FII Flows to India: Nature and Causes

Rajesh Chakrabarti *
Dupree College of Management,
Georgia Institute of Technology,
755 Ferst Drive, Atlanta GA 30332, USA

Tel: 404-894-5109; Fax: 404-894-6030

E-Mail: rajesh.chakrabarti@mgt.gatech.edu

Abstract

Since the beginning of liberalization FII flows to India have steadily grown in
importance. In this paper we analyze these flows and their relationship with other
economic variables and arrive at the following major conclusions:
• While the flows are highly correlated with equity returns in India, they are more
likely to be the effect than the cause of these returns;
• The FIIs do not seem to be at an informational disadvantage in India compared to the
local investors;
• The Asian Crisis marked a regime shift in the determinants of FII flows to India with
the domestic equity returns becoming the sole driver of these flows since the crisis.

*
I am grateful to Anupam Gupta and the editor, Mihir Rakshit, for helpful comments. All remaining errors
and shortcomings are my sole responsibility.
 FII Flows to India: Nature and Causes

I. Introduction

Portfolio investment flows from industrial countries have become increasingly

important for developing countries in recent years. The Indian situation has been no
different. In the year 2000-01 portfolio investments in India accounted for over 37% of
total foreign investment in the country and 47% of the current account deficit. The
corresponding figures in the previous year were 59% and 64% respectively. A significant
part of these portfolio flows to India comes in the form of Foreign Institutional Investors’
(FIIs’) investments, mostly in equities. Ever since the opening of the Indian equity
markets to foreigners, FII investments have steadily grown from about Rs. 2600 crores in
1993 to over Rs.11,000 crores in the first half of 2001 alone. Their share in total portfolio
flows to India grew from 47% in 1993-94 to over 70% in 1999-20001. The nature of the
foreign investor’s decision-making process, that lies at the heart of the portfolio flows, is
briefly outlined in Box 1.

[Box 1 about here]

While it is generally held that portfolio flows benefit the economies of recipient
countries2, policy-makers worldwide have been more than a little uneasy about such
investments. Portfolio flows – often referred to as “hot money” – are notoriously volatile
compared to other forms of capital flows. Investors are known to pull back portfolio
investments at the slightest hint of trouble in the host country often leading to disastrous
consequences to its economy. They have been blamed for exacerbating small economic
problems in a country by making large and concerted withdrawals at the first sign of
economic weakness. They have also been held responsible for spreading financial crises
– causing ‘contagion’ in international financial markets. In the wake of the Asian crisis,

1
RBI Bulletin, October 2000.
2
see Errunza (1999)

1
prominent economists 3 have, for these reasons, expressed doubts about the wisdom of the
IMF view of promoting free capital mobility among countries.
International capital flows and capital controls have emerged as an important
policy issues in the Indian context as well.4 The danger of Mexico-style ‘abrupt and
sudden outflows’ inherent with FII flows and their destabilizing effects on equity and
foreign exchange markets have been stressed. Some authors have argued that FII flows
have, in fact, had no significant benefits for the economy at large.
While these concerns are all well-placed, comparatively less attention has been
paid so far to analyzing the FII flows data and understanding their key features. A proper
understanding of the nature and determinants of these flows, however, is essential for a
meaningful debate about their effects as well as predicting the chances of their sudden
reversals. In an attempt to address this lacuna, this paper undertakes an empirical analysis
of FII investment flows to India.
The broad objective of the present paper is to gain a better understanding of the
nature and determinants of FII flows. Towards this end we first take a look at the FII
investment flows data to bring out the key features of these flows. Next we study the
relationship between FII flows and the stock market returns in India with a close look at
the issue of causality. Finally we study the impact of other factors identified in the
portfolio flows literature on the FII flows to India. In all of these investigations we make
a distinction between the pre-Asian crisis period and the post-Asian crisis period to check
if there was a regime shift in the relationships owing to the Asian crisis.
The paper is arranged as follows. The next section sketches a brief review of the
recent literature in the area. The third section provides an overview of the nature and
sources of portfolio flows in India pointing out their main characteristics. The fourth
section probes into the possible determinants of FII flows to India. The fifth and final
section concludes with a summary of the major findings and their policy implications.

3
See, for instance, Bhagwati (1998), Krugman (1997) and Stiglitz (1998)
4
See Samal (1997), Pal (1998) and Rangarajan (2000) for instance.

