigure 3. A Jarque-Bera test of normality in the distribution of FII flows fails to rejectthe null hypothesis of normality for the data during the sample period. The flows,however, are somewhat volatile with a coefficient of variation of over 1.22. They arealso considerably auto-correlated. The auto-correlation with one lag is over 0.5 and

that with two lags is over 0.26.CHART 3 Panel A

Histogram and descriptive statistics of FII flows

Panel A: Net FII flows (Rs. Crores)

02

175

15

125

01

075

05

025

025

05

075

01

125

15

175

02

225

25

275

03

325

35

375

04

425

45

475

05

re

CHART 3 Panel B

Histogram and descriptive statistics of FII flows

Panel B: FII flows as a proportion of previous months' BSE market capitalisation

Panel B of Figure 3 shows the histogram and descriptive statistics for FII flows as aproportion of the preceding months BSE market capitalisation. Here the coefficient ofvariationjust above 1.13is slightly less than in the flows themselves implying thatthe market capitalisation itself is more volatile than the FII flows. The Jarque-Bera teststatistic rejects the null hypothesis of normality at 1 per cent level in this case. Thedegree of auto-correlation is about as strong, i.e. 0.49 with one lag and much strongerover 0.38for two lags.

Sample: 1993:051999:12Observations 80

Mean 0.001024Median 0.000879Maximum 0.004929Minimum -0.001595Std. Dev. 0.001161Skewness 0.576284Kurtosis 4.249903

Jarque-Bera 9.635571Probability 0.008085

-0.002

-0.00175

-0.0015

-0.00125

-0.001

-0.00075

-0.0005

-0.000250

0.00025

0.0005

0.00075

0.001

0.00125

0.0015

0.00175

0.002

0.00225

0.0025

0.00275

0.003

0.00325

0.0035

0.00375

0.004

0.00425

0.0045

0.00475

0.005

More

Sample: 1993:051999:12

Observations 80

Mean 439.5139Median 406.6350Maximum 1673.000Minimum -896.4100Std. Dev. 539.2140Skewness 0.080577Kurtosis 3.274955

Jarque-Bera 0.338569Probability 0.844269

Net FII Flows (Rs. Crores)

Fre

quency

12

10

8

6

4

2

0

-900

-800

-700

-600

-500

-400

-300

-200

-1000

100

200

300

400

500

600

700

800

900

1000

1100

1200

1300

1400

1500

1600

1700

More

FII flows as a proportion of previous months BSE market capitalization

Frequency

18

16

14

12

10

8

6

4

2

0


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It is, however, instructive to bear in mind that these national affiliations

do not necessarily mean that the actual investor funds come from these

particular countries. Given the significant financial flows among the

industrial countries, national affiliations are very rough indicators of

the home of the FII investments. In particular institutions operating

from Luxembourg, Cayman Islands or Channel Islands, or even those

based at Singapore or Hong Kong are likely to be investing funds

largely on behalf of residents in other countries. Nevertheless, the

regional breakdown of the FIIs does provide an idea of the relative

importance of different regions of the world in the FII flows.

Some descriptive statistics about the FII flows are provided in

Box 2. The data used for this and the analysis in the remainder of the

paper are described in Appendix 1.

IV. Factors affecting FII flowsIn this section we shall study the relationship between FII flows

and possible economic factors affecting it, particularly stock returns in

the Indian market.

FII flows and stock returnsdetermining

the cause and the effect

FII flows and contemporaneous stock returns are strongly

correlated in India. The correlation coefficients between different

measures of FII flows and market returns on BSE during different

sample periods are shown in the different panels ofTable 1. While the

TABLE 1FII flows and Returns on BSECorrelations

Net FII FII flow as pro- Return onflow portion of pre- BSE Natio-

ceding months nal IndexBSE market cap (Rupees)

Panel A: Entire Sample: May1993 Dec 1999

FII flow as proportion of precedingmonths BSE market cap 0.93

Return on BSE National Index (Rupees) 0.52 0.56

Return on BSE National Index (US $) 0.53 0.58 0.98

Panel B: Pre-Asian Crisis period: May 1993 June 1997




Panel C: Asian Crisis and after: July 1997 Dec 1999




Given the significant

financial flows

among the industrial

countries, national

affiliations are very

rough indicators of

the home of the FII

investments.

