Retrospection of Capital Flows: With Emphasis on Foreign ...

www.theinternationaljournal.org > RJEBS: Volume: 03, Number: 02, December-2013

Retrospection of Capital Flows: With Emphasis on Foreign Institutional

Investments and Stock Market Volatility

Hemantkumar P. Bulsara,

Assistant Professor (Economics & Management), Management Section, Applied Mathematics and

Humanities Department, Sardar Vallabhbhai National Institute of Technology, Surat, Gujarat, India

Vaishali S. Dhingra

Ph. D. Research Scholar, Management Section, Applied Mathematics and Humanities Department,

Sardar Vallabhbhai National Institute of Technology, Surat, Gujarat, India

&

Shailesh Gandhi,

Associate Professor (Finance & Accounting), Indian Institute of Management, Ahmedabad,

Gujarat-380015, India

ABSTRACT : Undoubtedly after the end of capital restriction, there has been increased movement of

capital flows around the world. The globalisation and liberalisation has created enormous opportunities

to achieve economies of scale, to pave way in untapped markets and to increase efficiency and

effectiveness both at firm level as well as country level. Both debt creating flows and non-debt

creating flows have accelerated the growth of any country. But as it’s a known fact that every coin has

two sides, one cannot negate the adverse impact of capital flow movements. The entire financial and

economic crises are example of the contagion effect. This compelled many researchers to understand

various aspects of capital flows especially determinant and volatility. Out of the four types of

identified capital flows, foreign portfolio investment (Foreign Institutional Investment in India) is

considered as most volatile in nature, impacting adversely the capital markets of countries having low

absorption capacity. The attempted paper is an abstraction of various research studies taken up to

analyze such capital flows and particularly Foreign Institutional Investments. The paper will help other

researchers to understand and analyze conceptual work and identify research gap in area of cross

country capital flows.

Key Words - Capital flows, Capital market, Contagion, Foreign Institutional Investment, Foreign

Portfolio Investment

I. INTRODUCTION

During 1970-80s, the skyrocketed oil prices dragged the world economy into the recession.

Developing countries also felt chronic liquidity crunch. After the increase in oil price in 1973-74, all

oil exporting countries purged with cash which were invested with International Banks. The major

portion of their investment or capital was reused as debt or loan to Latin American Government. This

induced many countries to search for more loans to cope with the increased oil prices. As interest rates

increased in the United States of America and Europe in 1979, debt payments also increased which

made it harder for borrowing countries to pay back their debts(Schaeffer, 2003). The realisation of

debt crisis began in August, 1982 when Jesus Silva-Herzog, Mexico’s Finance Minister declared that

Mexico would no longer be able to service its debt payments. Afterwards, Monday of 19th

October,

1987, referred as Black Monday as the stock market around the world crashed, sloughing a huge value

in very short time. Till the end of October, stock markets in Hong Kong fell by 45.5%, Spain by 31%,

Australia by 41.8%, the United States by 22.68%, the United Kingdom by 26.45% and Canada

by 22.5%. The market of New Zealand faced biggest turmoil, falling about 60% from its 1987 peak

and took several years to recover(Zealand, 2003). It was then postulated that the speculative boom

was caused by program trading, and that the crash was merely a return to normal. The recession of the

early 1990s which described as the period of economic downturn affected much of the world in the

late 1980s and early 1990s. Panic that followed led to a sharp recession through financial contagion,


which hit hardest to those countries most closely linked to the United States, including Canada,

Australia, and the United Kingdom. During 1994, the economic crisis of Mexico evolved, which is

widely known as Mexican Peso Crisis or the Tequila Crisis was a result of sudden devaluation of

the Mexican Peso. The Asian Financial Crisis gripped much of Asian economies beginning in July

1997, and raised fear of a worldwide economic meltdown due to financial contagion and due to which

most of Southeast Asia and Japan saw slumping currencies(Yamazawa, 1998), devalued stock markets

and other asset prices and a precipitous rise in private debt. Indonesia, South Korea and Thailand were

the countries which were most affected by the crisis. Malaysia, Philippines, Hong Kong and Laos were

also hurt by the slump. Singapore, Taiwan, China, Vietnam and Brunei were less affected, more or less

all suffered due to loss of demand and confidence throughout the region. As an effect of the Asian

crisis, international investors were reluctant to lend to developing nations, leading to economic

slowdowns in developing countries in many parts of the world. The convulsion followed sharp

reduction in oil price, which reached about $11 per barrel towards the end of 1998, spreading financial

pinch in OPEC nations and other oil exporters. In whack of oil prices, the supermajors that emerged in

the late-1990s undertook some major mergers and acquisitions during 1998 and 2002 in an effort to

improve economies of scale, hedge against oil price volatility and reduce large cash reserves through

reinvestment. The financial crisis of 2007–2009, also known as the Global Financial Crisis and 2008

financial crisis, can be considered as the worst financial crisis. As a result there was a threat of total

collapse of large financial institutions, the bailout package for banks by national governments, and

disastrous crunch in stock markets around the world. The crisis rapidly spread into a global economic

shock, resulting in a number of European bank’s failures, decline in various stock indices, and sharpe

wash-out in the market value of equities and commodities(Norris, 2009). Yet the world has still not

evolved from financial crisis, Eurozone crisis hit the major European countries. Eurozone crisis is an

ongoing crisis that has been affecting the countries of the Eurozone since late 2009. It is a

combined sovereign debt crisis, a banking crisis and a growth and competitiveness crisis(Shambaugh,

REIS, & REY, 2012).

