Vous êtes sur la page 1sur 28

Foreign Institutional Investment in India: Determinants and the impact of crises

1.0 Introduction
Foreign investment plays an important role in the long term economic development of a
country by augmenting availability of capital, bridging the gap betwee n savings and
investment, raising productivity and providing foreign exchange. I nternational capital
flows particularly in the form of portfolio investment to developing and emerging
markets is a phenomenon, which began at a reasonable scale in the early 1 990s. The
phenomenon emerged mainly on account of two reasons. First, a high potential for
growth coupled with the lack of availability of capital have made these economies
embrace foreign capital. Second, there is an increased preference on the part of
developed economies to divert their available capital to destinations where it earns
good returns. Both these factors together with the widespread liberalisation and
globalisation of financial markets have open ed a new era of capital mobility whereby
private capital flows have assumed an important source of finance for emerging
markets.
Following the liberalisation of Indian economy in 1991, there was a gradual shift in
capital flows from debt to non -debt creating flows by encouraging foreign investment
into the country. In this process of encouraging both direct and portfolio investment,
the Foreign Institutional Investors (FIIs) 1 were allowed to invest in domestic financial
markets from September, 1992. The FIIs have now become important players in the

The term foreign institutional investor has been defined by Securities and Exchange Board of
India (SEBI) under its (Foreign Institutional Investors) Regulations, 1995 as: "an institution
established or incorporated outside India which proposes to make investment in India in
securities. It also includes investment by a sub-account. The entities who are eligible to get
registered in India as FIIs include pension funds, mutual funds, banks, university funds,
foundations, etc.
.

domestic financial markets and the Foreign Institutional investment (FII) has become
an important source of portfolio investment in the country. The cumulative FII
investment (purchases) in India since November 1992 till end of November 2012 stood
at around Rs. 63,80,223 crores while the net investment for the same period stood at
around Rs. 701680.12 crores (www.sebi.gov.in). The total number of registered FIIs
was 1752 till the end of November 2012 and the total number of Registered Sub accounts was 6306 on t he same date (www.sebi.gov.in).

FII investments as a

percentage of market capitalization increased from 1.52 per cent in 1993 -94, to 12.96
per cent in 2000-01 and further to 14.51 per cent in 2010 -11 (SEBI, 2011). The total
turnover of the FIIs in the equ ity market constituted 15.30 percent of the total turnover
on the BSE and the NSE in 2010 2011, an improvement from 11.56 percent recorded
in 20092010 (ISMR, 2011).
1.1 Rationale and objective of the study
While there are many benefits associated with FII inflows, such as increased
investment rate and augmented foreign exchange, there are concerns regarding the
sustainability of these flows. Since the basic motive of these flows is profit, they are
always prone to sudden withdrawals. Portfolio flows in the form of FII, thus, tend to be
volatile and the sudden flight of this form of investment can have adverse consequences
on the recipient countrys economy as happened in the case of East Asian crisis and
Mexico crisis.
In view of the increasing significance of FIIs in the Indian markets, the present study
aims to analyse the nature and determinants of FII inflows to India, with special
reference to the impact of crises on these flows. The present paper contributes to the
existing literature in many ways. First, while identifying determinants of FIIs, w e have
tried to analyse the impact of crisis as well, particularly the global financial crisis of
2

2008. To identify for the existence of structural breaks in the FII inflows, we have
included the dummy variables for the East Asian Financial Crisis of 1997 and the
Global Financial Crisis of 2008. Second, we have used a more refined methodology of
Principal Component Analysis (PCA) to augment the analytical richness of the model
employed. Third, we have taken a longer time period as compared to many studies that
have a shorter reference period.
1.2 Layout of the Paper
The present study is divided into five sections. The first section as already discussed
introduces the topic and lays out the objectives. Section 2 presents an overview of the
existing literature in this area of research. Section 3 describes the choice of the dataset, and
explains the methodology used in the study . Section 4 presents and discusses the empirical
results. Section 5 gives conclusions and recommendations.
2.0 Review of Literature
International Studies
The literature on the relationship between portfolio investment and domestic stock
market returns has generally shown a positive contemporaneous relationship [(Bohn
and Tesar (1996), Clark and Berko (1996), Griffin et. al (2002) and Richards (2005)].
This positive relationship however need not necessarily imply that portfolio investment
flows into a country as a result of returns in domestic stock market ; rather the portfolio
inflows may be caused by exogenous changes in investor preferences (Brennan and
Cao, 1997). Further, this positive association between domestic stock market returns
and portfolio investment may alter during a currency crisis [Choe et al. (1998), Kim
and Wei (2000)].
Results also vary across literature regarding the general question of whether external or
domestic factors are more important in influencing portfolio flows. While some studies
3

find domestic factors to be more important determinants of FII movement [Chuhan et