Nevertheless, the

regional breakdown

of the FIIs does

provide an idea of

the relative

importance ofdifferent regions of

the world in the FII

flows.


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correlations are quite high throughout the sample period, they exhibit a

significant rise since the beginning of the Asian crisis.

These positive correlations have often been held as evidence of

FII actions determining Indian equity market returns. However, correla-

tion itself does not imply causality. A positive relationship between

portfolio inflows and stock returns is consistent with at least four

distinct theories: (1) the omitted variables hypothesis; (2) the down-

ward sloping demand curve view; (3) the base-broadening theory;

and (4) the positive feedback strategy view.

The omitted variables view is the classic case of spurious

correlationthat the correlated variables, in fact, have no causal

relationship between them but are both affected by one or more other

variables missed out in the analysis. The downward sloping demand

curve view contends that foreign investment creates a buying pressure

for stocks in the emerging market in question and causes stock prices to

rise much in the same way as suddenly higher demand for a commodity

would cause its price to rise. The base-broadening argument contends

that once foreigners begin to invest in a country, the financial markets

in that country are now no longer moved by national economic factors

alone but rather begin to be affected by foreign market movements as

well. As the market itself is now affected by more factors than before,

its exposure to domestic shocks declines. Consequently the risk of the

market itself falls, people demand a lower risk premium to buy stocks,

and stock prices rise to higher levels. Finally the positive feedback

view asserts that if investors chase returns in the immediate past (like

the previous day or week) then aggregating their fund flows over the

month can lead to a positive relationship in the contemporaneous

monthly data.

In the present context, both directions of causation are equally

plausible. Detailed statistical tests (see Box 3) however, indicate that

the FII flows are likely to have been more of an effectof market returns

in India than their cause.

Further statistical tests (see Box 4) suggest that returns on the

Bombay Stock Exchange (BSE) Index explain close to a third of the

total variation in FII flows during the entire period. They also indicate,

however, that the Asian crisis marked a regime shift in the relationship

between FII flows and Indian stock market return. During and after the

crisis, the returns explained about 40 per cent of the total variation inFII flows.

The positive relationship between market return and FII flows,

however, serves only as a first-pass in understanding the nature of such

flows and their implications for the Indian markets. Since the FII flows

essentially serve to diversify the portfolio of foreign investors, it is only

normal to expect that several factorsboth domestic as well as exter-

nal to Indiaare likely to affect them along with the expected stock

The positive

relationship

between market

return and FII flows,however, serves

only as a first-pass

in understanding the

nature of such flows

and their

implications for the

Indian markets.


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BOX 3: FII flows and Equity Returns in India: Cause or Effect?

Pair-wise Granger causality tests between net FII inflows (as a proportion of preced-ing months BSE market capitalisation) and monthly return on the BSE NationalIndex, reported in Table 2, Panel A fail to categorically establish a causal directionsince non-causality is rejected in both directions at least at the 5 per cent level ofsignificance. During the pre-Asian Crisis period, however, there seems to be some

support for the causality running from flows to returns, while with the onset of theAsian Crisis, there is mild evidence of a reversal of causality. On the whole then, theissue of which is the cause and which is the effect remains indeterminate withmonthly data.

. . . continued on following page

TABLE 2

Granger Causality tests between Returns on the BSE National Index on

FII investment flows

Panel A: Monthly Data1993 to 1999

Null Hypothesis Entire Pre-Asian Asian Crisis

Sample Crisis and after Returns+ do not cause FII flows# 3.2105 0.975 2.29915

Flows do not cause returns 6.1471 2.74410 1.738

The tests use two lags.+ Monthly Returns on the BSE National Index# Ratio of net FII flows to BSE market capitalisation in the previous month1, 5,10 and 15 denote significance at 1 per cent, 5 per cent, 10 per cent and 15 per cent levels

respectively.