2
II. What we know about International Portfolio Flows

International portfolio flows are, as opposed to foreign direct investment, liquid in

nature and are motivated by international portfolio diversification benefits for individual
and institutional investors in industrial countries. They are usually undertaken by
institutional investors like pension funds and mutual funds. Such flows are, therefore,
largely determined by the performance of the stock markets of the host countries relative
to world markets. With the opening of stock markets in various emerging economies to
foreign investors, investors in industrial countries have increasingly sought to realize the
potential for portfolio diversification that these markets present. While the Mexican crisis
of 1994, the subsequent ‘Tequila effect’, and the widespread ‘Asian crisis’ have had
temporary dampening effects on international portfolio flows, they have failed to counter
the long-term momentum of these flows. Indeed, several researchers5 have found
evidence of persistent ‘home bias’ in the portfolios of investors in industrial countries in
the 90’s. This ‘home bias’ – the tendency to hold disproportionate amounts of stock from
the ‘home’ country – suggests substantial potential for further portfolio flows as global
market integration increases over time.
It is important to note that global financial integration, however, can have two
distinct and in some ways conflicting effects on this ‘home bias’. As more and more
countries – particularly the emerging markets – open up their markets for foreign
investment, investors in developed countries will have a greater opportunity to hold
foreign assets. However, these flows themselves, along with greater trade flows will tend
to cause different national markets to increasingly become parts of a more unified
‘global’ market, reducing their diversification benefits. Which of these two effects will
dominate is, of course, an empirical issue, but given the extent of the ‘home bias’ it is
likely that for quite a few years to come, FII flows would increase with global
integration.
In recent years, international portfolio flows to developing countries have
received the attention of scholars in the areas of finance and international economics
alike. In the 90’s several papers have explored the causes and effects of cross-border

5
Including French and Poterba (1991), Cooper and Kaplanis (1994) and Tesar and Werner (1995a).

3
portfolio investment. While papers in the finance tradition have focused on the nature and
determinants of portfolio flows from the perspective of the diversifying investors, those
from the international macroeconomics perspective have focused on the recipient
country’s situation and appropriate policy response to such flows. For the present
purposes, we shall focus only on papers that address the issue of portfolio flows
exclusively6.
Previous research has also attempted to identify the factors behind these capital
flows7. The main question is whether capital flew in to these countries primarily as a
result of changes in global (largely US) factors or in response to events and indicators in
the recipient countries like its credit rating and domestic stock market return. The
question is particularly important for policy makers in order to get a better understanding
of the reliability and stability of such flows. The answer is mixed – both global and
country-specific factors seem to matter, with the latter being particularly important in the
case of Asian countries and for debt flows rather than equity flows.
As for the motivation of US equity investment in foreign markets, recent
research8 suggest that US portfolio managers investing abroad seem to be chasing returns
in foreign markets rather than simply diversifying to reduce overall portfolio risk. The
findings include the well-documented ‘home bias’ in OECD investments, high turnover
in foreign market investments and that, in general, the patterns of foreign equity
investment were far from what an international portfolio diversification model would
recommend. The share of investments going to emerging markets has been roughly
proportional to the share of these markets in global market capitalization but the volatility
of US transactions were even higher in emerging markets than in other OECD countries.
Furthermore there was no relation between the volume of US transactions in these
markets and their stock market volatility.
The Mexican and Asian crises and the widespread outcry against international
portfolio investors in both cases have prompted analyses of short-term movements in
international portfolio investment flows. The question of ‘feedback trading’ has received
6
For the related literature on international capital flows in general (comprising both FDI and portfolio
flows) see Calvo et al (1993), World Bank (1997), and Feldstein (1999).
7
See Chuhan et al (1998)
8
See Bohn and Tesar (1996) and Tesar and Werner (1995a) for studies of flows to OECD countries and
Tesar and Werner (1995b) for a study of US portfolio flows to emerging markets.

4
considerable attention. This refers to investors’ reaction to recent changes in equity
prices. If a gain in equity values tends to bring in more portfolio inflows, it is an instance
of ‘positive feedback trading’ while a decline in flows following a rise in equity values is
termed ‘negative feedback trading’. Between 1989 and 1996 unexpected equity flows
from abroad raised stock prices in Mexico with at the rate of 13 percentage points for
every 1% rise in the flows9. There has been, however, no evidence of ‘feedback trading’
among foreign investors in Mexico. In the period leading to the Asian crisis, on the other
hand, Korea witnessed positive feedback trading and significant ‘herding’ among foreign
investors10. Nevertheless, contrary to the belief in some segments, these tendencies
actually diminished markedly in the crisis period and there has been no evidence of any
‘destabilizing role’ of foreign equity investors in the Korean crisis. While FII flows to the
Asian Crisis countries dropped sharply in 1997 and 1998 from their pre-crisis levels, it is
generally held that the flows reacted to the crisis (possibly exacerbating it) rather than
causing it.
More recent studies11 find that the effect of ‘regional factors’ as determinants of
portfolio flows have been increasing in importance over time. In other words portfolio
flows to different countries in a region tend to be highly correlated. Also the flows are
more persistent than returns in the domestic markets. Feedback trading or return-chasing
behavior is also more pronounced. The flows appear to affect contemporaneous and
future stock returns positively, particularly in the case of emerging markets. Finally stock
prices seem to behave on the assumption of persistent portfolio inflows.
It is commonly argued that local investors possess greater knowledge about a
country’s financial markets than foreign investors and that this asymmetry lies at the
heart of the observed ‘home bias’ among investors in industrialized countries. A key
implication of recent theoretical work in this area12 is that in the presence of such
information asymmetry, portfolio flows to a country would be related to returns in both
recipient and source countries. In the absence of such asymmetry, only the recipient
country’s returns should affect these flows.

