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Foreign Institutional Investment in the Indian Equity Market

An Analysis of Daily Flows during January 1999-May 2002
PARAMITA MUKHERJEE , SUCHISMITA BOSE ( AND DIPANKOR COONDOO
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ICRA BULLETIN

Money

&

Finance

APRIL–SEPT. 2002

Abstract
This paper explores the relationship of foreign institutional investment (FII) flows to the Indian equity market with its possible covariates based on a daily data-set for the period January 1999 to May 2002. The set of possible covariates considered comprises two types of variables. The first type includes variables reflecting daily market return and its volatility in domestic and international equity markets as well as measures of co-movement of returns in these markets (viz., relevant betas). The second type of variables, on the other hand, are essentially macroeconomic ones like exchange rate, shortterm interest rate and index of industrial production (IIP)—viz., variables that are likely to affect foreign investors’ expectation about return in Indian equity market. It may be mentioned that our analysis has been primarily motivated by the research done in this area by Chakrabarti (2001), results of which appeared in a recent issue of Money & Finance. Briefly, using a monthly dataset Chakrabarti examined the nature and causes of FII net inflow into the Indian equity market during the period May 1993 to December 1999. He obtained some interesting results: viz., (1) the FII net inflow is correlated with the return in Indian equity market and the former is more likely to be the effect than the cause of the Indian equity market return; (2) so far as investment in Indian equity market is concerned, foreign investors do not seem to be at an informational disadvantage compared to domestic investors; and (3) the Asian crisis marked a regime shift in the sense that in the post-Asian crisis period the return in the Indian equity market turned out to be the sole driver of the FII inflow, whereas for the pre-Asian crisis period other covariates reflecting return in other competing markets, urge for diversification etc., were also found to be correlated with FII net inflow.

This paper explores the relationship of foreign institutional investment (FII) flows to the Indian equity market with its possible covariates based on a daily data set.

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Monetary Research Project, ICRA Ltd., Kolkata Economic Research Unit, Indian Statistical Institute, Kolkata

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ICRA BULLETIN

Money

&

Finance

APRIL–SEPT..2002

Whereas the preMexican crisis period 1990-1994 saw most of the emerging markets performing much better compared to the matured markets in terms of both return and associated risk, the pattern reversed during 1995-2001.

Our endeavour has been to see if these results would carry through when the phenomenon of FII flows was examined using a set of daily data on the relevant variables. The data-set incorporates 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 tried to relate daily FII flows (distinguishing between three kinds of flows—viz., 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). We later modify the model specification to include a short past history of the variables over different time frames, like a week or fortnight. We have also made an attempt at relating FII flows to macroeconomic fundamentals for the Indian economy. Our results show that: (1) 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; (2) returns in the Indian equity market is indeed an important (and perhaps the single most important) factor that influences FII flows into the country; (3) while FII sale and FII net inflow are significantly affected by the performance of the Indian equity market, FII purchase is not responsive to this market performance; (4) FII investors do not seem to use Indian equity market for the purpose of diversification of their investment; (5) return from exchange rate variation and fundamentals of the Indian economy may have influence on FII decisions, but such influence does not seem to be strong, and; finally, (6) daily FII flows are highly auto-correlated and this auto-correlation could not be accounted for by the all or some of the covariates considered in our study.

I. Introduction
The performance of the emerging equity markets1 vis-à-vis their matured counterparts in the developed world have shown repeated reversals in recent times. Thus, whereas the pre-Mexican crisis period 1990-1994 saw most of the emerging markets performing much better compared to the matured markets in terms of both return and associated risk, the pattern reversed during 1995-2001; a period which in most part was affected by the Asian crisis and the associated contagion. The recent past (i.e., the first quarter of 2002) has seen another reversal of performance in which, the 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 (IMF, June and September 2002). The reasons behind these reversals may vary from one reversal to another. However, one thing seems to be pretty clear—viz., such

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1 This consists of capital markets in China, India, Indonesia, Korea, Malaysia, Pakistan, The Philippines, Sri Lanka, Taiwan and China in Asia, Czech Republic, Greece, Hungary, Poland Russia, Slovakia, Turkey, Egypt, Israel and Jordan in Europe and the Middle East, Morocco, South Africa and Zimbabwe in Africa and Brazil, Chile, Colombia, Mexico, Peru and Venezuela in Latin America.

reversals of market performances make foreign equity investment extremely volatile—a phenomenon which is capable of destabilising the domestic economy of the recipient country. It may therefore be essential to evolve appropriate built-in mechanisms in the economies of the countries receiving foreign equity investment such that destabilisation and damages can be minimised 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 is important, as it may help identify the strength of various factors (including macroeconomic ones like level of production, interest rate, etc.) that are likely to affect such flows and also the possible impact of such flows on the performance of the equity market concerned. Over the past ten years or so India has gradually emerged as an important destination of global investors’ investment in emerging equity markets. Today India has a share of about 20 per cent2 in the total global investment in all emerging equity markets together and the outstanding FII investment3 in India stood at around Rs. 86,287 crore, as on end-March, 2002. FII investments as a percentage of market capitalisation increased from 7.06 per cent in 1999-00, to 13.5 per cent in 2000-01 and further to 14.1 per cent in 2001-02. Given this growing importance of FII for the Indian economy, it is apparent that the nature and causation of such fund flows deserve careful examination. In a recent issue of Money & Finance a comprehensive analysis by Chakrabarti (2001) of the nature and causes of FII equity flows4 into the Indian market appeared. In his analysis Chakrabarti mostly used monthly data on FII net inflow as a proportion of the previous month’s market capitalisation, relevant stock market variables and other financial market indicators (like the deposit rate, exchange rate, etc.) and obtained the following main results: (a) though FII flows are highly correlated with equity returns in India, they are more likely to be the effect than the cause of such returns; (b) so far as investment in the Indian equity markets is concerned, global investors do not seem to be at an informational disadvantage compared to local investors; and (c) the Asian crisis marked a regime shift in the determinants of FII flows to India, with the domestic equity returns becoming the sole driver of these flows in the post Asian crisis period. Our motivation is essentially to take this analysis forward a few steps further. To be specific, using daily data for the post Asian crisis period January 1999—May 2002, we have done a study similar to that of Chakrabarti
2 This is a close approximation, since part of the FII flow data contains a small debt component. 3 Net FII, cumulative since 1990-91. 4 In case of India, the relative importance of the equity channel of FII compared to debt, can be gauged from the fact that, for the financial year 2001-02, the average monthly sales by FIIs was to the tune of Rs. 3771 crore and purchases Rs. 3102 crore in the equity segment, while for debt sales and purchases were a meagre Rs. 392 crore and Rs. 332 crore, respectively.

ICRA BULLETIN

Money

&

Finance

APRIL–SEPT. 2002

Over the past ten years or so India has gradually emerged as an important destination of global investors’ investment in emerging equity markets. Today India has a share of about 20% in the total global investment in all emerging equity markets together.

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channelling resources to countries where they will be most productive and thereby increasing growth and welfare globally. and the current policies being followed in India with respect to foreign capital. international capital flows to emerging markets is a somewhat recent phenomenon. we have carried out an in-depth statistical analysis to find out not only the factors that affect net FII flow. II. going beyond Chakrabarti’s analysis. Next. The paper is organised as follows: In Section II we discuss briefly about the importance of the and factors behind portfolio flows to emerging markets. we discuss how our analysis builds upon Chakrabarti’s. First. In the third section.. our results of causality between FII flows and their major covariates like domestic equity market return may prove to be useful from policy viewpoint.ICRA BULLETIN Money & Finance APRIL–SEPT. (a) free capital movements facilitate efficient allocation of global savings. we also describe our data-set and present the main results of our causality and regression analyses. mutual funds and investment trusts as repositories for the majority of . On the theoretical side. thus allowing them to obtain higher returns at lower risk. institutionalisation of savings in the USA and the developed world since the 1980s placed a massive and increasing volume of funds under the management of professional portfolio managers. in which we have tried to identify the relevant covariates of FII flow into and out of the Indian equity market and also to determine the nature of causality between the relevant variables. International Portfolio Flows to Emerging Markets As is well-known. the nature of such flows during the past decade. The last section concludes. but also those which affect FII sale and purchase decisions. (b) access to foreign capital markets enable investors to achieve a higher degree of portfolio diversification. and (d) liberalisation improves macroeconomic performance as it subjects governments to greater market discipline and penalises unsound monetary and fiscal policies. the surge in international portfolio investment over the past decade or so has been triggered by a number of parallel developments.. on the other hand. Since the use of daily data helps in determining the nature of causality with greater precision.5 who for tactical reasons tend to prefer a widely 24 5 That is. the case for liberalisation of international capital flows is built around a few basic tenets—viz. life insurance companies. which began at a reasonable scale in the early 90s.2002 Since the use of daily data helps in determining the nature of causality with greater precision. On the practical side. our results of causality between FII flows and their major covariates like domestic equity market return may prove to be useful from policy viewpoint. relating our analysis to policy implications from empirical studies in various emerging markets. their suggested role in causing volatility and contagion in emerging markets. the choice of pooled funds held by pension funds. (c) full convertibility for capital account transactions complement the multilateral trading system which broadens the channels through which countries obtain trade and investment finance on much easier terms.

