ROLE OF FOREIGN INSTITUTIONAL INVESTMENT IN

INDIAN CAPITAL MARKET

Dr. Anil G. Suryavanshi1

suryavanshi.a.g@gmail.com

Mr. Kedar V. Marulkar2

mkedarnath@rediffmail.com

Abstract

The year 1991 was a path-breaking year in many respects for the Indian capital market as
well as Indian financial system as a whole. The policy of Liberalisation, Privatisation and
Globalisation was initiated from the year 1991. The doors of Indian financial markets were
opened for the foreign investors. At the same time, the entire economy was going through a
phase of transformation. The increasing use of technology, inter-linkage of the economies
and markets and increased investment avenues resulted in flow of funds from one country to
another country.

The foreign investors throughout the world are continuously in search of a better opportunity.
Therefore, whenever these investors invest in a particular market, they invest in huge
quantity. Similarly, when they find another alternative in the global market, this money is
withdrawn and invested in another emerging market. This creates instability in the economy
in general and the capital and stock markets in particular. This paper tries to highlight the role
and impact of FIIs in Indian capital market.

Key Words: Foreign Investment, Capital Market, Globalisation, Institutional Investment

ROLE OF FOREIGN INSTITUTIONAL INVESTMENT IN

1
Assistant Professor, Department of Commerce, The New College, Kolhapur (Maharashtra)

2
Assistant Professor, Department of Commerce and Management, Shivaji University, Kolhapur (Maharashtra)
 INDIAN CAPITAL MARKET

1.0 Introduction

In the development of the financial sector, the role of capital market is indispensable apart
from the money market. Therefore, it is obvious that capital market development also has a
strong impact on the economic development of the nation. Well developed stock markets in a
country have the potential to offer innovative financial services and can thus provide push to
the economic activities. Capital markets in any country play an important role in supporting
technological progress and in the process, economic development by channelizing the funds
for productive and long term growth prospects. This facilitates economic development as a
whole. After the emergence of the new economic policy, the foreign investment in various
ways started growing rapidly. The Indian financial markets were flooded with various forms
of foreign investment like Foreign Direct Investment (FDI), Portfolio Investment (PI) as well
as Foreign Institutional Investment (FII). The experience from the recent trends shows that
the foreign investment has been substantial and it is significantly contributing in the
development of the Indian capital market.

1.1 Objectives of the Study

 To study the role of foreign institutional investment in the Indian capital market.
 To critically examine the impact of foreign institutional investment on Indian
capital market.
 To study the behaviour of foreign institutional investment during the period of
recession.

1.2 Hypothesis
 The foreign institutional investment may create substantial instability in the Indian
capital market
 During the recessionary phase, the foreign institutional investment slows down.
1.3 Methodology
 The present study is largely based on the available secondary data. The statistical
data regarding growth of the capital markets vis-a-vis foreign institutional
investment was available with various websites. Majority of the information was
 collected from the published records/reports of various players and intermediaries
in the financial markets in India as well as abroad. The data relating to the capital
market and FII for the years 1991 to 2011 was considered for the purpose of
study. This study is purely descriptive in nature and it studies the impact and role
of foreign institutional investment on Indian capital market.

1.4 Review of Literature

Tripathy Nalini Prava and Sahu Pramod K. (1998)1have put forward their observation that
the emergence of capital market as contributor to the growth of forex reserves is nothing but
an impact of liberalization.

‘Liberalization has resulted in a rapid restructuring of the economy much in tune with the
global trends. As a result, capital market has emerged as the major contributor to the growth
of foreign exchange reserves of the country. In a rapidly changing capital market, it is
essential to respond quickly and positively to events which tend to move share price.’

Avadhani V.A. (1999)2hints at the future of the Indian capital market, While commenting on
the future, he also notes the possibility of small investors being wiped out of the markets.

‘The future capital market should be sophisticated with less developed segments of all types
namely cash market, forward market, options and futures etc. These segments will attract
more foreign funds to come in through the FFIs and FIIs. The individuals and small investors
may be out of this market due to strict capital adequacy norms and high margins.’

Bhasin Niti (2004)3 further puts forward the challenges posed by the globalization before the
Indian markets. Here also the author gives importance to the efficiency of the markets.

‘A major issue which will influence India’s securities markets in future is the challenge of
globalization. There is need for greater thought and policy initiative in fully integrating a
global perspective in to the plans of firms, exchanges, regulators and policy makers.

In terms of information efficiency, India markets are not efficient, like most markets of the
world. Markets do not as such follow a random walk, especially when they seldom satisfy the
stringent criteria of stationary, independent, identical and normally distributed stock returns.’
Avadhani V.A. (2006)4 has further stated that the policy changes have facilitated the inflow of
funds in the country. Apart from this, raising the funds from abroad has also been facilitated
by these reforms.

‘With the recent economic reforms, markets have become free, competitive and globalised.
The FIIs and FFIs are allowed to operate in Indian financial markets. Current account
convertibility facilitates inflows and outflows of funds. These policy changes widened the
avenues or sources of funds as also the instruments through which they can raise the funds
from abroad.’