9
See Clark and Berko (1997)
10
See Choe et al (1999)
11
See, for instance, Froot et al (2001)
12
See Brennan and Cao (1997)

5
III. Foreign Institutional Investment in India: An Overview

India opened its stock markets to foreign investors in September 1992 and has,
since 1993, received considerable amount of portfolio investment from foreigners in the
form of Foreign Institutional Investor’s (FII) investment in equities. This has become one
of the main channels of international portfolio investment in India for foreigners13. In
order to trade in Indian equity markets, foreign corporations need to register with the
SEBI as Foreign Institutional Investors (FII) 14. SEBI’s definition of FIIs presently
includes foreign pension funds, mutual funds, charitable/endowment/university funds etc.
as well as asset management companies and other money managers operating on their
behalf.
The trickle of FII flows to India that began in January 1993 has gradually
expanded to an average monthly inflow of close to Rs. 1900 crores during the first six
months of 2001. By June 2001, over 500 FIIs were registered with SEBI. The total
amount of FII investment in India had accumulated to a formidable sum of over Rs.
50,000 crores during this time (see Fig. 1). In terms of market capitalization too, the share
of FIIs has steadily climbed to about 9% of the total market capitalization of BSE (which,
in turn, accounts for over 90% of the total market capitalization in India).

[Fig. 1 about here]

The sources of these FII flows are varied. The FIIs registered with SEBI come
from as many as 28 countries (including money management companies operating in
India on behalf of foreign investors). US-based institutions accounted for slightly over
41%, those from the UK constitute about 20% with other Western European countries
hosting another 17% of the FIIs (see Fig. 2). It is, however, instructive to bear in mind
13
The closed-end country fund, “The India Fund” launched in June 1986 provided a channel for portfolio
investment in India before the stock market liberalization in 1992. Global Depository Receipts, American
Depository Receipts, Foreign Currency Convertible Bonds and Foreign Currency Bonds issued by Indian
companies and traded in foreign exchanges provide other routes for portfolio investment in India by foreign
investors.
14
It is also possible for foreigners to trade in Indian securities without registering as an FII but such cases
require approval from the RBI or the Foreign Investment Promotion Board.

6
that these national affiliations do not necessarily mean that the actual investor funds come
from these particular countries. Given the significant financial flows among the industrial
countries, national affiliations are very rough indicators of the ‘home’ of the FII
investments. In particular institutions operating from Luxembourg, Cayman Islands or
Channel Islands, or even those based at Singapore or Hong Kong are likely to be
investing funds largely on behalf of residents in other countries. Nevertheless, the
regional breakdown of the FIIs does provide an idea of the relative importance of
different regions of the world in the FII flows.

[Fig. 2 about here]

Some descriptive statistics about the FII flows are provided in Box 2. The data
used for this and the analysis in the remainder of the paper is described in Appendix 1.

[Box 2 about here]

IV. Factors affecting FII flows

In this section we shall study the relationship between FII flows and possible
economic factors affecting it, particularly stock returns in the Indian market.

FII flows and stock returns – determining the cause and the effect

FII flows and contemporaneous stock returns are strongly correlated in India. The
correlation coefficients between different measures of FII flows and market returns on the
Bombay Stock Exchange during different sample periods are shown in the different
panels of Table 1. While the correlations are quite high throughout the sample period,
they exhibit a significant rise since the beginning of the Asian crisis.

[Table 1 about here]

7
 These positive correlations have often been held as evidence of FII actions
determining Indian equity market returns. However, correlation itself does not imply
causality. A positive relationship between portfolio inflows and stock returns is consistent
with at least four distinct theories: 1) the “omitted variables” hypothesis; 2) the
“downward sloping demand curve” view; 3) the “base-broadening” theory; and 4) the
“positive feedback strategy” view.
The “omitted variables” view is the classic case of spurious correlation – that the
correlated variables, in fact, have no causal relationship between them but are both
affected by one or more other variables missed out in the analysis. The “downward
sloping demand curve” view contends that foreign investment creates a buying pressure
for stocks in the emerging market in question and causes stock prices to rise much in the
same way as suddenly higher demand for a commodity would cause its price to rise. The
‘base-broadening’ argument contends that once foreigners begin to invest in a country,
the financial markets in that country are now no longer moved by national economic
factors alone but rather begin to be affected by foreign market movements as well. As the
market itself is now affected by more factors than before, its exposure to domestic shocks
decline. Consequently the ‘risk’ of the market itself falls, people demand a lower risk
premium to buy stocks, and stock prices rise to higher levels. Finally the ‘positive
feedback view’ asserts that if investors ‘chase’ returns in the immediate past (like the
previous day or week) then aggregating their fund flows over the month can lead to a
positive relationship in the contemporaneous monthly data.
In the present context, both directions of causation are equally plausible. Detailed
statistical tests, (see Box 3) however, indicate that the FII flows are likely to have been
more of an effect of market returns in India than their cause.