6 Third. Analysis of performance of emerging equity markets during the past decade has indicated that investment in these markets can provide global investors with attractive absolute returns as well as some scope to diversify their portfolios. Typically. In the United States. However. More importantly. the share of total financial sector assets held by institutional investors rose from 32% in 1978 to 52% in 1993. such speculative and opportunistic behaviour of these tactical investors has contributed to the volatility of FII inflows into emerging markets.diversified portfolio spread out internationally. the very elements that facilitated the inflow of foreign capital into developing countries have also meant that foreign capital can now be withdrawn from these countries far more quickly. the share that individual emerging markets get of such investment is often sizeable in relation to their total market capitalisation. such speculative and opportunistic behaviour of these tactical investors has contributed to the volatility of FII inflows into emerging markets. but the gains disappeared between 1995 and 2001 with the reversal of performances of these markets relative to their matured counterparts. Fourth. Such performance reversals have ushered in tactical investors such as a hedge fund (which tries to achieve high absolute returns essentially by exploiting the high volatility of returns in these markets through market timing). Second. as already mentioned (IMF. 2002 Performance reversals have ushered in tactical investors such as a hedge fund. developments in information technology have immensely lowered the cost of international trading in securities and made information dissemination on a near real time basis possible. savings—increased the share of funds invested in securities and enhanced the role of institutional investors compared to that of depository institutions. Performances of emerging equity markets vis-à-vis those of their matured counterparts in recent periods reveal the following ICRA BULLETIN Money & Finance APRIL–SEPT. 2002). Understandably. 6 Whose local capital markets were proving to be a bottleneck in the growth process. there has been a trend towards financial liberalisation both in developing countries and countries in transition thus allowing global fund managers to reach the financial markets of these countries. in absolute terms this investment has now crossed the US dollar 100 billion level (which is larger than the total market capitalisation of many individual emerging equity markets). a remarkable expansion of capital markets in emerging economies has taken place due mostly to the widespread privatisation of formerly State-owned enterprises. global investors reaped such benefits in the first half of the 1990s. In fact. while the share of depository institutions fell from 57% to 34% over the same period (Federal Reserve System [FRS]. 25 . Although this allocation is estimated to be a meagre 5 per cent of the total assets of global investors. global investors allocate a small portion of their total assets to equities in these markets to track a world or regional equity index 7 and also as a means to diversify the portfolio held by them. Understandably. for example. 7 Like the S&P/IFC Composite index which is used as a benchmark for measuring equity markets returns in emerging markets as a whole or IFC’s Asia or Latin America indices which reflects the corresponding returns in specific regional markets. Flow of Funds).

which has drastically pruned the US dollar returns on emerging market equities as well as concerns about corporate transparency and governance in the West and Japan and more so in the emerging markets. a priori. Some studies found clear evidence of benefits of such flow in the form of equity market development. 1. the corresponding figures for S&P/IFCI Composite. whereas that for the matured markets decreased. Securities markets in developing countries are typically both narrow and shallow.14 for the emerging markets as against 0. got reversed again during the first quarter of 20012002. Thus.2002 FII flows to the secondary equity market do not have any direct link with the level of real investment in the economy. It has been alleged 26 8 The underperformance of emerging market equities from a longer-term perspective does not appear to be due to overvaluation.68.48 and –0.62 per cent return. 1998. respectively. during 1995-2001) the emerging equity markets. As such. whereas S&P 500 and NASDAQ recorded 14. recorded much smaller returns than those in the matured markets. respectively. Some of the main factors in this underperformance have been identified as the string of financial crises.56 recorded for NASDAQ and S&P500. market co-movements. however. 2000. Kim and Singal. 9 See Errunza. pattern: in the post-Mexican crisis period (to be more specific..77 and 13. 2000. by and large. country experiences differ considerably.78 and 1.ICRA BULLETIN Money & Finance APRIL–SEPT. respectively. capital market integration. and hence tend to question policy concerns regarding resource mobilisation. . Therefore. It is only by enhancing the efficiency and liquidity of capital markets that such a flow can contribute to growth. be quite complicated and therefore are highly controversial.35. including India. contagion and volatility expressed by some policy makers and academics to be largely unwarranted. 2001. It is only by enhancing the efficiency and liquidity of capital markets that such a flow can contribute to growth. The effect of such mobile capital flows can. starting with Mexico in 1994. when the emerging markets (except those in Europe and the Middle East) recorded much higher return and lower risk compared to those of S&P500 and NASDAQ.24 and 0. In fact. EMEA (which covers emerging markets in Europe and the Middle East) and Latin America indices were –3. FII flows to the secondary equity market do not have any direct link with the level of real investment in the economy. analyse 20 countries from the IFC EM Database. for a very detailed review. Bekaert and Harvey.9 The causes of the instability and volatility of short-term portfolio capital flows to emerging markets are often related to the way in which investment funds are managed in order to confront uncertainty.81. –9. This was indicated by values of the Sharpe ratio (which is the ratio of excess return of an asset over that of a risk free asset and the standard deviation of return of the asset concerned) recorded between –0. though price/earnings ratios in emerging market equities have been high in some years. FII participation may. analyse pooled cross-section and time series data for US equity flows to about 20 emerging countries.8 Let us next discuss briefly the possible effects of FII flow on the recipient country’s economy. Also. however. the risk associated with investment in the emerging equity markets increased considerably during this period. This pattern. IFCI’s Asia. lowering cost of capital. induce considerable instability in these markets.

O’ Connell. we first explain our choice of the set of selected variables and describe briefly the data set used and then present the results that have been obtained. (1999).10 A common conclusion from research. Kho and Stulz. a global investor would continuously adjust investment portfolio round the clock using available market information and See. FII Flows to the Indian Equity Market As already mentioned. Jo. FII Flows and Their Covariates—Choice of Variables and Data As is well-known. disregard fundamentals and spread crisis even to countries with strong fundamentals. using data from the Korean stock markets. is that institutions sometimes panic. however. In what follows. Further. Empirical results of the effect of FII activities on the volatility of return are rather divided. particularly mutual funds and forcing fund managers to sell when fundamentals do not warrant such sale.1999. 11 10 27 . Chan. shifts in the portfolio composition of global investors are largely ascribed to changes in their perceptions of country solvency rather than to variations in underlying asset value.that international portfolio investors seek liquidity and use ‘quick exit’ as a means of containing downside risk. too. can contribute to this destabilisation process by fleeing from funds. To be specific. Froot. some studies do not find that foreign investors have any destabilising impacts on stock prices. which covers more than 2000 stocks from 45 emerging markets. the basic objective of our study is to carry forward and supplement the empirical research on the FII flow to India reported in Chakrabarti (2001). thus making frequent marginal adjustments to their portfolios. where data is available for different categories of traders. we have looked for covariates of FII flows to India and tried to ascertain whether FII flows adjust in response to changes in the condition of the Indian equity market or such flows exert strong enough influence on this market so as to affect significantly the return from variations in daily stock price level. for example FitzGerald. The literature also notes that individuals. given the set of investment opportunities available. Kim and Wei (1999) with Korean data. 12 For example. III. 2002 We have looked for covariates of FII flows to India and tried to ascertain whether FII flows adjust in response to changes in the condition of the Indian equity market or such flows exert strong enough influence on this market. 2002. 13 Bae and Chan. 13 These studies also show that volatility caused by FII jumped significantly around the crises period. and Seasholes (2001) based on data from 44 countries. analyse data from the Standard & Poor’s (formerly the IFC) Emerging Markets Database (EMDB). ICRA BULLETIN Money & Finance APRIL–SEPT. 11 Evidences to the contrary showing that foreign investors cause higher volatility in the market compared to domestic investors12 or that stocks in which foreign investors mainly trade experience higher volatility compared to those in which they do not show much interest also exist. 2001. in this context.