These recent economic crises are good illustrations of the adverse effects of free financial flows and

globalization. The waves of financial deregulation and globalization since the 1990s have transformed

the nature of capital flows, which earlier was dominated by the flows in terms of grants and aids, is

now dominated by the private capital from a variety of sources. After the inception of globalization,

there was a tremendous change in the composition of the private capital flows, with a marked increase

in the share of portfolio and short-term capital flows.

While spurring investment and economic growth can be seen potentially substantial benefits to

recipient economies with the increase in capital flows, the same can also bring significant risks and

challenges to emerging market economies. Capital flows, particularly driven by large short-term flows

have disrupted the functioning of domestic monetary policy and created financial instability in the past

with adverse outcomes for growth.

The strong post-crisis economic recovery along with the return of investors’ confidence and risk

appetite for emerging market assets has led to an upsurge in capital flows to developing Asia in the

latter half of 2009 until 2010. Private capital flows to emerging Asia reached US$447 billion in 2010

and are expected to average around US$430 billion in 2011 and 2012 (almost 40% of private capital

flows to total emerging markets), according to the Institute of International Finance. Following a dip in

late 2008 and early 2009, the strong rebound in capital inflows has been driven by foreign purchases of

emerging Asia stocks and a rebound in foreign direct investment flows, particularly into the People’s

Republic of China (China) and India(Mercado Jr & Park, 2011).

Large amounts of capital inflows particularly non-debt creating flows tend to create significant effects

on the economic performance of recipient countries. It is also suggested in the standard open economy

models that increase in capital inflows leads to a rise in consumption and investment. It may also

increase the amount of bank credits extended to the private sector, as resident banks often appear to act

as an intermediary between international capital markets and domestic borrowers. It may also


accelerate the growth in profitable investment opportunities and provides conducive environment for

their further advancement. This in turn generates more employment opportunities, which in turn raises

domestic consumption and investment demand given the increase in available funds. This development

gives rise to inflationary pressures in the economy led by the boost in total aggregate domestic

demand.

The upsurge in investment and consumption spending occurs for both tradable and non-tradable goods.

Since the non-tradable goods are more limited in supply, the increased demand will result in the

increase in relative prices of non-tradable goods. As a result, it will bring about an excessive growth in

services sector, as non-tradable goods are essentially provided by the services sector. Therefore,

countries which receive large capital inflows experience a considerable expansion in their services

sectors.

Another effect of capital inflows on aggregate demand appears through the appreciation of the real

exchange rate. Since an inflow of capital increases the supply of foreign exchange, the domestic

currency tends to appreciate leading to a boost in imports. Along with the enhanced consumption, this

development further widens the trade deficit and current account deficit and brings them to

uncomfortable levels.

Capital inflows can also lead towards increased or accumulated vulnerabilities in a country’s financial

system, such as liquidity and currency risks. If the banking system lacks a sufficient regulatory and

supervisory framework and has not even developed enough to handle such exposures, may even lead

the whole country towards bankruptcy. In a world of high capital mobility, where capital can leave a

country as swiftly as it arrives, it is well known that there is a real risk that, its effects on inflation, the

exchange rate and the banking sector might cause significant macroeconomic instability. How to

effectively manage capital flows re-surfaced as a major policy concern for many developing Asian

economies. Therefore, it is of great importance to elaborate the explanation for capital flows in order to

increase the understanding of how to avoid or minimize such costs.

The remaining paper is organized as follows: Section 2, 3 and 4 summarizes literature review on

International Capital Flows, International Portfolio Investment Flows and Foreign Institutional

Investment in India and Stock Market Volatility respectively and section 4 concludes the paper.

II. LITERATURE REVIEW ON INTERNATIONAL CAPITAL FLOWS

External finance for developing countries can come from one of the following four sources: (i) Official

loans and grants, (ii) External debt, (iii) Foreign Direct Investment (FDI) and (iv) Foreign Portfolio

Investment (FPI).

The above discussion postulates the criticality of capital flows. That’s why many research studies have

been contemplated to study the behaviour and factors affecting capital flows across the countries. The

processes of liberalisation, innovation, deregulations and globalisation have increased the volatility in

the capital flows and had added a source of volatility in terms of foreign portfolio flows which are

potentially more unstable(Claessens, Dooley, & Warner, 1995; Yamazawa, 1998). This in turns

imposes difficulty in pricing of financial assets. On constructive side it has also increased the

efficiency in working of capital markets (Clark & Berko, 1997). Also some evidences suggest that

volatility is not associated with any measure of financial integration and that it does not up rise

because of financial liberalization (Bekaert & Harvey, 1995). Fernandez-Arias (1996) first

summarized a number of arguments describing why large capital flows may under various

circumstances, untowardly affect emerging countries unless policies designed to neutralize such effects

are adopted. De Brouwer (1996) has focused on documenting the extraordinary reversal of capital

inflows to emerging East Asia in the past few years. The paper stated that the volatility in capital flows

is unlikely to come to an end: the outflows were preceded by inflows and they will most likely also be

followed by inflows. Calvo, Leiderman, and Reinhart (1993) tried to explain the co-movement of

capital inflows across countries in the region. They also argued that one would have to accept the

existence of strong reputational externalities (or "contagion" effects) along with the domestic reforms.

Therefore reforms in some countries give rise to expectations of future reforms in others. Table 1

draws the attention towards the major studies which attempted to understand the factors affecting

capital flows. By and large all the studies pointed towards two types of factors affecting capital flows


across the countries. Falling interest rates, a continuing recession, and balance of payments

developments in the developed nations have encouraged investors to shift resources to emerging

economies to take advantage of renewed investment opportunities and the regions’ increased solvency.