[Box 3 about here]

Further statistical tests (see Box 4) suggest that returns on the BSE Index explain
close to a third of the total variation in FII flows during the entire period. They also
indicate, however, that the Asian crisis marked a regime shift in the relationship between

8
FII flows and Indian stock market return. During and after the crisis, the returns
explained about 40% of the total variation in FII flows.
The positive relationship between market return and FII flows, however, serves
only as a first-pass in understanding the nature of such flows and their implications for
the Indian markets. Since the FII flows essentially serve to diversify the portfolio of
foreign investors, it is only normal to expect that several factors – both domestic as well
as external to India – are likely to affect them along with the expected stock returns in
India. Past research suggests 15 that the declining world interest rates have been among the
important “push” factors for international portfolio flows in the early 90’s. The “usual
suspects” in the literature include US and world equity returns, changes in interest rates,
stock market volatility, some measure of the country risk and the exchange rate. In the
Indian case, however these factors do not appear to have had a prominent role in
motivating FII flows (see Box 4). Finally it also appears that there has been no significant
informational disadvantage for FIIs vis-à-vis the local investors in the Indian market.

[Box 4 about here]

Other factors that may affect FII flows

Country risk measures, that incorporate political and other risks in addition to
the usual economic and financial variables, may be expected to have an impact on
portfolio flows to India though they are likely to matter more in the case of FDI flows. In
order to check the impact of such country risk on FII flows, semi-annual country risk
scores for India were taken from the Institutional Investor magazine, an important
country-rating agency. These raw ratings were then divided by the world average rating
to obtain normalized ratings. The intuition behind this normalization is as follows. If
India’s credit rating improves but that of other countries improve even more, then India
may not improve its relative attractiveness as a destination of investment flows. The
relation between the normalized country rating and the average monthly FII flows (as a
proportion of the preceding month’s BSE capitalization) is shown in Figure 5. The

15
See Calvo et al (1993)

9
correlation between the two variables is –0.15. No relationship is evident from the figure
itself and statistical testing confirms this view16. Thus we can conclude that broadly
speaking there is no evidence of India’ credit rating affecting FII flows.

[Fig. 5 about here]

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

[Box 5 about here]

VI. Main Findings and Conclusion

The empirical investigation of FII flows to India have elicited the following
‘stylized facts’ about the such flows:
a) FII flows are correlated with contemporaneous returns in the Indian markets.
b) This high correlation is not necessarily evidence of FII flows causing ‘price
pressure’ – if anything, the causality is likely to be the other way around.
c) A collection of domestic and international variables likely to affect both flows and
returns fail to diminish the importance of contemporaneous returns in explaining
FII flows.
d) Since the US and world returns are not significant in explaining the FII flows,
there is no evidence17 of any informational disadvantage of FIIs in comparison
with the domestic investors in India.
e) Changes in country risk ratings for India do not appear to affect the FII flows.

16
A Granger causality test fails to reject the null hypothesis that the rating does not cause FII flows at the
10% level.
17
In the sense of the Brennan and Cao (1997) model.

10
 f) The beta of the Indian market with respect to the S&P 500 index (but not the beta
with respect to the MSCI world index) seems to affect the FII flows inversely but
the effect disappears in the post-Asian crisis period.
g) There appears to be significant differences in the nature of FII flows before and
after the Asian crisis. In the post Asian crisis period it seems that the returns on
the BSE National Index have become the sole driving force behind FII flows.

The stylized facts listed above lead to a better understanding of FII flows to India.
The weakness of the evidence of causality from flows to returns contradicts the view that
the FIIs determine market returns in general, though ‘herding’ effects – particularly with
domestic speculators imitating FII moves – may well be present in cases of individual
stocks. Particularly since the Asian crisis – which seems to have brought about a regime
shift in the relationship between FII flows and stock market returns – the direction of
causation seems to be running from the returns to the flows. The relative stability in the
exchange rate of the Indian Rupee in the post-Asian crisis era seems to have outweighed
fluctuations in the country’s credit rating among foreign portfolio investors.
It is notable that the Asian crisis appears to have acted as a watershed in several of
the key relationships affecting the FII flows to India. This is not an overly surprising
result. Recent research18 has demonstrated that the Asian crisis caused several major
changes in the financial relationship among European countries half-way across the
globe. In fact the crisis appeared to have altered several of the ‘ground rules’ of
international portfolio investing around the world. Why exactly the relationships
analyzed here demonstrate a structural break at the outbreak of the Asian crisis is a matter
of speculation. However, it is plausible that the crisis and India’s relative imperviousness
to it increased India’s attractiveness to portfolio investors particularly as many other
emerging markets began to appear extremely risky. This ‘substitution effect’ may well
have drowned other long-term relationships. Besides, investors may have started paying
closer attention to obtaining and processing information in destination countries in the
wake of the Asian crisis causing an ‘information effect’ that could have altered the past

