With the liberalization of Indian economy since 1992, the Foreign Institutional Investments have started
coming in and have steadily gained importance subsequent to a series of structural reforms and stabilization
programs. The present study tries to examine the determinants of Foreign Institutional Investments in
India which has reached almost US$1bn during October 1-17, 2003 itself. Given the huge volume of
these flows, the understanding of the behavior and pattern of these investments is vital for finding out
their impact on domestic financial market. The nature and volatility of foreign capital inflows is hard to
model and predict precisely. A number of possible explanatory variables can be included for further
research purpose. The implication of this study is to explore and debate on the general belief that portfolio
flows are primarily determined by the stock returns. It is also debated that Indian Stock Market plays to
the tune of FII investments. Hence one of the major objectives of this study is to examine the causal
relationship between the net FII inflows and the Indian stock market represented by BSE Sensex. Using
monthly data of FII net investment and BSE market capitalization from 1998 to September 2003, the
authors explore the extent of correlation between net FII inflows and stock market returns. While the
FII flows are expected to be highly correlated with equity returns in India, they are more likely to be
the effect rather than the cause of these returns. The authors also discuss the implications for policy
makers with regard to attracting more FII inflows that have a positive impact on the real economy. Given
the susceptibility of Indian markets to manipulations and speculations, there is a high chance of equity
market bubbles aggravated by FII flows.
The analysis of foreign capital inflows and their nature of volatility and impacts have been
subjected to both theoretical and empirical debate. Foreign capital flows generally occur
in two forms—Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI).
FDI involves in the direct production activity and is of medium to long-term nature;
whereas FPI is a short-term investment mostly in financial markets and refers to Foreign
Institutional Investors (FII) which may be pension funds or mutual funds. FII, given its
short-term nature might have bidirectional causation with the returns of other domestic
financial markets like money market, stock market and foreign exchange market. The
potential benefits to the domestic country are reduced cost of capital, development of
domestic capital market, enhanced mobilization of domestic resources, to mention a few.
Hence, understanding the interdependence and causal relationship between FIIs and
Indian stock market is very important.
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