These factors are termed as global factors, external factors, real factors or push factors. Major macro

economic variables such as Growth of real GDP, Gross capital formation, Consumption (both private

and government), Inflation, Central Govt. fiscal balance, commodity prices (% change), terms of trade,

External debt, External debt to exports ratio, Debt service ratio, Reserves, reserves to import ratio and

financial openness, which are specific to different countries are considered domestic, country specific,

policy or pull factors affecting the inflow of capital flows.

Carlson and Hernandez (2002) talked about the contagion and financial crisis including three types of

flows FDI, Short Term Debt and Portfolio equity flows as a share of total net capital flows in their

paper. They described three ways by which contagion can occur: (1) through trade linkages (2) through

financial linkages and (3) through macroeconomic similarities.

Acc to the study of Mercado Jr and Park (2011), per capita income growth, trade openness, and change

in stock market capitalization are important determinants of capital inflows to developing Asia. Trade

openness increases the volatility of all types of capital inflows; while change in stock market

capitalization, global liquidity growth and institutional quality lowers the volatility. Moreover, the

global financial crisis of 2008-2009 was predated by the very low interest rate in developed nations.

III. LITERATURE REVIEW ON INTERNATIONAL PORTFOLIO INVESTMENT

FLOWS

The importance of PPP deviations in international finance stems from the way in which investors

compute the real returns from a given security. If PPP held exactly, i.e., if the two price indices were

exactly in line with the exchange rate, the two investors would view the real return identically. Their

notions of the real returns from the same security will differ to the extent that their price indices,

expressed or translated into a common currency, are different, i.e., to the extent that PPP is violated.

The empirical evidence regarding PPP deviation is important mainly for revealing that investors' real

returns do differ and therefore that their portfolio compositions should differ (Adler & Dumas, 1983).

They predicted that in multicurrency, global setting with homogenous beliefs and no transaction costs

or taxes, risky assets should optimally be held in proportion to their market weights. However, in the

presence of purchasing power risk, there is also a hedging demand possibly tilting the optimal portfolio

away from the market-weighted portfolio. Frankel (1991) opined, albeit there was capital controls and

other barriers to the investment of capital across national borders, interest differentials for major

industrialized countries have been eliminated by 1988. But due to real and nominal exchange rate

variability, currency premium remains i.e. an exchange risk premium plus expected real currency

depreciation which gives rise to difference in real interest rate. This differential in real interest rate is

not so significant to explain the observed home bias. They further pointed out, as bonds are not perfect

substitutes for equities and equities are not perfect substitutes for plant and equipment, changes in

national saving do not crowd at Investment because they are readily financed by borrowing from

abroad.

Table 1 Conceptual Framework for Literature Review on International Capital Flows

Author Statistical

Techniques Used

Findings Remarks (if any)

Calvo et al.

(1993)

Granger Causality

Test, Structural

Vector auto

regression

Reserve accumulation preceded the

real exchange rate appreciation and

foreign factors have much

significant effect for movements in

exchange rate reserves.

Monthly data has been

used

Bekaert and

Harvey

(1995)

Granger Causality

Test, Auto

regressive models

with four lags

STI follows other flows, while DI

does not and the four categories of

flows do not appear to be perfect

substitutes.

Four main types of

capital flows identified

by International Balance

of Payments statistics


have been used viz.

short-term investment

(STI), long-term

investment, portfolio

investment, and direct

investment (DI).

Fernandez-

Arias (1996)

Contemporary policies are

appropriate, if causes of capital

flows are largely exogenous and

direct policies are effective if the

causes are domestic.

Claessens et

al. (1995)

Standard Deviation,

Coefficients of

variation,

Autocorrelation,

Impulse Response

Function, univariate

AR(4) model

In most cases the labels of capital

flows do not provide any

information about the time series

properties of the flow. In particular,

long term flows are often as volatile

as short term flows and the time it

takes for an unexpected shock to a

flow to die out is similar across

flows

Conventional Wisdom:

"short-term capital

movements are deemed

speculative and

reversible-hot money-

and long-term capital

flows –cold money-are

based on fundamentals

and are deemed

reversible only when the

fundamentals

change.”(p.154)

Chuhan,

Claessens,

and Mamingi

(1993)

Autoregressive

models with four

lags

Equity flows, relative to bond flows,

are more responsive to global

factors; bond flows, however, are

more responsive to a country's credit

rating and to the secondary-market

price of debt.

Identified two sets of

factors affecting capital

flows: country-specific-

pull-factors & global-

push-factors

Clark and Berko (1997)

and Claessens et al.

(1995) also supported

the arguments given by

Chuhan et al. (1993)

Bekaert and

Harvey

(1995)

Regression to

compute correlation

Rate of return, credit ratings and

secondary market prices of

sovereign debt are identified as

factors affecting capital flows

Global factors account

for a small fraction of

the time variation in

expected returns in most

markets and emerging

markets exhibit differing

degrees of market

integration with the U.S.

market, and the

differences are not

necessarily associated

with direct barriers to

investment.

Taylor and

Sarno (1997)

Two complementary

co-integration

techniques

Long-run equity and bond flows are

about equally sensitive to global and

country-specific factors

Country Specific

Factors: country credit

rating, secondary-market

debt prices

Global Factors: Treasury


bill rate(short term),

government bond

yield(long term),level of

real U.S. industrial

production

Goldstein

(1991)

Equity related flows particularly

FDI may be attracted by the

opportunity to use local raw

materials or employ a local labour

force, where as the right to

repatriate dividends and capital may

be the most important factor in

attracting significant foreign equity

flows.

Calvo et al.

