FII Flows to India: Nature and Causes

RAJESH CHAKRABARTI
*

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Abstract
Since the beginning of liberalisation FII flows to India have steadily grown in importance. In this paper we analyse these flows and their relationship with other economic variables and arrive at the following major conclusions: (a) While the flows are highly correlated with equity returns in India, they are more likely to be the effect than the cause of these returns; (b) The FIIs do not seem to be at an informational disadvantage in India compared to the local investors; (c) The Asian Crisis marked a regime shift in the determinants of FII flows to India with the domestic equity returns becoming the sole driver of these flows since the crisis. Given the thinness of the Indian market and its susceptibility to manipulations, FII flows can aggravate the equity market bubbles, though they do not actually start them.

While it is generally held that portfolio flows benefit the economies of recipient countries, policy-makers world-wide have been more than a little uneasy about such investments. Portfolio flows often referred to as hot moneyare notoriously volatile compared to other forms of capital flows.

I. Introduction
Portfolio investment flows from industrial countries have become increasingly important for developing countries in recent years. The Indian situation has been no different. In the year 2000-01, portfolio investments in India accounted for over 37 per cent of total foreign investment in the country and 47 per cent of the current account deficit. The corresponding figures in the previous year were 59 per cent and 64 per cent respectively. A significant part of these portfolio flows to India comes in the form of Foreign Institutional Investors (FIIs) investments, mostly in equities. Ever since the opening up of the Indian equity markets to foreigners, FII investments have steadily grown from about Rs. 2,600 crore in 1993 to over Rs.11,000 crore in the first half of 2001 alone. Their share in total portfolio flows to India grew from 47 per cent in 1993-94 to over 70 per cent in 1999-2000.1 The nature of the foreign investors decision-making process that lies at the heart of the portfolio flows is briefly outlined in Box 1. While it is generally held that portfolio flows benefit the economies of recipient countries2, policy-makers world-wide have been more than a little uneasy about such investments. Portfolio flowsoften

* I am grateful to Anupam Gupta and Mihir Rakshit for helpful comments. All remaining errors and shortcomings are my sole responsibility. 1 RBI Bulletin, October 2000. 2 see Errunza (1999)

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Box 1: The International Portfolio Investors decision-making problem International portfolio flows, as opposed to foreign direct investment (FDI) flows, refer to capital flows made by individuals or investors seeking to create an internationally diversified portfolio rather than to acquire management control over foreign companies. Diversifying internationally has long been known as a way to reduce the overall portfolio risk and even earn higher returns. Investors in developed countries can effectively enhance their portfolio performance by adding foreign stocks, particularly those from emerging market countries where stock markets have relatively low correlations with those in developed countries. For instance, according to Morgan Stanley Capital Internationals estimates, between 1985 and 1990, an investor holding an allUS portfolio could improve her returns by over 25 per cent by holding the MSCI world index instead and at the same time, reduce her risk by about 2 per cent*. The portfolio investors problem may be thought of as deciding upon appropriate country weights in the portfolio so as to maximise portfolio returns subject to a risk constraint, or in the absence of a pre-specified risk level, to reach the optimum portfolio, that which has the highest Sharpe ratio, S, where the Sharpe ratio is the ratio of expected excess return (excess over the risk-free rate) to the dispersion (standard deviation) of the return. The problem, therefore, is as follows:

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Max
{ xi }

S=

E ( rP ) rf

where {xi} refers to the portfolio weights for different countries and E(rP) and P refer to the expected return and standard deviation of the return for the entire portfolio respectively. Since the variability of the portfolio return (P) depends on the correlation matrix of the country level returns, emerging markets with their lower correlation with developed markets help to reduce the overall risk of the investor. Thus, emerging markets like India are naturally attractive to international portfolio investors as investment destinations. Beginning in the mid-80s several of these markets that were previously closed to foreign investors, began to liberalise making portfolio investments possible and portfolio investments poured into them in the 90s till the Asian crisis.
*

See Tesar (1999).

referred to as hot moneyare notoriously volatile compared to other forms of capital flows. Investors are known to pull back portfolio investments at the slightest hint of trouble in the host country often leading to disastrous consequences to its economy. They have been blamed for exacerbating small economic problems in a country by making large and concerted withdrawals at the first sign of economic weakness. They have also been held responsible for spreading financial crisescausing contagion in international financial markets. In the wake of the Asian crisis, prominent economists3 have, for these rea-

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

sons, expressed doubts about the wisdom of the IMF view of promoting free capital mobility among countries. International capital flows and capital controls have emerged as important policy issues in the Indian context as well.4 The danger of Mexico-style abrupt and sudden outflows inherent with FII flows and their destabilising effects on equity and foreign exchange markets have been stressed. Some authors have argued that FII flows have, in fact, had no significant benefits for the economy at large. While these concerns are all well placed, comparatively less attention has been paid so far to analysing the FII flows data and understanding their key features. A proper understanding of the nature and determinants of these flows, however, is essential for a meaningful debate about their effects as well as for predicting the chances of their sudden reversals. In an attempt to address this lacuna, this paper undertakes an empirical analysis of FII investment flows to India. The broad objective of the present paper is to gain a better understanding of the nature and determinants of FII flows. Towards this end we first take a look at the FII investment flows data to bring out the key features of these flows. Next we study the relationship between FII flows and the stock market returns in India with a close look at the issue of causality. Finally we study the impact of other factors identified in the portfolio flows literature on the FII flows to India. In all of these investigations we make a distinction between the pre-Asian crisis period and the post-Asian crisis period to check if there was a regime shift in the relationships owing to the Asian crisis. The paper is arranged as follows. The next section sketches a brief review of the recent literature in the area. The third section provides an overview of the nature and sources of portfolio flows in India, pointing out their main characteristics. The fourth section probes into the possible determinants of FII flows to India. The fifth and final section concludes with a summary of the major findings and their policy implications.