thereby tracking returns in all possible markets.14 As regards the data frequency. since we felt that a set of daily data should be more appropriate for examining the nature of causality. a priori. sale and purchase—and a corresponding overall measure of net sale or net purchase. So far as the trading behaviour of these investors is concerned. since we felt that a set of daily data should be more appropriate for examining the nature of causality. To be precise. Similarly defined ratio variables for FIIP (henceforth denoted by RATIO_FIIP) and FIIS (henceforth denoted by RATIO_FIIS) have also been considered. for a given unit time interval (may be a time span of a few minutes. For the sake of comparison with Chakrabarti’s results. a day. FII purchase (henceforth denoted by FIIP) and net FII investment (henceforth denoted by FIIN). any analysis using this ratio as the explained variable may fail to capture the true relationship between FII flow and its various covariates identified as important explanatory factors for this flow in the literature as well as in Chakrabarti’s own analysis. we have also considered FIIN as a proportion of MCAP (henceforth denoted by RATIO_FIIN).. as the case may be. Further.2002 We have chosen to use daily data. The first set of variables include daily return in Rupee terms in the Indian market and corresponding returns in US 28 14 In this context. the following point may be noted: As FII transactions take place on a day to day basis (or for that matter. since the ratio of net FII flow to the total size of market capitalisation (henceforth denoted as Mcap) is rather small for India (and the monthly variation in this ratio is even smaller).. so far as the relationship between FII flows and their major covariates are concerned. . Further.ICRA BULLETIN Money & Finance APRIL–SEPT. we have chosen to examine the nature of FII flow to India in terms of three variables—viz. to the extent possible we have tried to incorporate into the analysis a set of variables that appear. we have chosen to use daily data. a week or a month).. even over shorter time intervals). FII sale (henceforth denoted by FIIS). Following this logic. since daily data on MCAP are unavailable. we have considered two different sets of variables—one relating to the Indian and other equity markets which tend to compete for global investors’ investment and the other relating to the Indian economy which may be relevant for investors’ expectation formation about the Indian market. the investor’s actions may be aggregated and summarised into two basic measures—viz. However. so far as the relationship between FII flows and their major covariates are concerned. studies examining such behaviour suggest broadly two types of trading behaviour (see Box 1 for a brief description of these trading types). It may be noted that in his analysis Chakrabarti used monthly data on net FII flow as a proportion of the size of market capitalisation (henceforth denoted by MCAP) of the previous month as the variable to be explained instead of the net FII flow. to be the primary determinants of global investors’ demand/supply for/of stocks in the Indian market. we have had to calculate a time series of daily MCAP using a method of approximation. As regards the choice of covariates of the FII variables. use of monthly aggregates may blur the picture considerably.

e. month or quarter. to buy recent winners and sell recent losers3.. and is not a management strategy6. if investors are influenced into reversing a planned investment decision after observing others. trading is based on return information pertaining to the previous day.. which may or may not be within the bounds of rational behaviour2. Understandably.15 2. momentum (M) or positive-feedback trading(PT) and herding(H) strategies1. 2001. 4 Such studies take into account returns for the same day. More specifically. Daily return in the international equity market based on the 15 BSE Sensex is compiled using a set of 30 major shares and reports from stock markets suggest that FIIs mostly restrict their trading to the shares covered in the BSE Sensex. month or quarter. Bikhchandani and Sharma. strategy M is the tendency of an investor to buy and sell stocks based on their observed See for example. Herding is intentional. Briefly. strategy M is the tendency of an investor to buy and sell stocks based on their observed return records—i. 3. this set consists of the following variables: 1. The H strategy refers to a situation in which all investors act/react in a similar manner. 29 . and this in turn. they systematically sell assets from one country when asset prices fall in another.ICRA BULLETIN BOX 1 Studies examining foreign institutional investors’ behaviour suggest broadly two types of trading behaviour—viz. measures of volatility of these returns (taken as proxy of the corresponding risks). Momentum trading at a lag5 is observed during non-crisis periods. induced both by the managers and investors when trading is done on the basis of contemporaneous return information4. Typically. 5 That is. 2002. using data from 13 US mutual funds.e. provides an overview of the recent theoretical and empirical research on herd behaviour in financial markets. Money & Finance APRIL–SEPT. which are dedicated Latin America funds. 6 As found by Kaminsky et al . 2002 Briefly. 3 This form of herd behaviour is not rational under the efficient-markets hypothesis since market prices are assumed to reflect all available information. such contagion trading is primarily to meet redemption by individual investors.. Dollar terms in competing markets. however. Froot et al (2001). Daily return in the Indian market calculated on the basis of day to day variations in the value of BSE Sensex (henceforth denoted by BSE_RET). daily return implied by day to day variations in the Rupee-Dollar exchange rate. such trading decisions are mostly taken at the managerial level. increases volatility in the market. Volatility of daily return in the Indian market calculated as the standard deviation of previous 7/ 15/ 30 days’ daily returns based on the BSE Sensex (henceforth denoted by BSE_RETVOL). It is also found that funds often go in for contagion trading—i. There are strong evidences of contemporaneous momentum trading by funds. Such momentum trading is especially found to be strong during periods of financial crisis. Kim and Wei (1999). the M or PT strategy may exacerbate price movements and thus accentuate volatility. The H strategy refers to a situation in which all investors act/ react in a similar manner. 2 1 return records.

Extent of co-movement of daily returns in Indian and International equity markets as measured by the beta of returns from BSE Sensex and MSCI World Index (henceforth denoted by BETA_MSCI). The Results In the present analysis we have mostly used appropriate linear regression techniques to testify various hypotheses concerning FII flows to the Indian equity market. These two variables. Finance APRIL–SEPT. Volatility of daily return in the international equity market calculated as the standard deviation of previous 7/ 15/ 30 days’ daily returns based on MSCI World index (henceforth denoted by MSCIRET_VOL).ICRA BULLETIN Money & 4. 9.. . variables—viz. taken to reflect the short run variations in the fundamentals of the Indian economy. have been used together with the equity market-related variables to see whether or not global investors take into account their expectations about the state of the Indian economy. day to day variations in the value of the MSCI World Index (henceforth denoted by MSCI_RET). For the hypotheses relating to the direction 30 16 This index.2002 6. includes two macroeconomic variables—viz. The second set. See also Appendix 1 some general information on FII investment activities as well as the Indian stock market and related charts and Appendix 2 for a description of the method used to build up the time series of daily MCAP. is known to be closely tracked by FIIs operating in India.Asian crisis period.. which wholly relates to the post. 5. Extent of co-movement of daily returns in Indian and the US equity markets as measured by the beta of returns from BSE Sensex and S&P500 Index (henceforth denoted by BETA_MSCI). The sample period of the daily data set is January 1999—May 2002. Volatility of daily return in the US equity market calculated as the standard deviation of previous 7/ 15/ 30 days’ daily returns based on the S&P500 index (henceforth denoted by S&PRET_VOL). also used by Chakrabarti. includes two macroeconomic 8. the index of industrial production and the call money rate. see Box 2.16 Daily return in the US equity market based on the day to day variations in the S&P500 (henceforth denoted by S&P_RET). The second set. and finally Daily return from day to day variations in the Rupee—USD exchange rate (henceforth denoted by EXCH). 7. the index of industrial production (henceforth denoted by IIP) taken as a proxy for short run real income changes and the call money rate (henceforth denoted by CMR) taken as a proxy for shortterm interest rate.. For a fuller description of these variables and the sources of data on them. on the other hand.

A possible econometric rationale for taking the ratio variables could be to eliminate heteroscedasticity.com Daily market capitalisation on the BSE.in Daily Net FII inflows into the Indian equity markets. 2002 International S&P 500 MSCI WI The daily series for the S&P500 stock price index. k=7. www. k=7. Source: website of Morgan Stanley Capital International Inc. heteroscedasticity is not eliminated for FIIN and FIIS series.in DailyFII Sales or outflows from the Indian equity markets. k-day moving average value of FIIP calculated using FIIP(t-k) to FIIP(t-1). 2001 and CMIE Monthly Review of the Indian Economy Estimated series Ratio_FIIN Ratio_FIIP Ratio_FIIS FIIN_MAk(t-1) FIIP_MAk(t-1) FIIS_MAk(t-1) BSE_Ret Ratio of FIIN to previous day’s Mcap2 Ratio of FIIP to previous day’s Mcap Ratio of FIIS to previous day’s Mcap k-day moving average value of FIIN calculated using FIIN(t-k) to FIIN(t-1).sebi.org. returns on BSE Sensex or the standard deviation of BSE_Ret(t-k) to BSE_Ret(t-2).15. k=7. however. www. www. Source RBI website. 2 1 31 . it is found that even if we take the ratio to MCap.bseindia.30.gov. BSERET_MAk(t-2) k-day moving average value of return on BSE calculated using BSE_Rte(t-k) to BSE_RET(t-2). Daily returns on the BSE Sensex. daily closing values.sebi. BSE_RetVol k(t-2) k-day moving average volatility of. calculated as the excess of the logarithm of the index value on a date over the logarithm of the index value on the previous day.sebi. This index includes India.30. k=7. Source: website of Standard and Poors The daily series for the MSCI World Index. the difference between FIIP and FIIS.30. www.15.com Others Exch CMR IIP Daily exchange rate of the Indian rupee vis a vis the US dollar Daily Call money rate. a weighted stock price index for all countries1.gov. Source: BSE website and our estimation as per Appendix1. Source :website of SEBI. k-day moving average value of FIIS calculated using FIIS(t-k) to FIIS(t-1). www.ICRA BULLETIN BOX 2 The data series and Sources: Stock Market Series Domestic FIIP FIIS FIIN BSE Sensex Mcap: Money & DailyFII Purchses or inflows into the Indian equity markets.msci.15.rbi.gov. k=7. Source: website of SEBI. www.15.30. Source: RBI Handbook of Statistics on Indian Economy.in The 30 share BSE stock price index. Source: website of the Mumbai Stock Exchange. Finance APRIL–SEPT. Source: website of SEBI.30.15.in Index of Industrial production reported weekly.