al. (1998); Garibaldi et al (2002)], others find external factors to be more important
[Calvo et al. (1993); In-Mee Baek (2006)]. Still others find that both domestic and
external factors have an important role to play in determining FII flows [Taylor and
Sarno (1997); Portes and Rey (2005)]. Regional factors have also been considered as an
important determinant in a number of studies [ Buckberg (1996); Richards (2005);
Griffin et al. (2002); Froot et al. (2001)]
Indian Studies
The extant literature in the Indian context adopts a common approach in separating the
determinants of foreign portfolio flows into domestic influences such as domestic stock
market returns, the volatility and liquidity of the domestic stock markets, exchange
rates, and the external influences such as global stock market returns and interest rates
[Agarwal (1997); Pal (1998); Mukherjee, Bose and Coondoo (2002) ; Batra (2003);
Gordon and Gupta (2003); Rai and Bhanumurthy (2004) ; Roy (2007); Saraogi (2008);
Kaur and Dhillon (2010); Bhanumurthy and Singh (2011); Shankar (2011)] .
3.0 Data and Methodology
3.1 Sample Period and Data Sources
Sample Period
The study uses monthly time series data from April 1994 to December 2011. We have
chosen to use monthly data because of the lack of availabil ity of daily data on various
macroeconomic variables considered in the study, namely, Index of Industrial
Production (IIP), Wholesale Price Index (WP I), Call Money Rate (CMR), etc. Though,
the FII inflows to the country was allowed from September 1992, but the starting point
for the data has been selected from April 1994 as these two years can be regarded as
learning period for investors.
4

Data Sources
The data on FII inflows has been taken from SEBIs website. The data on S&P 500 has
been taken from the website of yahoo finance (in.finance.yahoo.com). The data on
MSCI Emerging Market (EM) Index has been taken from the website of Morgan
Stanley Capital International. The data on London InterBank Offer Rate (LIBOR) is
taken from fedprimerate.com. The data o n Sensex has been taken from the website of
Bombay Stock Exchange (BSE) (www.bseindia.com). The data on exchange rate, call
money rate, index of industrial production and wholesale price index has been taken
from the website of Reserve Bank of India (www.rbi.org.in). The data on volatility and
market capitalisation has been taken from the SEBIs Handbook of Statistics on Indian
Securities Market, 2011.
3.2 Data Description
Dependent Variables
In the literature, researchers have used several alternative form s of the
dependent/explained variable. We have used three different specifications of the
dependent variable. First, we have taken gross FII equity inflows/purchases expressed
in absolute values in rupees crore. Second, we have also tried to identify the
determinants of FII net (inflows -outflows) equity inflows expressed in rupees crore. FII
net inflows are considered to serve as an overall measure of FIIs activities in the Indian
stock market. Third, we have used gross FII equity inflows as a percentage of market
capitalisation on the BSE. This form of dependent variable has been taken to capture
the relative importance of FIIs in the Indian stock market.

Independent Variables
Regarding the choice of the independent variables, we have drawn upon the existing
literature to identify the primary determinants of global investors decision to invest in
the Indian markets. We classify the factors determining the FII inflows into domestic
and external factors. Domestic factors are also referred to as pull factors as they attract
the portfolio investment into the country, whereas external factors are referred to as
push factors as they try to push the portfolio investment out of the country.
We further classify the domestic determinants of FII inflows into those which relate to
financial market factors such as stock market returns and volatility, and those which
relate to the macroeconomic fundamentals of the country. If foreign investors focus on
the macroeconomic factors while deciding to invest in any country, they are described
as following a top-down approach. On the contrary, if they focus more on the financial
market variables, then they are said to follow a bottom -up approach. A general belief
regarding the FIIs in India is that they invest on a bottom-up basis. They invest in some
selected stocks and are less concerned with macroeconomic fundamentals. In this study
we try to assess whether the investment decisions of FIIs in case of India are affected
by Indias macroeconomic performance or not.
Before actually conducting a regression analysis we can form a priori expectations on
the behaviour of the selected independent variables with respect to FII investments.
Based on the above discussion, the determinants explaining the FII inflows to India
along with their expected relationship with each of the dependent variable can be stated
as follows.

Global Variables
1. Monthly return2 on S&P 500 in order to represent global stock market returns. The
reason for taking U.S. market is that stock market in U.S. act s as a benchmark for
other countries indices. FII inflows are expected to have a negative relationship
with returns on S&P 500. An increase in the U.S stock markets returns will make
the FIIs to invest more in their home countries thereby reducing the flow o f funds to
emerging markets like India.
2. Monthly returns on MSCI Emerging Market (EM) Index which is one of the most
popular emerging market ind ex and is widely used by foreign portfolio investors for
making investment decisions in emerging markets. FIIs in vestment in India is
expected to have a negative relationship with returns on MSCI EM index. A
negative relationship would suggest that India compete s with other emerging
markets in order to attract FII.
3. Changes in 3-month London InterBank Offered Rate (LIBOR) to represent short
term global interest rates. Declining foreign interest rates would lead to an increase
in FII inflows to India because of cheaper availability of funds. Another reason for
this inverse relationship can be that an increase in LIBOR would mean high returns
on the LIBOR linked investments and therefore lesser investment to stock markets
of countries like India because of funds flowing towards high yield instruments.
Thus we expect a negative relationship.
Domestic Variables
A. Financial Variables

Returns have been calculated as the excess of the logarithm of the month -end index value
over the logarithm of the index value on the previous month -end.
7

1. Monthly returns on BSE Sensex to represent domestic stock market returns. An


increase in BSE Sensex would lead to an increase in FIIs investment in India and
vice-versa thereby suggesting positive feedback trading. FIIs will invest in Indian
markets in search of higher returns. Thus a positive relationship is expected.
2. Lagged monthly returns on BSE Sensex with a lag of one month. FIIs may also take
into account the past domestic stock market returns while taking their current
investment decisions. Thus, the relationship is expected to be positive.
3. Volatility 3 in monthly returns on BSE Sensex used as a proxy for risk associated
with investing in Indian equities of the index. In theory volatility is expected to
have a negative sign with FII inflows. The markets with high volatility would see
less investment by FIIs.
Apart from these financial market variables, we also consider various macroecon omic
variables. These variables are taken to reflect the variations in the fund amentals of the
Indian economy.
B. Macroeconomic Variables
4. Monthly returns in exchange rate denoted by variations in the rupee -dollar
exchange rates. A positive return means depreciation of Indian rupee against US
dollar. FII inflows are expected to go up (down) when there are expectations of
domestic currency appreciation (depreciation). Going by our definition of the
monthly exchange rate return , it is expected to have a negative relationship with FII
inflows