18
See Chakrabarti and Roll (2002).

11
relationship as well. Finally behavioral changes among international portfolio investors
following the crisis cannot be ruled out either.
Another important area is the mild evidence towards the FII flows being affected
by returns in the Indian markets in the immediate past. Such a relationship suggests that
given the thinness of the Indian market and its evident susceptibility to manipulations, FII
flows can, in fact, aggravate the occurrence of equity market bubbles though they may
not actually start them. This is obviously an important concern for policy makers and
market regulators.
This paper provides a preliminary analysis of FII flows to India and their
relationship with several relevant variables especially returns in the Indian stock market.
A more detailed study using daily data for a longer period or, better still, disaggregated
data showing the transactions of individual FIIs at the stock level can help address
questions regarding the extent of herding or return-chasing behavior among FIIs –
indicators that can help us estimate the probability of sudden Mexico-type reversals of
these FII flows which now account for a significant part of the capital account balance in
our balance of payments. The extent to which FII participation in Indian markets has
helped lower cost of capital to Indian industries is also an important issue to investigate.
Broader and more long-term issues involving foreign portfolio investment in India
and their economy-wide implications 19 have not been addressed in this paper. Such issues
would invariably require an estimation of the societal costs of the volatility and
uncertainty associated with FII flows. A detailed understanding of the nature and
determinants of FII flows to India would help us address such questions in a more
informed manner and allow us to better evaluate the risks and benefits of foreign
portfolio investment in India.

19
Like those raised in Pal (1998).

12
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14
 Appendix I: A Description of the Data
The data used in this paper comes from several sources. We use monthly net FII
investment figures obtained from the websites of the RBI and SEBI. Market
capitalization data are obtained from the BSE web site. Other financial data like the
exchange rate, short-term interest rate in India, returns on the MSCI world index, S&P
500 as well as the BSE national index are obtained from Datastream. Country credit
rating data are obtained from several issues of the Institutional Investor magazine.
The FII net investment series starts from January 1993 and the BSE market
capitalization series starts in April 1993. The series of FII flows as a proportion of
preceding month’s BSE market capitalization therefore begins in May 1993.
Since the net monthly FII flows and the returns in the Indian equity markets
constitute two key variables in this study, we present, in the three panels of Figure 1, the
net FII flows, the BSE National Index and net FII flows as a proportion of the preceding
month’s BSE market capitalization from May 1993 to June 2001. The BSE National
Index immediately reveals the massive and short-lived ‘bubble’ during 2000, a
phenomenon that is likely to have caused temporary but marked deviations from the
long-term relationship between FII flows and Indian market returns. In order to avoid
misleading results from this potentially ‘tainted’ period, we restrict our sample to the end
of 1999 for carrying out empirical analyses.
In order to check if the Asian crisis marked a structural break in the relationships
studied here; we sub-divide the sample period into two sub-samples. Dating the Asian
crisis to begin in July 1997*, the pre-Asian Crisis sub-sample runs from May 1993 to
June 1997 (50 months) and the Asian crisis sub-sample runs from July 1997 to December
1999 (30 months).
In order to study the causal linkage between FII flows and contemporaneous stock
returns in greater detail, we also use daily FII flows data and daily returns on the BSE
National Index for the year 1999. The daily FII flows data come from the SEBI website
while the daily returns data are, once again, obtained from Datastream. All returns are
computed on continuous compounding basis – i.e. as the excess of the logarithm of the
index value on a date over the logarithm of the index value on the previous date.

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

15
Box 1: The International Portfolio Investor’s decision-making problem
International portfolio flows, as opposed to foreign direct investment (FDI) flows,
refer to capital flows made by individuals or investors seeking to create an internationally
diversified portfolio rather than to acquire management control over foreign companies.
Diversifying internationally has long been known as a way to reduce the overall
portfolio risk and even earn higher returns. Investors in developed countries can
effectively enhance their portfolio performance by adding foreign stocks particularly
those from emerging market countries where stock markets have relatively low
correlations with those in developed countries. For instance, according to Morgan Stanley
Capital International’s estimates, between 1985 and 1990, an investor holding an all-US
portfolio could improve her returns by over 25% by holding the MSCI world index
instead and at the same time, reduce her risk by about 2%*.
The portfolio investor’s problem may be thought of as deciding upon appropriate
country weights in the portfolio so as to maximize portfolio returns subject to a risk
constraint, or in the absence of a pre-specified risk level, to reach the optimum portfolio,
that which has the highest Sharpe ratio, S where the Sharpe ratio is the ratio of expected
excess return (excess over the risk-free rate) to the dispersion (standard deviation) of the
return. The problem, therefore, is as follows:

E (rP ) − rf
Max S=
{ xi } σP

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

*
See Tesar (1999).