Biswas Joydeep (2007)5 commented that volatility in the stock exchange is seen where there
is no integration of the market. In case of globally integrated markets, there is less volatility.

‘The big stock markets are highly volatile and trade in high volumes, while the stock markets
that are more integrated globally are likely to be less volatile.’

Reddy B.B., Ramaiah M.V., Reddy B.P. (2008)6 have concluded that there is a significant
impact of FIIs on the prices and volatility in Indian market.
‘The fortune of investors in stock market is often determined by behavior of FIIs. This has
been proved several times. Though there is a high degree of volatility due to investments
made by FIIs, it is proved that the FIIs are one of the main factors for the growth of Indian
stock market.’

2.0 Results and Discussion

Over the years, different types of FIIs have been allowed to operate in Indian stock markets.
They now include institutions such as pension funds, mutual funds, investment trusts, asset
management companies, nominee companies, incorporated/institutional portfolio managers,
university funds, endowments, foundations and charitable trusts/societies with a track record.
Proprietary funds have also been permitted to make investments through the FII route subject
to certain conditions.

2.1 Foreign Investment and Indian Capital market

The year 1990 was a path breaking year in the history of Indian capital market as well as in
Indian economy as a whole. Before 1990, the foreign investment was not freely permitted in
India. After 1990, foreign investment was allowed in Indian market.
 Table No. 2.1 Foreign Investment Inflows (Rs. Crore)

Year Direct Investment Portfolio Investment Total

1990-91 174 (94.05) 11 (5.95) 185

1991-92 316 (96.93) 10 (3.07) 326

1992-93 965 (56.73) 748 (43.27) 1713

1993-94 1838 (14.11) 11188 (85.89) 13026

1994-95 4126 (25.57) 12007 (74.43) 16133

1995-96 7172 (43.52) 9192 (56.48) 16364

1996-97 10015 (45.99) 11758 (54.01) 21773

1997-98 13220 (66.05) 6794 (33.95) 20014

1998-99 10358 (102.54) -257 (-2.54) 10101

1999-2000 9338 (41.59) 13112 (58.41) 22450

2000-01 18406 (59.34) 12609 (40.66) 31015

2001-02 29235 (75.20) 9639 (24.80) 38874

2002-03 24367 (83.72) 4738 (16.28) 29105

2003-04 19860 (27.53) 52279 (72.47) 72139

2004-05 27188 (39.37) 41854 (60.63) 69042

2005-06 39674 (41.77) 55307 (58.23) 94981

2006-07 103367 (76.52) 31713 (23.48) 135080

2007-08 138276 (55.75) 109741 (44.25) 248017

2008-09 161536 (165.00) -63618 (-65.00) 97918

2009-10 176304 (53.45) 153511 (46.55) 329815

Figures in the bracket indicate percentage to total inflow.

Source:- www. rbi.org.in , Handbook on Indian Securities Market, SEBI, 2009 pp.53
 Graph No.2.1 Foreign Investment Inflows (Rs. Crore)

700000

600000

500000

400000
Total
300000
Portfolio Investment
200000 Direct Investment

100000

The Table No. 2.1 states clearly that there is consistent increase in both direct investment as
well as portfolio investment as the element of foreign investment in India. The direct
investment (FDI) grew steadily over the last two decades. But in case of portfolio
investments, there are ups and downs over the last two decades. The Compounded Annual
Growth Rates (CAGR) in respect of Direct Investment is 43.94 % while CAGR in case of
Portfolio investment is 65.25 %. While as regards the total investment, CAGR is 48.29 %.
Thus, though there is increasing trend in direct as well as portfolio investment, foreign
portfolio investment is growing at more pace as compared to foreign direct investment. In the
year 1998-99 and 2008-09, there was negative portfolio investment. Especially in the year
2008-09, due to global financial crisis, there was divestment as the foreign investors opted to
take the money back and go away from the market. Thus, due to direct investment, there is no
instability, but portfolio investment involves instability as there is no consistency in foreign
portfolio investment.

2.2 Foreign Investment and Volatility

But it is even more significant to observe the relationship between the foreign Institutional
Investment (FIIs) and the volatility in the Indian capital market. Volatility is a measure of
instability in the market. Normally, it is calculated with the help of standard deviation of
returns.
 Table No.2.2

FIIs in Indian markets and volatility*

Year Net Investment (Rs. Crore) Volatility

1992-93 13 ---

1993-94 5127 ---

1994-95 4796 1.3

1995-96 6942 1.5

1996-97 8575 1.7

1997-98 5958 1.8

1998-99 -1584 1.8

1999-2000 10122 2.0

2000-01 9933 1.6

2001-02 8763 1.1

2002-03 2689 1.3

2003-04 45764 1.8

2004-05 45880 1.1

2005-06 41467 1.7

2006-07 30841 1.6

2007-08 66179 2.7

2008-09 -45811 2.9

2009-10 142658 1.9

2010-11 146438 1.0

*Volatility is standard deviation of returns.