(1993)

Regression, R-

squared, VAR,

Variance

Decomposition

Fast and marked fall of U.S. interest

rates and the slowdown of the U.S.

economy in the late 1980s have

attracted U.S. capital flows to many

developing countries because of

stable macroeconomic policies,

labour market conditions, and

exchange rate policies prevailing

there.

There are three types of

concerns that

policymakers tend to

voice about capital

inflows: (1) since capital

inflows are typically

associated with real

exchange rate

appreciation and with

increased exchange rate

volatility, they may

adversely affect the

export sector; (2) capital

inflows-particularly

when massive-may not

be properly

intermediated and may

therefore lead to a

misallocation of

resources; and (3) capital

inflows especially the

"hot money" variety-

may be reversed on short

notice, possibly leading

to a domestic financial

crisis

De Brouwer

(1996)

Graphical

representation of

facts and figures

Volatility in capital flows is unlikely

to have come to an end: the

outflows were preceded by inflows

and they will most likely also be

followed by inflows. The pattern of

capital movement to emerging

markets over the past 30 years or so

has been one of ebb and flow, rather

than stasis.

Supported the findings

of Calvo et al. (1993).


Fernandez-

Arias (1996)

Panel Data

Regression,

weighted average of

variables and

equation estimation

Past year debt service capacity and

investment rate as important

determinant of debt flows. Portfolio

equity flows are less sensitive to

both the variables (External and

Domestic). Exchange rate

appreciation and availability of

funds to all developing countries

play important role in determining

the flows. They also provided

evidence for contagion effect.

Their study showed no

significant effect of real

interest rate prevailing in

international capital

markets, which is quite

contradicting with the

result of previous

available literatures.

Carlson and

Hernandez

(2002)

Panel data

regression with

fixed effect for each

country and

unrelated regression

technique (SUR) on

pooled sample with

country and year

dummies

Capital controls and change in GDP

growth rate positively while floating

exchange rate negatively affects the

FDI and Portfolio equity

investment, whereas these variables

have totally opposite effect on short

term debt. This suggested that

portfolio equity investors are not of

short term nature rather they are

concerned with fundamentals and

have longer time horizons than debt

holders.

Exchange rate regime,

capital controls and the

measure of sterilization

are considered as policy

variables, whereas

Change in GDP growth

rate, Countries’ interest

rate differentials with

international rates are

considered as real

factors. Included

location dummies to

account for regional

effects.

Rigobon and

Broner

(2005)

Standard deviation,

panel data

regression with

more importance on

R-squared

The high volatility of capital flows

to emerging countries reflects three

statistical properties of capital flows

i.e. emerging countries are more

subject to “crises”; shocks to capital

flows are more persistent in

emerging countries; and capital

flows to emerging countries are

more correlated across countries.

Capital flows as a

percentage of GDP in

emerging countries are

found 80 percent more

volatile than those to

developed countries.

External factors have

very little explanatory

power; the R-squared is

only 1 percent for

emerging countries and

0.2 percent for

developed economies.

Çulha (2006) Structural Vector

Auto Regression,

Impulse Response

Function and

Variance

Decomposition

Foreign interest rates (US interest

rate), foreign industrial output and

return on stock exchange index of

Turkey tend to increase, whereas

shocks to domestic real interest

rates, deteriorating budget and

current account deficit tend to

decrease capital flows to Turkey.

Shocks to pull factors

explain 40 percent,

whereas shocks to push

factors explain 26

percent of the variation

in capital flows,

suggesting that pull

factors are dominant

over the push factors in

the determination of

capital flows to Turkey

during the whole sample

period.


Chinn and

Ito (2008)

binary dummy

variables

KAOPEN index reflects the widely

held perception that the world is

moving steadily toward greater and

greater financial openness.

Constructed KAOPEN

index which is based on

the binary dummy

variables that codify the

tabulation of restrictions

on cross-border financial

transactions reported in

the IMF’s Annual

Report on Exchange

Arrangements and

Exchange Restrictions

(AREAER).

Broto, Díaz-

Cassou, and

Erce-

Dominguez

(2008)

GARCH (1,1) Used the work of Bekaert and

Harvey (1995) and fit a

GARCH(1,1) model to obtain

estimates of capital flows

volatilities.

Later on they themselves

critically analyzed their

own work in upcoming

paper Broto, Díaz-

Cassou, and Erce-

Domínguez (2008).

Broto, Díaz-

Cassou, and

Erce-

Domínguez

(2008)

ARIMA Models and

Driscoll and

Kraay’s (1998)

correction for the

covariance matrix

estimator

Found significant non linear

relationship between economic

development, as measured by the

GDP pc and negative association

with ratio of deposit money as

bank's assets to GDP to the

volatility of FDI flows. The

volatility of portfolio flows appears

to be weakly correlated with

domestic macroeconomic factors,

but domestic financial factors do

play a stronger role in shaping the

volatility of portfolio flows.

Criticized the

methodology which uses

standard deviation and

GARCH(1,1) to measure

the volatility of capital

flows. They used large

set of explanatory

factors as the

determinants of the

volatility of capital

flows. These factors are

grouped in four broad

categories: domestic

(both macroeconomic

and financial), global,

legal and institutional,

and geopolitical.

Becker and

Noone

(2008)

Autocorrelation for

persistence and

panel data

regeression

Statistically significant relationship

between the exchange rate regime,

the development of domestic

financial markets, the freedom of

capital flows and capital account

variability.

FDI described as "cold"

whereas other flows are

described as "hot". They

also checked persistence

of capital flows

Ito,

Jongwanich,

and Terada-

Hagiwara

(2009)

Graphical Analysis,

gravity equation

model with an

unbalanced panel

econometric

procedure and Tobit

model

A developing country

with more open capital

market tends to

experience lower

output volatility.