The results are presented below. induces the daily market return to be what it is. some believe that the day to day FII trading in Indian market. FIIS and FIIN). When it comes to the case of foreign investment in a thin equity market like that of India. The results are given in Table 1.30 BETA_MSCIkk(t-2) betas of BSE wrt MSCI based on previous kk day’s data starting from (t-2).30. domestic or foreign. S&PRet_MAk(t-2) k-day moving average value of returns on S&P500 calculated using S&P_Ret(t-k) to S&P_Ret(t-2).30.15. k=7. we have used the technique of pair-wise Granger Causality test.15. It may be mentioned here that Chakrabarti (2001) also examined the nature of causality between FIIN and BSE_RET mostly on the basis of 32 . returns on MSCIWI or the standard deviation of MSCI_Ret(t-k) to MSCI_Ret(t-2). of causation between FII flows and some of their covariates.30 Exch_Ret Daily returns on the Rupee’s exchange rate.30 MSCIRetVol k(t-2) k-day moving average volatility of. Direction of Causation between FII flows and Return in the Indian Stock Market For any type of investor. calculated as the excess of the logarithm of Exch on a date over the logarithm of Exch on the previous day.15. there is a prevalent feeling that FII activities exert a strong demonstration effect and thus drive the domestic stock market. k=7. there is a prevalent feeling that FII activities exert a strong demonstration effect and thus drive the domestic stock market. A. Notes : (a) The problem of non-synchronised trading in the different markets have been overcome by removing such dates. As a starting point we examine the nature of pair-wise causality between daily measures of FII investment and corresponding BSE_RET separately for the three FII variables (viz.30. kk=15.ICRA BULLETIN Money S&P_Ret & Finance APRIL–SEPT. MSCIRet_MAk(t-2) k-day moving average value of returns on MSCIWI calculated using MSCI_Ret(t-k) to MSCI_Ret(t-2). returns on S&P500 or the standard deviation of S&P_Ret(t-k) to S&P_Ret(t-2). S&P_RetVol k(t-2) k-day moving average volatility of..2002 Daily returns on the S&P500. In other words. FIIP. However. BETA_S&Pkk(t-2) betas of BSE wrt S&P500 based on previous kk day’s data starting from (t-2). k=7.15. (b) The routine tests of normality and unit root for stationarity for all series have been conducted and the regressions framed accordingly.. market return is generally the prime driver of equity investments. when it comes to the case of foreign investment in a thin equity market like that of India. rather than being influenced by the market return. calculated as the excess of the logarithm of the index value on a date over the logarithm of the index value on the previous day. calculated as the excess of the logarithm of the index value on a date over the logarithm of the index value on the previous day. k=7. MSCI_Ret Returns on the MSCIWI. kk=15.

19* 4.99 4.88* 2.24 3.18* 2.02 1.96 PANEL 6 BSE Return does not Granger Cause RATIOFIIS 18.95* 1.53* 11.20 8.91* RATIOFIIN does not Granger Cause BSE_RET 2.76* 2. examination of causality based on a monthly data set may fail to capture the exact nature of causality.04+ RATIOFIIP does not Granger Cause BSE Return 0.41 2.99* 8. 11.97* 3.33* 15.18* 4.87 13.74 5. 2002 25.39* 5.80 4.83* 2.98 6. 4.67 causality.41 14.50* 2.75* 3.60 4.69 examination of causality based on a monthly data set may fail to capture the exact nature of PANEL 4 BSE_RET does not Granger Cause RATIOFIIN 28.37* 4.55* 3. given the facts that Granger causality test is designed essentially to detect statistically significant short run lead-lag relationship present in a data-set on a pair of variables and that equity market responses are typically extremely quick and of very short run nature.70* 3.07 3.67* 4.31 *’ Denotes rejection at 1% level of significance +’ Denotes rejection at 5% level of significance 17 He has done the causality test taking the daily data for a limited period of one year (1999.72* 10.35* 2.80+ 0.25* 4.41 1.62 4.monthly data on these variables.42 That equity market responses are typically extremely quick and of very short run nature.71 2.98* 1.32+ 1.16* RATIOFIIS does not Granger Cause BSE Return 6.11* 12.86* 2.27* 2.42* 0.21* 2.34* 3. most of his analysis of causality for the pre-crisis period was based on monthly data (1993 to 1999). in the post-Asian crisis period).90 17.49* 2.89 PANEL 5 BSE Return does not Granger Cause RATIOFIIP 3.22* 19.69* 7.33 4.84* 2.69* 2.96 2.45 1.03 3.94 5.37* 6.84 1.09* 17.44 4.17* 10. The results in Table 1 clearly suggest that causation runs from TABLE 1 Pairwise Granger Causality Tests between BSE Return and FII Value of F-statistics at different lags Lags —> PANEL 1 BSE Return does not Granger Cause FIIN FIIN does not Granger Cause BSE Return PANEL 2 BSE Return does not Granger Cause FIIP FIIP does not Granger Cause BSE Return PANEL 3 BSE Return does not Granger Cause FIIS FIIS does not Granger Cause BSE Return 2 3 4 5 6 7 ICRA BULLETIN Money & Finance APRIL–SEPT.17 However. 33 .94* 5.02* 3.

The last mentioned study also found sensitivity of local stock prices to foreign inflows to be positive and large and also that inflows had positive forecasting power for future emerging-market returns. On the other hand. 1997 and Froot. As day to day variation in the FII flow variables as well as the market return is likely to contain relatively large random components. Since the RATIOFIIP and RATIOFIIS which are the components of RATIO_FIIN are not affected by contemporaneous value of BSE_RET. 1996.. the estimated positive coefficient of BSE_RET turned out to be significant at 5 per cent level—a result. BSE_RET again was found to be non-significant determinant for RATIOFIIP and RATIOFIIS. 2001). Regression of the FIIN. barring a few cases where no definite conclusion can be drawn. which was also obtained by Chakrabarti. We therefore tried next to explore whether the FII flow variables would show up any stronger dependence on market return if daily variations were filtered through moving average smoothing. FIIP. O’ Connell. one would not expect high correlation between FII flow and market return (which indeed was the case in our exercise). B. Brennan and Cao.2002 BSE_RET to FIIN and not the other way. one would not expect high correlation between FII flow and market return. causality. For these variables. we next examine whether or not contemporaneous BSE_RET significantly affect daily FII inflows/outflows. as to be expected). FIIP.1). FII purchase is not responsive to variations in market return (Tab 2.2).ICRA BULLETIN Money & Finance APRIL–SEPT. However. This is true for FIIS and FIIP and their ratios also. a drop/rise in average return over the previous 7 days would induce a FI investor to 18 Studies examining the pattern of aggregate international portfolio flows found evidences of contemporaneous positive correlation between inflows and returns and lagged returns (Bohn and Tesar. Bhatia (2000) has shown that daily net FII inflows are a significant determinant of the daily returns on the BSE. it becomes somewhat difficult to reconcile the observed dependence of RATIO_FIIN on the current level BSE_RET. 1999). Other studies on the Indian equity market have also found evidence of the relationship between net FII and returns on equity (Batra. is unidirectional running from BSE_RET to FII flows. 18 This lends further credence to the supposition that FII flows to India are mostly in response to contemporaneous returns in the Indian stock markets (in the post Asian crisis period) rather than FII inflows and outflows being the cause of returns in the national markets. when RATIOFIIN was taken as the dependent variable. Effect of BSE Returns Having identified the nature of causality. In other words. 34 . FIIS and RATIO_FIIN on the corresponding 7-day moving average values of BSE_RET suggest that while FII sale and FII net inflow are significantly affected by market return (the former being affected positively and the latter negatively. and Seasholes. FIIS on BSE_RET yielded results quite contrary to expectations as the coefficient of BSE_RET turned out to be statistically non-significant in all of these regressions (Table 2. As day to day variation in the FII flow variables as well as the market return is likely to contain relatively large random components. However. if found statistically significant. The results obtained by regressing 7-day moving average values of FIIN.

06 (0. Figures in parenthesis are p-values of the regression coefficients 3.0) 0.057) (0.0055 0. TABLE 2.39 0. BSE_RETVOL. 0.080 81. but it might fail to induce a change in the level of her purchase. BETA_MSCI. of regression Durbin-Watson stat Note: FIIN_MA 34.25* 0.0) 0.04) 0.0003 141.0009 -0.0053 0.01 -447.00 0.001* (0.raise/reduce sale promptly. C.60 (0.09 0. As already mentioned.76* (0.01 (0.61 RatioFIIN 0.0036 1.171 FIIP_MA 220.E.0022 0.004 1.4054* (0.003 0.0) (0.0) 0.0037 119.2 Regression of FII_MA on BSE Return_MA Regressands ——> Regressors Constant Moving Average of BSE Return R-squared Adjusted R-squared S.066 1.08 0.0043 0. of regression Durbin-Watson stat Note: FIIN 34.0049 0. we considered a set of other possible determinants.99) RatioFIIP FIIS RatioFIIP ICRA BULLETIN Money & Finance APRIL–SEPT.001* (0.3* (0.11 0.09* (0. Other Factors Influencing FII Flows To identify other significant non-domestic return determinants of different FII flows.42) (0.0) 447.0) -3246.0000 0.15 0.95 1.03 -0.0019 0.0012 -0.0004) 0.0041 0.05) 0.55) 0.83* (0.11 1.053 FIIS_MA 185.01* (0. this set comprised MSCI_RET.089* (0.E. S&P_RET.087 62.0) (0.81 1.17* (0.18 0.81 0.14 0. Regressions are formulated keeping in voew the stationarity of variables 35 .149* (0.39 1. Figures in parenthesis are p-values of the regression coefficients 3.02 (0.007* 185. Regressions are formulated keeping in view the stationarity of variables TABLE 2. domestic as well as international.0) 0.0003) 0.006* (0.25 0.163 RatioFIIN_MA 0.001 101. 2002 A drop/rise in average return over the previous 7 days would induce a FI investor to raise/ reduce sale promptly.0010 113.0) 2603.21) 0.0001) 0.1 Regression of FII on BSE Return Regressands ——> Regressors Constant BSE Return R-squared Adjusted R-squared S.0) -641.58 FIIP 219. ‘*’ denotes significant at 5% 2.112 0. ‘*’ denotes significant at 5% 2. but it might fail to induce a change in the level of her purchase—a result which is suggestive of some kind of asymmetry of behaviour so far as FII trading in Indian market is concerned.

