International Research Journal of Finance and Economics ISSN 1450-2887 Issue 41 (2010) EuroJournals Publishing, Inc. 2010 http://www.eurojournals.com/finance.

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Foreign Institutional Investments and Real Economic Growth in India: A Causality Test
P. K. Mishra Siksha O Anusandhan University, Bhubaneswar, Orissa, India, Pin-751030 E-mail: pkmishra1974@gmail.com K. B. Das Dept. of A&A Economics, Utkal University, Bhubaneswar, Orissa, India, Pin-751004 E-mail: drkumardas@gmail.com B. B. Pradhan Siksha O Anusandhan University, Bhubaneswar, Orissa, India, Pin-751030 E-mail: registrar@soauniversity.ac.in Abstract The role of investment in promoting economic growth has received considerable attention in India since independence. But the role of foreign institutional investment in the economic development of India is a recent topic of discussion among economists and development planners. Since the implementation of the new economic policies in early 1990s, India emerged as an important destination of global investors investment. It is from September 14, 1992, FIIs have been investing on financial instruments in India and providing incentives for financial innovations in the country. Recently, they have become the movers and shakers of the market. Given this growing importance of FIIs for the Indian economy, it is essential that the dynamics of such cross-border portfolio investment in the context of economic growth of the country be examined. It is with this aim an attempt has been made in this paper to test the causality between foreign institutional investments and the real economic growth in India over a period 1993:Q1 to 2009:Q2. The Granger Causality test in the VAR framework provides the evidence of bi-directional causality running between these two variables. Therefore, by the formulation and implementation of prudential norms concerning cross-border investments, the planners and policy makers in India can help the country moving in a high growth trajectory. Keywords: Foreign Portfolio Investment, FIIs, Economic growth of India, Granger Causality Test, Vector Auto Regressive Model. JEL Classification Codes: C10, C22, E44, F21, F36, F41, G10, G28

1. Introduction
The less well known Foreign Institutional Investors (FIIs) have been a key part of India's growth story this decade. The term FIIs is most commonly used to refer the companies that are established or incorporated outside India and are investing in the financial markets of India by registering themselves with the Securities & Exchange Board of India (SEBI). FIIs include overseas pension funds, mutual

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funds, investment trusts, asset management companies, nominee companies, banks, institutional portfolio managers, university funds, endowments, foundations, charitable trusts, charitable societies, a trustee or power of attorney holder incorporated or established outside India proposing to make proprietary investments on behalf of a broad-based fund (i.e., fund having more than 20 investors with no single investor holding more than 10% of the shares or units of the fund). Foreign Institutional Investment is basically short-term in nature and mostly made in the financial markets. Foreign Institutional Investors (FIIs) are allowed to invest in the primary and secondary capital markets in India through the Portfolio Investment Scheme (PIS) administered by the Reserve Bank of India (RBI). Under this scheme, FIIs can acquire shares/debentures of Indian companies through the stock exchanges in India. The ceiling for overall investment by FIIs is 24 per cent of the paid up capital of the Indian company (20 per cent in the case of public sector banks, including the State Bank of India). The ceiling of 24 per cent for FII investment can be raised subject to (i) approval by the companys board and the passing of a special shareholder resolution to that effect (ii) certain sector caps imposed by RBI and the Government of India. The RBI monitors the ceilings on FII investments in Indian companies on a daily basis and publishes a list of companies allowed to attract investments from FIIs with their respective ceilings. The FIIs have been playing a significant role in the process of capital formation and economic growth of the country. There has been a dramatic increase in net FII flows to India over the period 2003-2007, and especially over the bull rally that climaxed in January 2008 when the Sensex reached a lifetime high of 21,206.77 points. FIIs invested US$17 billion in Indian stocks in 2007 only. However, the onset of the recent global financial crisis saw FIIs pulling out a record $13 billion (Rs 67,470) in 2008, the largest outflows since India opened its doors to FIIs 15 years ago. The Economic Times has just reported that FII investment is up, with the Indian Stock Market taking in $13 billion so far in 2009 from foreign institutions. This is in stark contrast to the scenario in 2008. FIIs such as pension managers, investment houses and sovereign wealth funds have been both a growth driver and a beneficiary of this growth, with stocks now worth more than double what they were at their March lows. The key aspect of FII investment is that as many as 120 new foreign institutional investors have registered in India since the global financial crisis broke out in September 2008. These FIIs come from a diverse set of operational areas, and includes names like American Airlines, International Finance Corporation, University of Southern California, Bank of Korea, the Bill & Melinda Gates Foundation, and Warburg Pincus International. More importantly, the months of September-November, 2008 have seen registration of 358 new sub-accounts1 - the highest in any block of three months in 2008. This shows that we are a fairly large attractor of foreign institutional investment. There are a number of reasons huge FII investment is being made in India. One of the main reasons for the FII flows has been an increased recognition of the long-term growth potential of Indian economy. India offers favourable demographics and has quickly established its competitive advantage in many spheres including software. Indian entrepreneurs have been quite successful in launching businesses in India. FIIs have recognised the fact and unlike other countries where FDI has gained predominance, India has seen significant growth in FII investment. Though there could be temporary slowdown or reversals based on interest rate cycles, flow of funds, global contagion etc, over the long term, given the nascence of many Indian businesses and the growth potential, one would see continued inflows. Another reason may be the fact that Indians have the ability to produce goods and services at a lower cost. The scarcity of employment opportunities brings good competition in the labour force and automatically improves the quality and productivity which is highly favourable for foreign corporations. Thus, there is hardly any big company in the entire world who does not have their presence in Indian investment scene. This is the reason that industries like