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While the Mexican crisis of 1994, the subsequent Tequila effect, and the widespread Asian crisis have had temporary dampening effects on international portfolio flows, they have failed to counter the longterm momentum of these flows.

II. What we know about International Portfolio Flows

International portfolio flows are, as opposed to foreign direct investment, liquid in nature and are motivated by international portfolio diversification benefits for individual and institutional investors in industrial countries. They are usually undertaken by institutional investors like pension funds and mutual funds. Such flows are, therefore, largely determined by the performance of the stock markets of the host countries relative to world markets. With the opening of stock markets in various emerging economies to foreign investors, investors in industrial countries have increasingly sought to realise the potential for portfolio diversification that these markets present. While the

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

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The main question is whether capital flew into these countries primarily as a result of changes in global (largely US) factors or in response to events and indicators in the recipient countries like their credit rating and domestic stock market return.

Mexican crisis of 1994, the subsequent Tequila effect, and the widespread Asian crisis have had temporary dampening effects on international portfolio flows, they have failed to counter the long-term momentum of these flows. Indeed, several researchers5 have found evidence of persistent home bias in the portfolios of investors in industrial countries in the nineties. This home biasthe tendency to hold disproportionate amounts of stock from the home countrysuggests substantial potential for further portfolio flows as global market integration increases over time. It is important to note that global financial integration, however, can have two distinct and in some ways conflicting effects on this home bias. As more and more countriesparticularly the emerging marketsopen up their markets for foreign investment, investors in developed countries will have a greater opportunity to hold foreign assets. However, these flows themselves, along with greater trade flows will tend to cause different national markets to increasingly become parts of a more unified global market, reducing their diversification benefits. Which of these two effects will dominate is, of course, an empirical issue, but given the extent of the home bias it is likely that for quite a few years to come, FII flows would increase with global integration. In recent years, international portfolio flows to developing countries have received the attention of scholars in the areas of finance and international economics alike. In the 1990s several papers have explored the causes and effects of cross-border portfolio investment. While papers in the finance tradition have focused on the nature and determinants of portfolio flows from the perspective of the diversifying investors, those from the international macroeconomics perspective have focused on the recipient countrys situation and appropriate policy response to such flows. For the present purposes, we shall focus only on papers that address the issue of portfolio flows exclusively.6 Previous research has also attempted to identify the factors behind these capital flows.7 The main question is whether capital flew into these countries primarily as a result of changes in global (largely US) factors or in response to events and indicators in the recipient countries like their credit rating and domestic stock market return. The question is particularly important for policy makers in order to get a better understanding of the reliability and stability of such flows. The answer is mixedboth global and country-specific factors seem to matter, with the latter being particularly important in the case of Asian countries and for debt flows rather than equity flows.
Including French and Poterba (1991), Cooper and Kaplanis (1994) and Tesar and Werner (1995a). 6 For the related literature on international capital flows in general (comprising both FDI and portfolio flows) see Calvo et al (1993), World Bank (1997), and Feldstein (1999). 7 See Chuhan et al (1998)
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As for the motivation of US equity investment in foreign markets, recent research8 suggests that US portfolio managers investing abroad seem to be chasing returns in foreign markets rather than simply diversifying to reduce overall portfolio risk. The findings include the well-documented home bias in OECD investments, high turnover in foreign market investments and that, in general, the patterns of foreign equity investment were far from what an international portfolio diversification model would recommend. The share of investments going to emerging markets has been roughly proportional to the share of these markets in global market capitalisation but the volatility of US transactions was even higher in emerging markets than in other OECD countries. Furthermore, there was no relation between the volume of US transactions in these markets and their stock market volatility. The Mexican and Asian crises and the widespread outcry against international portfolio investors in both cases have prompted analyses of short-term movements in international portfolio investment flows. The question of feedback trading has received considerable attention. This refers to investors reaction to recent changes in equity prices. If a gain in equity values tends to bring in more portfolio inflows, it is an instance of positive feedback trading while a decline in flows following a rise in equity values is termed negative feedback trading. Between 1989 and 1996 unexpected equity flows from abroad raised stock prices in Mexico at the rate of 13 percentage points for every 1 per cent rise in the flows.9 There has been, however, no evidence of feedback trading among foreign investors in Mexico. In the period leading to the Asian crisis, on the other hand, Korea witnessed positive feedback trading and significant herding among foreign investors.10 Nevertheless, contrary to the belief in some segments, these tendencies actually diminished markedly in the crisis period and there has been no evidence of any destabilising role of foreign equity investors in the Korean crisis. While FII flows to the Asian Crisis countries dropped sharply in 1997 and 1998 from their pre-crisis levels, it is generally held that the flows reacted to the crisis (possibly exacerbating it) rather than causing it. More recent studies11 find that the effect of regional factors as determinants of portfolio flows has been increasing in importance over time. In other words portfolio flows to different countries in a region tend to be highly correlated. Also the flows are more persistent than returns in the domestic markets. Feedback trading or return-chasing behaviour is also more pronounced. The flows appear to affect contemporaneous and future stock returns positively, particularly in the case of
See Bohn and Tesar (1996) and Tesar and Werner (1995a) for studies of flows to OECD countries and Tesar and Werner (1995b) for a study of US portfolio flows to emerging markets. 9 See Clark and Berko (1997) 10 See Choe et al (1999) 11 See, for instance, Froot et al (2001)
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As for the motivation of US equity investment in foreign markets, recent research suggests that US portfolio managers investing abroad seem to be chasing returns in foreign markets rather than sim-ply diversifying to reduce overall portfolio risk.