Volatility is calculated as the standard deviation of the natural log of daily returns in Sensex.
8

5. Changes in Call Money Rate (CMR) as a proxy for short term domestic interest
rates and real economic activity. We expect a positive relationship of CMR with FII
inflows
6. Index of Industrial Production 4 (IIP) as a proxy for short run real income changes.
An increasing IIP suggests an increase in the level of industrial production thereb y
an increase in growth rate of the economy. Hence FII investments in India should
be a positive function of IIP.
7. Wholesale Price Index (WPI)5 as an indicator of inflation rate in the Indian
economy. An increasing WPI suggest an increase in general price l evels. A high
rate of inflation is a signal for macroeconomic instability and erodes the returns of
FIIs in rupee terms. Hence, we expect that FII investments in India should be a
negative function of inflation or the WPI index.
8. Lagged value of the depende nt variable with a lag of one time period that is, one
month. The relationship of FII investment with its own lagged value is expected to
be positive. Such a positive relation would suggest that FIIs indulge in herd
behaviour.
Impact of the Crises
In addition to the above variables, we have introduced two dummy variables, one for
East Asian financial crisis of 1997 and the other for the Global financial crisis of the
year 2008. Specifically, we want to capture the impact of these two crises on FII
inflows to India.
Thus, the general form of the function is:

Sector-wise index number (general index) of industrial production with b ase year 1993-94.

Monthly average of wholesale price index (all commodities) with base year 1993 -94.
9

FII = f (S&P_RET, MSCI_RET, LIB, BSE_RET, BSE_RETL, ER_RET, VOL, CMR,


IIP, WPI, D2, D3, LDV)
where
S&P_RET

: Returns on US S&P 500 index

MSCI_RET : Returns on MSCI EM index


LIB
BSE_RET

: Changes in LIBOR
: Returns on BSE Sensex

BSE_RETL : One month lagged returns on BSE Sensex


ER_RET

: Return on US dollar -rupee exchange rate

VOL

: Volatility in returns on BSE Sensex

CMR

: Changes in call money rate

IIP

: Index of Industrial Production

WPI

: Wholesale Price Index

D2

: Dummy variable for East Asian financial crisis (value of 1 for all months

after the onset of crisis, (i.e., July 1997 6 till September 2008 and 0 otherwise) and
D3

: Dummy variable for Global financial crisis (value of 1for all months after

October 2008 7 and 0 otherwise)


LDV

: One month Lagged dependent variable

3.3 Methodology
Multiple regression

6
7

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

The crisis marked its beginning around the time of August 2007, however it aggravated
around
October
2008
when
the
markets
came
down
heavily.
See
http://www.nber.org/papers/w14631
10

The study uses multiple reg ression analysis to identify the determinants of FII
investment. As a first step, we check for the stationarity of the underlying time series .
We use the Augmented Dickey-Fuller (ADF) test and Phillips -Perron (PP) test to
investigate whether the time serie s of dependent and independent variables are
stationary or not. Having tested for stationarity, we then conduct a multiple regression
analysis to identify the determinants of FII inflows to India. As mentioned earlier, we
make use of dummy variables in ord er to test for the presence of structural break in our
data. In our case we make use of two dummy variables to identify structural breaks ; one
for the East Asian Financial Crisis of 1997 and the second for the Global Financial
Crisis of 2008. The dummy var iables take the value 1 during the crisis period and 0
otherwise.
After introducing the dummy variables, e ach specification of the dependent variable
was regressed on the independent variables in following regression framework or
model:
FII = + 1 S&P_RET + 2MSCI_RET + 3LIB + 4BSE_RET + 5BSE_RETL +
6ER_RET + 7VOL + 8CMR + 9IIP + 10WPI + 11LDV + 12D2 + 13D3 + u
.(1)
where
FII: different specification of the dependent variable
: constant term
(1 to 13) : the respective beta coefficients for each independent variable
u : error term
All other variables carry their usual meaning as stated in section 3.2.
The original regression results were found to be suffering from t he problem of
multicollinearity due to a large number of expl anatory variables. When the data suffers
11

from the problem of multicollinearity then though the estimation of regression


coefficients is possible but their standard errors tend to be large. In such a situation ,
while overall measure of goodness of fit (R 2) can be very high, the estimated
coefficients of most of the explanatory variables are largely insignificant.
Principal Component Analysis
As seen above, retaining all variables leads to multicollinearity. If we try to avoid
multicollinearity by dropping a ll correlated variables, there is a great loss of
information. Alternatively, we could use Principal Component Analysis to determine
the principal variables. By using this procedure, we eliminate some variables without
affecting the explanatory power of the equation because the retained variables contain
the information of those which are eliminated.
The basic principle behind the application of factor analysis is that the initial set of
variables should be highly correlated. This could be checked with th e help of a test
known as Barttlet test of sphericity, which tests the null hypothesis that the variables
are uncorrelated. Another condition which needs to be fulfilled before a factor analysis
could be carried out is the value of Kaiser -Meyer-Olkin (KMO) measure of sampling
adequacy. This test statistic takes a value between 0 & 1. For the application of factor
analysis, however, value of KMO statistics greater than 0.5 is considered desirable
(Malhotra and Dash, 2011).
The following consideration should be kept in mind while applying PCA:
1. For determining the retained component we need a criterion.
2. The PCA methodology tells us the total variance explained by each retained principal
component as well as the cumulative percentage of the explained var iation. This is a
measure of the explanatory power of the component for the information content of the
procedure.
12