Panel B: Daily DataJanuary 1, 1999 to December 31, 1999

Lags considered 2 3 4 5 6

Null Hypothesis

Returns+ do not cause FII flows# 8.3861 5.5331 4.2231 4.0851 3.2561

Flows do not cause returns 0.963 0.766 1.891 1.732 1.399

+ Daily Returns on the BSE National Index# Ratio of net FII flows to BSE market capitalisation in the previous month1, 5,10 and 15 denote significance at 1 per cent, 5 per cent, 10 per cent and 15 per cent levels

respectively.

In order to dig deeper into the issue of direction of causality then, we have to usedaily data. Fortunately daily data are available (from SEBI website) on net FII flowssince January 1999. Thus in order to get a better sense of the direction of causality werun pair-wise Granger-causality tests with daily data for 1999 at several lags andreport these results in Panel B of Table 2. Here the results seem to be far moreunequivocal. At all lags the Granger causality tests reject the hypothesis of returnsnot causing flows at the 1 per cent level while the null hypothesis of reverse non-causality is never rejected. Thus this data seems to support the view that the FII flowsare more an effectthan a cause of market returns in India. Chart 4shows the weeklypatterns in returns and FII flows during 1999.

One qualifier may not, however, be out of place here. Loosely speaking, Table 2,Panel A seems to suggest a slight reversion of causality between flows and returns in


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the pre-Asian crisis period and that of the later period. Since the daily data comesentirely from the post-Asian crisis period, it may be still be true that the reversecausation was in effect in the pre-crisis period.Finally, the model-free approach of detecting causality between the two variablessimply by using Granger causality can only serve as a preliminary check for thedirection of causality. The orthodox way of doing such analysis would almost alwaysbegin with a priorimodelling of these variables. However, since in financial markets,information flows drive both returns and investment flows, implications about cau-sality between these two variables can also be highly model-specific. In such asituation an agnostic test like Granger causality does have some usefulness in detect-ing the direction of causality.

CHART 4

Returns and FII flows during 1999

returns in India. Past research suggests15 that the declining world

interest rates have been among the important push factors for

international portfolio flows in the early 90s. The usual suspects in

the literature include US and world equity returns, changes in interest

rates, stock market volatility, some measure of the country risk and the

exchange rate. In the Indian case, however, these factors do not appear

to have had a prominent role in motivating FII flows (see Box 4).

Finally it also appears that there has been no significant informationaldisadvantage for FIIs vis--vis the local investors in the Indian market.

Other factors that may affect FII flows

Country risk measures, that incorporate political and other

risks in addition to the usual economic and financial variables, may be

expected to have an impact on portfolio flows to India though they are

15 See Calvo et al (1993)

Return

.II flow

AverageFIIflowduringtheweek(as

aproportion

ofpreviousmonths'BSEmarketcapitalization)

Averagedailyreturnduringa

week

0.0004

0.0003

0.0002

0.0001

0

-0.0001

-0.0002

0.03

0.025

0.02

0.015

0.01

0.005

0

-0.005

-0.01

-0.015

-0.02

-0.025

Return

FII flow

Weeks

1/8/1999

3/19/1999

6/11/1999

8/20/1999

10/29/1999


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Box 4: Further Analysis of the Determinants of FII flows

Equity Market returns

Table 3 presents the results of a regression of FII flows (as a proportion of theprevious months BSE capitalisation) on monthly rupee returns* on the BSE NationalIndex. Because of evidence of auto-correlated residuals from the Durbin-Watsonstatistic, Newey-West heteroskedasticity and auto-correlation consistent standard

errors and co-variances are used in these regressions. The results indicate thatreturns on the BSE Index explain over three-tenths of the total variation in FII flowsduring the entire period. The explanatory power rises considerably with the onset ofthe Asian crisis when the regression accounts for over four-tenths of the variation.The results of a Chow breakpoint test shown in Table 3, Panel B, shows that the onsetof the Asian Crisis does mark a structural break in the relationship implying a rise inthe effect of market return in explaining FII flows.