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emerging markets. Finally stock prices seem to behave on the assumption of persistent portfolio inflows. It is commonly argued that local investors possess greater knowledge about a countrys financial markets than foreign investors and that this asymmetry lies at the heart of the observed home bias among investors in industrialised countries. A key implication of recent theoretical work in this area12 is that in the presence of such information asymmetry, portfolio flows to a country would be related to returns in both recipient and source countries. In the absence of such asymmetry, only the recipient countrys returns should affect these flows.

The effect of regional factors as determinants of portfolio flows has been increasing in importance over time. In other words portfolio flows to different countries in a region tend to be highly correlated.

III. Foreign Institutional Investment in India: An Overview

India opened its stock markets to foreign investors in September 1992 and has, since 1993, received considerable amount of portfolio investment from foreigners in the form of Foreign Institutional Investors (FII) investment in equities. This has become one of the main channels of international portfolio investment in India for foreigners.13 In order to trade in Indian equity markets, foreign corporations need to register with the Securities and Exchange Board of India (SEBI) as FIIs.14 The SEBI definition of FIIs presently includes foreign pension funds, mutual funds, charitable/endowment/university funds etc. as well as asset management companies and other money managers operating on their behalf. The trickle of FII flows to India that began in January 1993 has gradually expanded to an average monthly inflow of close to Rs. 1,900 crore during the first six months of 2001. By June 2001, over 500 FIIs were registered with SEBI. The total amount of FII investment in India had accumulated to a formidable sum of over Rs. 50,000 crore during this time (see Chart 1). In terms of market capitalisation too, the share of FIIs has steadily climbed to about 9 per cent of the total market capitalisation of BSE (which, in turn, accounts for over 90 per cent of the total market capitalisation in India). The sources of these FII flows are varied. The FIIs registered with SEBI come from as many as 28 countries (including money management companies operating in India on behalf of foreign investors). US-based institutions accounted for slightly over 41 per cent, those from the UK constitute about 20 per cent with other Western European countries hosting another 17 per cent of the FIIs (see Chart 2).
See Brennan and Cao (1997) The closed-end country fund, The India Fund launched in June 1986 provided a channel for portfolio investment in India before the stock market liberalisation in 1992. Global Depository Receipts, American Depository Receipts, Foreign Currency Convertible Bonds and Foreign Currency Bonds issued by Indian companies and traded in foreign exchanges provide other routes for portfolio investment in India by foreign investors. 14 It is also possible for foreigners to trade in Indian securities without registering as an FII; but such cases require approval from the RBI or the Foreign Investment Promotion Board.
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CHART 1 Growth of FII Investment in India

600 Number of registered .IIs Cumulative Investment 60000

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20000

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CHART 2 Sources of FII Investment in India

UK 20%

USA 42%

W.Europe 17%

Others 2% India 1%

Australia 4% Japan 1% Middle East 1% Canada 2%

Singapore 4%

Hong Kong 6%

Source: SEBI website

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Box 2: Some descriptive statistics of FII flows to India The histogram and descriptive statistics for net FII flows between January 1993 and December 1999, the sample period selected for our analysis, are given in Panel A of Figure 3. A Jarque-Bera test of normality in the distribution of FII flows fails to reject the null hypothesis of normality for the data during the sample period. The flows, however, are somewhat volatile with a coefficient of variation of over 1.22. They are also considerably auto-correlated. The auto-correlation with one lag is over 0.5 and that with two lags is over 0.26.
CHART 3 Panel A Histogram and descriptive statistics of FII flows Panel A: Net FII flows (Rs. Crores)
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Frequency

Sample: 1993:05 1999:12 Observations 80 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis 439.5139 406.6350 1673.000 -896.4100 539.2140 0.080577 3.274955

6 6

4 4

2 2

Jarque-Bera 0.338569 Probability 0.844269

CHART 3 Panel B Histogram and descriptive statistics of FII flows Panel B: FII flows as a proportion of previous months' BSE market capitalisation
p p p p

18 16 14 12
Frequency

-900 -800 -700 -600 -500 -400 -300 -200 -100 0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500 1600 1700 More

0 0

Net FII Flows (Rs. Crores)

Sample: 1993:05 1999:12 Observations 80 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis 0.001024 0.000879 0.004929 -0.001595 0.001161 0.576284 4.249903

10 8 6 4 2 0
002 -0.002 -0.00175175 -0.0015015 0125 -0.00125 -0.00101 0075 -0.00075 -0.0005005 0025 -0.00025 0 0 0.00025025 005 0.0005 0.00075075 0.00101 0.00125125 015 0.0015 0.00175175 0.00202 0.00225225 025 0.0025 0.00275275 0.00303 0.00325325 035 0.0035 0.00375375 0.00404 0.00425425 045 0.0045 0.00475475 0.00505 Morere