16
Box 2: Some descriptive statistics of FII flows to India
The histogram and descriptive statistics for net FII flows between January 1993
and December 1999, the sample period selected for our analysis, is given in Panel A of
Figure 3. A Jarque-Bera test of normality in the distribution of FII flows fail to reject the
null hypothesis of normality for the data during the sample period. The flows, however,
are somewhat volatile with a coefficient of variation of over 1.22. They are also
considerably auto-correlated. The auto-correlation with one lag is over 0.5 and that with
two lags is over 0.26.

[Figure 3, Panels A and B about here]

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

17
Box 3: FII flows and Equity Returns in India: Cause or Effect?
Pair-wise Granger causality tests between net FII inflows (as a proportion of
preceding month’s BSE market capitalization) and monthly return on the BSE National
Index, reported in Table 2, Panel A fail to categorically establish a causal direction since
non-causality is rejected in both directions at least at the 5% level of significance. During
the pre-Asian Crisis period, however, there seems to be some support for the causality
running from flows to returns, while with the onset of the Asian Crisis, there is mild
evidence of a reversal of causality. On the whole then, the issue of which is the cause and
which is the effect remains indeterminate with monthly data.

[Table 2 about here]

In order to dig deeper into the issue of direction of causality then, we have to use
daily data. Fortunately daily data is available (from the SEBI web site) on net FII flows
since January 1999. Thus in order to get a better sense of the direction of causality we run
pair-wise Granger-causality tests with daily for 1999 data at several lags and report these
results in Panel B of Table 2. Here the results seem to be far more unequivocal. At all
lags, the Granger causality tests reject the hypothesis of returns not causing flows at the
1% level while the null hypothesis of reverse non-causality is never rejected. Thus this
data seems to support the view that the FII flows are more an effect than a cause of
market returns in India. Figure 4 shows the weekly patterns in returns and FII flows
during 1999.

[Figure 4 about here]

One qualifier may not, however, be out of place here. Loosely speaking, Table 2,
Panel A seems to suggest a slight reversion of causality between flows and returns in the
pre-Asian crisis period and that of the later period. Since the daily data comes entirely
from the post-Asian crisis period, it may be still be true that the reverse causation was in
effect in the pre-crisis period.
Finally, the model-free approach of detecting causality between the two variables
simply by using Granger causality can only serve as a preliminary check for the direction
of causality. The orthodox way of doing such analysis would almost always begin with a
priori modeling of these variables. However, since in financial markets, information
flows drive both returns and investment flows, implications about causality between these
two variables can also be highly model-specific. In such a situation an agnostic test like
Granger causality does have some usefulness in detecting the direction of causality.

18
Box 4: Further Analysis of the Determinants of FII flows

Equity Market returns

Table 3 presents the results of a regression of FII flows (as a proportion of the
previous month’s BSE capitalization) on monthly rupee returns * on the BSE National
Index. Because of evidence of autocorrelated residuals from the Durbin-Watson statistic,
Newey-West heteroskedasticity and auto-correlation consistent standard errors and
covariances are used in these regressions. The results indicate that returns on the BSE
Index explain over three-tenths of the total variation in FII flows during the entire period.
The explanatory power rises considerably with the onset of the Asian crisis when the
regression accounts for over four-tenths of the variation. The results of a Chow
breakpoint test shown in Table 3, Panel B, shows that the onset of the Asian Crisis does
mark a structural break in the relationship implying a rise in the effect of market return in
explaining FII flows.
[Table 3 about here]
The effect of other factors
As a second step in analyzing the FII flows to India, we regress the FII flows on
other factors identified in the literature and find out to what extent they help explain the
FII flows. To the extent that these factors may be affecting the Indian stock returns
themselves, this exercise throws light on the possibility of “omitted variables” giving rise
to the correlation between FII flows and monthly stock returns.
Table 4 reports the results from a regression of monthly FII flows (as a
proportion of preceding month’s BSE market capitalization) on several variables in
addition to the monthly return on the BSE National Index. These variables are as follows:
returns on the S&P 500 index (a major US index), returns on the MSCI world index (a
major international index tracked by several international investment funds), volatility of
daily US dollar return on the BSE National Index in the preceding month (as a measure
of total risk in the Indian market), the change in the short-term (45-day) fixed deposit rate
in India and the return in the foreign exchange market (a positive return means
depreciation of rupee). Once again Newey-West standard errors and covariances are used
in response to the low D-W statistics. Only the exchange rate movements turn out to be
significant (in addition to the stock returns) in these regressions. A comparison with table
3 shows that in the entire sample the adjusted R2 goes up only marginally (presumably
because of the exchange rate effect) while it declines in both sub-samples. These
variables thus collectively do little to explain the FII flows. The Chow test (Panel B)
continues to detect a structural break with the onset of the Asian crisis.

