Final Dissert

8/8/2019 Final Dissert

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1. Introduction

The financial sector plays an important role in the economy of any nation. A well

regulated and well-developed financial sector is vital to achieving the most basic

need of efficient allocation of scarce resources. An article by EnnisKnupp

estimates the world total investable market capitalization as on December 2005

as $93.7 trillion. It can be observed from Figure1 that the % of emerging market

stocks is less than 2%. So there is a huge growth opportunity over the next few

decades

However according to Business Line dated September 9, 2006 an international

survey of 175 fund managers, conducted by Standards & Poor's suggests that

emerging market stocks now account for a high 16 per cent of all global equities.

Figure 1: World Total Investable Capital Market

Total Investable Capital Market (December 31,2005)

2%

21%

4%

3%

21%

1%

24%

6%

1%

17%

Emerging Market Stocks

All Other Stocks

Cash Equivalents

Emerging Market Debt

Non-US Bonds

High Yield Bonds

US Bonds

Real Estate

Private Capital

US Stocks

Source: UBS Global Asset Management, Venture Economics, EnnisKnupp

The far-reaching changes in the Indian economy since liberalization in the early

1990s have had a deep impact on the Indian financial sector. The financial

sector has gone through a complex restructuring, capitalising on new

opportunities as

ALLIANCE BUSINESS SCHOOL

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well as responding to new challenges.

During the last decade, there has been a broadening and deepening of financial

markets. Several new instruments and products have been introduced. Existing

sectors have been opened to new private players. This has given a strong

impetus to the development and modernization of the financial sector. New

players have adopted international best practices and modern technology to offer

a more sophisticated range of financial services to corporate and retail

customers. This process has clearly improved the range of financial services and

service providers available to Indian customers. The entry of new players has led

to even existing players upgrading their product offerings and distribution

channels. This is particularly evident in the non banking financial services sector,

such brokerage industry, where innovative products combined with new delivery

methods are allowing the sector to achieve very high growth rates.

Over the past few years, the sector has also witnessed substantial progress in

regulation and supervision. Financial intermediaries have gradually moved to

internationally acceptable norms for income recognition, asset classification, and

provisioning and capital adequacy. The past decade was an eventful one for the

Indian capital markets. Reforms, particularly the establishment and

empowerment of securities and Exchange Board of India (SEBI), market-

determined prices and allocation of resources, screen-based nation-wide trading,

dematerialisation and electronic transfer of securities, rolling settlement and

derivatives trading have greatly improved both the regulatory framework and

efficiency of trading and settlement. The National Stock Exchange (NSE) and the

Bombay Stock Exchange (BSE) are among the top five exchanges in the world

with respect to the number of transactions.

The portfolio flows have been one of the major forces that has changed the

quantum and nature of international capital flows to India. Portfolio flows include

the investment in ADRs/GDRs and offshore funds in addition to investment by

Foreign Institutional Investors (FIIs).


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The FIIs are finding good company in domestic Mutual funds (MFs) in terms of

inflow in to Indian equity market. The increased MF inflow in the recent past has

been supported by the lot of money raised through IPO finding its way to the

market.

1.1 Research Motivation

FII has a very short history in India. Prior to 1992, only non-resident Indians

(NRIs) and overseas corporate bodies (OCBs) were allowed to undertake

portfolio investment in India. All this changed from September 14th, 1992 when

in line with the recommendations of the High Level Committee on Balance of Payments ,foreign institutional investors (FIIs) were allowed to invest in the

Indian debt and equity markets. Repatriation of income was allowed, the ceilings

of FII investments were progressively relaxed, and they have also been allowed

in other segments of the market such as Futures and Options.

The emergence of Foreign Institutional Investors (FIIs) as a force in India’s

capital markets is an important part of the story of economic reforms initiated in

1991.FII inflows and outflows and conditions in the international markets are

today constantly monitored for clues to the direction of FII flows into the country.

A drying up of inflows is seen as pulling down the stock market and keen interest

on the part of FIIs is seen as signalling a rise in stock prices.

FII investment is viewed as compensating in some way for the relatively low

levels of foreign direct investment (FDI) and as a welcome sign of international

interest in the Indian economy. At the same time, there is unease over the

impact of volatility in FII flows on the stock market and the Indian economy.

In the first year of allowing FII participation in the Indian markets (1992-93),

inflows though this route was a mere USD 4 million. This increased to a net


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inflow of USD 1.6 bn in the following year. In each of the subsequent years, the

net inflows from FIIs have been positive (except for in 1998-99 when there were

events such as the Pokhran nuclear detonation, the Kargil tensions etc). The net

FII inflow in Indian equities was $8 billion in 2006.

SENSEX, India’s benchmark index has been breaking all kinds of records and

creating new historical highs and Indian GDP has also been growing at a very

good pace. All these can be partially attributed to foreign investors .So this

motivated me to carry out the study on Foreign Institutional Investors and their

impact on the Indian stock market.

This study therefore explores the relationship between the net foreign

institutional investment flows and SENSEX, identifying the impact of net FII flows

and SENSEX on each other, if any.

1.2 Research Objectives

1.2.1 Statement of the Problem

The stock market is influenced by many factors. Both institutional and individual

investors have a critical role to play in the stock market. The volatility in the

market is the result of buying and selling pressure on the stocks. The excessive

buying pressure results in the bull market and the excessive selling pressure

result in bear market. Under these circumstances it may be useful to study the

impact of institutional investors on the market. This study basically aims at

studying the influence of Foreign Institutional Investors on the Indian stockmarket.


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1.2.2 Objectives of the study

The main objectives of the study is

•

To study the impact of FII investments on stock market liquidity• To investigate causality between SENSEX and net FII flow

1.2.3 Scope of the study

The rise in equity prices in emerging markets has happened on account of a

surge in foreign inflows in recent years. India has turned out to be one of the

favourite markets for the Foreign Institutional Investors (FIIs). FIIs are

understood to play a vital role in Indian stock market. But the scope of the studyis limited to the impact of FII investments in equity market.


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2. Literature Review

Linkages between financial markets across geographical boundaries as well as

the impact of one market on another have been the object of many studies. The

importance of such studies has come to the fore in recent years owing to events

like sudden ups and downs in the equity market.

There have been several studies in the last few years relating to the movement

of indices in Indian financial markets with the changes in foreign institutional

investment (FII) investment. Some studies have suggested that the

strengthening of Indian financial markets has been because of the influence of

FII.