While an FII registration allows a fund manager to operate in the Indian markets, a separate sub-account is registered for every distinct fund run by the FII to be invested in India.

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BPO, IT and Manufacturing are steadily rising in India. Therefore, FII investment flow appears to influence and be influenced by the economic growth of India. It is with this backdrop, this paper attempts to investigate the causality between the FII investment flow and economic growth in India. The rest of the paper is organised as follows: Section 2 discusses the data and methodology of the study; Section 3 makes the analysis; and Section 4 concludes.

2. Data and Methodology

The objective of this paper is to investigate the direction of relationship between FII investment and the economic growth in India. The sample period of the study spans from 1993 to 2009. This study uses the quarterly time series data on two variables, viz., the Net FII investment flow to India and the Real GDP of India. The Net FII investment flow to India is the value of FII inflows to equities in India minus that of outflows from the country in a month. The data on monthly net FII flows have been collected from the archives of SEBI and then converted into quarterly series. The second variable, Real GDP, is the quarterly estimates of Gross Domestic Product at factor cost and constant prices. Such GDP data are collected from the RBI database on Indian economy. The study employs the Granger causality test in the Vector Autoregressive Regression framework to examine the causality between FII investment flow to India and the real economic growth of the country. This necessitates the empirical analysis to be performed in three steps: First, the stationarity test; second, the Cointegration test; third, the Granger causality test. A. Stationarity Test The pre-requisite of cointegration test is the stationarity of each individual time series over the sample period. In this study, we relied on Augmented Dickey-fuller unit root test to investigate stationarity of each time series as proposed by Dickey and Fuller (1981). This ADF unit root test requires the estimation of the regression: Yt = 0 + 1Yt 1 + i Yt i + t
i =1 p

Where Yt is the first differences of the Yt , 0 is the intercept, 1 are the coefficients, t is the time or trend variable, p is the number of lagged terms chosen to ensure that t is the white noise. The optimal lag length of p is selected by using the Schwarzs information criteria (SIC) suggested by Schwarz. The hypotheses of this test are: H 0 : = 0 , i.e., there is a unit root the time series is non-stationary. H1 : < 0 , i.e., there is no unit root the time series is stationary. If the estimated t - statistic (ADF test statistic) is found to be less than the critical value, the null hypothesis is accepted, otherwise rejected. B. Cointegration Test In financial economics, two variables are said cointegrated when they have long-term, or equilibrium relationship between them (Engle and Granger, 1987). Thus, in this study cointegration analysis has been performed to investigate long term relationship between cross-border capital flows and real economic growth in India. The purpose of the cointegration test is to determine whether a group of non-stationary series are cointegrated or not. We implement VAR-based cointegration test using the methodology developed by Johansen (1991, 1995). The vector autoregressive (VAR) model as considered in this study is: Yt = AYt 1 + A2Yt 2 + ..... + ApYt p + BX t + t 1