[Table 4 about here]

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

19
Box 5: India’s status as a “hedge” against world shocks

According to the standard International Capital Asset Pricing Model (ICAPM)

approach, the measure of risk of holding the Indian market in an internationally
diversified portfolio is given by the beta of the Indian market (slope of the regression of
Indian returns on world returns) with respect to the relevant ‘world’ market. Thus, if the
beta of the Indian market decreases, it is likely to improve the attractiveness of the Indian
market to the international investor simply for the benefits of total risk reduction through
diversification.

In order to check this relationship we compute the beta of monthly US dollars

return on the BSE National Index with returns on the S&P 500 index [ β = Cov(rBSE , rSP 500 ) ]
Var(rSP500 )
and returns on the MSCI world index. The betas for each month are computed using
returns data for the previous 24 months. Figure 7 shows the data and table 5 shows the
regression estimates. The regressions indicate that the beta of the Indian market with
respect to the S&P 500 has a significant effect in explaining FII investment flows before
the Asian crisis but not during or after the crisis period. The beta with respect to the
world market is insignificant in both periods. The Chow test (Panel B), however, rejects
the null hypothesis of no structural break at the onset of the Asian crisis only at the 15%
level.

[Figure 6 about here]

[Table 5 about here]

20
 Table 1: FII flows and Returns on BSE – Correlations

Net FII flow FII flow as proportion of Return on BSE

preceding month’s BSE National Index
market cap (Rupees)

Panel A: Entire Sample: May1993 – Dec 1999

FII flow as proportion of preceding month’s 0.93
BSE market cap
Return on BSE National Index (Rupees) 0.52 0.56

Return on BSE National Index (US $) 0.53 0.58 0.98

Panel B: Pre-Asian Crisis period: May 1993 – June 1997

FII flow as proportion of preceding month’s 0.88
BSE market cap
Return on BSE National Index (Rupees) 0.40 0.56
Return on BSE National Index (US $) 0.41 0.58 0.98

Panel C: Asian Crisis and after: July 1997 – Dec 1999

FII flow as proportion of preceding month’s 0.99
BSE market cap
Return on BSE National Index (Rupees) 0.67 0.66

Return on BSE National Index (US $) 0.67 0.66 0.98

21
 Table 2: Granger Causality tests between Returns on the BSE National Index on
FII investment flows

Panel A: Monthly Data – 1993 to 1999

Null Hypothesis: Entire Sample Pre-Asian Asian Crisis and

Crisis after

Returns+ do not cause FII flows# 3.2105 0.975 2.29915

Flows do not cause returns 6.1471 2.74410 1.738

The tests use two lags.

+
Monthly Returns on the BSE National Index
#
Ratio of net FII flows to BSE market capitalization in the previous month
1 5 10
, , and 15 denote significance at 1%, 5%, 10% and 15% levels respectively.

Panel B: Daily Data – January 1, 1999 to December 31, 1999

Lags considered 2 3 4 5 6
Null Hypothesis:
8.3861 5.5331 4.2231 4.0851 3.2561
Returns+ do not cause FII flows#
0.963 0.766 1.891 1.732 1.399
Flows do not cause returns

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

22
Table 3: Regressions of FII investment flows on Monthly Returns on the BSE
National Index
Panel A
Dependent variable: Net monthly FII inflow as a proportion of the preceding month’s BSE
market capitalization
Asian Crisis and
Entire sample Pre Asian Crisis after
(1993:05 – 1999:12) (1993:05 – 1997:06) (1997:07 – 1999:12)
0.001 0.001 0.0003
Constant (5.624) (8.300) (1.566)

Return on the BSE 0.008 1 0.008 1 0.0091

(4.517) (2.836) (6.124)
National Index

Adjusted R2 0.310 0.304 0.419

Durbin-Watson 1.016 1.241 1.24

The regressions are estimated by OLS with Newey-West heteroskedasticity autocorrelation

consistent standard errors and covariance. The figures in parentheses are t-statistics.
1
denotes significance at 1% level.

Panel B: Chow Breakpoint Test: (Breakpoint – 1997:07)

F-statistic 9.767 Probability 0.000168

Log likelihood ratio 18.301 Probability 0.000106

23
Table 4: Regressions of FII investment flows on Monthly Returns on the BSE
National Index

Dependent variable: Net monthly FII inflow as a proportion of the preceding month’s
BSE market capitalization
Asian Crisis and
Entire sample Pre Asian Crisis after
(1993:05 – 1999:12) (1993:05 – 1997:06) (1997:07 – 1999:12)

Constant 0.002 0.002 0.0000

(4.870) (4.053) (0.032)
Return on the BSE 0.0081 0.0075 0.0101
National Index (4.336) (2.439) (5.530)

Return on the MSCI 0.000 0.007 -0.018

World Index (0.013) (1.103) (-1.671)

Return on the S&P 500 -0.004 -0.010 0.016

index (-0.520) (-1.552) (1.564)

Change in Indian short- 0.008 0.070 -0.154

term interest rate (0.082) (0.456) (-0.824)

Return Volatility in the -0.038 -0.014 0.019

preceding month (-1.784) (-0.474) (0.476)

Return on exchange -0.0105 -0.008 -0.005

rate (-2.363) (-1.609) (-0.883)

Adjusted R2 0.321 0.277 0.361

Durbin-Watson 1.123 1.361 1.363

The regressions are estimated by OLS with Newey-West heteroskedasticity

autocorrelation consistent standard errors and covariance. The figures in parentheses are
t-statistics.
1 5 10
, and denote significance at 1%, 5% and 10% levels respectively.