Pan (2006) certified the positive correlation between BSE SENSEX and FII

inflows by analyzing the monthly trend of FIIs inflows and BSE SENSEX and

inferred that “The upswings in the FII inflows from around May 2003 have also

led to quantum jumps in the BSE SENSEX. But despite the general upward

trajectory of the BSE SENSEX there have been some months of correction and

such corrections occurred in months with negative FII flows. Only in the recent

period of the past 5 years, FII activity has become more important in the total

activity level in the equity market and logically leading to an increase in their

ability to swing the market either way.”

Parthapratim Pal (2005) in his detailed study on “Volatility in stock markets inIndia and FIIs” has concluded that not only are the FIIs major players in the

domestic stock market in India, but their influence on the domestic markets is

also growing. “The influence of FIIs on the movement of the SENSEX became

apparent after the 2004 general elections in India when the sudden reversal of


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FII flows triggered a panic reaction which resulted in very high volatility in the

Indian stock market.”

However a study by Ashok Banerjee & Sahadeb Sarkar (2006) has shown that

the FIIs’ participation in the Indian stock market over a period of time has not led

to a significant increase in the market volatility.

According to Mukherjee, Bose and Coondoo (2002), contrary to the general

perception of FII activities having a strong demonstration effect and driving the

domestic stock market in India, evidence from causality tests suggests that FII

flows to and from the Indian market tend to be caused by return in the domestic

equity market and not the other way round . They find, in particular, that Indian

equity market returns is an important (perhaps the most important) factor

influencing FII inflow, but not influencing FII outflow.

Chandrasekhar (2005) also suspect that the stock price spiral is largely because

of surging FII inflows and is not based on the fundamental strength of the Indian

economy or the Indian companies. “Movements in the SENSEX during these two

years have clearly been driven by the behavior of FIIs. The sudden FII interest in

Indian markets in the last two years account for the two bouts of medium-termbuoyancy that the SENSEX recently displayed.”

In a recent article published by the Market Bureau of the Financial Express, the

FIIs are perceived to be the drivers of the Indian equity market. “The

dependence of the Indian equity markets on the foreign investors is further

proved by the fact that in the period between May 10, 2006 and June 14, 2006,

when the SENSEX moved from a high of 12,612.38 to a low of 8,928.44, FIIs

were net sellers at nearly Rs 9,500 crore.


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3. The Indian Capital Market

3.1 The Indian Capital Market - An Overview

The function of the financial market is to facilitate the transfer of funds from

surplus sectors (lenders) to deficit sectors (borrowers). Normally, households

have investible funds or savings, which they lend to borrowers in the corporate

and public sectors whose requirement of funds far exceeds their savings. A

financial market consists of investors or buyers of securities, borrowers or sellers

of securities, intermediaries and regulatory bodies. Financial market does not

refer to a physical location. Formal trading rules, relationships and

communication networks for originating and trading financial securities link the

participants in the market.

Indian financial system consists of money market and capital market.

Figure 2: Financial Market


CapitalMarket

MoneyMarket

FinancialMarket

FinancialInstitutions

SecuritiesMarket

Primary Secondary

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DerivativeMarket

Corporate Securities

(Debt and Equity)

Government Securities

(Debt and Equity)



The money market has two components - the organised and the unorganised.

The organized market is dominated by commercial banks. The other major

participants are the Reserve Bank of India, Life Insurance Corporation, General

Insurance Corporation, Unit Trust of India, Discount and Finance House of India,

other primary dealers and mutual funds. The core of the money market is the

inter-bank call money market whereby short-term money borrowing/lending is

effected to manage temporary liquidity mismatches. The Reserve Bank of India

occupies a strategic position of managing market liquidity through open market

operations of government securities, access to its accommodation, cost (interest

rates), availability of credit and other monetary management tools. Normally,

monetary assets of short-term nature, generally less than one year, are dealt in

this market.

The unorganized sector of the money market comprises the indigenous bankers

and the moneylenders. In the unorganised market, there is no clear demarcation

between short-term and long-term finance and even between the purposes of

finance. The unorganised sector continues to provide finance for trade as well aspersonal consumption. The inability of the poor to meet the "creditworthiness"

requirements of the banking sector make them take recourse to the institutions

that still remain outside the regulatory framework of banking. But this market is

shrinking.

The capital market consists of primary and secondary markets. The primary

market deals with the issue of new instruments by the corporate sector such as

equity shares, preference shares and debt instruments. Central and State

governments, various public sector industrial units (PSUs), statutory and other

authorities such as state electricity boards and port trusts also issue bonds/debt

instruments.

The secondary market mainly deals with the securities which are previously

issued and enables participants who hold securities to adjust their holdings in


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Options

Market

Futures

Market





Custodians and Depositories are capital market intermediaries that provide

important infrastructure services for both primary and secondary markets.

Market Regulation:

The financial market in India was highly segmented until the initiation of reforms

in 1992-93 on account of a variety of regulations and administered prices

including barriers to entry. The reform process was initiated with the

establishment of Securities and Exchange Board of India (SEBI).

SEBI

In 1988 the Securities and Exchange Board of India (SEBI) was established by

the Government of India through an executive resolution, and was subsequently

upgraded as a fully autonomous body (a statutory Board) in the year 1992 with

the passing of the Securities and Exchange Board of India Act (SEBI Act) on

30th January 1992. In place of Government Control, a statutory and autonomous

regulatory board with defined responsibilities, to cover both development &

regulation of the market, and independent powers have been set up.

Paradoxically this is a positive outcome of the Securities Scam of 1990-91.

The basic objectives of the Board were identified as:

• to protect the interests of investors in securities;

• to promote the development of Securities Market;

• to regulate the securities market and

• for matters connected therewith or incidental thereto.

Since its inception SEBI has been working targeting the securities and is

attending to the fulfillment of its objectives with commendable zeal and dexterity.The improvements in the securities markets like capitalization requirements,

margining, establishment of clearing corporations etc. reduced the risk of credit

and also reduced the market.

SEBI has introduced the comprehensive regulatory measures, prescribed


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registration norms, the eligibility criteria, the code of obligations and the code of

conduct for different intermediaries like, bankers to issue, merchant bankers,

brokers and sub-brokers, registrars, portfolio managers, credit rating agencies,

underwriters and others. It has framed bye-laws, risk identification and risk

management systems for Clearing houses of stock exchanges, surveillance

system etc. which has made dealing in securities both safe and transparent to

the end investor.