Jarque-Bera 9.635571 Probability 0.008085

FII flows as a proportion of previous months BSE market capitalization

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

It is, however, instructive to bear in mind that these national affiliations do not necessarily mean that the actual investor funds come from these particular countries. Given the significant financial flows among the industrial countries, national affiliations are very rough indicators of the home of the FII investments. In particular institutions operating from Luxembourg, Cayman Islands or Channel Islands, or even those based at Singapore or Hong Kong are likely to be investing funds largely on behalf of residents in other countries. Nevertheless, the regional breakdown of the FIIs does provide an idea of the relative importance of different regions of the world in the FII flows. Some descriptive statistics about the FII flows are provided in Box 2. The data used for this and the analysis in the remainder of the paper are described in Appendix 1.

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Given the significant financial flows among the industrial countries, national

IV.

Factors affecting FII flows

In this section we shall study the relationship between FII flows and possible economic factors affecting it, particularly stock returns in the Indian market. FII flows and stock returnsdetermining the cause and the effect FII flows and contemporaneous stock returns are strongly correlated in India. The correlation coefficients between different measures of FII flows and market returns on BSE during different sample periods are shown in the different panels of Table 1. While the
TABLE 1 FII flows and Returns on BSECorrelations Net FII flow FII flow as pro- Return on portion of pre- BSE Natioceding months nal Index BSE market cap (Rupees)

affiliations are very rough indicators of the home of the FII investments. Nevertheless, the regional breakdown of the FIIs does provide an idea of

Panel A: Entire Sample: May1993 Dec 1999 FII flow as proportion of preceding months BSE market cap Return on BSE National Index (Rupees) Return on BSE National Index (US $) 0.93 0.52 0.53

0.56 0.58

the relative
0.98

importance of different regions of

Panel B: Pre-Asian Crisis period: May 1993 June 1997 FII flow as proportion of preceding months BSE market cap Return on BSE National Index (Rupees) Return on BSE National Index (US $) FII flow as proportion of preceding months BSE market cap Return on BSE National Index (Rupees) Return on BSE National Index (US $) 0.88 0.40 0.41

0.56 0.58

the world in the FII

0.98

Panel C: Asian Crisis and after: July 1997 Dec 1999 0.99 0.67 0.67

flows.
0.66 0.66

0.98

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The positive relationship between market return and FII flows, however, serves only as a first-pass in understanding the nature of such flows and their implications for the Indian markets.

correlations are quite high throughout the sample period, they exhibit a significant rise since the beginning of the Asian crisis. These positive correlations have often been held as evidence of FII actions determining Indian equity market returns. However, correlation itself does not imply causality. A positive relationship between portfolio inflows and stock returns is consistent with at least four distinct theories: (1) the omitted variables hypothesis; (2) the downward sloping demand curve view; (3) the base-broadening theory; and (4) the positive feedback strategy view. The omitted variables view is the classic case of spurious correlationthat the correlated variables, in fact, have no causal relationship between them but are both affected by one or more other variables missed out in the analysis. The downward sloping demand curve view contends that foreign investment creates a buying pressure for stocks in the emerging market in question and causes stock prices to rise much in the same way as suddenly higher demand for a commodity would cause its price to rise. The base-broadening argument contends that once foreigners begin to invest in a country, the financial markets in that country are now no longer moved by national economic factors alone but rather begin to be affected by foreign market movements as well. As the market itself is now affected by more factors than before, its exposure to domestic shocks declines. Consequently the risk of the market itself falls, people demand a lower risk premium to buy stocks, and stock prices rise to higher levels. Finally the positive feedback view asserts that if investors chase returns in the immediate past (like the previous day or week) then aggregating their fund flows over the month can lead to a positive relationship in the contemporaneous monthly data. In the present context, both directions of causation are equally plausible. Detailed statistical tests (see Box 3) however, indicate that the FII flows are likely to have been more of an effect of market returns in India than their cause. Further statistical tests (see Box 4) suggest that returns on the Bombay Stock Exchange (BSE) Index explain close to a third of the total variation in FII flows during the entire period. They also indicate, however, that the Asian crisis marked a regime shift in the relationship between FII flows and Indian stock market return. During and after the crisis, the returns explained about 40 per cent of the total variation in FII flows. The positive relationship between market return and FII flows, however, serves only as a first-pass in understanding the nature of such flows and their implications for the Indian markets. Since the FII flows essentially serve to diversify the portfolio of foreign investors, it is only normal to expect that several factorsboth domestic as well as external to Indiaare likely to affect them along with the expected stock

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BOX 3: FII flows and Equity Returns in India: Cause or Effect? Pair-wise Granger causality tests between net FII inflows (as a proportion of preceding months BSE market capitalisation) and monthly return on the BSE National Index, reported in Table 2, Panel A fail to categorically establish a causal direction since non-causality is rejected in both directions at least at the 5 per cent level of significance. During the pre-Asian Crisis period, however, there seems to be some support for the causality running from flows to returns, while with the onset of the Asian Crisis, there is mild evidence of a reversal of causality. On the whole then, the issue of which is the cause and which is the effect remains indeterminate with monthly data.
TABLE 2 Granger Causality tests between Returns on the BSE National Index on FII investment flows

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Panel A : Monthly Data1993 to 1999 Null Hypothesis