13 (0.00 (0.96 (0.72) 2. 36 .0) 408.71 (0.03 (0.88 (0.09 0.06 FIIP 137.09 (0.0003 (0.0) -422.72 (0.02 (0.21 (0.91) 0.42 (0. FIIP.45 (0.53 (0.01 (0.84 (0. FIIS_MA20—using TABLE 3A Stage 1 Regression results of FII on all relevant variables REGRESSION A: Stage 1 Regression Coefficients Constant Lagged BSE Return BSE Return 15-day MA(t-2) BSE Return 15-day Volatility(t-2) Lagged MSCI Return MSCI Return 15-day MA(t-2) MSCI Return 15-day Volatility(t-2) Lagged S&P Return S&P Return 15-day MA(t-2) S&P Return 15-day Volatility(t-2) Beta_MSCI 15-day (t-2) Beta (S&P) 15-day (t-2) FIIN -29.04 17196.05 0.0004) 2134.30 (0.02) 0.65 (0.48 FIIP_MA 15(t-1) 136.78) 0.42 (0.77) 0.69 (0.989) 771.32 0.17 70.18) 1455.66) 0.82 (0..36) -1470.23) 0.02 (0.17 (0.79) 4783.01 (0. RATIOFIIP.36 0. FIIN.68) 4.0005) 677.15 (0.002 (0.12 (0.03 (0.06 0.01 (0.59) 0.66) -592.67) -0.19) 7840.0) 0.87) 15.03 (0.0003) -922.33) -981. of regression Durbin-Watson stat Note: Figures in parenthesis are the p-values of coefficients 19 So far as the volatility variables are concerned.51 (0.89 (0.92 (0.83 (0.50 (0.00 1. EXCH (all these variables were considered by Chakrabarti (2001) for explaining FIIN) and.0095) -2993.94) 0. RATIOFIIS and also their moving average versions FIIN_MA.018) -0.47) 0.04 110.14) -0.70) 0.71) 2577.85) Ratio FIIN -0.0096) 9631.20) -5.19 Multiple regression analysis was done separately for each of the FII variables—viz.70 R-squared Adjusted R-squared S.19 Ratio FIIP 0.99 1.003 1.56 (0.39) 0.69) FIIN_MA 15(t-1) -9.07) -150.05 0.76) 0. respectively.0) -0.51) 16217.11 (0.03 (0.41 (0.42 (0.46 (0.38) 656.46) 7935.00 (0.88 (0.19) -7372.05) 2649.57) -0.05 (0.35) 1623.03) -1237.18) 0.554 (0.01 (0.96) -0.74 (0.41) 0.04 (0.07 0.016) 433.10 0.60 (0.47 (0.03 0.99) 72.14) 0.18) -0.80 (0.18 (0.06 (0.48 (0.16 (0.68) -12.35) -0.46 (0. S&P_RETVOL.73) -16601.86 (0.15) -160.017) -7446.01 (0.ICRA BULLETIN Money & Finance APRIL–SEPT.80 (0.58) -15.05 0.64 (0.44) 33.02 (0. in addition. This was done essentially to see whether or not the regression results would be sensitive to the choice of the period of moving average.87) 3426.001 (0.39 (0.19 (0.17 84.64 (0.01 (0.63 (0.12) 0.52) 587.41 (0. for each of them we considered two different versions—measured as the standard deviation of the values observed over the previous 7 and 15 days.52 (0.24 FIIS_MA 15(t-1) 146.34 (0. their ratio versions RATIOFIIN.0) -877.15) 0.23 (0.76) 357.0099) -662.003 1.58 (0.04) -1630.0) 776.14 49.27 (0.30 (0. 20 Three different sets of moving averaged variables were compiled using moving average period of 7.75) -15.53) -2105.18 0.0001 (0.96 (0.49) 393.15 0.01 (0.73) 403.39 (0.03 (0.14) 1285.05 (0.001 (0.87) 14.94) 0.92) -1790.60 0.33) -16763.28) -10479.87 (0.08 115.17 (0.57 1.05 FIIS 166.42 (0.19) 0.98 (0.58) 48.86) 45.008) 7.00 (0.03) -0.48) -0.57) 970.13) 0.0) -0.05 (0.E. 15 and 30 days.86) 2571.004) -260.84 (0.63 (0.48 (0.22 (0.73 0.09 (0.51) 10508.697) 11.87) -17.06 (0.11 (0.46 (0.0) -437.009) (0.35) -2060.03 (0.78) 0. FIIS.08 0.25 0.299) -8372. FIIP_MA. IIP and CMR.44) 3164.69) 0.10 (0.76 (0. MSCI_RETVOL.99 (0.12) 0.05 (0.0) 0.58 (0.297) 621.50 (0.86 (0. respectively.2002 BETA_S&P.04 138.21 (0.01 (0.18 0.07) -0.02) 0.49) 0.61) 0.97 (0.59 0.28 (0..99 Ratio FIIS 0.

of regression Durbin-Watson stat 0. 2002 FIIS 57.13) 14899.0) Ratio FIIN -0.95 (0.04 (0.01) 7411.50 (0.84 (0.18) 21.27 (0.23 Lag2 FIIP_ MA15 -0.30 2.15 (0.04 (0.29 Lag1 FIIP_ MA15 1.24 0.21 Here let us first summarise the qualitative results obtained on the nature of relationship of different types of FII flows with the variables that we identified to be possible covariates of these flows.67) Lag1 FIIS 0. we included only the significant variables at stage 1 and the lagged dependent variable as the regressors.0) FIIP_MA 15(t-1) 2.01 (0.37 (0.32 Lag2 Ratio FIIS 0.21 (0.65) ICRA BULLETIN Money & Finance APRIL–SEPT.) TABLE 3B Stage 2 Regression Results of FII on all relevant variables REGRESSION A: Stage 2 Regression Co-efficients Constant Lagged BSE Return BSE Return 15-day MA(t-2) BSE Return 15-day Volatility(t-2) Lagged MSCI Return MSCI Return 15-day MA(t-2) MSCI Return 15-day Volatility(t-2) S&P Return 15-day MA(t-2) S&P Return 15-day Volatility(t-2) Other Regressors -14793.02) 0.68 (0.96 0.27) 1252.26 2.002) Lag1 Ratio FIIN 0.11 0.13) 74.23) -14. 37 .26 (0.0) -694.10 0. 3.07 (0.10 0.17 0.78 (0. we have run the regressions again.79) FIIP 69. (We present here only some representative results in Tables 3A and 3B.77 2.25) 1132.37 89.12 0.11 0.004 2.003) 324.06 0.0) -0.59 (0. P-values for all the lagged dependent variables are less than or equal to zero.36 Lag2 FIIS 0.302 Lag1 Ratio FIIP 0.83 2.21 Lag1 FIIP 0. we report the DW here.12 0.07) -9.05 Note: 1.86 (0.01) FIIN -17.296 Lag2 FIIP 0.03 (0. In all cases the regressions have been done in two stages.0) Ratio FIIP 0.50 (0.11 0.04 0.003 (0.92 (0.003 2. Since the package we used doesn’t provide Durbin h-stats. we have checked for stationarity of all the variables concerned.27 120.56 2.25 0.80 2.37 0.04) -31.43 (0.12 (0.99 0.11 0.04) -0.48) -0.01) Lag1 FIIN 0.37) 187.27 Lag2 FIIS_ MA15 -0.0007) Ratio FIIS_MA FIIS 15(t-1) 0.10 0. 21 First.36 (0.93 (0.005 (0.E.0) 1.39 (0.13 0.08 0.28 (0.18 Lag2 FIIN_ MA15 -0.99 0.00 2.11 114.19) 0.25 (0.43 (0. Figures in brackets are the p-values of coefficients 2.02) -5046.30 (0.99 7.22 Lag1 FIIS_ MA15 1. Then.99 10. This analysis was done in several stages.001 (0. we have specified the regressions keeping in view to the order of integration of the variables concerned.19 Lag1 FIIN_ MA15 1. detecting residual auto-correlation at the first stage.18 (Lagged Variables) R-squared Adjusted R-squared S.0) 159.96 10.26 0.BSE_RET along with the set of non-domestic return determinants listed above.31 Lag1 Ratio FIIS 0.27 0.10 Lag3 FIIS_ MA15 -0. In stage 2.03) -0.67) FIIN_MA 15(t-1) -0.40 (0.