Two broad approaches of SEBI is to integrate the securities market at the

national level, and also to diversify the trading products, so that there is an

increase in number of traders including banks, financial institutions, insurance

companies, mutual funds, primary dealers etc. to transact through theExchanges. In this context the introduction of derivatives trading through Indian

Stock Exchanges permitted by SEBI in 2000 is a real landmark

Bombay Stock Exchange

Bombay Stock Exchange Limited is the oldest stock exchange in Asia with a rich

heritage. Popularly known as "BSE", it was established as "The Native Share &

Stock Brokers Association" in 1875. It is the first stock exchange in the country toobtain permanent recognition in 1956 from the Government of India under the

Securities Contracts (Regulation) Act, 1956.The Exchange's pivotal and pre-

eminent role in the development of the Indian capital market is widely recognized

and its index, SENSEX , is tracked worldwide. Earlier an Association of Persons

(AOP), the Exchange is now a demutualised and corporatised entity incorporated

under the provisions of the Companies Act, 1956, pursuant to the BSE

(Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities

and Exchange Board of India (SEBI).

The Exchange has a nation-wide reach with a presence in 417 cities and towns

of India. The systems and processes of the Exchange are designed to safeguard

market integrity and enhance transparency in operations. The Exchange


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provides an efficient and transparent market for trading in equity, debt

instruments and derivatives

3.2 Foreign Investment

Foreign Investment refers to investments made by residents of a country in

financial assets and production process of another country. After the opening up

of the borders for capital movement these investments have grown in leaps and

bounds. But it had varied effects across the countries. It can affect the factor

productivity of the recipient country and can also affect the balance of payments.

In developing countries there was a great need of foreign capital, not only to

increase their productivity of labor but also helps to build the foreign exchange

reserves to meet the trade deficit. Foreign investment provides a channel

through which these countries can have access to foreign capital. It can come in

two forms: foreign direct investment (FDI) and foreign portfolio investment (FPI).

Foreign direct investment involves in the direct production activity and also of

medium to long-term nature. But the foreign portfolio investment is a short-term

investment mostly in the financial markets and it consists of Foreign Institutional

Investment (FII).

Figure 3 schematically shows how foreign portfolio investment can affect the

economy through the stock markets.


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Figure 3: Diagrammatic Representation of how Foreign Funds encourageDomestic Secondary and Primary Market.

Source: Foreign Portfolio Investment, Stock Market and Economic Development:

A Case Study of India, Parthapratim Pal, 2006

3.2.1 Foreign Institutional Investor Defined

A Foreign Institutional Investor or FII is any institution established or incorporated

outside India and intends to make investment in India in securities. According to

SEBI, FIIs including institutions like pension funds, investment trusts, asset

management companies, nominee companies and incorporated/institutional

portfolio managers or their power of attorney holders (providing discretionary and

non-discretionary portfolio management services) can make investment in India.

Further ,FIIs can also make investment in India on behalf of sub-accounts ,which

include foreign corporates or individuals and institutions established or


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incorporated outside India and funds or portfolios established outside India

whether incorporated or not. Further the domestic asset management companies

or portfolio managers can also register as FII and manage the sub account.

3.2.2 Evolution of FII

With an intention of having an outward oriented economy that interacts with rest

of the world apart from bringing about considerable growth, the Government of

India in 1991 took up liberalization and economic reforms. One of the significant

aspects of these reforms was the opening up of Indian capital market to global

players. For the first time ever, the Government of India permitted the FIIs,

Overseas Corporate Bodies (OCBs) and Non-Resident Indians (NRI) to invest in

the Indian capital market subject to some restrictions. In consonance with this

decision, the Finance Ministry came up with guidelines on September 14,

1992.Since then, the guidelines have been amended from time to time to keep

liberalizing the foreign investment further. In 1995, the guidelines were suitably

incorporated in the regulations and in 2000 when Foreign Exchange

Management Act came into force, regulations were issued regarding foreign

exchange controls in the RBI permitting foreign transactions of FIIs.

3.2.3 Benefits of FII Investments

Reduced cost of equity capital

FIIs operating in Indian capital market have eventually assumed a position so

vital that its not practical to mention the stock prices without an elaborate

discussion about their impact on the cost of equity capital. FII investment

reduces the required rate of return for equity, enhances stock prices, and fosters

investment by Indian firms in the country.

Imparting stability to India's Balance of Payments

It becomes imperative for a developing economy like India to have a

comprehensive expansion of domestic investment, over and beyond the

domestic savings, through capital flows. The excess of domestic investment over


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domestic savings result in a current account deficit and this deficit is financed by

capital flows in the balance of payments. Prior to 1991, debt flows and official

development assistance dominated these capital flows. Portfolio flows in the

equity markets, and FDI, as opposed to debt-creating flows, are important as

safer and more sustainable mechanisms for funding the current account deficit.

Knowledge flows

The activities of international institutional investors help strengthen Indian

finance. FIIs advocate modern ideas in market design, promote innovation,

development of sophisticated products such as financial derivatives, enhance

competition in financial intermediation, and lead to spillovers of human capital by

exposing Indian participants to modern financial techniques, and international

best practices and systems.

Strengthening corporate governance

Domestic institutional and individual investors accept ongoing practices of Indian

corporates even when these do not measure up to the international benchmarks

of best practices. FIIs, with their vast experience with modern corporate

governance practices, are less tolerant of malpractice by corporate managersand owners (dominant shareholder). FII participation in domestic capital markets

often lead to vigorous advocacy of sound corporate governance practices,

improved efficiency and better shareholder value.

Improvements to market efficiency

A significant presence of FIIs in India can improve market efficiency through two

channels. First, when adverse macroeconomic news, such as a bad monsoon,

unsettles many domestic investors, it may be easier for a globally diversified

portfolio manager to be more dispassionate about India's prospects, and engage

in stabilising trades. Second, at the level of individual stocks and industries, FIIs

may act as a channel through which knowledge and ideas about valuation of a

firm or an industry can more rapidly propagate into India. For example, foreign


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investors were rapidly able to assess the potential of firms like Infosys, which are

primarily export-oriented, applying valuation principles that prevailed outside

India for software services companies.

3.2.4 A Gist of the FII Guidelines and Regulations

• Investment by FIIs is regulated under SEBI (FII) Regulations, 1995 and

Regulation 5(2) of FEMA Notification No.20 dated May 3, 2000. SEBI acts

as the nodal point in the entire process of FII registration.

• The FIIs inclined to purchase, sell or deal in Indian securities need to

obtain a initial registration from the capital market regulator, SEBI. The

nominee companies, affiliates and subsidiary companies of a FII will be

regarded as individual FIIs for the purpose of registration. The prospective

FIIs shall hold a certificate of registration from the stock market regulatory

organization in the country of their domicile. The initial registration issued

by SEBI will be valid for a period of 5 years. After expiry of 5 years, the

registration needs to be renewed.