3. There were various methods of rotation but the most popular method is the Varimax
with the Kaiser normalization. The purpose of the rotatio n is to make the interpretation
of the PCA more meaningful. Method of rotation however retains the same information
and explanatory power.
After doing these procedures there was a choice between retained principal components
in a regression framework or se lecting the principal variables that are associated with
each of those components. This involves the Jolliffe procedure. In the first case
regression is known as principal component regression and in the second case it is
known as principal variable regres sion. We have chosen the latter because it is difficult
to interpret the principal component regression. We have used the Joliffes procedure
for selecting principal variables. We take up each rotated component and select the
variable that has the highest component score. Then we move to the next component
and so on. This way we get the principal variables which represent the maximum
information and eliminate the variables that are correlated to them and hence create
multicollinearity.
4.0 Empirical Results and Analyses
The summary statistics of the dependent and independent variables are presente d in
Table 1 of the appendix.
4.1 Unit Root Tests Results
To detect the presence of unit root in the underlying series of all variables , two unit root
tests are employed, namely Augmented Dickey Fuller Test (ADF) and Phillip Perron
(PP) test. The lag length, for the ADF tests is chosen so as to minimize Schwarz
Information Criterion (SIC) where the upper bound on the lag length of 14 was
selected. The bandwidths fo r the PhillipsPerron test follow the Newey West
13

suggestion using Bartlett kernel. The null hypothesis under these tests is that the
underlying time series is non -stationary or has a unit root. Rejection of null hypothesis
would signify that the underlying variable is stationary. Table 4.1 summarises the
results of unit root tests.
Table 4.1: Unit Root Test Results for Dependent and Independent Variables
Variables

FIIP
FIIN
FIIPCAP
S&P_RET
MSCI_RET
LIB
BSE_RET
ER_RET
VOL
CMR

ADF test statistics


Intercept and
Intercept and
no trend
trend
-1.858987
-3.545008**
-5.018195*
-5.367088*
-2.039284
-2.516148
-13.05018*
-13.17062*
-12. 18680*
-12. 18155 *
-10.26279*
-10.26893*
-13. 81063*
-13. 80263*
-11.66984*
-11.65376*
-4.791111*
-4.777311*
-13. 60035*
-13. 56707*

PP test statistics
Intercept and no Intercept and
trend
trend
-1.994177
-4.299723*
-10.73613*
-11.04012*
-2.916575**
-5.611506*
-13.13599*
-13.22413*
-12. 30543*
-12. 26394*
-10.68751*
-10.69920*
-13. 89546*
-13. 87156 *
-11.65360*
-11.60982*
-9.217622*
-9.219286*
-26. 11990*
-26. 04323 *

IIP

1.326333

0.545931

WPI

2.270884

-0.207717

2.758014

0.398913

Inferences

Stationary at level
Stationary at level
Stationary at level
Stationary at level
Stationary at level
Stationary at level
Stationary at level
Stationary at level
Stationary at level
Stationary at level
Non-stationary at
level
Non-stationary at
level

*denotes significance at 1% level of significance


** denotes significance at 5% level of significance
-Means that the E.Views was showing insufficient number of observations

Table 4.1 suggests that except for the Index of Industrial production (IIP) and
Wholesale Price Index (WPI), all other series came out to be stationary at level
implying that these variables can be used at level in regression analysis. FIIPCAP was
found to be non-stationary at level using ADF tests, however it came out to stationary
at level using PP test. Since PP test is considered to be a powerful test than ADF test,
so we take the FIIPCAP se ries to be stationary at level. As far as the IIP and WPI are
concerned we took their first difference and again checked for their stationarity. Both
these series came out to be stationary at first difference. The first differenced series of
14

these variables are now onwards denoted by DIIP and DWPI, respectively. The resul ts
are reported in the table 4.2.
Table 4.2: Unit Root Test Results for IIP and WPI after differencing
Variables

ADF test statistics


Intercept and
Intercept
no trend
and trend

PP test statistics
Intercept and
Intercept
no trend
and trend

DIIP

-25.56906*

-25.56661*

-37.03304*

-40.77019*

DWPI

-8.781424*

-9.189777*

-8.950275*

-9.317136*

Inferences

Stationary at
first difference
Stationary at
first difference

*denotes significance at 1% level of signifi cance

4.2 Preliminary Regression Results


Each specification of the dependent variable was regressed on the independent
variables. The results are summarised in Table 4.3. The table shows that inspite of high
R2, only few coefficients turns out to be signi ficant in explaining FII inflows to India . A
high R2 with few significant t-ratios is a symptom of multicollinearity. The correlation
matrix (given in table 2 of appendix) also reveals that there are indeed high correlations
between quite a few of our inde pendent variables. We address the problem of
multicollinearity in our data using factor analysis technique through Principal
Component analysis (PCA).
Table 4.3: Preliminary Regression Results