Additionally, the more

bank lending or more

net portfolio inflows a

country receives, the

more likely it is to

experience volatile

They introduced

“trilemma” hypothesis, “The

hypothesis states that a country may

simultaneously choose any two, but

not all, of the following three goals:

monetary independence, exchange

rate stability, and financial

integration.”(p.4)


output, reflecting the

“hot money” argument

regarding cross-border

bank lending and

portfolio investment.

Mercado Jr

and Park

(2011)

Panel Regression,

Standard Deviation,

A Fisher type

Augmented Dickey-

Fuller and Im-

Pesaran-Shin panel

unit root tests,

Feneralized Method

of moments (GMM)

Institutional quality

plays vital role in

attracting capital

flows. Other various

pull factors or

economic conditions:

as institutional quality,

financial openness, per

capita income growth,

change in stock market

capitalization, and

volatility of real

exchange rates are

found significant as

the main determinants

of the size of total

capital inflows to

emerging market

economies. Global

growth expectation is

found significant as

push factor in their

study.

Domestic and global macroeconomic

and financial indicators were used.

Domestic macroeconomic factors

include per capita income growth,

inflation, and trade openness.

Domestic financial indicators are the

change in stock market capitalization,

financial openness, and nominal

interest rate differential. Global

economic indicators are global growth

expectation (measured as the lagged

value of global GDP growth rate),

global broad money growth, and

growth of world stock price index.

Apart from the macro-financial

indicators, institutional quality index,

volatility of real exchange rates, and

regional dummy variables for

developing Asia; emerging Europe,

and emerging Latin America countries

are added.

French and Poterba (1991a) observed that investors of different countries assume higher return in their

home country as compared to foreign investors because first institutional factors may reduce returns

from investing abroad or they may explicitly limit investor’s ability to hold foreign stocks and second

is statistical uncertainties associated with estimating expected returns in equity markets vary

systematically across groups of investors. Moreover another behavioural aspect would be, they

attribute extra risk to foreign investment due to less familiarity with foreign markets, institutions and

firms. Gehrig (1993) also supported stronger home bias for equity investment than bonds because

informational requirements for stocks are larger. Cooper and Kaplanis (1994) empirically proved that

investors with low level of risk aversion reflect home bias in equity portfolio if equity returns are

negatively correlated with domestic inflation. They also estimated the deadweight costs for observed

home bias which is consistent with observable withholding taxes if investors have low levels of risk

aversion using AD model. Gordon and Bovenberg (1996) portrayed foreign investors, as handicapped

relative to domestic investors because they are poorly informed and vulnerable of being overcharged

when they acquire shares of firms or purchase inputs or services. Foreign investors faces “lemons”

problem while investing in foreign countries. They advised foreign capital flow should take a form of

domestic government bond purchase instead domestic equity purchase. Albeit asymmetric information

about future interest rates, inflation rates, and tax policy would still put foreign investors at somewhat

of a disadvantage but perhaps less so when purchasing domestic bonds than domestic equity. They

estimated the model based on consumption, capital investment and rate of return prevailing in home as

well as in international market. Coval and Moskowitz (1999) find that even portfolios of U.S. domestic

mutual funds are geographically biased toward the home of the fund; and problems of distance are

dwarfed by problems of language and communication, so that while information about the domestic

economy may be acquired virtually costlessly by regular reading of the local press and normal


business activities, information about foreign economies requires considerably more effort to acquire -

subscriptions to foreign newspapers, translations, and so forth. When Brennan and Cao (1997)

substituted the lagged local market returns for the contemporaneous return; they found U.S. residents

being at an informational disadvantage relative to locals in foreign markets and trading on new

information with a lag.

Domowitz, Glen, and Madhavan (1998) showed that segmentation increases with firm capitalization,

presumably because larger companies tend to be favoured by foreign investors, and during periods in

which foreign perceptions of currency risk are small. Kang and Stulz (1997) for the first time used,

firm-specific data rather than country-wide data to get insight about home-bias puzzle. If explicit

barriers differ across securities, foreign investors will overweight securities that have lower explicit

barriers. Further, investors want to hold a portfolio which is hedged against purchasing power of their

currency, that has a return negatively correlated with the return to their human capital, or that has a

return correlated with the spot rate of interest. They found that foreign investors overweight the

manufacturing sector, underweight the utilities and the services sector. The panel data regression

showed a strong effect of firm size on ownership, significantly negative coefficients for Leverage and

book-to-market value and positive coefficient for ROA. They concluded that ownership by foreign

investors is consistently and strongly biased against small firms. They invest their capital in foreign

firms that can produce a pattern of ownership. Merton (1987) argues that investors hold shares in firms

they know of and that investors are more likely to know about large firms.

Coval and Moskowitz (1999) grouped the explanations for home bias into two broad categories. First

explanation is associated with the existence of national boundaries and second explanation is

associated with a preference for geographic proximity. Under the first set of explanations, when capital

crosses political and monetary boundaries, it faces exchange rate fluctuation, variation in regulation,

culture, taxation and sovereign risk, which many home bias explanations focus on as the primary

factors discouraging investment abroad. Others claim that the primary cause is informational

differences between foreign and domestic investors and investor’s concern about hedging the output of

firms that produce goods not traded internationally. They employed multivariate regression for firm

size (market capitalization), leverage, current ratio, return on assets, and market-to-book ratio, number

of employees of the firm and the tradability of firm output. They found that local equity preference is

strongly related to three firm characteristics: firm size, leverage, and output tradability. Specifically,

locally held firms tend to be small and highly levered, and they tend to produce goods not traded

internationally. These results suggest an information based explanation for local equity preference

because small, highly levered firms, whose products are primarily consumed locally, are exactly those

firms where one would expect local investors to have easy access to information and they are firms in

which such information would be most valuable. These findings are consistent with the findings of

Kang and Stulz (1997) that foreign investors under-weight small, highly levered firms, and firms that

do not have significant exports, which they claim may be a response to the severe information

asymmetries associated with such firms. By extrapolating their findings to the international scale, they

found that distance may account for roughly one-third of the observed home country bias in U.S.

portfolios estimated by French and Poterba (1991b), i.e. as much as one-third of the home bias puzzle

may only be a feature of a geographic proximity preference and the relative scale of the world

economy, rather than a consequence of national borders.