This is in conformity with the result that Chakrabarti (2001) obtained for the post-Asian crisis sub-period using monthly data. The results 38 . FII sale/purchase should be positively/negatively related to average return and negatively/positively related to volatility. Similarly. daily FII sale may be thought to depend.e.. its negative association with the other two FII flows appears somewhat unrealistic. a definite positive association with the previous day’s return was observed in all the regressions estimated. but on the history of return over the previous few days. We checked the correlation between these variables which. FII purchase and FII sale with return and volatility. FII Flows and Return and Volatility in Competing markets As already mentioned. we did get result supporting the hypothesis of return maximisation only in some cases... MSCI_RETVOL and S&P_RETVOL) in the set of possible regressors. The hypothesis of portfolio return maximisation suggests reallocation of investment in favour of markets in which risk is minimised (as measured by Sharpe ratio—i. Very similar results were obtained when the FII variables were used in ratio form. other than the Indian one (see Box 3 in this context). we included the return and volatility variables relating to the S&P500 index and MSCI index (viz. turned out to be quite high (Table 4) implying thereby the possibility of multicollinearity. as indicators of return and risk involved in investing in the US and the World equity markets. But use of moving average variables—i. C2. a positive/negative partial association with competing market returns/volatility of FII net inflow and FII purchase and a negative/positive association with FII sale. failed to observe any definite association with average return or return volatility of any of the daily FII flow variable. not just on previous day’s return but also on the average and the standard deviation of returns observed during the previous 7 or 15 days (the standard deviation being taken as a measure of volatility of returns). While a positive association of return volatility with FII sale seems intuitively justifiable. We also found in most of the cases that S&P variables and MSCI variables are simultaneously significant. for daily FII sale the association with the previous day’s return was always found to be negative and significant. not just on previous day’s return information. FIIN_MA. in our regression strategy. but on the history of return over the previous few days. for example. However. but not with average return.. C1. not unequivocally. MSCI_RET.2002 One might surmise that daily FII activities might be based. FIIP_MA and FIIS_MA—showed definite positive association of FII net inflow. In our exercise. excess return per unit of volatility) and this in turn means. FII Flows and BSE Return As regards the relation between daily FII net inflow and BSE return. S&P_RET. Ceteris paribus. One might surmise that daily FII activities might be based. We therefore ran separate regressions for S&P variables and MSCI variables. not just on previous day’s return information. no definite association between daily FII purchase and previous day’s market return was noticed.e. Thus. ceteris paribus. given the extent of integration of the world and US markets. We. however.ICRA BULLETIN Money & Finance APRIL–SEPT.

03 1.02 0.89 0.15 -0.01 1.00 -0.50 -0. 2002 Value of F-statistics at different lags SP500_RET does not Granger Cause BSE_RET 7.04* + 4.09 1.01 1.36 0.05 1.07 0.05 -0.07 1.23 0.24 0.86 1.01 -0.00 0.32* + 3.00 0. To see whether or not S&P return exerts a significant causal effect on the BSE return we carry out a Granger causality test for the same the results are as below.30 0.02 -0.01 0.00 -0.01 -0.42 -0.02 1.14 0.00 0.31 0.10 -0.30* + *’ Denotes rejection at 1% level of significance +’ Denotes rejection at 5% level of significance There is clear evidence of S&P return causing BSE return unilaterally.32 1. (Table 5) showed that while only the MSCI return volatility but not the average return itself was significant.06 -0.08 0.95 0.00 0.76* + 3.88 -0.04 -0.03 -0. Granger Causality Tests between S&P and BSE Returns Money & Finance APRIL–SEPT.16 -0.00 -0.02 -0.00 39 .11 0.03 -0.06 -0.12 1.13 -0. See. in more than one cases both S&P return and its volatility were significant.10 0.05 0.06 -0.16 0.02 -0. TABLE 4 Correlation Set of Regressors in Table 3A and 3B BSE_R1 BSE_RE ETLAG TVOL15 (t-2) BSER ET_MA 15(t-2) BETA _MSCI 15(t-2) BETA _SP 15 (t-2) MSCI MSCI_ _RET RETVOL LAG1 15(t-2) MSCI SP_RE SP_RE SPRET RET_ TLAG1 TVOL _MA MA 15(t-2) 15(t-2) 15(t-2) BSE_RETLAG1 BSE_RETVOL15(t-2) BSERET_MA15(t-2) BETA_MSCI15(t-2) BETA_SP15(t-2) MSCI_RETLAG1 MSCI_RETVOL15(t-2) MSCIRET_MA15(t-2) SP_RETLAG1 SP_RETVOL15(t-2) SPRET_MA15(t-2) 1.01 -0.11 -0.00 0.00 -0.79* + 6.5* + 5.05 -0.08 0.02 0. This was to be expected and perhaps suggestive of the fact that a fluctuation in the US (matured) equity market would get transmitted to the Indian market.00 0.01 -0. however. Table 3A which suggests that whereas FII net inflow is affected by return and volatility of both MSCI and S&P.50 -0. the corresponding purchase and sale flows are mostly not affected by these.ICRA BULLETIN BOX 3 We have also tried to see to what extent the performance of matured equity markets affect that of the Indian equity market and therefore we examined the possible interdependence of BSE and S&P returns.05 0.14 0.07 0.

001 (0.0) 2283.56 (0. Figures in brackets are the p-values of coefficients 2.18 0. Second stage regressions for FIIN in B1 and RatioFIIP in B1 and B2 have not been done since neither of the MSCI/S&P variables were significant at the first stage.0) 0.001) Note: 1.002) 0.14) 0. in case the hypothesis that FII flow to India essentially serve as a means of diversification is true.00 0.10 0.e.22 TABLE 5 Regression of FII on MSCI and S&P separetely STAGE 2 Results REGRESSION B1: on MSCI variables Coefficients Constant Lagged BSE Return MSCI Return Fortnightly Volatility(t-2) Lag1RatioFIIN R-squared Adjusted R-squared S.102 0.097 114.105 0. FII Flows and Return on Exchange Rate We selected the return from day to day variations in RupeeUSD exchange rate as a possible covariate on the presumption that this being an opportunity cost. BETA_S&P and BETA_MSCI) with FII net inflow and sale (FII purchase).07 (0. its effect mostly turned out to be statistically non-significant. However. However. we considered IIP Initially both the beta variables were included together in the regression equations on the presumption that they would be independent.ICRA BULLETIN Money & Finance APRIL–SEPT. FII Flows and Betas of the Indian Equity Market Following the logic of hedging and diversification of portfolio.21 0.21) 1265. we report the DW here.11) 3944. Even in that case the effects of these variables were found statistically non-significant. implying thereby a high degree of integration of the markets.. FII Flows and Macroeconomic Variables In order to verify whether or not foreign investors track the state of Indian economy for making investment here. as the concerned markets were very different. of regression Durbin-Watson stat RatioFIIN -0. of regression Durbin-Watson stat FIIN -19. 3. the sample correlation of these variables was found to be very high.101 0. one would expect a significant negative (positive) partial association of the betas for Indian market with respect to S&P500 and MSCI indices (i.04 (0. 22 40 .13 (0. Our results failed to find support for this hypothesis as in most cases these variables turned out to be statistically non-significant.13 STAGE 2 Results REGRESSION B2: on S&P variables Coefficients Constant Lagged BSE Return S&P Return Fortnightly MA(t-2) S&P Return Fortnightly Volatility(t-2) Lag1FIIN Lag1RatioFIIN R-squared Adjusted R-squared S.003 2.109 0.003 2.104 0.80 (0.04 (0.0001 (0. We next tried to see the effects of these variables on FII flows separately.11 (0. P-values for all the lagged dependent variables are less than or equal to zero.2002 C3. 4.31 (0. C4..E. Since the package we used doesn’t provide Durbin h-stats.77) 0.58 (0.07 RatioFIIN -0.17) 0.0) 0. C5.877 2.02) 0. foreign investors might take into account this for investment flows to the Indian equity market.E.