• The FII can invest in securities traded on the primary and secondary

markets including shares, debentures and warrants of companies,

unlisted, listed or to be listed on a recognized stock exchange as well as

dated governments securities, derivatives traded on a recognized stock

exchange, commercial papers and units of mutual funds.

• SEBI will grant the initial registration to FII after verifying the track record,

professional competency, financial soundness, experiences and other

relevant criteria.

• In line with the foreign exchange controls in force, FII will have to file with

SEBI an application addressing RBI to seek various permissions. Upon

receipt of fees from the applicant and FEMA approval from Reserve Bank

of India , SEBI grants the certificate of registration


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• There are two categories of FII registered with SEBI

1. Regular FIIs who can invest 70% of their total investments in equity

and equity related instruments and 30% in non-equity instruments.

2. FIIs with 100% debt funds, who can invest only in debt instruments.

• All FIIs and their sub-accounts taken together cannot acquire more than

24% of the paid up capital of an Indian Company. Indian Companies can

raise the above mentioned 24% ceiling to the Sectoral Cap / Statutory

Ceiling by passing a resolution by its Board of Directors followed by

passing a Special Resolution to that effect by its General Body.

• No individual FII/sub-account can acquire more than 10% of the paid up

capital of an Indian company. Broad-based / Proprietary sub-accounts are

allowed to individually invest upto 10% of the total issued capital.

• Investments by each sub-account in the category Foreign Corporates and

foreign individuals should not exceed 5% of the issued capital

• The investment ceilings of FII/NRI/PIO are monitored on a daily basis by

the RBI and it has put in place a cut-off point that is 2 percentage less

than the ceiling rate. The RBI grants investment till the aggregate ceiling

limit when the link offices approach them on reaching the cut-off mark.

Once the aggregate limits or sectoral caps are reached, RBI directs the

banks not to purchase any shares on behalf of FII/NRI/PIO without its

prior approval.


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• No permission from RBI is needed so long as the FIIs purchase and sell

on recognized stock exchange. All non-stock exchange sales/purchases

require RBI permission

Of late, FIIs have been investing in Participatory Notes (PNs) also. A

‘Participatory Note’ is a derivative instrument issued by FIIs registered in the

country to foreign investors who like FIIs are not registered with SEBI but want

an exposure to Indian equities. In a way it is an understanding between a foreign

investor who is registered here and the other one who is not registered.

Underlying securities in Participatory notes are Indian stocks. The overseas

investor deposits the funds in the European or the US operations of FII who

purchase stocks on their behalf. In due course of these transactions, the FII acts

as an exchange by executing and settling the trades.

3.2.5 FIIs Registered in India

The number of Foreign Institutional Investors registered with the Securities and

Exchange Board of India (Sebi) crossed the 1,000 mark.

The total number of FIIs having their offices in India has increased to 1,030 tillDecember 28, 2006. In the beginning of calendar year 2006, the figure was 813.

As many as 217 new FIIs opened their offices in India during 2006. This is the

highest number of registrations by FIIs in a year till date. The previous highest

was 209 in 2005.

As many as 37 foreign entities registered with the market regulator till December

28, 2006 highest ever single month registrations by the FIIs since their entry into

Indian market in 1993.

In 1993, Pictet Umbrella Trust Emerging Markets’ Fund, an institutional investor

from Switzerland, was the only FII to enter the Indian market.


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While in 1994, no new registrations were reported, between 1995 and 2003, an

average of 51 new FIIs opened their shops in the country each year. The number

of new registrations with the Sebi increased to 144 in 2004 and 209 in 2005.

It can be observed from Figure 4 that out of 1,030 FIIs (till December 2006) from

42 different countries, as many as 388 FIIs are from the US, 167 from the Great

Britain, 73 from Luxembourg, 51 from Singapore, 35 each from Australia and

Hong Kong, 32 from Canada, 29 from Ireland, 27 from Netherlands, 25 from

Mauritius, 22 from Switzerland and 20 from France.

Figure 4: Country wise breakdown of FIIs registered in India

Country wise breakdown of FIIs Registered in India

USA, 338, 34%

United Kingdom,

167, 16%Luxembourg, 73, 7%

Singapore, 51, 5%

Australia, 35, 3%

Hong Kong, 35, 3%

Canada, 32, 3%

Ireland, 29, 3%

Netherland, 27, 3%

Mauritius, 25, 2%

Switzerland , 22, 2%

France, 20, 2%

Others, 176, 17%

3.2.6 Contribution by FIIs

Positive tidings about the Indian economy combined with a fast-growing market

have made India an attractive destination for foreign institutional investors (FIIs).


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The diversity of FIIs has been increasing with over 1030 FIIs from over 30

countries, registered with SEBI as at December 31st, 2006. Of these, 34%

originate from the US and 16% from the UK. Recently FIIs from Japan and

continental Europe are increasing their India exposure.

The fact that FIIs have always been loyal to the Indian markets can be witnessed

by their contribution in all the main rallies since the time the SENSEX touched

5000. It can be observed from Table 1 that between 5000 and 14000, FIIs have

pumped in money in the range of Rs 76.30 crore- Rs 1017.20 crore.

Table 1: FIIs Contribution in major SENSEX rallies

FIIs contribution(Rs core)Sensex's milestones FII contribution

5000 76.3

6000 76.6

7000 298.9

8000 543.2

9000 420.1

10000 935.6

11000 550.2

12000 224.9

13000 1017.2

14000 433.2

Source: Moneycontrol.com (20-12-2006)

FIIs constituted approximately 11% of the total market and approximately 10% of

the total market turnover in FY 2006.

Of the new issuances in FY 2006 FIIs contributed over 75 % of new equity and

equity-linked issuances. Evidently FIIs supplement domestic savings and

augment domestic investment without increasing foreign debt.