TABLE 3

Regressions of FII investment flows on Monthly Returns on the

BSE National Index

Panel A: Dependent variable: Net monthly FII inflow as a proportion of thepreceding months BSE market capitalisation

Entire sample Pre Asian Cris is Asian Cris is and after

(1993:05 (1993:05 (1997:07

1999:12) 1997:06) 1999:12)

Constant 0.001 0.001 0.0003

(5.624) (8.300) (1.566)

Return on the BSE 0.008 1 0.008 1 0.0091

National Index (4.517) (2.836) (6.124)

Adjusted R2 0.310 0.304 0.419

Durbin-Watson 1.016 1.241 1.24

The regressions are estimated by OLS with Newey-West heteroskedasticity auto-correlation

consistent standard errors and covariance. The figures in parentheses are t-statistics.1 denotes significance at 1 per cent level.

Panel B: Chow Breakpoint Test: (Breakpoint1997:07)

F-statistic 9.767 Probability 0.000168

Log likelihood ratio 18.301 Probability 0.000106

The effect of other factors

As a second step in analysing the FII flows to India, we regress the FII flows on otherfactors identified in the literature and find out to what extent they help explain the FII

flows. To the extent that these factors may be affecting the Indian stock returnsthemselves, this exercise throws light on the possibility of omitted variables givingrise to the correlation between FII flows and monthly stock returns.Table 4reports the results from a regression of monthly FII flows (as a proportion ofpreceding months BSE market capitalisation) on several variables in addition to themonthly return on the BSE National Index. These variables are as follows: returns onthe S&P 500 index (a major US index), returns on the MSCI world index (a majorinternational index tracked by several international investment funds), volatility ofdaily US dollar return on the BSE National Index in the preceding month (as a



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measure of total risk in the Indian market), the change in the short-term (45-day)fixed deposit rate in India and the return in the foreign exchange market (a positivereturn means depreciation of rupee). Once again Newey-West standard errors andco-variances are used in response to the low D-W statistics. Only the exchange ratemovements turn out to be significant (in addition to the stock returns) in theseregressions. A comparison with Table 3shows that in the entire sample the adjustedR2 goes up only marginally (presumably because of the exchange rate effect) while it

declines in both sub-samples. These variables thus collectively do little to explain theFII flows. The Chow test (Panel B) continues to detect a structural break with theonset of the Asian crisis.

TABLE 4

Regressions of FII investment flows on Monthly Returns

on the BSE National Index

Dependent variable: Net monthly FII inflow as a proportion of the preceding

months BSE market capitalisation

Entire sample PreAsian Crisis Asian Cris is and after

(1993:05 (1993:05 (1997:07

1999:12) 1997:06) 1999:12)

Constant 0.002 0.002 0.0000

(4.870) (4.053) (0.032)

Return on the BSE 0.0081 0.0075 0.0101

National Index (4.336) (2.439) (5.530)

Return on the MSCI 0.000 0.007 -0.018

World Index (0.013) (1.103) (-1.671)

Return on the S&P -0.004 -0.010 0.016

500 index (-0.520) (-1.552) (1.564)

Change in Indian short- 0.008 0.070 -0.154

term interest rate (0.082) (0.456) (-0.824)

Return Volatility in the -0.038 -0.014 0.019

preceding month (-1.784) (-0.474) (0.476)

Return on exchange rate -0.0105 -0.008 -0.005

(-2.363) (-1.609) (-0.883)

Adjusted R2 0.321 0.277 0.361

Durbin-Watson 1.123 1.361 1.363

The regressions are estimated by OLS with Newey-West heteroskedasticity auto-correlation

consistent standard errors and covariance. The figures in parentheses are t-statistics.1, 5 and 10 denote significance at 1 per cent, 5 per cent and 10 per cent levels respectively.