19 R-squared Adjusted R-squared S.58 (0.69 (0.00 (0.16) 0.16 FIIN_MA 15(t-2) -237.60 (0.53) LAG1FII S_15MA 1.09 ICRA BULLETIN Money & Finance APRIL–SEPT.07) 1.99 2.and CMR as indicators of the real economic activity in India and tried these as possible determinants of the FII flows.22 68.48 (0.16 0.99 10.E. was done on a very limited scale and only the possible effects of these variables on FII net flow was examined (Table 6A and 6B).05 FIIP_MA 15(t-2) -558.0) 1.21 90.54) 218.0) 10.30 (0.0) 0.60 (0.68 (0. however. of regression Durbin-Watson stat Note: 0.0) 2.42) 0.62 (0.42 0.03 (0. of regression Durbin-Watson stat Stage 2 Coefficients Constant Lagged BSE Return BSE Return Weekly MA(t-2) IIP CMR Other Regressors (Lagged Variables) FIIN_MA 15(t-2) -3.05 (0. Figures in brackets are the p-values of coefficients 41 .01) -32.37) 0.96 10.00) -3251. 2002 Some evidence of positive association of both IIP and CMR with FIIN was obtained.0) 0.99 0.87 (0.0) 12.54) -0.E.81 (0.52 (0. This exercise.21 0.22 0.36 LAG2FII S_15MA -0.25 (0.0) -503.99 7.26) -24.6) -9.96) LAG1FII N_15MA 1.20 LAG2FII P_15MA -0.92 (0.04 (0.68) 13.53 (0.87 (0.04) 4.51) 0.08 FIIS_MA 15(t-2) -6.10 0.09 50.20 (0.16) 31.30 (0.99 0.47 2.03 FIIP_MA 15(t-2) -4.8) LAG1FII P_15MA 1.22 0.01 (0. Some TABLE 6A Regression of FII on real sector variables REGRESSION A Stage 1 Coefficients Constant Lagged BSE Return BSE Return Weekly MA(t-2) IIP CMR R-squared Adjusted R-squared S.66) 243.37 0.94 (0.14 (0.0) 0.53 (0.20 0. 1.96 0.21 82.05 (0.0) 0.0) -471.24 (0.16 LAG2FII N_15MA -0.47 (0.02) -2078.04 (0.78) 1172.15 2.08 FIIS_MA 15(t-2) -321.

34) 0.04 FIIS_MA 15(t-2) -447.09 50.0) -0.0) 5.0) 0.7 (0.22) LAG1FII S_15MA 1.0 (0.26 66.37) 0.16) 27.02 (0.05 & Finance APRIL–SEPT.87) 1199.007) 0. 3. of regression Durbin-Watson stat Note: 0.03 (0.22 (0.15 2.57 (0..2 (0.1 (0.07) 1.E.10 0.11 0.38) -24.E. of regression Durbin-Watson stat Stage 2 Coefficients Constant Lagged BSE Return BSE Return Weekly MA(t-2) IIP Weekly MA(t-2) Lagged CMR CMR Weekly MA(t-2) Other Regressors (Lagged Variables) FIIN_MA 15(t-2) -4.95) 3.16 LAG2FII N_15MA -0. P-values for all the lagged dependent variables are less than or equal to zero.08 (0.64) 238.3 (0. R-squared Adjusted R-squared S.25 80.43) 0.41) LAG1FII N_15MA 1.07) 4.21 0.02 42 1.99 0.75) -9.1 (0.15) 14.30 (0.0) -461.08 R-squared Adjusted R-squared S.1 (0.2 (0.05 FIIP_MA 15(t-2) -711.99 2.37 0.76) FIIS_MA 15(t-2) -6.20 LAG2FII P_15MA -0.46 2.26 0.19 LAG1FII P_15MA 1.96 10.5 (0.01) -20.0 (0.45 0.04 (0.5 (0.32 (0.2002 Such regression results would have economic explanation in terms some kind of dynamic adjustment mechanism being involved in the determination of current daily value a given FII flow.6 (0.ICRA BULLETIN Money TABLE 6B Regression of FII on real sector variables REGRESSION B Stage 1 Coefficients Constant Lagged BSE Return BSE Return Weekly MA(t-2) IIP Weekly MA(t-2) Lagged CMR CMR Weekly MA(t-2) FIIN_MA 15(t-2) -263.57) FIIP_MA 15(t-2) -3.95) 0.13 (0.99 0.1 (0.96 0.9 (0.01) 0. Since the package we used doesn’t provide Durbin h-stats.0) 4.76 (0.71 (0.48) 0.0) 0.005) -3163.9 (0.99 7.06) 11. .99 10.15 219.3 (0.82 (0.24 (0.0) 3.02 (0.36 LAG2FII S_15MA -0.58 0.1 (0.0) -441. Figures in brackets are the p-values of coefficients 2.03) -1964.26 0.8 (0. we report the DW here.

removed the auto-correlation altogether. As a result.e. Such regression results would have economic explanation in terms some kind of dynamic adjustment mechanism being involved in the determination of current daily value a given FII flow.23 C6. While the dependence of net FII flows on daily return in the domestic equity market—at a day’s lag. However. But inclusion of the lagged value of FII flow variable in most of the cases caused the erstwhile significant determinant to turn non-significant. Auto-correlation of FII Flows Preliminary statistical analysis of the original series of daily FII flows indicated that these were stationary in nature (i. 2002 While the dependence of net FII flows on daily return in the domestic equity market is suggestive of foreign investors’ return-chasing behaviour. In other words. contained no significant time trend but were auto-correlated). This auto-correlation got reflected in all the regression equations estimated to find out statistically significant covariates of the various measures of FII flows. specially when the moving average of the concerned variables are used in regression. We also found that the sets of factors affecting FII sale and purchase were not the same.24 the latter is not significantly influenced by variation in these flows. however. one or the other variant of BSE_RET) and lagged value of the concerned FII flow.. the regression results were far from satisfactory as there was strong indications of highly autocorrelated regression disturbance term of the specified regression equations. Concluding Observations Our results suggest that though FII flows to and from India are significantly affected by return in the domestic equity market. to be more specific—is suggestive of foreign investors’ return-chasing behaviour. their decisions seem to get affected also by the recent history of market return and its volatility in international and domestic stock markets as well..evidence of positive association of both IIP and CMR with FIIN was obtained. It appeared that some factors would affect purchase or sale decision of foreign investors. ICRA BULLETIN Money & Finance APRIL–SEPT. the only statistically satisfactory regression results turned out to be the ones having market return (i.e. their decisions seem to get affected also by the recent history of market return and its volatility in international and domestic stock markets as well. 24 In the sense of Granger causality. Use of lagged value of the concerned FII flow variable as a regressor. 43 . these results may be taken to mean that for individual FII flow there is a desired level determined solely by BSE_RET or some variant of it and the actual value constantly tries to reach this desired level. It is also found that apart from the return in the domestic market there are other covariates of such flows. This means none of the covariates—be it related to equity market performances or to the performance of the Indian economy—could explain singly or jointly the observed auto-correlation of the FII flows. as we shall discuss next. IV. but not the corresponding 23 But one cannot possibly avoid this auto-correlation.

market liquidity. a drop of return in the India equity market may result in sudden massive withdrawals of FII which may result in quite disturbing consequences on the country’s economy. Findings of several studies on FII flows to emerging equity markets over the world have shown the importance of financial market infrastructure such as the market size. though the effect of exchange rate return on the net FII inflow was sometimes found to be significant. while FII purchase from and sale to the Indian market appeared to be sensitive to the volatility of domestic market return (with both purchase and sale responding positively to volatility change in the recent past). . Further cause for concern relates to the finding that unlike in the pre-Asian crisis period. the scope of using the Indian equity market for the purpose of portfolio diversification arose due to the non-synchronised movement of the Indian equity market vis-à-vis the other equity markets of the world. Recent evidences suggest a stronger co-movement of market returns and it is possibly for that reason foreign investors no longer are able to use the Indian equity market for portfolio diversification. We however failed to find evidence of any portfolio diversification benefit reaped by FIIs by investing in the Indian market (as suggested by lack of statistical significance of the effect of betas of the BSE Sensex with respect to the MSCI world and S&P 500 indices on various FII flows). Day to day variations in the exchange rate also turned out to be unimportant so far as FII transactions were concerned (in fact. This might be due to the simultaneous portfolio adjustment in several markets together done by foreign investors. Given the fact that FII flows can be extremely volatile. foreign investors no longer use equity investment in India as a means of diversification of their portfolio.ICRA BULLETIN Money & Finance APRIL–SEPT. one may notice quite a few agreements. as found by Chakrabarti. trading costs. lies elsewhere—viz. however. be outside the monetary authority’s control.. the corresponding net inflow appeared to be positively related to the volatility of return in the foreign market. Juxtaposing results of our study with those obtained by Chakrabarti for the comparable post-Asian crisis period. In fact. unless an appropriate stabilisation mechanism is built into the domestic economic system.. The point of concern. For example. For example. its effect on FII purchase or sale was never significant). This may be a matter of concern as this suggests that the rate of FII inflow into the country would be governed mostly by the performance of the domestic equity market and/ or foreign investors’ expectation about this performance and hence variation in the country’s foreign exchange reserve would. both the studies tend to show the predominance of the Indian equity market return as the prime mover of the FII net inflow into India. to some extent. a stronger integration of the Indian market with the equity market elsewhere exposes the country to the danger of contagion of global financial crises in future. 44 net FII flow.2002 The scope of using the Indian equity market for the purpose of portfolio diversification arose due to the nonsynchronised movement of the Indian equity market vis-à-vis the other equity markets of the world.