3.2.7 FII Inflows to India


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The rise in equity prices in emerging markets has happened on account of a

surge in foreign inflows in recent years. India is part of this surge. FII investment

in emerging countries over a period of 10 years is shown in the Table 2

Table 2 :FII Investment in emerging markets(in USD Mn)

India Indonesi

a

Korea Phillippines Taiwan Thailand EM Asia

(Excluding

Malaysia)2006

YTD

2579 832 -3168 488 6252 1448 8431

2005 10546 -1741 3584 355 24389 2976 401092004 8430 2191 11212 319 8140 119 304112003 6595 1117 12430 -82 13542 -634 329682002 751 856 -2015 -53 517 289 3452001 2802 441 6875 86 8161 -149 182162000 1593 86 11238 -123 5127 -828 170931999 1724 1595 1197 400 8261 -65 131121998 -148 526 3314 264 749 679 53841997 1569 130 526 -406 -227 1811 34031996 3036 1837 3933 2101 2194 499 13600

(Source: Dalal Street Journal,June 26-July9, 2006)

It can be observed from Figure 5 that net FII inflows into India increased steadily

through the decade of the 1990s to $8 billion in 2006 compared to a record

inflow of $10.7 billion in 2005 The cumulative FII inflow till December 31, 2006

has been $49.09 billion from $4 million in 1992, reflecting the strong economic

fundamentals of the country, as well as confidence of the foreign investors in the

growth and stability of the Indian market. Every year since FIIs were allowed to

participate in the Indian market, FII net inflows into India have been positive,

except for 1998-99.The decline during 1998-99 was due to the nuclear tests and

East Asian Crisis but their effects were short lived.

Figure 5: Net FII flows to India


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Net FII flows to India

-10000

0

10000

20000

30000

40000

50000

1 9 9 2

- 9 3

1 9 9 3

- 9 4

1 9 9 4

- 9 5

1 9 9 5

- 9 6

1 9 9 6

- 9 7

1 9 9 7

- 9 8

1 9 9 8

- 9 9

1 9 9 9

- 0 0

2 0 0 0

- 0 1

2 0 0 1

- 0 2

2 0 0 2

- 0 3

2 0 0 3

- 0 4

2 0 0 4

- 0 5

2 0 0 5

- 0 6

C r o r e ( R u p e e s )

Net

.

3.2.8 FII versus FDI

According to the International Monetary Fund’s Balance of Payments Manual 5,

FDI is that category of international investment that reflects the objective of

obtaining a lasting interest by a resident entity in one economy in an enterprise

resident in another economy. The lasting interest implies the existence of a long-

term relationship between the direct investor and the enterprise and a significant

degree of influence by the investor in the management of the enterprise.

According to EU law, foreign investment is labeled direct investment when the

investor buys more than 10 per cent of the investment target, and portfolio

investment when the acquired stake is less than 10 per cent. Institutional

investors on the other hand are specialized financial intermediaries managing

savings collectively on behalf of investors, especially small investors, towards

specific objectives in terms of risk, returns, and maturity of claims.

While permitting foreign firms/high net worth individuals in February, 2000 to

invest through SEBI registered FII/domestic fund managers, it was noted that

there was a clear distinction between portfolio investment and FDI. The basic

presumption is that FIIs are not interested in management control. To allay fears


23



of management control being exercised by portfolio investors, it was noted that

adequate safety nets were in force, for example, (i) transaction of business in

securities on the stock exchanges are only through stock brokers who have been

granted a certificate by SEBI, (ii) every transaction is settled through a custodian

who is under obligation to report to SEBI and RBI for all transactions on a daily

basis, (iii) provisions of SEBI (Substantial Acquisition of Shares and Takeovers)

Regulations, 1997 (iv) monitoring of sectoral caps by RBI on a daily basis.

There is often a popular preference for FDI over FII on the assumption that FIIs

are fair-weather friends, who come when there is money to be made and leave

at the first sign of impending trouble. FDI, by contrast, have a lasting interest in

their company and stay with it through thick or thin. While there is some justified

strength in this preference, some further arguments need to be taken into

account while exercising the choice. First, all portfolio investors, whether

domestic or foreign, are ‘fair-weather’ friends, and exit as soon as there is

evidence that they will lose money by staying invested in a particular company.

Second, the strength of domestic home-grown entrepreneurship in India is widely

acknowledged. Because of this strength, some commentators describe the

Indian growth process as an organic one. This entrepreneur class may prefer tohave portfolio investors who share the project and business risk without

interfering in the critical management decisions of the company. Thus, there may

be a preference for FII over FDI as far as this class is concerned. This

preference has a close analogy with the choice between allowing a strategic

investor to have management control in a public sector company and allowing a

diversified mutual fund to hold a large part of the shares of such a company.

Finally, if there is intent to encourage FDI, then this constitutes a case for easing

restrictions upon FDI-style control oriented purchases by portfolio investors

which is done through FII.

According to Shah and Patnaik (2004): “Net FDI flows into India have remained

small, either when compared with Indian GDP or when compared to global FDI

flows. In contrast with the Chinese experience, relatively little FDI has come into


24



India in setting up factories which are 21 parts of global production chains. This

may be associated with infirmities of Indian indirect taxes and transportation

infrastructure. India is more important as a platform for services production as a

part of global production chains, where difficulties of indirect taxes and

transportation infrastructure are less important. However, services production is

less capital intensive, and induces smaller net FDI flows. Given the size of the

Indian economy, and the relative lack of correlation with the global business

cycle, Indian equities have had low correlations with global risk factors. In

addition, India has fared well in creating the institutional mechanisms of a

modern, liquid equity market. India’s share in global portfolio flows is higher than

India’s share in global FDI flows, and net portfolio flows are substantial when

compared to Indian GDP.

Fig. 6: Total Foreign Investment, FDI and FII flows (net):1995-96 to 2004-05

Source: Economic Survey 2005-2006

India has one of the highest exposures to FII inflows among other emerging

economies. While in India, FIIs formed nearly 70 per cent of foreign investment

(FDI plus net portfolio equity flows) flow, in China and Brazil the percentage was

26 per cent and 30 per cent, respectively, for '05. Unlike India, a major chunk of

foreign investment entered China, Brazil and Russia as FDI.


25



India, on the other hand, attracted nearly 20% of the net portfolio investments

flowing into developing countries, while its FDI inflows were barely 2.4% of what

was received by emerging economies, according to data from the Global

Development Finance report ‘06.

During January-December ‘05, while India’s current account deficit stood at

$13bn, it had a large capital account surplus amounting to $26bn. Nearly half of

these inflows, however, were portfolio investments considered volatile by RBI.

In comparison, not only are the other three BRIC economies running a surplus in

their current account, Brazil and Russia received nearly $15bn of FDI each in

‘05, and China received close to $53bn, forming a substantial portion of the

capital inflows. India, on the other hand, received barely $6.5bn.

With FDI inflows stuck at the $5-6bn range, the country has been unable to

attract larger direct investments inspite of a GDP growth of 8%, which is higher

than Brazil and Russia’s growth rate.