Returns+ do not cause FII flows# Flows do not cause returns

Entire Sample
3.210 5 6.147 1

Pre-Asian Crisis
0.975 2.744 10

Asian Crisis and after

2.299 15 1.738

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

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

Lags considered Null Hypothesis Returns+ do not cause FII flows# Flows do not cause returns
+ #

2 8.386 1 0.963

3 5.533 1 0.766

4 4.223 1 1.891

4.085 1 3.256 1 1.732 1.399

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

In order to dig deeper into the issue of direction of causality then, we have to use daily data. Fortunately daily data are available (from SEBI website) on net FII flows since January 1999. Thus in order to get a better sense of the direction of causality we run pair-wise Granger-causality tests with daily data for 1999 at several lags and report these results in Panel B of Table 2. Here the results seem to be far more unequivocal. At all lags the Granger causality tests reject the hypothesis of returns not causing flows at the 1 per cent level while the null hypothesis of reverse noncausality is never rejected. Thus this data seems to support the view that the FII flows are more an effect than a cause of market returns in India. Chart 4 shows the weekly patterns in returns and FII flows during 1999. One qualifier may not, however, be out of place here. Loosely speaking, Table 2, Panel A seems to suggest a slight reversion of causality between flows and returns in
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Return Return FII flow .II flow

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1/8/1999 3/19/1999 6/11/1999 8/20/1999 10/29/1999

-0.0001

-0.0002

Weeks

the pre-Asian crisis period and that of the later period. Since the daily data comes entirely from the post-Asian crisis period, it may be still be true that the reverse causation was in effect in the pre-crisis period. Finally, the model-free approach of detecting causality between the two variables simply by using Granger causality can only serve as a preliminary check for the direction of causality. The orthodox way of doing such analysis would almost always begin with a priori modelling of these variables. However, since in financial markets, information flows drive both returns and investment flows, implications about causality between these two variables can also be highly model-specific. In such a situation an agnostic test like Granger causality does have some usefulness in detecting the direction of causality.

returns in India. Past research suggests15 that the declining world interest rates have been among the important push factors for international portfolio flows in the early 90s. The usual suspects in the literature include US and world equity returns, changes in interest rates, stock market volatility, some measure of the country risk and the exchange rate. In the Indian case, however, these factors do not appear to have had a prominent role in motivating FII flows (see Box 4). Finally it also appears that there has been no significant informational disadvantage for FIIs vis--vis the local investors in the Indian market. Other factors that may affect FII flows Country risk measures, that incorporate political and other risks in addition to the usual economic and financial variables, may be expected to have an impact on portfolio flows to India though they are

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15

See Calvo et al (1993)

Average FII flow during the week (as a proportion of previous months' BSE market capitalization)

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CHART 4 Returns and FII flows during 1999

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Box 4: Further Analysis of the Determinants of FII flows

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Equity Market returns Table 3 presents the results of a regression of FII flows (as a proportion of the previous months BSE capitalisation) on monthly rupee returns* on the BSE National Index. Because of evidence of auto-correlated residuals from the Durbin-Watson statistic, Newey-West heteroskedasticity and auto-correlation consistent standard errors and co-variances are used in these regressions. The results indicate that returns on the BSE Index explain over three-tenths of the total variation in FII flows during the entire period. The explanatory power rises considerably with the onset of the Asian crisis when the regression accounts for over four-tenths of the variation. The results of a Chow breakpoint test shown in Table 3, Panel B, shows that the onset of the Asian Crisis does mark a structural break in the relationship implying a rise in the effect of market return in explaining FII flows.
TABLE 3 Regressions of FII investment flows on Monthly Returns on the BSE National Index

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Panel A: Dependent variable: Net monthly FII inflow as a proportion of the preceding months BSE market capitalisation Entire sample (1993:05 1999:12)
Constant Return on the BSE National Index Adjusted R 2 Durbin-Watson 0.001 (5.624) 0.008 1 (4.517) 0.310 1.016

Pre Asian Crisis (1993:05 1997:06)

0.001 (8.300) 0.008 1 (2.836) 0.304 1.241

Asian Crisis and after (1997:07 1999:12)

0.0003 (1.566) 0.009 1 (6.124) 0.419 1.24

The regressions are estimated by OLS with Newey-West heteroskedasticity auto-correlation consistent standard errors and covariance. The figures in parentheses are t-statistics. 1 denotes significance at 1 per cent level.

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

F-statistic Log likelihood ratio 9.767 18.301 Probability Probability 0.000168 0.000106

The effect of other factors As a second step in analysing the FII flows to India, we regress the FII flows on other factors identified in the literature and find out to what extent they help explain the FII flows. To the extent that these factors may be affecting the Indian stock returns themselves, this exercise throws light on the possibility of omitted variables giving rise to the correlation between FII flows and monthly stock returns. Table 4 reports the results from a regression of monthly FII flows (as a proportion of preceding months BSE market capitalisation) on several variables in addition to the monthly return on the BSE National Index. These variables are as follows: returns on the S&P 500 index (a major US index), returns on the MSCI world index (a major international index tracked by several international investment funds), volatility of daily US dollar return on the BSE National Index in the preceding month (as a
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measure of total risk in the Indian market), the change in the short-term (45-day) fixed deposit rate in India and the return in the foreign exchange market (a positive return means depreciation of rupee). Once again Newey-West standard errors and co-variances are used in response to the low D-W statistics. Only the exchange rate movements turn out to be significant (in addition to the stock returns) in these regressions. A comparison with Table 3 shows that in the entire sample the adjusted R2 goes up only marginally (presumably because of the exchange rate effect) while it declines in both sub-samples. These variables thus collectively do little to explain the FII flows. The Chow test (Panel B) continues to detect a structural break with the onset of the Asian crisis.
TABLE 4 Regressions of FII investment flows on Monthly Returns on the BSE National Index