F-statistic 2.448 Probability 0.0271Log likelihood ratio 18.465 Probability 0.0100

The lack of significance of the world stock returns in explaining the portfolio flowsmay be interpreted, in light of Brennan and Cao (1997), to suggest that there is nosignificant informational asymmetry between FIIs and domestic investors in India.The presence of any informational disadvantage for the FIIs would have made theworld indices a significant determinant of their investment flows.

*The dollar returns and returns in excess of the short-term (45-day) interest rates were also used and they

produce nearly identical results.


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likely to matter more in the case of FDI flows. In order to check the

impact of such country risk on FII flows, semi-annual country risk

scores for India were taken from the Institutional Investor magazine, an

important country-rating agency. These raw ratings were then divided

by the world average rating to obtain normalised ratings. The intuition

behind this normalisation is as follows. If Indias credit rating improves

but those of other countries improve even more, then India may not

improve its relative attractiveness as a destination of investment flows.

The relation between the normalised country rating and the average

monthly FII flows (as a proportion of the preceding months BSE

capitalisation) is shown in Chart 5. The correlation between the two

variables is 0.15. No relationship is evident from the figure itself and

statistical testing confirms this view16. Thus we can conclude that

broadly speaking there is no evidence of India credit rating affecting

FII flows.

CHART 5

Credit Rating and Subsequent FII flows

It is also conceivable that the extent to which the Indian market

moves out of step with the world market is a factor in determining its

attractiveness to foreign investors. The lower the co-movement, the

greater the protection that investment in India provides to investorsagainst world market shocks. Statistical tests (see Box 5) indicate that

this was indeed true in the pre-Asian Crisis period but ceased to hold in

the Crisis period.

16 A Granger causality test fails to reject the null hypothesis that therating does not cause FII flows at the 10% level.

Normalized Rating

.II flow

Averagemonthly

FIIflow(asapercentageofBSEmarket

capintheprecedingmonth)forthefollowing6months0.30%

0.25%

0.20%

0.15%

0.10%

0.05%

0.00%

-0.05%

Sep-9

3

Mar-9

4

Sep-9

4

Mar-9

5

Sep-9

5

Mar-9

6

Sep-9

6

Mar-9

7

Sep-9

7

Mar-9

8

Sep-9

8

Mar-9

9

Sep-9

9

India'scre

ditratingasamultipleofglobal

averagecreditrating

1.9

1.7

1.5

1.3

1.1

0.9

Normalised Rating

FII flow

It is also

conceivable that the

extent to which the

Indian market

moves out of step

with the world

market is a factor in

determining its

attractiveness to

foreign investors.

. . . Statistical tests

indicate that this

was indeed true in

the pre-Asian Crisis

period but ceased tohold in the Crisis

period.


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BOX 5: Indias status as a hedge against world shocks

According to the standard International Capital Asset Pricing Model (ICAPM) ap-proach, the measure of risk of holding the Indian market in an internationallydiversified portfolio is given by the beta of the Indian market (slope of the regres-sion of Indian returns on world returns) with respect to the relevant world market.Thus, if the beta of the Indian market decreases, it is likely to improve the attractive-

ness of the Indian market to the international investor simply for the benefits of totalrisk reduction through diversification.

In order to check this relationship we compute the betaof monthly US dollarsreturn on the BSE National Index with returns on the S&P 500 index

[)(

),(

500

500

SP

SPBSE

rVar

rrCov= ] and returns on the MSCI world index. The betas for

each month are computed using returns data for the previous 24 months. Chart 6shows the data and Table 5shows the regression estimates. The regressions indi-cate that the beta of the Indian market with respect to the S&P 500 has a significanteffect in explaining FII investment flows before the Asian crisis but not during or

after the crisis period. The beta with respect to the world market is insignificant inboth periods. The Chow test (Panel B), however, rejects the null hypothesis of nostructural break at the onset of the Asian crisis only at the 15 per cent level.