Independent Variables
Constant
S&P_RET
MSCI_RET
LIB
BSE_RET
BSE_RETL
ER_RET
VOL
CMR

FIIP
Coefficients
p-values
-695.1622
-228.0027
125.1649
-448.8021
158.6252
211.1818
-822.0009
760.9154
-102.3592

0.7187
0.2708
0.4167
0.8622
0.1489
0.0103**
0.0344**
0.4076
0.5636

Dependent Variables
FIIN
Coefficients
p-values
1921.153
-21.60837
94.51165
-81.96247
158.0085
28.68618
-914.4197
-997.6255
-14.22695
15

0.0550***
0.8391
0.2347
0.9507
0.0056*
0.5421
0.0000*
0.0373**
0.876

FIIPCAP
Coefficients
p-values
0.000157
-0.000119
5.36E-05
0.000368
-1.14E-05
5.89E-05
-0.000193
0.000387
-6.44E-05

0.7306
0.0162**
0.1448
0.5449
0.6591
0.0024*
0.0355**
0.0790***
0.1245

DIIP
DWPI
Lagged Dependent
Variable
(FIIPL/FIINL/FIIPCAPL)
D2
D3
ADJ. R2
Prob. (F-statistic)

788.4217
83.00815
0.898972

0.1165
0.0627***
0.0000*

247.6811
17.28118
0.186724

1080.742
0.5315
3239.726
0.2001
0.897926
0.000000

0.3171
0.4509
0.0042*

689.8973
0.4239
3673.959
0.0012*
0.416348
0.000000

0.000126
2.25E-05
0.781689

0.267
0.0323**
0.0000*

0.001162
0.0132**
0.001065
0.0627***
0.803692
0.000000

*denotes significance at 1% level of significance,


**denotes significance at 5% level of significance,
***denotes significance at 10% level of significance

4.3 Principal Component Analysis (PCA)


As a first step we identify whether the technique of factor analysis is applicable to our
set of data. For this we use two measures namely, Barttlet test of sphericity and Kaiser Meyer-Olkin (KMO) measure of sampling adequacy. Since we have taken three
specifications of dependent variables, therefore the lagged dependent varia ble which
has been used as an independent variable in our analysis will be different in each case.
As a result, we have applied PCA thrice with a different lagged dependent variable
each time. The other independent variables remain the same. The results o f KMO and
Barttlet test are reported in the table 4.4.
Table 4.4: Results of KMO and Bartletts test
Dependent Variable

FIIP
FIIN
FIIPCAP

Kaiser-Meyer-Olkin (KMO)
measure of sampling adequacy

Barttlet test of Sphericity

0.621
0.647
0.624

481.844 (0.000*)
504.652 (0.000*)
474.488 (0.000*)

Figures in parentheses represent p -values. *denotes 1% level of significance

The results indicate that PCA can be applied to the set of independent variables as the
value of KMO statistics is greater than 0.5 and the B artlett test is significant in all three

16

cases thereby leading to the rejection of null hypothesis that correlation matrix is
insignificant.
In all the three cases, four factors/components were extracted following Kaisers rule,
the Eigen values of all the se factors was greater than 1. The total variation explained in
each of the three cases was 60.650%, 61.148% and 59.878% respectively .
In order to facilitate a better interpretation of factor loadings, we rotate the initial
component matrix using varimax r otation, thereby resulting in a Rotated Component
Matrix. The Rotated component matrix was then used to select the principal variables.
The cut-off point was taken to be 0.60 and negative values were ignored. The variable
with the highest loading factor o n each of the component was taken to be as a principal
variable and was used as an independent variable in the final regression.
Rotated Component Matrix for FIIP
The Rotated Component Matrix for FIIP is presented in the ta ble 4.5. On the basis of
setting 0.60 as cut-off, the four principal variables that can explain FII inflows to India
are MSCI_RET, LIB, FIIPL and DIIP. The selection of last two variables has been
done on the basis of theoretical considerations.
Table 4.5: Rotated Component Matrix a for FIIP
Component
Variables
S_P_RET
MSCI_RET
LIB
BSE_RET
BSE_RETL
ER_RET
VOL
CMR
DIIP
DWPI
FIIPL

1
0.765
0.907

0.785
0.800
-0.665
-0.607
0.706
0.673
0.797
0.790

Extraction Method: Principal Component Analys is.


Rotation Method: Varimax with Kaiser Normalization.

17

Extraction Method: Principal Component Analys is.


Rotation Method: Varimax with Kaiser Normalization.
a. Rotation converged in 6 iterations.

Rotated Component Matrix for FIIN


The Rotated Component Matrix for FIIN is p resented in the table 4.6. The four
variables that are selected are MSCI_RET, FIINL, DIIP and LIB.

Variables
S_P_RET
MSCI_RET
LIB
BSE_RET
BSE_RETL
ER_RET
VOL
CMR
DIIP
DWPI
FIINL

Table 4.6: Rotated Component Matrix a in case of FIIN


Component
1
2
3
0.766
0.908

0.857
0.815
0.791
-0.640

0.765
-0.614
0.815

Extraction Method: Principal Component Analysis.


Rotation Method: Varimax with Kaiser Normalization.
a. Rotation converged in 6 iterations.