Not surprisingly, India’s FDI inflows as a percentage of GDP were barely 0.8%

compared to 1.8% for Brazil and Russia and 2.7% for China. Interestingly, in

Brazil and Russia, even with heavy FDI inflows, the capital and financial account

of both these economies ended in the red in ‘05.

This is primarily because of the prepayment of debt owed by them to the IMF

and the Paris Club. Moreover, in Russia’s case, there were large commercial

borrowings as well as heavy investments abroad by Russian companies.

In fact, while Russia received $77bn as private capital inflows, Russian

corporations and banks invested nearly $66bn abroad during the year.

Recent developments


26



According to The Economic Times, January 17, 2007 edition the government is

examining the possibility of redefining foreign investments in companies by

removing the distinction between FDI and FII investments.

At present, investments by GE Capital, for instance, are termed as FII, while

funds from GE are bracketed as FDI. This, despite the fact that GE Capital could

be a subsidiary of GE. And in sectors which have a cap on investments, matters

are even more complicated. In such a situation, treating all foreign investments,

irrespective of FDI or FII, as the same when it comes to investment limits and

conditions could be seen as a more realistic approach.

Once the changes are in place, the policy would be more in tune with

investments in developed countries where the distinctions between FDI and FII

are fast disappearing.

As reported in Financial Express, January 12, 2007, the Prime Minister’s

Economic Advisory Council (EAC) has projected that for the first time in recent

years FDI is likely to exceed FII. According to the EAC, net FDI for 2006-07

would be around $9 billion, up from $4.7 billion last year while FII or portfolio

inflows are likely to be $7 billion.

3.2.9 Advantages to FIIs

1. Institutional investors have an edge over the private investors as they are

equipped with the resources to analyze the relevant financial information

which enables them to earn higher returns


27



2. Further, the large volumes of funds permit then them to hold well-

diversified portfolios and thereby earn higher returns for less risk.

3.2.10 Disadvantages to FIIs

1. A large part of the FII funds are dealt by agents like domestic depository,

designated banks ,whose interests are different and conflicts with that of

the institution.

2. The FIIs often exhibit herd mentality due to which a wrong move by one of

the participants could adversely affect the remaining participants too.

4. Data and Methodology

The study is empirical in nature, using secondary data only. The data for the

study consists of closing price of SENSEX reported by BSE on a daily basis,

monthly market capitalization of BSE, monthly net FII flows and daily net FII


28



flows (i.e. inflows minus outflows).The data source was SEBI, The Economic

Times, BSE, Moneycontrol , myiris websites and several monthly publication of

CMIE Economic Review.

The study spans for the period from January 2000 to December 2006.During this

period SEBI/RBI initiated various policy initiatives, guidelines and enacted

investment limit of FII’s from time to time in the capital market.

One of the objectives of the study was to investigate causality between SENSEX

and net FII flow. For this purpose, following Granger (1969), the linear Granger

causality tests were employed. The Granger causality tests involve the

estimation of the following models:

t

m

j

jt i

m

i

it it F S S 1

1

1

1

11

21

ε γ β α +∆+∆+=∆ ∑∑=

−

=

−

t

m

j

jt i

m

i

it it S F F 2

1

2

1

22

21

ε γ β α +∆+∆+=∆ ∑∑′

=

−

′

=

− ,

Where 1−−=∆

t t t S S S is the first order forward difference in the daily closing

prices of the BSE SENSEX and 1−−=∆

t t t F F F is the first order forward

difference in the net FII flows; α, β, γ are the parameters to be estimated, and ε 1,

ε2 are standard random errors with zero mean and constant variance. Finally, the

orders 2121 ,,, mmmm ′′ are the optimal lags chosen by Akaike’s (1969)

information criterion. In order to test the significance of γ 1 and γ2, F-statistic was

employed:

( )

UR

UR R

UR R

MSE df df

SSE SSE

F )( −

−

=

The equations above provide a convenient framework for examining linear

causality relationships. If the estimated lagged coefficient vector γ1 is statistically


29



significant while the estimated lagged coefficient vector γ2 is not statistically

significant, then it can be inferred that net FII flows Granger cause changes in

SENSEX with no feedback (i.e. a unidirectional causality exists from net FII flows

to SENSEX), implying that knowledge of past values of net FII flows improves

the predictions of changes in SENSEX, while knowledge of past values of

changes in SENSEX has no predictive power over net FII flows. On the other

hand, if the estimated lagged coefficient vector γ1 is not statistically significant

while the estimated lagged coefficient vector γ2 is statistically significant, then it

can be inferred that changes in SENSEX Granger cause changes in net FII flows

with no feedback (i.e. a unidirectional causality exists from SENSEX to net FII

flows), implying that knowledge of past values of changes in SENSEX improves

the predictions of changes in net FII flows, while knowledge of past values of

changes in net FII flows has no predictive power over changes in SENSEX. If

both estimated lagged coefficient vectors γ1 and γ2 are statistically significant, the

bi-directional causality exists, implying that knowledge of past values of either

variable is useful in the prediction of the other. Finally, if neither estimated lagged

coefficient vectors γ1 and γ2 are statistically significant, then no causality exists

between net FII flows and changes in SENSEX.

5. Analysis and Interpretation


30



5.1 Descriptive Analysis

The distribution of monthly net FII flows is shown in Figure 7. It can be seen from

the graph that the year 2003 marked a turning point in FII investment in India.

FIIs started the year 2003 in a big way by investing Rs 888.1 crore in Januaryitself. Meanwhile, corporate India continued to report good operational results.

This, along with good macroeconomic fundamentals, growing industrial and

service sectors led FIIs to perceive great potential for investment in the Indian

economy. In April 2003, prices of commodities like steel and aluminium went up,

increasing FII investment in June 2003 to Rs 2581.7 crore. Calendar year 2004

ended with net FII inflows of US$9.2 billion. The buoyant inflows continued in

2005. In 2005, after reversing direction briefly during the period May -June, FII

inflows became robust again, leading to net inflows of US$ 10.7 billion during the

year, an all-time high since the liberalization. Indian stock markets witnessed a

great fall in the month of May 2006 and FII were net sellers in this month with net

sales of US$ 1.6 billion. However after that the inflows became robust again

leading to net inflows of $8 billion in the calendar year 2006.