Dependent variable: Net monthly FII inflow as a proportion of the preceding months BSE market capitalisation Entire sample (1993:05 1999:12)
Constant Return on the BSE National Index Return on the MSCI World Index Return on the S&P 500 index Change in Indian shortterm interest rate Return Volatility in the preceding month Return on exchange rate Adjusted R2 Durbin-Watson 0.002 (4.870) 0.008 1 (4.336) 0.000 (0.013) -0.004 (-0.520) 0.008 (0.082) -0.038 (-1.784) -0.010 5 (-2.363) 0.321 1.123

PreAsian Crisis (1993:05 1997:06)

0.002 (4.053) 0.007 5 (2.439) 0.007 (1.103) -0.010 (-1.552) 0.070 (0.456) -0.014 (-0.474) -0.008 (-1.609) 0.277 1.361

Asian Crisis and after (1997:07 1999:12)

0.0000 (0.032) 0.010 1 (5.530) -0.018 (-1.671) 0.016 (1.564) -0.154 (-0.824) 0.019 (0.476) -0.005 (-0.883) 0.361 1.363

The regressions are estimated by OLS with Newey-West heteroskedasticity auto-correlation consistent standard errors and covariance. The figures in parentheses are t-statistics. 1, 5 and 10 denote significance at 1 per cent, 5 per cent and 10 per cent levels respectively.

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

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

The lack of significance of the world stock returns in explaining the portfolio flows may be interpreted, in light of Brennan and Cao (1997), to suggest that there is no significant informational asymmetry between FIIs and domestic investors in India. The presence of any informational disadvantage for the FIIs would have made the world indices a significant determinant of their investment flows.
*The dollar returns and returns in excess of the short-term (45-day) interest rates were also used and they

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produce nearly identical results.

likely to matter more in the case of FDI flows. In order to check the impact of such country risk on FII flows, semi-annual country risk scores for India were taken from the Institutional Investor magazine, an important country-rating agency. These raw ratings were then divided by the world average rating to obtain normalised ratings. The intuition behind this normalisation is as follows. If Indias credit rating improves but those of other countries improve even more, then India may not improve its relative attractiveness as a destination of investment flows. The relation between the normalised country rating and the average monthly FII flows (as a proportion of the preceding months BSE capitalisation) is shown in Chart 5. The correlation between the two variables is 0.15. No relationship is evident from the figure itself and statistical testing confirms this view16. Thus we can conclude that broadly speaking there is no evidence of India credit rating affecting FII flows.
CHART 5 Credit Rating and Subsequent FII flows
0.30% 1.9
India's credit rating as a multiple of global average credit rating Average monthly FII flow (as a percentage of BSE market cap in the preceding month) for the following 6 months

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It is also conceivable that the extent to which the Indian market moves out of step

Normalized Rating Rating Normalised .II flow flow FII

0.25% 0.20% 0.15% 0.10%

with the world market is a factor in determining its attractiveness to foreign investors. . . . Statistical tests indicate that this was indeed true in

1.7

1.5

1.3 0.05% 1.1 0.00% -0.05%

Sep-93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Sep-99

0.9

It is also conceivable that the extent to which the Indian market moves out of step with the world market is a factor in determining its attractiveness to foreign investors. The lower the co-movement, the greater the protection that investment in India provides to investors against world market shocks. Statistical tests (see Box 5) indicate that this was indeed true in the pre-Asian Crisis period but ceased to hold in the Crisis period.

the pre-Asian Crisis period but ceased to hold in the Crisis period.

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

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BOX 5: Indias status as a hedge against world shocks According to the standard International Capital Asset Pricing Model (ICAPM) approach, the measure of risk of holding the Indian market in an internationally diversified portfolio is given by the beta of the Indian market (slope of the regression of Indian returns on world returns) with respect to the relevant world market. Thus, if the beta of the Indian market decreases, it is likely to improve the attractiveness of the Indian market to the international investor simply for the benefits of total risk reduction through diversification. In order to check this relationship we compute the beta of monthly US dollars return on the BSE National Index with returns on the S&P 500 index

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Cov( rBSE , rSP 500 ) ] and returns on the MSCI world index. The betas for Var( rSP 500 ) each month are computed using returns data for the previous 24 months. Chart 6 shows the data and Table 5 shows the regression estimates. The regressions indi[ = cate that the beta of the Indian market with respect to the S&P 500 has a significant effect in explaining FII investment flows before the Asian crisis but not during or after the crisis period. The beta with respect to the world market is insignificant in both periods. The Chow test (Panel B), however, rejects the null hypothesis of no structural break at the onset of the Asian crisis only at the 15 per cent level.
CHART 6 FII flows and the beta of the Indian market with respect to S&P 500

0.006 0.005
FII flow (percentage of preceding month's BSE market capitalization)

1
Beta of BSE National Index with respect to S&P 500

FIIflow flow .II beta_S$P500 beta_S&P500

0.5

0.004 0.003

-0.5 0.002 -1 0.001 0 -0.001 -0.002

Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jul-99

-1.5

-2

-2.5

Months (May 1993 to December 1999)