CHART 6

FII flows and the beta of the Indian market with respect to S&P 500


.II flow

beta_S&P500

FII flow

beta_S$P500

BetaofBSENationalIndexwithrespecttoS&P500

1

0.5

0

-0.5

-1

-1.5

-2

-2.5

FIIflow(percentageofprecedingmonth's

BSEmarketcapitalization)

0.006

0.005

0.004

0.003

0.002

0.001

0

-0.001

-0.002

Months (May 1993 to December 1999)

Jul-93

Jan-9

4

Jul-94

Jan-9

5

Jul-95

Jan-9

6

Jul-96

Jan-9

7

Jul-97

Jan-9

8

Jul-98

Jan-9

9

Jul-99


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TABLE 5

Regressions of FII investment flows on betas of the BSE National Index with

respect to S&P500 and the MSCI World Index

Panel A: Dependent variable: Net monthly FII inflow as a proportion of the

preceding months BSE market capitalisation

Entire sample Pre Asian Cris is Asian Cris is and after

(1993:05 (1993:05 (1997:07 1999:12) 1997:06) 1999:12)

Constant 0.001 0.001 0.001

(5.685) (6.980) (2.408)

Beta (S&P 500) -0.001 -0.0015 0.0001

(-1.848) (-2.324) (0.391)

Beta (MSCI World Index) -0.0002 0.0002 -0.002

(-0.314) (0.387) (-1.330)

Adjusted R2 0.179 0.119 0.067

Durbin-Watson 1.323 1.349 1.457

The regressions are estimated by OLS with Newey-West heteroskedasticity auto-correlationconsistent standard errors and covariance. The figures in parentheses are t-statistics.5 denotes significance at the 5 per cent level.


F-statistic 1.983 Probability 0.123

Log likelihood ratio 6.186 Probability 0.103

VI. Main Findings and ConclusionThe empirical investigation of FII flows to India have elicited

the following stylised facts about the such flows:

a. FII flows are correlated with contemporaneous returns in the

Indian markets.

b. This high correlation is not necessarily evidence of FII flows

causing price pressureif anything, the causality is likely to

be the other way around.

c. A collection of domestic and international variables likely to

affect both flows and returns fails to diminish the importance of

contemporaneous returns in explaining FII flows.

d. Since the US and world returns are not significant in explainingthe FII flows, there is no evidence17 of any informational

disadvantage of FIIs in comparison with the domestic investors

in India.

e. Changes in country risk ratings for India do not appear to

affect the FII flows.

f. The beta of the Indian market with respect to the S&P 500

index (but not the beta with respect to the MSCI world index)

17 In the sense of the Brennan and Cao (1997) model.


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seems to affect the FII flows inversely but the effect disappears

in the postAsian crisis period.

g. There appears to be significant differences in the nature of FII

flows before and after the Asian crisis. In the post Asian crisis

period it seems that the returns on the BSE National Index have

become the sole driving force behind FII flows.

The stylised facts listed above lead to a better understanding ofFII flows to India. The weakness of the evidence of causality from flows

to returns contradicts the view that the FIIs determine market returns in

general, though herding effectsparticularly with domestic specula-

tors imitating FII movesmay well be present in cases of individual

stocks. Particularly since the Asian crisiswhich seems to have brought

about a regime shift in the relationship between FII flows and stock

market returnsthe direction of causation seems to be running from the

returns to the flows. The relative stability in the exchange rate of the

Indian Rupee in the post-Asian crisis era seems to have outweighed

fluctuations in the countrys credit rating among foreign portfolioinvestors.

It is notable that the Asian crisis appears to have acted as a

watershed in several of the key relationships affecting the FII flows to

India. This is not an overly surprising result. Recent research18 has

demonstrated that the Asian crisis caused several major changes in the

financial relationship among European countries half-way across the

globe. In fact the crisis appeared to have altered several of the ground

rules of international portfolio investing around the world. Why

exactly the relationships analysed here demonstrate a structural break

at the outbreak of the Asian crisis is a matter of speculation. However,it is plausible that the crisis and Indias relative imperviousness to it