2002). These apart. 2000. liquidity. Only then would it be possible to reap fully the benefits of capital market integration. Rangarajan. 29 To take care of malpractice which discourage stock market participation by a majority of savers in our country (see NSE.25 In some studies variables relating to investment barriers. Regressions showed that the presence of a financial market infrastructure and property rights indicator were the only significant explanatory variables for FPI. Further regulatory authorities would need to look into alleged restrictive practices by FIIs like price rigging as suggested by Samal (1997).. and legal mechanisms relating to property rights etc. 25 Applying a panel data approach on bilateral gross cross-border equity flows between 14 countries. have also been found to be significant determinants of FII inflow. firm size and profitability26 etc. in this context). policy makers in India have justifiably treated capital account liberalisation as a process and not an event and reiterated that capital account liberalisation and reform of the financial system should move in tandem (Rangarajan and Prasad. in which both information and the transaction technology play a role. 2000. 1999. A survey by SEBI and NCAER showed that alleged malpractice like insider trading and low confidence in brokers/sub-brokers.27 Policy implications of the findings just mentioned above are that a move towards a more liberalised regime in the emerging market economies should be accompanied by further improvements in the regulatory system of the financial sector. Claessens et al (2002) analysing data from 77 countries. listing and other rules with those followed in international financial centres as well as strengthening of securities markets’ enforcement have also been stressed for improving competitiveness in attracting foreign portfolio investment inflow.information dissemination. 2001. accounting. 27 Classens et al (2002). 26 Liljeblom and Löflund (2000). Portes and Rey. 2002 The prime focus should be on regaining investors’ confidence in the equity market so as to strengthen the domestic investor base of the market. dividend yield. for attracting foreign portfolio investments into those countries. find that factors such as shareholder protection and the quality of local legal systems which make it and easier for investors to buy shares and firms to list in public markets play a prime role in determining the degree of integration with international capital markets. Garibaldi et al (2002) analysing capital flows to 25 European transition economies showed that FPI was volatile and concentrated in a handful of countries (notably Russia). using company specific data on degree of foreign ownership. a built-in cushion against possible destabilising effects of sudden reversal of foreign inflows might develop. 28 The present stance on capital controls of Indian policy makers is in place. during1989-96 find that asset flows depend on market size in both source and destination country as well as trading costs. company management/auditors were the main causes behind lack of domestic savers’ confidence in the equity markets. the need for harmonisation of corporate governance.. in the Finnish market.29 Once this is achieved. ICRA BULLETIN Money & Finance APRIL–SEPT. Jalan. 45 . which recently abolished capital controls.28 Our results additionally suggest that in the case of 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.

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all non-stock exchange sales/purchases require RBI permission. All FIIs and their sub-accounts taken together cannot acquire more than 24 per cent of the paid-up capital of an Indian Company. A Company to which no sectoral cap/statutory ceiling is applicable can raise the limit of permissible FII investment to 100% of the paid-up capital. • FIIs can trade in Exchange Traded Derivative Contracts. & Finance APRIL–SEPT. where the price has been approved by RBI.2002 The presence of Sectoral Cap/ Statutory Ceiling means that foreign investment from all sources cannot exceed a specified level. • FIIs are required to allocate their investment between equity and debt instruments in the ratio of 70:30. • No permission from RBI is needed so long as the FIIs purchase and sell on recognised stock exchange. • SEBI acts as the nodal point in the entire process of FII registration. Investment Trusts as Nominee Companies. RBI approval under FEMA enables an FII to buy/sell securities on Stock Exchanges and open foreign currency and Indian Rupee accounts with a designated bank branch. it is also possible for an FII to declare itself a 100 per cent debt FII in which case it can make its entire investment in debt instruments).ICRA BULLETIN Money Appendix 1: Some Information Relating to FII Operations in India • FIIs in India include Asset Management Companies. Charitable Trusts and Charitable Societies. They can also invest in listed and unlisted securities outside Stock Exchanges. • High Net Worth Individuals /foreign corporates can invest through SEBI Registered FIIs subject to a sub-limit of 5 per cent each.. A Company to which a 49 per cent Sectoral Cap is applicable can raise the limit of permissible FII investment to 49 per cent and if there is an existing foreign direct investment of 15 per cent. 1995 and Regulation 5(2) of FEMA. The presence of Sectoral Cap/Statutory Ceiling means that foreign investment from all sources cannot exceed a specified level. possible FII investment can only be up to 34 per cent. • No individual FII/sub-account can acquire more than 10 per cent of the paid-up capital of an Indian company. A Company to which no sectoral cap/statutory ceiling is applicable can raise the limit of permissible FII investment to 100 per cent of the paid-up capital. Indian Companies can raise the above-mentioned 24 per cent ceiling to the Sectoral Cap/Statutory Ceiling as applicable by passing a resolution by its Board of Directors followed by passing a Special Resolution to that effect by its General Body. Investment by FIIs in India is regulated under SEBI (FII) Regulations . Mutual Funds. Pension Funds. Incorporated/Institutional Portfolio Managers or their Power of Attorney holders. Source: RBI and SEBI websites. 48 . However. within the aggregated limit of 24 per cent. (However. Endowment Foundations. • FIIs can buy/sell securities on Stock Exchanges. • FIIs can avail of the Forward Cover Facility from the Authorised Dealer subject to certain conditions. University Funds.

3 0.3 Cumulative BSE Returns APRIL–SEPT. 500 400 300 FII net 200 100 0 -100 -200 -300 FIIN Sensex (Close) 31-May-02 1-Jan-99 29-Mar-00 16-Mar-01 28-Sep-99 21-Sep-00 29-Dec-99 18-Dec-00 27-Jun-00 13-Jun-01 4-Mar-02 7-Sep-01 5-Jul-99 6-Apr-99 6-Dec-01 6000 5500 5000 4500 4000 3500 3000 Sensex 14-May-99 1-Jan-99 21-Mar-00 5-Mar-99 16-Nov-99 11-Aug-99 16-Dec-99 14-Jun-99 18-Jan-00 9-Sep-99 20-Apr-00 13-Jul-99 9-Apr-99 12-Oct-99 17-Feb-00 3-Feb-99 49 .5 0.2 -0.6 0.1 -0. for 3 sub periods of the sample.Cr) 30000 25000 20000 15000 10000 5000 0 -5000 Cumulative Returns on BSE 0.4 0.8 0.1 0 -0.2 0. 2002 CHART A2.7 0.Trends in BSE and FII Operations in India During Our Sample Period CHART A1 Returns on BSE and Net FII ICRA BULLETIN Money & Finance Cumulative FIIN 35000 Cumulative FIIN (Rs.1 Net FII and the Sensex.

2 25-Sep-00 19-Oct-00 14-Nov-00 Sensex (Close) 7-Dec-00 2-Jan-01 25-Jan-01 20-Feb-01 19-Mar-01 12-Apr-01 5000 4800 4600 4400 4200 4000 3800 3600 3400 3200 3000 Sensex Sensex .50 APRIL–SEPT.2002 ICRA BULLETIN Money & Finance FII net 350 300 250 200 150 100 50 0 -50 -100 -150 2-May-01 28-May-01 21-Jun-01 17-Jul-01 10-Aug-01 7-Sep-01 4-Oct-01 31-Oct-01 27-Nov-01 26-Dec-01 21-Jan-02 14-Feb-02 12-Mar-02 10-Apr-02 7-May-02 31-May-02 2400 2600 2800 3000 3200 3400 3600 3800 4000 CHART A2.3 FII net 1200 1000 800 600 400 200 0 -200 -400 -600 2-May-00 25-May-00 19-Jun-00 FIIN Sensex (Close) FIIN 12-Jul-00 4-Aug-00 30-Aug-00 CHART A2..

∑p ∑p i i ijt qijt qijt i0 ∑p ∑p i i i0 q ijt qi 0 i0 ∑p i i0 qi 0 = Π P jt ∑p ∑p i i i0 q ijt qi 0 i0 ∑p i i0 qi 0 ( ) 1 where Π P is the Paasche share price index for the j-th day of jt month t with respect to some base date 0.APPENDIX 2: Approximation of Daily Market Capitalisation Notation: qijt : No. Substituting the Paasche daily stock price index Π jt by the corresponding available daily stock price index.e. ∑p i i0 qio is the aggregate market capitalisation on the base We assume Q jt = Qt i. of outstanding shares of the i-th company on the j-th day of month t pijt : Price of a share of the i-th company on the j-th day of month t mcijt = pijt q ijt : market capitalisation of the i-th company’s shares on the j-th day of month t ICRA BULLETIN Money & Finance APRIL–SEPT. Then (1) yields: MC jt = Π P Qt MC 0 . index of volume of outstanding shares is same for all days of a month. date. we may approximate QtMC0 by (MCt/ P t ). Π t : the available stock price index for month t. P jt give us the following approximate formula for daily market capitalisation P  MC t MC jt = Π jt   Π  t     51 . ∑p ∑p i i i0 qijt qi 0 = Q jt is an index of volume of outstanding shares i0 for the j-th day of month t with respect to the base date. 2002 MC jt = ∑ mcijt : aggregate market capitalisation on the j-th i day of month t We want to find approximate value of We have MC jt = ∑ p ijt qijt = i MC jt . say.. where MC 0 = ∑ p i 0 q i 0 jt i We have data on MCt: aggregate market capitalization for month t.

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