. . . continued on following page

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TABLE 5 Regressions of FII investment flows on betas of the BSE National Index with respect to S&P500 and the MSCI World Index

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Panel A: Dependent variable: Net monthly FII inflow as a proportion of the preceding months BSE market capitalisation Entire sample (1993:05 1999:12)
Constant Beta (S&P 500) Beta (MSCI World Index) Adjusted R 2 Durbin-Watson 0.001 (5.685) -0.001 (-1.848) -0.0002 (-0.314) 0.179 1.323

Finance

Pre Asian Crisis (1993:05 1997:06)

0.001 (6.980) -0.0015 (-2.324) 0.0002 (0.387) 0.119 1.349

Asian Crisis and after (1997:07 1999:12)

0.001 (2.408) 0.0001 (0.391) -0.002 (-1.330) 0.067 1.457

O C T. D E C . . 2 0 0 1

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

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

F-statistic Log likelihood ratio 1.983 6.186 Probability Probability 0.123 0.103

VI.

Main Findings and Conclusion

The empirical investigation of FII flows to India have elicited the following stylised facts about the such flows: a. FII flows are correlated with contemporaneous returns in the Indian markets. b. This high correlation is not necessarily evidence of FII flows causing price pressureif anything, the causality is likely to be the other way around. c. A collection of domestic and international variables likely to affect both flows and returns fails to diminish the importance of contemporaneous returns in explaining FII flows. d. Since the US and world returns are not significant in explaining the FII flows, there is no evidence17 of any informational disadvantage of FIIs in comparison with the domestic investors in India. e. Changes in country risk ratings for India do not appear to affect the FII flows. f. The beta of the Indian market with respect to the S&P 500 index (but not the beta with respect to the MSCI world index)
17

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

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seems to affect the FII flows inversely but the effect disappears in the postAsian crisis period. g. There appears to be significant differences in the nature of FII flows before and after the Asian crisis. In the post Asian crisis period it seems that the returns on the BSE National Index have become the sole driving force behind FII flows. The stylised facts listed above lead to a better understanding of FII flows to India. The weakness of the evidence of causality from flows to returns contradicts the view that the FIIs determine market returns in general, though herding effectsparticularly with domestic speculators imitating FII movesmay well be present in cases of individual stocks. Particularly since the Asian crisiswhich seems to have brought about a regime shift in the relationship between FII flows and stock market returnsthe direction of causation seems to be running from the returns to the flows. The relative stability in the exchange rate of the Indian Rupee in the post-Asian crisis era seems to have outweighed fluctuations in the countrys credit rating among foreign portfolio investors. It is notable that the Asian crisis appears to have acted as a watershed in several of the key relationships affecting the FII flows to India. This is not an overly surprising result. Recent research18 has demonstrated that the Asian crisis caused several major changes in the financial relationship among European countries half-way across the globe. In fact the crisis appeared to have altered several of the ground rules of international portfolio investing around the world. Why exactly the relationships analysed here demonstrate a structural break at the outbreak of the Asian crisis is a matter of speculation. However, it is plausible that the crisis and Indias relative imperviousness to it increased Indias attractiveness to portfolio investors particularly as many other emerging markets began to appear extremely risky. This substitution effect may well have drowned other long-term relationships. Besides, investors may have started paying closer attention to obtaining and processing information in destination countries in the wake of the Asian crisis causing an information effect that could have altered the past relationship as well. Finally, behavioural changes among international portfolio investors following the crisis cannot be ruled out either. Another important area is the mild evidence towards the FII flows being affected by returns in the Indian markets in the immediate past. Such a relationship suggests that given the thinness of the Indian market and its evident susceptibility to manipulations, FII flows can, in fact, aggravate the occurrence of equity market bubbles though they

There appears to be significant differences in the nature of FII flows before and after the Asian crisis. In the post Asian crisis period it seems that the returns on the BSE National Index have become the sole driving force behind FII flows.

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18

See Chakrabarti and Roll (2002).

may not actually start them. This is obviously an important concern for policy makers and market regulators. This paper provides a preliminary analysis of FII flows to India and their relationship with several relevant variables especially returns in the Indian stock market. A more detailed study using daily data for a longer period or, better still, disaggregated data showing the transactions of individual FIIs at the stock level can help address questions regarding the extent of herding or return-chasing behaviour among FIIsindicators that can help us estimate the probability of sudden Mexico-type reversals of these FII flows which now account for a significant part of the capital account balance in our balance of payments. The extent to which FII participation in Indian markets has helped lower cost of capital to Indian industries is also an important issue to investigate. Broader and more long-term issues involving foreign portfolio investment in India and their economy-wide implications19 have not been addressed in this paper. Such issues would invariably require an estimation of the societal costs of the volatility and uncertainty associated with FII flows. A detailed understanding of the nature and determinants of FII flows to India would help us address such questions in a more informed manner and allow us to better evaluate the risks and benefits of foreign portfolio investment in India.

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Like those raised in Pal (1998).