Grinblatt and Keloharju (2000) reported that foreign investors tend to be momentum investors, i.e.

buying past winning stocks and selling past losers. They used buy ratio differences for finding

momentum trading and particularly binomial non parametric test which assumes an AR(1) process in

the buy ratio differences. They studied how investment behaviour relates to past returns by examining

whether the buy ratio of past winning stocks exceeds the buy ratio of past losing stocks. They found all

Finnish investor categories less sophisticated than the foreign investors (mutual funds, hedge funds,

and foreign investment banks). Finnish investors, particularly households, are contrarians, buying


losers and selling winners. Choe, Kho, and Stulz (2001) separated investors in stock market into three

categories; domestic individual investors which constitute more than 75% of total trade, Domestic

institutional investors whose share range between 12-14 % and rest foreign investors (institutional).

They suggested that foreign investors seem at informational disadvantage than domestic individual

investors but not than domestic institutional investors.

Private investment in developing countries is stimulated by real GDP growth, increase in government

investment, improvements in financial intermediation, reductions in credit to the government, and

declines in world interest rates. Educational development also accumulates private investment in any

country. Macroeconomic policies designed to lower and stabilize the rate of inflation have the

potential for stimulating private investment in a high inflation environment and countries having

greater political and social freedom are likely to enjoy higher levels of private investment (Ghura &

Goodwin, 2000).

By examining the flows across countries Froot, O’connell, and Seasholes (2001) found a small but

significant correlation in contemporaneous cross-country flows and this correlation is larger within

regions. They next examined the persistence of order flow, using variance ratio statistics as a measure.

Their finding supports that flows are persistent with the specification that gross outflows are more

persistent than gross inflows. They found statistically positive contemporaneous covariance between

(net) inflows and both dollar equity and currency returns as well as strong evidence of correlation

between net inflows and lagged equity and currency returns, with the sign generally positive, which

suggest that international investors engage in positive feedback trading (mean that an increase in

today's returns leads to an increase in future flows, without holding current and past inflows constant)

or “trend chasing”. Indeed, positive feedback trading behaviour interpreted to. Using bi-variate VAR

they found that if the exogenous flow is transitory, prices tend to decline once the inflow recedes. The

forecasting power of inflows for future returns occurs because current inflows predict future inflows,

and future inflows drive up prices. The main tool of analysis in the paper of Bekaert, Harvey, and

Lumsdaine (2002) is a vector-autoregressive (VAR) framework as in Froot et al. (2001), but with some

modifications. They added two new variables the world interest rate and local dividend yields to the

bi-variate set-up of returns and equity flows in Froot et al. (2001). The inclusion of the world interest

rate helps in that endeavour in that it removes the effect of exogenous global determinants of capital

flows. They added dividend yields to the VAR as their cost of capital measure, since it captures

potential permanent price effects induced by increased foreign capital after liberalizations better than

average returns and it also serve as an indicator of expected returns allowing differentiation of the

‘return chasing’ and ‘momentum investing’ hypotheses. Their result showed the “push effect” from

world interest rates to capital flows to be consistent, i.e. a 0.3% decrease in interest rates eventually

increases foreign holdings by about 0.04% of market capitalization, a small effect and interest rate

decreases do generate strong but very short-lived increases in returns. An unexpected shock to equity

flows have a strong positive contemporaneous effect on returns, in line with the findings of Clark and

Berko (1997) and Froot et al. (2001) and positive shocks in net equity capital flows lead to lower

dividend yields, which suggests part of the initial effect may be due to “price pressure” but part of the

response is near permanent and beneficial. Moreover, positive returns shocks are followed by

increased short-term equity capital flows, indicating a momentum effect.

Zealand (2003) examines whether the data on equity returns, equity flows, and exchange-rate returns

are supportive of a portfolio rebalancing channel. They found that the data are consistent with an

important role for the portfolio rebalancing channel. Their variance-covariance de-composition

showed that global investors repatriate foreign equity wealth after its appreciation either because of

foreign-equity excess returns or after an unexpected appreciation of the foreign currency. Moreover,

these equity flows move the exchange rate in line with a price-inelastic supply of foreign-exchange

balances. Portfolio flow shocks appreciate the foreign-exchange rate and create foreign equity market

excess returns.


IV. LITERATURE REVIEW ON FOREIGN INSTITUTIONAL INVESTMENT IN INDIA

AND STOCK MARKET VOLATILITY

Several researchers have evident that portfolio investment in emerging markets is a classic example of

speculative bubble. They opine foreign institutional investors pump the capital flow to create a bubble

which increases the volatility of particular stock market after liberalization (Yamazawa, 1998). Some

observers, however, believe that the built-in volatility of capital flows, as demonstrated most severely

in ‘‘sudden stops’’(Norris, 2009), ‘‘hot money’’ (Stiglitz, 1999) and even capital flight, drags to

adverse effects, especially during economic downturns in countries with small ‘‘absorptive capacity’’

(Prasad, Rogoff, Wei, & Kose, 2003) and weak investor protection. On balance, it is possible that

openness and integration might even depress growth (Claessens et al., 1995).