Rotated Component Matrix for FIIPCAP


The Rotated Component Matrix for FII PCAP is presented in the table 4.7. The

four

selected principal variables are MSCI_RET, FIIPCAPL, DWPI and BSE_RETL. The
variables, FIICAPL and BSE_RETL have been selected on the basis of theoretical
considerations.
Table 4.7: Rotated Component Matrix a in case of FIIPCAP
Component
1
2
3
Variables
S_P_RET
0.751
MSCI_RET
0.909
LIB
BSE_RET
0.806
BSE_RETL
18

0.634

ER_RET
VOL
CMR
DIIP
DWPI
FIIPCAPL

-0.673
0.634
0.686
0.771
0.738

Extraction Method: Principal Component Analysis.


Rotation Method: Varimax with Kaiser Normalization.
a. Rotation converged in 6 iterations.

Thus, the variables selected as independent variables under Factor Analysis accounts
for the maximum variance in the data. The selected variables in all the three cases are
summarized in table 4.8.
Table 4.8: Principal Variables Selected after Factor Analysis

Independent
variables

Dependent variables
FIIN
MSCI_RET
FIINL
DIIP
LIB

FIIP
MSCI_RET
LIB
FIIPL
DIIP

FIIPCAP
MSCI_RET
FIIPCAPL
DWPI
BSE_RETL

4.4 Principal Variable Regression Results


After selecting the principal variables to be used in further regression, we again ra n the
regressions taking the principal variables extracted in factor analysis and the two
dummy variables, namely D2 and D3. The regression results are presented in the table
4.9.
Table 4.9: Principal Variable Regression Results

-29.92675
239.9998
315.302

0.9835
0.0041*
0.8997

Dependent variables
FIIN
pCoefficients
values
310.2478
0.6949
323.0616
0.0000*
188.5094
0.891

0.919211

0.0000*

0.25441

FIIP
Independent variables
Constant
MSCI_RET
LIB
Lagged Dependent
Variable
(FIIPL/FIINL/FIIPCAPL)

Coefficients p-values

19

FIIPCAP
Coefficients p-values
0.000406
4.81E-06
N.A.

0.0000* 0.810874

0.2535
0.8068
N.A.
0.0000*

DIIP
DWPI
BSE_RETL
D2
D3
ADJ. R2
Prob. (F-statistic)

74.92327
0.0921***
N.A.
N.A.
N.A.
N.A.
1941.72
0.2599
3619.616
0.1591
0.892024
0.000000

20.54843
0.3972
N.A.
N.A
N.A.
N.A
784.3273
0.3821
3379.987
0.0035*
0.302995
0.000000

N.A.
N.A.
2.35E-05
0.8293
5.84E-05
0.0023*
0.00128
0.0071*
0.001251
0.0302**
0.792185
0.000000

*denotes significance at 1% level of significance


**denotes significance at 5% level of significance
*** denotes significance at 10% level of significance
N.A. means not applicable

Regression Analysis for FIIP as the Dependent Variable


The regression results for FIIP as a dependent variable indicate that 89.20 per cent
variation in gross FII inflows is explained by the selected principal variables. The
estimated coefficient of MSCI_RET is positive and significa nt. Thus, the regional
factor represented by MSCI Emerging Market Index has come out to be an important
determinant of FII inflows. While we had expected a negative sign for the coefficient,
we get a positive sign. This could be due to the reason that FIIs look at emerging
markets as a whole and therefore an increase in the EM index wou ld mean that India
also receive greater FII inflows. However this positive association also suggests the
contagion effect in the sense that adverse changes in any other emerg ing economy
would also lead to an outflow of FII from Indian economy.
The one month lagged dependent variable turns out to be a significant determinant of
gross FII inflows. Further, we get a positive sign for the estimated coefficient which
can possibly be explained as herd behavior by FIIs. The FIIs are positively influenced
by the amount of investments in the preceding month . DIIP is positively associated to
gross FII inflows to India. This independent variable was found to be significant at 10%
level of significance. The significance of this variable may suggest that FII flows
follow a top-down approach while investing and are affected by the growth rate of the
20

country. Our results are in contradiction with the general belief that FIIs are only
interested in stock market returns and not least concerned about the growth rate of the
economy. Both the dummy variables are insignificant. Thus we can say that there was
no significant impact of both the crises on FII inflows to India.
Thus the principal variabl es explaining FII inflows to India are MSCI EM returns,
lagged values of FII inflows and the growth rate of India.
Regression Analysis for FIIN as the Dependent Variable
The regression results for FIIN as a dependent variable indicate that 30.30 per cent
variation in net FII inflows (inflows -outflows) is explained by the independent
variables. The coefficient of MSCI_RET is positively and significantly associated with
FII net inflows. The results are consistent with the results for FIIP as FIIP is one of th e
components of FIIN. One month lagged dependent variable is positive and significant .
DIIP which is acting as a measure of growth is insignificant for FII net inflows. This
can be explained by the fact that while investing in India, FIIs do consider the g rowth
of the economy but for withdrawing money from the Indian markets, they are not really
influenced by growth. Thus for net inflows which also incorporates the effect of FIIs
sales, the growth rate of India is an insignificant factor. While the dummy variable for
East Asian Financial Crisis is insignificant , the dummy variable for the global financial
crisis of 2008 has a significant impact on net FII inflows. A possible reason for this
could be that India had stricter capital controls in 1997 as compare d to other South-East
Asian economies and it was relatively less integrated with other economies of the
world. Consequently, FII movement was less and hence there were not sudden large
withdrawals by the FIIs from the Indian markets as was seen in case of other emerging
markets like Malaysia and Thailand. The crisis of 2008, however, marks a structural
break in the net FII inflows to India. This result is supported by the fact that capital
21