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Where Yt is a k -vector of non-stationary I(1) endogenous variables, X t is a d -vector of exogenous deterministic variables, A1......... Ap and B are matrices of coefficients to be estimated, and

t is a vector of innovations that may be contemporaneously correlated but are uncorrelated with their
own lagged values and uncorrelated with all of the right-hand side variables. Since most economic time series are non-stationary, the above stated VAR model is generally estimated in its first-difference form as:
Yt = Yt 1 + i Yt i + BX t + t
p 1 i =1 p

i =1 j =i +1 Where, Grangers representation theorem asserts that if the coefficient matrix has reduced r < k , then there exist k r matrices and each with rank r such that = ' and 'Yt is rank I(0). r is the number of co-integrating relations (the co-integrating rank) and each column of is the co-integrating vector. is the matrix of error correction parameters that measure the speed of adjustments in Yt . The Johansen approach to cointegration test is based on two test statistics, viz., the trace test statistic, and the maximum eigenvalue test statistic.

= Ai I ,

and i = Aj

(a) Trace Test Statis tic The trace test statistic can be specified as: trace = T
i = r +1

log(1 ), where
i

i is the i th largest

eigenvalue of matrix , and T is the number of observations. In the trace test, the null hypothesis is that the number of distinct cointegrating vector(s) is less than or equal to the number of cointegration relations ( r ). (b) Maximum Eigenvalue Test The maximum eigenvalue test examines the null hypothesis of exactly r cointegrating relations against the alternative of r + 1 cointegrating relations with the test statistic: max = T log(1 r +1 ), where r +1 is the ( r + 1)th largest squared eigenvalue. In the trace test, the null hypothesis of r = 0 is tested against the alternative of r + 1 cointegrating vectors. C. Granger Causality Test This study uses Granger Causality Test proposed by C. W. J. Granger (1969) for testing the causality between net FII investment flow to India and real economic growth. This test in the VAR framework formulates the null and alternative hypotheses as: H0: No causal relation between Net FII investment flows and real economic growth H1: Causality between Net FII investment flows and real economic growth These hypotheses are tested in the context of the VAR of the form: FII t = i FII t 1 + j EGt j + 1t
i =1 n j =1 n n n

EGt = i EGt i + j FII t j + 2t

i =1 j =1

Where FII is the ratio of net FII investment flows to India, and EG is the real economic growth as measured by real GDP. As is evident from the time series literature, the Granger Causality Test is

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very sensitive to number of lags included in the model. In view of this, the Schwarz Information Criterion (SIC) for the selection of appropriate lag length has been used.

3. Empirical Analysis
This paper makes the empirical analysis by examining the causality between foreign portfolio investment flow to India and the economic growth in the VAR framework. Since VAR assumes stationarity of the variables, we tested the order of integration of the variables using ADF unit root test. The descriptive statistics and the ADF unit root test of the variables are presented in Table 1. The results show that Net FII investment flows and real GDP series are stationary at levels indicating absence of trend and long run mean reversion. Thus, the variables are integrated of same order, ie., I(0). The results of Johansen cointegration test are summarized in Table 2.
Table 1: Descriptive Statistics and unit root test of variables
Net FII Investment Flow (FII) No. of Observations Mean Median Maximum Minimum Standard Deviation Skewness Kurtosis ADF Unit Root Test (Levels) *: denotes statistical significance at 1% level. 66 450263.8 454443.5 902924.0 175616.0 224637.2 0.408849 1.780091 -1.3804(6)* Real GDP(EG) 66 0.009921 0.013266 0.193070 -0.278871 0.070257 -0.376243 3.935105 0.6165(4)*

Table 2:

Cointegration Test of Variables

Sample: 1993 Q1 to 2009 Q2 Sample (adjusted): 1993 Q4 to 2009 Q2 Included observations: 63 after adjustments Trend assumption: No deterministic trend (restricted constant) Series: FII and GDP Lags interval (in first differences): 1 to 2 Unrestricted Cointegration Rank Test (Trace) Hypothesized Trace 0.05 No. of CE(s) Eigenvalue Statistic Critical Value None * 0.292354 39.94455 20.26184 At most 1 * 0.250410 18.15843 9.164546 Trace test indicates 2 cointegrating equations at the 0.05 level *: denotes rejection of the hypothesis at the 0.05 level **: MacKinnon-Haug-Michelis (1999) p-values Unrestricted Cointegration Rank Test (Maximum Eigenvalue) Hypothesized Max-Eigen 0.05 No. of CE(s) Eigenvalue Statistic Critical Value None * 0.292354 21.78613 15.89210 At most 1 * 0.250410 18.15843 9.164546 Max-eigenvalue test indicates 2 cointegrating equations at the 0.05 level *: denotes rejection of the hypothesis at the 0.05 level **: MacKinnon-Haug-Michelis (1999) p-values

Prob.** 0.0000 0.0008

Prob.** 0.0053 0.0008

The Trace test indicates the existence of two cointegrating equations at 5% level of significance. And, the maximum eigenvalue test makes the confirmation of this result. Thus, the two variables of this study have long-run or equilibrium relationship between them. Now, the causality test can be performed to determine the direction of causation between these two variables in the

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environment of VAR. This VAR model uses the lag length up to 7 as determined by Akaike Information Criteria (AIC). The results of the Granger Causality Test are shown in the Table 3.
Table 3: Results of Granger Causality Test
Lag Length(AIC) 7 7 Degrees of Freedom (2, 120) (2, 120) F-Statistic 3.0618* 5.4627* Probability 0.0505 0.0054 Decision Reject# Reject

Null Hypothesis Net FII Investment Flows do not Granger-cause Real Economic Growth Real Economic Growth does not Granger-cause Net FII Investment Flows

*: The critical value of F for (2, 120) degrees of freedom at 1%, 5% and 10% levels of significance are 4.786510, 3.071779, and 2.347338 respectively. #: Null hypothesis is rejected at 10% level of significance.

It is seen from the Table 3 that both the null hypotheses of this causality test are rejected. It shows that the FII investment flow to India can be a cause of the real economic growth of the country. It is also inferred from the table-3 that the growth of real GDP promotes the FIIs investing in India. In other words, the strong fundamentals of the country as well as its robust growth potential indeed attracts voluminous cross-border institutional investment leading to a surge in the performance of macro-economic indicators. During 2001 and 2007, there has been a phenomenal increase in the portfolio investment by FIIs in the Indian market with the trend reversal in 2008. Again, 2009 is witnessing coming back of FIIs in drove. Several factors are responsible for this increasing confidence of FIIs on the Indian market which include strong macro-economic fundamentals of the economy, transparent regulatory system, abolition of long-term capital gains tax, and encouraging corporate results. The pros of allowing FIIs to invest in the Indian markets far outweigh the cons. The portfolio investment by the FIIs in India improves corporate capital structures, helps bridging the investment gap, and promotes financial innovation and development of hedging instruments. Such investment flow not only enhances competition in financial markets, but also improves the alignment of asset prices to fundamentals. FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms operations, improve corporate governance. It has been a long standing consensus that the equity market development aids economic development of the country. And, the case of India is no exception. By increasing the availability of riskier long-term capital for projects, and increasing firms incentives to provide more information about their operations, FIIs can help in the process of economic development. Furthermore, FIIs incoming to India with handful of investment resources will contribute to institutionalization of the country. Institutionalization will increase dividend payouts, and will enhance productivity growth.

4. Conclusion
This paper examined the causality between FII portfolio inflows and real economic growth in Indian economy. The issue assumes much relevance in the context of the almost non-existing literature and recent impacts of global financial crisis in India. In the vector autoregressive framework this paper studies the dynamics of net inflow of cross-border institutional investment and economic growth in India. The analysis provides the evidence of bi-directional causality running from net FII flows to real economic growth. This shows that the real economic growth of India both determines and determined by the volume of portfolio institutional investments in the country. The foreign institutional investment inflows have the potential of influencing the process of economic development of India through the positive impacts on macro-economic fundamentals of the country. Therefore, the outlook is that the

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policy makers of India should provide the FIIs with more opportunities and reasons to invest in Indian markets by suggesting and implementing prudential norms.

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