increased Indias attractiveness to portfolio investors particularly as

many other emerging markets began to appear extremely risky. This

substitution effect may well have drowned other long-term relation-

ships. Besides, investors may have started paying closer attention to

obtaining and processing information in destination countries in the

wake of the Asian crisis causing an information effect that could have

altered the past relationship as well. Finally, behavioural changes

among international portfolio investors following the crisis cannot be

ruled out either.Another important area is the mild evidence towards the FII

flows being affected by returns in the Indian markets in the immediate

past. Such a relationship suggests that given the thinness of the Indian

market and its evident susceptibility to manipulations, FII flows can, in

fact, aggravate the occurrence of equity market bubbles though they

18 See Chakrabarti and Roll (2002).

There appears to be

significant

differences in the

nature of FII flows

before and after the

Asian crisis. In the

post Asian crisis

period it seems that

the returns on the

BSE National Index

have become the

sole driving force

behind FII flows.


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may not actually startthem. This is obviously an important concern for

policy makers and market regulators.

This paper provides a preliminary analysis of FII flows to India

and their relationship with several relevant variables especially returns

in the Indian stock market. A more detailed study using daily data for a

longer period or, better still, disaggregated data showing the transac-

tions of individual FIIs at the stock level can help address questions

regarding the extent of herding or return-chasing behaviour among

FIIsindicators that can help us estimate the probability of sudden

Mexico-type reversals of these FII flows which now account for a

significant part of the capital account balance in our balance of pay-

ments. The extent to which FII participation in Indian markets has

helped lower cost of capital to Indian industries is also an important

issue to investigate.

Broader and more long-term issues involving foreign portfolio

investment in India and their economy-wide implications19 have not

been addressed in this paper. Such issues would invariably require an

estimation of the societal costs of the volatility and uncertainty associ-

ated with FII flows. A detailed understanding of the nature and determi-

nants of FII flows to India would help us address such questions in a

more informed manner and allow us to better evaluate the risks and

benefits of foreign portfolio investment in India.

19 Like those raised in Pal (1998).


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ReferencesBhagwati, Jagadish N., 1998. The Capital Myth: The Difference between Trade in

Widgets and Dollars, Foreign Affairs, Vol. 77, pp. 7-12.Bohn, Henning and Linda Tesar, 1996. U.S. equity investment in foreign markets:

Portfolio rebalancing or return chasing? American Economic Review,Vol.86, pp. 77-81.

Brennan, Michael J. and H. Henry Cao, 1997. International Portfolio InvestmentFlows, Journal of Finance, Vol. LII, No.5, December, pp. 1851- 1880.

Calvo, Guillermo A., Leonardo Leiderman and Carmen M. Reinhart, 1993. Inflows

of Capital to Developing Countries in the 1990s, Journal of EconomicPerspectives, Vol. 10, No.2, Spring, pp. 123-139.

Choe, Hyuk, Bong-Chan Kho and Rene M. Stulz, 1999. Do foreign investorsdestabilize stock markets? The Korean experience in 1997, Journal ofFinancial Economics, Vol. 54, pp. 227-264.

Chakrabarti, Rajesh and Richard Roll, 2002, East Asia and Europe during the 1997Asian collapse: a clinical study of a financial crisis, Journal of FinancialMarkets, 5(1), pp. 1-30.

Chuhan, Punam, Claessens Stijn, Mamingi Nlandu, 1998. Equity and bond flows toLatin America and Asia: the role of global and country factors, Journal ofDevelopment Economics, Vol.55, No.2, pp. 441-465.

Clark, John and Elizabeth Berko, 1997. Foreign Investment Fluctuations andEmerging Market Stock Returns, Federal Reserve Bank of New York Staff

Papers, Number 24, May.Cooper, Ian A., and Evi Kaplanis, 1994. Home bias in equity portfolios, inflation

hedging, and international capital market equilibrium, Review ofFinancial Studies, vol.7, pp. 45-60.

Corsetti, G., P. Pesenti and N. Roubini, 1999. What caused the Asian Currency andFinancial Crises, Japan and the World Economy, Vol. 11, pp. 305-373.