controls had eased in India by this time as compared to 1997. Hence, Indian markets
were affected more by the crisis of 2008 than the crisis that happened in 1997. There
were sudden withdrawals by the FIIs in 2008 indicating increasing linkages of the
Indian economy with the other economies in the world. Thus the principal variables
explaining net FII inflows to India are MSCI EM returns, lagged values of FII net
inflows. Also, the crisis of 2008 had a significant impact on the net FII inflows to India.
Regression Analysis for FIIPCAP as the Dependent Variable
The third set of regression analysis was conducted with FII inflows as a percentage of
market capitalization at BSE (FIIPCAP) as a dependent variable. This was primarily
done to gauge the relative importance of the FIIs in the Indian markets. The results
indicate that 79.22 per cent variation in dependent variable is expl ained by independent
variables. Returns on MSCI Emerging Market index is insignificant here but the returns
on BSE SENSEX with one month lag are positive and significant. The lagged
dependent variable is also positive and significant. Both the dummy variables are
significant. Thus the relative importance of the FII inflows in the Indian market was
significantly impacted by both the crisis.
5.0 Summary and Conclusions
This study aimed at identifying the determinants of FII inflows to India , with special
reference to financial crisis . We have incorporated two dummy variables in our study to
account for the East Asian financial crisis of 1997 and the global financial crisis of
2008 to examine if any structural break occurred in FII inflows due to these crises.
The most important factors affecting FII inflows to India were found to be the returns
on MSCI Emerging Market Index, past values of FII inflows and the growth rate of the
Indian economy. The East Asia n financial crisis of 1997 and the global financial crisis
of the year 2008 had no significant impact on the gross FII inflows to India though the
22

global financial crisis of the year 2008 had a significant impact on net FII inflows
which confirms our view that India was more affected by the crisis of 2008 than the
crisis of 1997. This was probably because of the fact that Indian economy was less
integrated with the other economies of the world in 1997 than in 2008. On the other
hand both the crises had a si gnificant impact on FII inflows as a proportion of market
capitalisation.
Thus our results suggest that the FII inflows to India are in response to a combination
of both global as well as domestic factors. However, the tendency of return chasing and
herd behavior on part of FIIs makes the FII inflows coming to the Indian equity
markets volatile. These results have important implications for Indian policymakers.
The policymakers in India should try to develop some in -built cushions to protect the
economy from the ill effects resulting from volatile nature of FIIs. One such way could
be to encourage both the retail as well as domestic institutional investor to actively
participate in the Indian equity markets so as to broaden the investor base of the Indian
equity markets. Another way could be to discourage the speculative part of the FII
investment. Only then India would be able to fully reap the benefits arising out of
increasing foreign investment.
References
Journals
Agarwal, R. (1997). Foreign Portfolio Investment in some Developing Countries: A
Study of Determinants and Macroeconomic Impact. Indian Economic Review, 32(2),
217-229.
Baek, In-M. (2006). Portfolio investment flows to Asia and Latin America: Pull, push
or market sentiment? . Journal of Asian Economics, 17, 363373.

23

Batra, A. (2003). The Dynamics of Foreign Portfolio Infl ows and Equity Returns in
India. ICRIER Working Paper No. 109, New Delhi.
Bhanu Murthy, K.V. and A. Singh (2011). Do Foreign Institutional Investors really
drive the Indian stock market?. Presented at Second World Finance Conference,
Rhodes, Greece, 17-18 June, 2011.
Bohn, H. and L. Tesar (1996). U.S. Equity Investment in Foreign Markets: Portfolio
Rebalancing or Return Chasing?. American Economic Review, 86(2), Papers and
Proceedings of the Hundredth and Eighth Annual Meeting of the American Economic
Association San Francisco, CA, 77-81.
Brennan, M. J. and H. H. Cao (1997). International Portfolio Investment Flows.
Journal of Finance, 52(5), 1851-80.
Buckberg, E. (1996). Institutional Investors and Ass et Pricing in Emerging Markets.
IMF Working Paper 96/2.
Calvo, G. A., L. Leiderman, and C. M. Remhart (1993). Capital Inflows and Real
Exchange Rate Appreciation in Latin America: The Role of External Factors. Staff
Papers -IMF, 40(1), 108-151.
Choe, H., B. Kho, and R. M. Stulz (1998). Do Foreign Investors Destabilize Stock
Markets? The Korean Experience in 1997. Journal of Financial Economics , 54, 227264.
Chuhan, P., S. Claessens, and N. Mamingi (1998). Equity and Bond Flows to Latin
America and Asia: The Role of Global and Country Factors. Journal of Development
Economics, 55, 439-63.
Clark, J. and E. Berko (1996). Foreign Investment Fluctuations and Emerging Market
Stock Returns: The Case of Mexico. Federal Reserve Bank of New York, Research
Paper no. 9635.
24