Table 2 Conceptual Framework for Literature Review on Foreign Institutional Investment

Flows

Author Objective/Objectives Statistical

Techniques Used

Findings Remarks (if

any)

Wang and Shen (1999)

Tried to find whether

the effects of FI on

stock and exchange

rate markets is

stabilizing or

destabilizing and

whether the FI has a

demonstration effect

on the stock market

Conventional

Moving Average,

Granger Causality

Test,

Autoregressive

Conditional

Heteroscedasticity

(ARCH),

GARCH(1,1)

FI inflow and net

FI inflow

suggested the

existence of a

destabilizing

effect, but

outflow doesn’t

show any lead–

lag relationship.

Application of

GARCH(1,1)

model supported

that foreign

investments

increase the

volatility of the

exchange rate

and in the

Taiwan stock

market mildly

increases the

volatility of

stock returns.

Non-

fundamental

factors are the

key influence on

stock returns

prior to foreign

investment and

both non-

fundamental and

fundamental

factors are

influential after

1991.

Demonstration

hypothesis: the

investment

strategy of

individuals can

shift from a focus

on `non-

fundamental

factors’ (also

referred to as the

`speculation

factor’ hereafter)

to a focus on

`fundamental

factors’ when FI

is permitted in

the local stock

market.


Chakrabarti (2001) Tried to analyse FII

flows to India and

their relationship with

other economic

variables.

Regression

Analysis

(a) While the

flows are highly

correlated with

equity returns in

India, they are

more likely to be

the effect than

the cause of

these returns; (b)

The FIIs do not

seem to be at an

informational

disadvantage in

India compared

to the local

investors; (c)

The Asian Crisis

marked a regime

shift in the

determinants of

FII flows to

India with the

domestic equity

returns becoming

the sole driver of

these flows since

the crisis.

Used mainly

‘push’ and ‘pull’

factors.

Mukherjee, Bose, and Coondoo (2002)

Tried to identify the

relevant covariates of

FII flow into and out

of the Indian equity

market and also to

determine the nature

of causality between

the relevant variables.

Linear

Regression, Pair-

wise Granger

causality Test

Causation runs

from BSE return

series to FII sale,

purchase and net

series and not the

other way. The

dependence of

net FII flows on

daily return in

the domestic

equity market—

at a day’s lag is

suggestive of

foreign

investors’ return-

chasing

behaviour; their

decisions seem

to get affected

also by the

recent history of

market return

and its volatility

in international

and domestic

Failed to find

evidence of any

portfolio

diversification

benefit reaped by

FIIs by investing

in the Indian

market.


stock markets as

well.

Coondoo and Mukherjee (2004)

Tried to examine the

nature of volatility of

FII flows and the

impact (if any), of the

FII policy reforms on

FII portfolio flows to

the Indian stock

markets.

Chow Test for

Structural Break,

Multivariate

GARCH

The

liberalisation

policies that

expanded the

membership of

FII categories

and their scope

of investment in

the Indian

market,

enhanced

sectoral and

individual caps,

made provision

for hedging FIIs’

risk of making

investment in the

Indian stock

markets by

allowing them to

enter the foreign

exchange and

derivatives

market, and

made procedural

simplifications

and fees

reduction, seem

to have a

significant

expansionary

effect on net

inflows.

Considered 10

policy

interventions

made at different

time points in the

period January

1999 through

January 2004.


Ananthanarayanan, Krishnamurti, and Sen (2009).

Inter-relationship

between FII flows

and domestic market

returns.

Regression

Analysis

Their results

were consistent

with the base-

broadening

hypothesis. They

did not find

compelling

confirmation

regarding

momentum or

contrarian

strategies being

employed by

foreign

institutional

investors.

Moreover, they

did not find any

substantiation to

the claim that

foreigners’

destabilize the

market.

Base-broadening

hypothesis

suggests that the

expansion of

investor base to

include foreign

investors leads to

increased

diversification

followed by

reduced risk and

consequently

lowering the

required risk

premium. Thus

there is a

permanent

increase in the

equity share price

through risk

pooling.

Gabaix, Gopikrishnan, Plerou, and Stanley (2006)

Present a model in

which volatility is

caused by the trades

of large institutions.

Power law

Distribution

The specific

structure of large

movements is

due to the desire

to trade of

sizable

institutional

investors,

stimulated by

news. The

distribution of

fund sizes,

coupled with

large traders’

moderation of

their trading

volumes and a

concave price

impact function,

generates the

Pareto exponents

3 and 3⁄2 for the

distribution of

returns and

volumes.

They argued

traditional

measures such as

variances and

correlations are

of limited use in

analyzing spikes

in market

activity, Instead,

a natural object

of analysis turns

out to be the tail

exponent of the

distribution. This

accumulated

evidence on tail

behaviour is

useful to guide

and constrain any

theory of the

impact of large

investors. This

article is also part

of a broader

movement

utilizing concepts

and methods

from physics to

study economic


issues, a

literature

sometimes

referred to as

“econophysics”.

Chuang, Lu, and Lee (2007)

To test the predictive

accuracy of volatility

forecasts generated

by the GARCH

model with various

distributional

assumptions.

13 Distribution

Functions,

GARCH model

The LOG, the

SST distributions

and the

Riskmetrics

model are the

most robust

models with

respect to the

stock markets.

Moreover,

complex

distributions are

not necessarily

preferable. When

the exchange

rate data used,

the LOG, the

SST, the SGT,

the EGB2,

Riskmetrics and

N distributions

provide some of

the most

accurate

forecasts. The

EXP and M2N

are less

preferable.