Figure 7: Distribution of Net FII flows (Monthly)

-10000

-8000

-6000

-4000

-2000

0

2000

4000

6000

8000

10000

12000

J a n - 0 1

A p r - 0 1

J u l - 0

1

O c t - 0 1

J a n - 0 2

A p r - 0 2

J u l - 0

2

O c t - 0 2

J a n - 0 3

A p r - 0 3

J u l - 0

3

O c t - 0 3

J a n - 0 4

A p r - 0 4

J u l - 0

4

O c t

- 0 4

J a n - 0 5

A p r - 0 5

J u l - 0

5

O c t - 0 5

J a n - 0 6

A p r - 0 6

J u l - 0

6

O c t - 0 6

I n R s c r o r

The distribution of daily net FII flows in the sample period is shown in Figure 8,

and the descriptive statistics of daily net FII flows is shown in table 1. The overall

mean daily net FII flow was Rs 112.8 crore, with standard deviation Rs 332.45


31



crore, indicating high variability in daily net FII flows. Also more than 80% of the

daily net FII flows was within the range -Rs 750 crore – +Rs 1250 crore, with very

few extreme values

Figure 8: Distribution of daily net FII flows

Net FII Inflow

3 2 5 0 .0

2 7 5 0 .0

2 2 5 0 .0

1 7 5 0 .0

1 2 5 0 .0

7 5 0 .0

2 5 0 .0

- 2 5 0 .0

- 7 5 0 .0

- 1 2 5 0 .0

- 1 7 5 0 .0

- 2 2 5 0 .0

- 2 7 5 0 .0

1000

800

600

400

200

0

Std. Dev= 332.45

Mean = 112.8

N= 1493.00

5.2 Impact of FII investments on Stock Market Liquidity

In recent times, the boom in the Indian stock markets is frequently making

headlines in the important newspapers. The Indian stock market entered a new


1493249

112.771332.445

1.065.063

23.396.127

-2813.83490.5

ValidMissing

N

MeanStd. DeviationSkewnessStd. Error of SkewnessKurtosisStd. Error of KurtosisMinimumMaximum

Table 3: Descriptive Statistics of daily net FII flows

32



bull phase in November 2004 .The BSE SENSEX crossed the 7700 mark in July

2005 and is fully gaining strength. The market ended calendar 2006 on a strong

note, with the SENSEX settling at 13,786.91, less than 200 points off its all time

closing high of 13,972.03 of 7 December 2006. The BSE SENSEX touched a

new intra-day record high of 14,462.77 and closed at an all-time closing peak of

14,403.77 on 2 February 2007.

A major factor that has been driving the SENSEX to new highs has been the

increasing liquidity in the Indian stock market, with strong flows from FIIs. Infact,

in recent times, the number of FIIs registering with SEBI has gone up sharply

from 637 in 2004 to 1057 as on 4 February 2007 resulting in sharp increase in

inflows. The net inflows from FIIs during 2007 have been Rs 492.1 crore as on

31 January 2007 and experts believe that this year could see the FII inflows

surpassing 2006’s number. Their optimism is based on the fact that the Indian

economy has been growing at a faster rate and attracting more and more FIIs

across the globe. The Japanese investors also came to India in 2005 for the first

time and have emerged as one of the biggest investors.

The stock market rally was ignited by FII inflows into the equity segment. This

pattern is examined by taking the proportion of FII investments in market

capitalization. Market capitalization refers to the value of the stock multiplied bythe total number of shares outstanding. The relationship between FII investments

and market capitalization indicates the degree of liquidity in the market. The

increased investment leads to the increased capital employed and vice versa in

the short run.

Table4:Investment Behavior of FIIs and Market Capitalization

Months Net Investment

(Rs Cr)

Cumulative Investment

(Rs Cr)

X

BSE Market Capitalization

(Rs Cr)

Y2000


33



January 151.2 35619 927383February 2711.6 38330.6 1029257

March 1064.4 39395 912842April 2690.5 42085.5 755914May 484.1 42569.6 702777June -952.9 41616.7 793230

July -1418 40198.7 720884August 1346.2 41544.9 766642

September 142.5 41687.4 692757October -271.7 41415.7 653437

November 932.6 42348.3 699229December -576.9 41771.4 6925652001

January 4045.5 45816.9 736631February 1819.1 47636 716172

March 1972.9 49608.9 625553April 1769.9 51378.8 567728May 1046.5 52425.3 595938June 715.3 53140.6 553230

July 722.4 53863 531576August 437.5 54300.5 523036

September -415.6 53884.9 456263October 715.7 54600.6 481851

November 150.6 54751.2 535724December 250.2 55001.4 5323282002


March 391.3 57782.3 612224April 11.6 57793.9 625587May -56 57737.9 605065June -381.1 57356.8 637753July 333.1 57689.9 584042

August 240.3 57930.2 605303September 468.6 58398.8 570273

October -776.4 57622.4 563750November 601.8 58224.2 601289December 427.2 58651.4 6281972003

January 888.1 59539.5 611472February 378.7 59918.2 619873

March 411.7 60329.9 572197April 430.3 60760.2 572526May 1220.8 61981 660982

June 2581.7 64562.7 734389July 2346.5 66909.2 775996August 2091.3 69000.5 905193

September 3851.3 72851.8 933087October 6797.5 79649.3 1000494

November 3300.5 82949.8 1065853December 6161.1 89110.9 12733612004

January 3176.8 92287.7 1206854


34



February 2397.5 94685.2 1196221March 5604.4 100289.6 1201207April 7638.2 107927.8 1255347May -3246.9 104680.9 1023131June 516.4 105197.3 1047258July 913.6 106110.9 1135589

August 2892.3 109003.2 1216566September 2385.6 111388.8 1309318

October 3263.3 114652.1 1337191November 6740.8 121392.9 1539594December 6683.8 128076.7 16859892005

January 457.1 128533.8 1661533February 8376.3 136910.1 1730941

March 7502.2 144412.3 1698428April -654.1 143758.2 1635766May -1140.1 142618.1 1783221June 5328.6 147946.7 1850377July 7934.1 155880.8 1987170

August 5051.2 160932 2123900September 4646.8 165578.8 2254376

October -3693.9 161884.9 2065610November 4038.7 165923.6 2323063December 9335 175258.6 24893842006


March 6688.8 193212.8 3022189April 521.9 193734.7 3255565May -7354.2 186380.5 2842049June 479.5 186860 2721677July 1145.2 188005.2 2712143

August 4643.1 192648.3 2993779September 5424.7 198073 3185678

October 8013.1 206086.1 3370674November 9380.1 215466.2 3577306December -3667.4 211798.8 3624355

Correlation Rxy

Coefficient of Determination (%)

t-Test (calculated)

t-.05 (table value)

0.96593

13.2673.246

The following points are observed from the table


35



There has been steady growth in investment by FIIs in India over the

years. The highest amount of FIIs’ net investment was Rs 9380.1 crore

and was recorded in the month of November 2006.