Corsetti, G., P. Pesenti and N. Roubini (1999). What caused the Asian Currency and
Financial Crises. Japan and the World Economy , 11, 305-373.
Froot, Kenneth A., Paul G.J. OConn ell and Mark S. Seaholes (20 01). The Portfolio
flows of international investors. Journal of Financial Economics, 59, 151-193.
Garibaldi, P., N. Mora, R. Sahay and J. Zettlemeyer (2002). What Moves Capital to
Transition Economies. IMF Working Paper No. WP/02/64.
Gordon, J. and P. Gupta (2003). Portfolio Flows into India: Do Domestic
Fundamentals Matter?. IMF Working Paper No. WP/03/20.
Granger C. W. J. (1969). Investigating Causal Relations by Econometric Mod els and
Cross- Spectral Methods. Econometrica, 424438.
Griffin, J. M., F. Nardari, and R. M. Stulz (2002). Daily Cross-Border Equity Flows:
Pushed or Pulled?. National Bureau of Economic Resea rch Working Paper Series,
Working Paper 9000.
Kaur, M. and S. S. Dhillon (2010). Determinants of Foreign Institutional Investors
Investment in India. Eurasian Journal of Business and Economics, 3 (6), 57-70.
Kim, W. and S. Wei (2000). Foreign Portfolio Investors Before and During a Crisis.
Journal of International Economics, 56, 77-96.
Mukherjee, P., S. Bose and D. Coondoo (2002) . Foreign Institutional Investment in the
Indian Equity Market: An Analysis of Daily Flows during Janua ry 1999 May 2002.
Money and Finance, ICRA Bulletin , April-September, 21-51.
Indian Securities Market Review (ISMR) . (2011). National Stock Exchange.
Pal, P. (1998). Foreign Portfolio Investment in Indian Equity Mark ets: Has the
Economy Benefited?. Economic and Political Weekly , March 14, 589-598.
Portes, R. and H. Rey (2005 ). The Determinants of Cross-Border Equity Flows: The
Geography of Information. Journal of International Economics , 65, 269 296.
25

Rai, K. and N.R Bhanumurthy (2004). Determinants of Foreign Institutional


Investment in India: The Role of Return, Risk, and Infl ation. The Developing
Economies, XLII(4), December, 47993.
Richards, A. (2005). Big Fish in Small Ponds: The Trading Behaviour and Price
Impact of Foreign Investors in Asian Emerging Equity Markets. Journal of Financial
and Quantitative Analysis, 40(1), 1-27.
Roy, Nirmal V P. (2007). Foreign Portfolio Capital flows into India: An Exploration
into

its

Openness

and

basic

motives .

Retrieved

from

http://www.igidr.ac.in/money/mfc_10/Nirmal%20Roy_submission_13.pdf (as on 30th


January, 2011).
Saraogi, R. (2008). Determinants of FII Inflows: India.

Retrieved from

http://mpra.ub.uni-muenchen.de/22850/ (as on 14 th December, 2010).


SEBI, (2011), Handbook of Statistics on Indian Securities Mark et.
Shankar, A. (2011). QE-II and FII inflows into India - Is there a Connection?. RBI
Working Paper Series, WPS (DEPR): 19/2011.
Taylor, M. and L. Sarno (1997). Capital Flows to Developing Countries: Long- and
Short-Term Determinants. The World Bank Economic Review , 11(3), 451-470.
Book
Malhotra, N. and Dash, S. (2011). Marketing Research: An Applied Orientation (6th
ed.). Pearson Education.

26

Appendix

Table 1: Descriptive Statistics of Dependent and Independent Variables


Variables
S_P_RET
MSCI_RET
LIB
BSE_RET
ER_RET
VOL
CMR
IIP
WPI
FIIN
FIIP
FIIPCAP

Mean
0.480271
0.293171
-0.01929
0.661246
0.250824
1.498578
0.015146
205.3997
181.3606
2085.965
22956.05
0.007918

Median
1.103473
0.725651
0
0.941215
0.049086
1.3
0.03
182.2
171.6
633.5
7831.7
0.008234

Std. Dev.
4.611877
7.348009
0.24487
7.641777
1.793185
0.714974
3.498632
72.5657
49.06582
5739.767
26695.84
0.004545

27

Skewness
-0.82497
-1.12747
-2.43362
-0.28913
0.685827
1.752654
-0.01733
0.656605
0.577103
1.484582
1.152142
0.190227

Kurtosis
4.358435
6.241315
18.48055
3.392817
6.621019
7.312886
21.7891
2.352937
2.375278
8.177801
3.631151
2.20638

Table 2: Correlations between Dependent and Independent Varia bles

Correl

S_P_
RET

MSCI
_RET

S_P_
RET
MSCI
_RET

1
0.747
*

LIB

0.012

-0.066

BSE_
RET

0.435
*
0.300
*
0.243
*

ation

ER_R
ET

VOL

0.458*
0.285*
0.116*
**

1
0.01
9
0.11
7***
0.19
4*

BSE_
RET

1
0.445
*
0.302
*
0.176
**

ER_
RET

VO
L

CM
R

IIP

WP
I

FII
N

FIIP
CAP

1
0.145
**

1
0.01
0
1

0.05
1
0.021
0.06
0.03 0.0
IIP
0.072 0.0425 5
0.023 0.035 0
15
1
0.05
0.012 0.03 0.0 0.9
WPI
0.100 0.0123 7
0.006 3
8
07
82
1
0.302
0.01 0.455 0.473 0.28 0.0 0.2 0.2
FIIN
*
0.442* 9
*
*
5*
35
78* 44* 1
0.09
0.10 0.0 0.8 0.8 0.3
FIIP
0.064 0.046
8
0.040 0.072 9
119 57* 33* 71* 1
FIIPC 0.152
0.03
0.125 0.19 0.0 0.6 0.6 0.2 0.72
AP
**
0.060
0
0.056 ***
7*
25
46* 55* 94* 6*
*denotes significance at 1% level of significance , **denotes significance at 5% level of
CMR

0.018

0.655*

LIB

F
I
I
P

significance, ***denotes significance at 10% level of significance

28