Errunza, Vihang R., forthcoming. Foreign Portfolio Equity Investments in EconomicDevelopment, Review of International Economics.

Feldstein, Martin, ed. 1999. International Capital Flows, The University of ChicagoPress, Chicago and London.

French, Kenneth R., and James M. Poterba, 1991. Investor diversification andinternational equity markets, American Economic Review, Papers andProceedings 81, pp. 222-226.

Froot, Kenneth A., Paul G.J. OConnell and Mark S. Seasholes, 2001. The Portfolioflows of international investors, Journal of Financial Economics, Vol. 59,pp. 151-193.

Krugman, Paul, 1998. Saving Asia: Its Time to Get Radical, Fortune, September 7.Pal, Parthapratim, 1998. Foreign Portfolio Investment in Indian Equity Markets:

Has the Economy Benefited?, Economic and Political Weekly, March 14,pp. 589-598.

Rangarajan, C., 2000. Capital Flows: Another Look, Economic and PoliticalWeekly, December 9, pp. 4421-4427.

Samal, Kishore C., 1997. Emerging Equity Market in India: Role of ForeignInstitutional Investors, Economic and Political Weekly, October 18, pp.2729-2732.

Stiglitz, Joseph, 1998. Boats, planes and capital flows, Financial Times, March 25.

Tesar, Linda, 1999. The Role of Equity Markets in International Capital Flows, inFeldstein, Martin, ed. International Capital Flows, The University ofChicago Press, Chicago and London.

Tesar, Linda and Ingrid Werner,1995a. Home bias and high turnover, Journal ofInternational Money and Finance, vol. 14, pp. 467-492.

Tesar, Linda and Ingrid Werner,1995b. U.S. Equity Investment in Emerging StockMarkets, The World Bank Economic Review,Vol. 9, No. 1, January.

World Bank, 1997. Private Capital Flows to Developing Countries: The Road toFinancial Integration, Oxford University Press, New York.


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Appendix I: A Description of the DataThe data used in this paper comes from several sources. We use

monthly net FII investment figures obtained from the websites of RBI

and SEBI. Market capitalisation data are obtained from the BSE

website. Other financial data like the exchange rate, short-term interest

rate in India, returns on the MSCI world index, S&P 500 as well as the

BSE national index are obtained from Datastream. Country credit

rating data are obtained from several issues of the Institutional Investor

magazine.

The FII net investment series starts from January 1993 and the

BSE market capitalisation series starts in April 1993. The series of FII

flows as a proportion of preceding months BSE market capitalisation

therefore begins in May 1993.

Since the net monthly FII flows and the returns in the Indian

equity markets constitute two key variables in this study, we present, in

the three panels of Figure 1, the net FII flows, the BSE National Index

and net FII flows as a proportion of the preceding months BSE market

capitalisation from May 1993 to June 2001. The BSE National Index

immediately reveals the massive and short-lived bubble during 2000,

a phenomenon that is likely to have caused temporary but marked

deviations from the long-term relationship between FII flows and Indian

market returns. In order to avoid misleading results from this poten-

tially tainted period, we restrict our sample to the end of 1999 for

carrying out empirical analyses.

In order to check if the Asian crisis marked a structural break

in the relationships studied here, we sub-divide the sample period into

two sub-samples. Dating the Asian crisis to begin in July 1997*, the

pre-Asian Crisis sub-sample runs from May 1993 to June 1997 (50

months) and the Asian crisis sub-sample runs from July 1997 to Decem-

ber 1999 (30 months).

In order to study the causal linkage between FII flows and

contemporaneous stock returns in greater detail, we also use daily FII

flows data and daily returns on the BSE National Index for the year

1999. The daily FII flows data come from the SEBI website while the

daily returns data are, once again, obtained from Datastream. All

returns are computed on continuous compounding basis i.e. as the

excess of the logarithm of the index value on a date over the logarithm

of the index value on the previous date.

*This is the date generally accepted in the literature: see Corsetti et al (1999).


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FII Flows to India