The calendar year 2005 has received a historic net inflow from FIIs to

the tune of Rs 47181.9 crore

The correlation between FIIs’ cumulative net investment and market

capitalization on BSE was recorded 0.965

This highly correlated relation also gives the higher percentage of

determination i.e. 93 % was observed on BSE. The higher percentage

of determination explains any change that has been taken place in

capital employed was because of the FIIs investment.

This is also proved by the t-test .The calculated value of t is greater

than the table value. Hence, it says that the capital employed was

influenced by FII investments in BSE.

The reasons for such enormous enthusiasm of FIIs in the Indian

capital market can be on account of the following ;

1. The Indian capital market is well structured, regulated and mature

market.

2. The optimistic growth rate in the GDP

3. Implementation of further capital market reform along with

liberalization of FII investment in India in different sectors,

4. The overseas investment companies’ mutual funds – the US, the

UK and other European countries, Japan find India a safe heaven

for investment.


36



5.3 Granger Causality Test

The Granger causality tests were performed to test the direction of causality

between daily net FII flows and SENSEX. In performing the Granger regressions,

a lag structure of twenty five lags was chosen, as autocorrelations in daily net FII

flows and SENSEX were significant up to twenty five lags.

Regression of first order difference in SENSEX on its lagged values and on first

order difference in daily net FII flows and its lagged values yielded the following

results:

R

Square

Adjusted R Square

.145 .098

On the other hand, regression of first order difference in SENSEX on its lagged

values alone (i.e. the restricted vector autoregressive model) yielded the

following results:

R

Square

Adjusted R Square

.109 .077


Sum of

Squares df Mean Square F Sig.Regression 1897990.792 77 24649.23107 3.057299664 3.66E-16

Residual 11198700.06 1389 8062.419053Total 13096690.86 1466

37



The F-test for significance of effect of first order difference in net FII on first order

difference in SENSEX yielded:

ΔR-square

Δadjusted .R

square ΔFCritical

value

.036 .0212.258462082 1.503593694

Thus, the results of the Granger causality regressions indicate that variation in

changes in net FII (and its lagged values) explained 2.1% of the variation in

changes in SENSEX and it was statistically significant at 5% level of significance.

Regression of first order difference in net FII on its lagged values and on first

order difference in SENSEX and its lagged values yielded the following results

R

Square

Adjusted R Square

.478 .449

Sum of


Residual 109061256 1389 78517.82287Total 208956153.3 1466


Sum of


Residual 11672125.43 1415 8248.851891Total 13096690.86 1466

38



On the other hand, regression of first order difference in daily net FII flows on its

lagged values alone yielded the following results:

R

Square

Adjusted R Square

.407 .385

Sum of


Residual 123949371.2 1415 87596.7288Total 208956153.3 1466

The F-test for significance of effect of first order difference in SENSEX on first

order difference in daily net FII flows yielded:

ΔR-square

Δadjusted .R

square ΔFtable

value

.071 .0647.292864185 1.503593694

The results of the Granger causality regressions indicate that variation in

changes in SENSEX (and its lagged values) explained 6.4% of the variation in

changes in net FII, and this was statistically significant at 5% level of significance

Thus it can be concluded that there was bi-directional Granger causality .


39



6. Findings

• The FII investments in Indian equity market have shown a fluctuating

trend year after year.

•

The overall mean daily net FII flow was Rs 112.8 crore and more than80% of the daily net FII flows was within the range -Rs 750 crore – +Rs

1250 crore, with very few extreme values

• The correlation between FIIs’ cumulative net investment and market

capitalization on BSE was recorded 0.965

• This highly correlated relation also gave the higher percentage of

determination i.e. 93 % was observed on BSE. The higher percentage of

determination explains any change that has been taken place in capital

employed was because of the FIIs investment.

• The results of the Granger causality regressions indicate that variation in

changes in net FII (and its lagged values) explained 2.1% of the variation

in changes in SENSEX and it was statistically significant at 5% level of

significance.

• The results of the Granger causality regressions indicate that variation in

changes in SENSEX (and its lagged values) explained 6.4% of the

variation in changes in net FII, and this was statistically significant at 5%

level of significance


40



7. Conclusion

After the initiation of economic reforms in the early 1990s, the movement of

foreign capital flow has increased tremendously. This increase in capital

movement would be expected to have very significant impact on the domestic

real economy. Hence there is a great need to understand the behavior of theseflows to minimize the impact of this on the real economy.

A number of studies in the past have observed that investments by FIIs and the

movements of SENSEX are quite closely correlated in India and FIIs wield

significant influence on the movement of SENSEX (Pan 2006). A note by

National Stock Exchange “Indian Securities Markets: A review Vol IV, 2001” also

observes that FIIs have a disproportionately high level of influence on the market

sentiments and price trends. This is so because other market participantsperceive the FIIs to be infallible in their assessment of the market and tend to

follow the decisions taken by FIIs. This ‘herd instinct’ displayed by other market

participants amplifies the importance of FIIs in the domestic stock market in

India.

The results of the Granger causality tests indicate that there is bidirectional

Granger causality from changes in daily net FII flows to changes in SENSEX in

the short run; that is, in the short run, changes in daily net FII flows tend to cause

changes in SENSEX, and vice versa.

The worst-case scenario where foreign institutional investors suddenly remove

their capital overnight from Indian capital markets is of course a serious threat,

and would undoubtedly have drastic consequences for Indian capital markets


41



and the Indian economy as a whole. Therefore, the priority should be to stabilize

domestic markets so that any outflow from the country would not lead the

economy in the situation of crises (like East Asian crises).

There is possibly a need to gear up macro-economic policies to target other form

of foreign investments into the economy and reduce the over-reliance of the

economy on portfolio flows.

Also understanding the determinants of FII will help in predicting the behavior,

which is very important for any emerging economy as it would have larger impact

on the domestic financial markets in the short run and real impact in the long run.

Limitations:

• The study is based on the secondary data only.

• The study is restricted to the impact of FII flows on SENSEX only and its

effect on S&P CNX Nifty and macro economic variables such as

exchange rate has not been considered.

• FII investments in debt market has not been considered.

Scope for Further Research:

The increasing role of foreign institutional investors in the capital market can be

further analyzed and the effect of FIIs inflows can be extended to economic

variables like exchange rate.

.


42



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Neeraja, S. (2006, December), “Foreign Institutional Investors Back in Action”,

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http://www.financialexpress.com/fe_full_story.php?content_id=140455

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