Panel B: Chow Breakpoint Test: (Breakpoint – 1997:07)

F-statistic 2.448 Probability 0.0271

Log likelihood ratio 18.465 Probability 0.0100

24
Table 5: Regressions of FII investment flows on betas of the BSE National Index
with respect to S&P500 and the MSCI World Index

Panel A

Dependent variable: Net monthly FII inflow as a proportion of the preceding month’s
BSE market capitalization
Asian Crisis and
Entire sample Pre Asian Crisis after
(1993:05 – 1999:12) (1993:05 – 1997:06) (1997:07 – 1999:12)
0.001 0.001 0.001
Constant (5.685) (6.980) (2.408)

Beta (S&P 500) -0.001 -0.0015 0.0001

(-1.848) (-2.324) (0.391)

Beta (MSCI World -0.0002 0.0002 -0.002

(-0.314) (0.387) (-1.330)
Index)

Adjusted R2 0.179 0.119 0.067

Durbin-Watson 1.323 1.349 1.457

The regressions are estimated by OLS with Newey-West heteroskedasticity

autocorrelation consistent standard errors and covariance. The figures in parentheses are
t-statistics.
5
denotes significance at the 5% level.

Panel B: Chow Breakpoint Test: (Breakpoint – 1997:07)

F-statistic 1.983 Probability 0.123

Log likelihood ratio 6.186 Probability 0.103

25
 Figure 1: Growth of FII Investment in India

Cumulative FII Investment in India (Rs. crores)

600 60000
Number of FIIs registered with SEBI

500 50000

400 40000

300 30000

200 20000

100 10000

0 0
93 94 95 96 97 98 99 00 01

FII_REG CUM_INV

26
 Fig. 2: Sources of FIIs in India

UK
20%
USA
42% W.Europe
17%

Hong Kong
6%

Singapore 4%
Others Australia 4%
2% Canada 2%
India 1%
Japan 1% Middle East 1%
Source: SEBI web site

Figure 3: Histogram and descriptive statistics of FII flows

Panel A: Net FII flows (Rs. crores)
12
Series: NET_INV
Sample 1993:05 1999:12
10
Observations 80

8 Mean 439.5139
Median 406.6350
Maximum 1673.000
6
Minimum -896.4100
Std. Dev. 539.2140
4 Skewness 0.080577
Kurtosis 3.274955
2
Jarque-Bera 0.338569
Probability 0.844269
0
-500 0 500 1000 1500

27
 Panel B: FII flows as a proportion of previous month’s BSE market capitalization

20
Series: PROP_INV_BSE_LAG
Sample 1993:05 1999:12
Observations 80
15
Mean 0.001024
Median 0.000879
Maximum 0.004929
10
Minimum -0.001595
Std. Dev. 0.001161
Skewness 0.576284
5 Kurtosis 4.249903

Jarque-Bera 9.635571
Probability 0.008085
0
0.0000 0.0025 0.0050

Figure 4: Returns and FII flows during 1999

0.03 0.0004
Return FII flow

Average FII flow during the week (as a proportion

of previous month's BSE market capitalization)
0.0003
Average daily return during a week

0.02

0.0002
0.01
0.0001
0.00
0.0000

-0.01
-0.0001

-0.02 -0.0002
5 10 15 20 25 30 35 40 45 50
Weeks

28
 India's credit rating as a multiple of
global average credit rating

1.1
1.3
1.5
1.7
1.9

0.9
Sep-93
Mar-94

Sep-94
Mar-95

Sep-95
Mar-96

29
Sep-96
Mar-97

Sep-97
Mar-98
FII flow

Sep-98
Mar-99
Normalized Rating
Fig. 5: Credit rating and Subsequent FII flows

Sep-99
0.0%
0.1%
0.2%
0.3%

0.05%
0.15%
0.25%

-0.05%

Average monthly FII flow (as a percentage of BSE

market cap in the preceding month) for the following 6 months
 Figure 6: FII flows and the beta of the Indian market with
respect to S&P500

0.60% 1
FII flow
0.50% beta_sp500
0.5
FII flow (percentage of preceding month's BSE

Beta of BSE National Index with respect to

0.40%
0
market capitalization)

0.30%
-0.5

S&P500
0.20%
-1
0.10%
-1.5
0.00%

-0.10% -2

-0.20% -2.5
Months (May 1993 to December 1999)

30