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References
Bhagwati, Jagadish N., 1998. The Capital Myth: The Difference between Trade in Widgets and Dollars, Foreign Affairs, Vol. 77, pp. 7-12. Bohn, Henning and Linda Tesar, 1996. U.S. equity investment in foreign markets: Portfolio rebalancing or return chasing? American Economic Review, Vol.86, pp. 77-81. Brennan, Michael J. and H. Henry Cao, 1997. International Portfolio Investment Flows, Journal of Finance, Vol. LII, No.5, December, pp. 1851- 1880. Calvo, Guillermo A., Leonardo Leiderman and Carmen M. Reinhart, 1993. Inflows of Capital to Developing Countries in the 1990s, Journal of Economic Perspectives, Vol. 10, No.2, Spring, pp. 123-139. Choe, Hyuk, Bong-Chan Kho and Rene M. Stulz, 1999. Do foreign investors destabilize stock markets? The Korean experience in 1997, Journal of Financial Economics , Vol. 54, pp. 227-264. Chakrabarti, Rajesh and Richard Roll, 2002, East Asia and Europe during the 1997 Asian collapse: a clinical study of a financial crisis, Journal of Financial Markets, 5(1), pp. 1-30. Chuhan, Punam, Claessens Stijn, Mamingi Nlandu, 1998. Equity and bond flows to Latin America and Asia: the role of global and country factors, Journal of Development Economics, Vol.55, No.2, pp. 441-465. Clark, John and Elizabeth Berko, 1997. Foreign Investment Fluctuations and Emerging Market Stock Returns, Federal Reserve Bank of New York Staff Papers, Number 24, May. Cooper, Ian A., and Evi Kaplanis, 1994. Home bias in equity portfolios, inflation hedging, and international capital market equilibrium, Review of Financial Studies, vol.7, pp. 45-60. Corsetti, G., P. Pesenti and N. Roubini, 1999. What caused the Asian Currency and Financial Crises, Japan and the World Economy, Vol. 11, pp. 305-373. Errunza, Vihang R., forthcoming. Foreign Portfolio Equity Investments in Economic Development, Review of International Economics . Feldstein, Martin, ed. 1999. International Capital Flows, The University of Chicago Press, Chicago and London. French, Kenneth R., and James M. Poterba, 1991. Investor diversification and international equity markets, American Economic Review, Papers and Proceedings 81, pp. 222-226. Froot, Kenneth A., Paul G.J. OConnell and Mark S. Seasholes, 2001. The Portfolio flows of international investors, Journal of Financial Economics, Vol. 59, pp. 151-193. Krugman, Paul, 1998. Saving Asia: Its Time to Get Radical, Fortune, September 7. Pal, Parthapratim, 1998. Foreign Portfolio Investment in Indian Equity Markets: Has the Economy Benefited?, Economic and Political Weekly, March 14, pp. 589-598. Rangarajan, C., 2000. Capital Flows: Another Look, Economic and Political Weekly, December 9, pp. 4421-4427. Samal, Kishore C., 1997. Emerging Equity Market in India: Role of Foreign Institutional Investors, Economic and Political Weekly , October 18, pp. 2729-2732. Stiglitz, Joseph, 1998. Boats, planes and capital flows, Financial Times, March 25. Tesar, Linda, 1999. The Role of Equity Markets in International Capital Flows, in Feldstein, Martin, ed. International Capital Flows, The University of Chicago Press, Chicago and London. Tesar, Linda and Ingrid Werner,1995a. Home bias and high turnover, Journal of International Money and Finance, vol. 14, pp. 467-492. Tesar, Linda and Ingrid Werner,1995b. U.S. Equity Investment in Emerging Stock Markets, The World Bank Economic Review,Vol. 9, No. 1, January. World Bank, 1997. Private Capital Flows to Developing Countries: The Road to Financial Integration, Oxford University Press, New York.

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Appendix I: A Description of the Data

The data used in this paper comes from several sources. We use monthly net FII investment figures obtained from the websites of RBI and SEBI. Market capitalisation data are obtained from the BSE website. Other financial data like the exchange rate, short-term interest rate in India, returns on the MSCI world index, S&P 500 as well as the BSE national index are obtained from Datastream. Country credit rating data are obtained from several issues of the Institutional Investor magazine. The FII net investment series starts from January 1993 and the BSE market capitalisation series starts in April 1993. The series of FII flows as a proportion of preceding months BSE market capitalisation therefore begins in May 1993. Since the net monthly FII flows and the returns in the Indian equity markets constitute two key variables in this study, we present, in the three panels of Figure 1, the net FII flows, the BSE National Index and net FII flows as a proportion of the preceding months BSE market capitalisation from May 1993 to June 2001. The BSE National Index immediately reveals the massive and short-lived bubble during 2000, a phenomenon that is likely to have caused temporary but marked deviations from the long-term relationship between FII flows and Indian market returns. In order to avoid misleading results from this potentially tainted period, we restrict our sample to the end of 1999 for carrying out empirical analyses. In order to check if the Asian crisis marked a structural break in the relationships studied here, we sub-divide the sample period into two sub-samples. Dating the Asian crisis to begin in July 1997*, the pre-Asian Crisis sub-sample runs from May 1993 to June 1997 (50 months) and the Asian crisis sub-sample runs from July 1997 to December 1999 (30 months). In order to study the causal linkage between FII flows and contemporaneous stock returns in greater detail, we also use daily FII flows data and daily returns on the BSE National Index for the year 1999. The daily FII flows data come from the SEBI website while the daily returns data are, once again, obtained from Datastream. All returns are computed on continuous compounding basis i.e. as the excess of the logarithm of the index value on a date over the logarithm of the index value on the previous date.

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

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