In general, there

are three types of

parameters

determining a

probability

density function:

location, scale

and shape. They

introduced

density functions

of these

distributions, the

discrete mixture

of N

distributions, the

LOG, the EXP

distribution, the

mixed diffusion

jump, the SUN

distribution, the

ST distribution,

the SST

distribution, the

SGT distribution,

the exponential

generalized beta

type two, the

TPM, N

distribution, and

the Riskmetrics

model.


Inoue (2009) Tried to investigate

the causal

relationship between

FII flows and stock

returns in India.

Cross Correlation

Function (CCF)

approach, Lag

Augmented

Vector Auto

regression (LA-

VAR) based

Granger Test

There has been a

bi-directional

relationship

between stock

returns and FII

flows both in

mean and

variance during

the period

beginning in

May 2003, while

there was a uni-

directional

causal

relationship from

stock returns to

FII flows both in

mean and

variance during

the period before

May 2003. The

LA-VAR based

Granger test

supports the

results of the

CCF approach

given above.

The use of CCF

approach is

unconventional

and innovative

from other

studies

Kumar (2009) To investigate the


macroeconomic

parameters like

Exchange rate and

foreign institutional

investment with stock

returns in India.

Augmented

Dickey-Fuller

(ADF), Phillips

Perron (PP)test,

Engle-Granger

Test, LA-VAR

Exchange rate

and stock returns

were found to

have no causality

from either of

the sides where

as stock return

was found to

Granger cause

FII series.

Partly supports the findings of Inoue (2009).

Khan (2010) Tried to investigate

the causal


FII flows and stock

returns in India.

ADF, PP, VAR,

Impulse Response

Function (IRF)

Nifty Granger

causes FII

whereas reverse

causality doesn’t

hold true.

Only Net flows

are considered


James and Karoglou (2010)

Examine the


financial

liberalization and

stock market

volatility in

Indonesia.

CUSUM Test,

Vector

Autoregressive

Heteroscedasticity

and

Autocorrelation

Consistent

(VARHAC),

Generalized

Autoregressive

Conditional

Heteroscedastic

(GARCH) model

Find, (i) a

significant

decrease in

volatility after

the ‘official’

opening of the

stock market to

foreign

participation; (ii)

a significant

increase in

volatility in the

year before

market opening

following

reforms that

eased entry

requirements and

the issuance of

brokerage

licenses and (iii)

a significant

increase in

volatility at the

time of the Asian

crisis followed

by a significant

decrease in the

second and sixth

years after the

crisis.

They first

identify the

number and

timing of existing

breaks and then

estimate

volatility in each

defined segment

or period. The

techniques that

are employed to

detect the

number and

identify the

timing of

structural breaks

are the Inclan and

Tiao (I–T, 1994)

test and the test

of Sanso´ et al.

(2003), joined

with the Bartlett

kernel (SACBT).

Clark and Berko (1997) emphasized the beneficial effects of allowing foreigners to trade in stock

markets and outlined the “base-broadening” hypothesis. The theory behind the base-broadening

hypothesis suggests that the expansion of investor base to include foreign investors leads to increased

diversification followed by reduced risk and consequently lowering the required risk premium. Thus

there is a permanent increase in the equity share price through risk pooling (Merton, 1987). Other

researchers and policy makers are more concerned about the attendant risks associated with the trading

activities of foreign investors. Clark and Berko (1997) also find similar relation between foreign equity

purchases in Mexico and market returns. The rationale behind this hypothesis is that the shocks from

increased flows generate expectations of additional future flows. Grabel (1995) posits that the rise in

prices caused by inflow surges are due to temporary illiquidity and such a theory predicts that the

prices would return to fundamentals. This theory seems appropriate in the context of an emerging

market like India. Grabel (1995) posits that the rise in prices caused by inflow surges are due to

temporary illiquidity and such a theory predicts that the prices would return to fundamentals. This

theory seems appropriate in the context of an emerging market like India.

Researchers in favour of Foreign Institutional Investment state that due to its demonstration and

stabilization effects, local stock markets get positively affected. As FIIs focus on fundamental of

stocks, their trading strategies tend to stabilize the capital market and in a long run, give depth and

maturity to the market. Researchers against the FIIs hold that without proper and strict regulations,

sudden increase and reversal of FIIs can destabilize the market and increase the volatility. Due to their


inward and outward movements, exchange rates tend to be more volatile. This in turn may affect the

export-import of country and finally this vicious cycle makes the country more vulnerable. Table 2

provides brief conceptual framework for studies related to FIIs in Indian context.

V. CONCLUSION

The paper attempted to study various literatures available for capital flows. In particular, second

section discussed about the Identifying different types of flows and factors affecting International

Capital Flows movements. Generally four types of flows have been identified viz. Official loans and

grants, External debt, Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). For

generalising determinants of capital flows, two sets of factors have been identified push or global

factors and pull or country specific factors.

While studying the literatures of International portfolio investments following inferences have been

made. Earlier research studies reveal home bias for foreign portfolio flows. They tried to identify

reasons for this and came across two arguments, one of them states that foreign portfolio investors

suffer from information asymmetry, thus they avoid cross country investment. On the other hand no

such evidences have been identified. They are also termed as ‘momentum investors’.

In India Foreign Portfolio Investors are known as Foreign Institutional Investors and it is now

empirically proven fact that FIIs get attracted towards Indian Capital market due to its reward

generating capability and here the causality runs from Indian capital markets to FII flows and not the

other way. Moreover, many studies also tried to identify factors affecting FII flows.

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