Source: Bloomberg L.P.

– Handbook of Statistics on Indian Securities Market, 2009, pp. 51

 Graph No.2.2 : Net Investment by FIIs in Indian Capital Market

Net Investment (Rs. Crore)

200000

150000

100000

Net Investment (Rs.

50000
Crore)

-50000

-100000

Graph No.2.3 : Volatility in Indian Capital Market

Volatility
3.5
3
2.5
2
1.5
1 Volatility
0.5
0
2002-03
2003-04
1994-95
1995-96
1996-97
1997-98
1998-99

2000-01
2001-02

2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
1999-2000

The table no. 2.2 and the graphs indicate the net investment made by FIIs in the Indian capital
markets vis-à-vis volatility in the Indian capital markets. During the year 1998-99, the net
investment by FIIs was negative. The same thing has been observed during the year 2008-09.
For the year 1998-99, the reason for negative net investment by FIIs was political instability.
Again after 1999, there was increase in FIIs net investment in the Indian markets. Especially,
after 2003, the net FIIs investment flourished in the Indian markets. During the year 2008-09,
there was negative FIIs net investment again which was the result of global financial crisis
which emerged at that time. But in the corresponding year, the volatility was at its highest
level since 15 years. These facts prove hypothesis set for the study

Table No. 2.3 Impact of Recession on FII in Indian capital market

Year Net
Investment (Rs. Croers)

2006-07 30841

2007-08 66179

2008-09 -45811

2009-10 142658

2010-11 146438

Graph No. 2.4 Impact of Recession on FII in Indian capital market

Net Investment (Rs. Croers)

200000
150000
100000
50000 Net Investment (Rs. Croers)
0
-50000 2006-07 2007-08 2008-09 2009-10 2010-11

-100000

The year 2008-09 is known as the year of depression in the recent economic history. If we
analyse the FII in Indian capital market from 2006-07 to 2010-11, it can be easily understood
that during the year 2008-09, there was negative net investment by FIIs in the Indian capital
market. This is purely because of the recession throughout the world. The players in the
global market withdrew their money anticipating the fears of deep depression and that is why
there was huge decline in net investment.
2.3 Testing of Hypotheses

2.3.1 Foreign investment in Indian capital market may create substantial instability in
financial markets-

r = correlation = 0.495655

δ = correlation coefficient between foreign investment and volatility

HO = δ = 0 H1 = δ > 0

r n2
Under HO, to = ~ t (n – 2)
1 r2

to = 1.8928

at 5% level of significance, the critical value is 1.796.

tO > 1.796 hence, reject HO

i.e. there is positive correlation between ‘foreign investment’ and ‘volatility’.

It means foreign investment in Indian capital market creates substantial instability in

financial market. Hence, the hypothesis ‘foreign investment in Indian capital market
may create substantial instability in financial market’ is accepted.

2.3.2 During the recessionary phase, the foreign institutional investment slows down.

Graph No. 2.4 Impact of Recession on FII in Indian capital market

Net Investment (Rs. Croers)

200000
150000
100000
50000 Net Investment (Rs. Croers)
0
-50000 2006-07 2007-08 2008-09 2009-10 2010-11

-100000
 The graph no.2.4 clearly indicates that during the years 2006-07 and 2007-08 the net
investment has shown an increasing trend. Similarly, the years 2009-10 and 2010-11 also
show an increasing trend in respect of net investment by FIIs in Indian capital market. But
only during the year 2008-09, the trend was reverse. It was not only decline, but the net
investment was negative during the year 2008-09. Thus we can conclude that during the
recessionary phase, the foreign investment slows down. This proves our second hypothesis
set for the study.

3.0 Conclusion

A positive contribution of the FIIs has been their role in improving the stock market
infrastructure. The SEBI has no doubt contributed much in improving the stock exchange
infrastructure. However, it is doubtful whether one would have witnessed such rapid
developments in computerising the operations of the stock markets and introduction of
paperless trading in the demat form if the FIIs had not built up pressure on the authorities to
move in this direction.

The FIIs are playing an important role in bringing in funds needed by the equity market.
However, the fact remains that FII investments are volatile and market driven, but this risk
has to be taken if the country has to ensure steady inflow of foreign funds. It is also equally
important to note that, since recent past, FIIs have made Indian capital markets more volatile.
Further, due to recession, there is sharp fall in the net investment by the FIIs in the Indian
capital market.

References :

1
Tripathy Nalini P. and Saha P.K. (1998) “Performance of Selected Growth Oriented Mutual Funds in India” ,
Indian Capital Markets- Theories and Empirical Evidence– UTI Institute of Capital Markets and Quest
Publications (1998), p.193-204.
2
Avadhani V.A.(1999) “Investment and Securities Markets in India”, Himalaya Publishing, p.265.

Bhasin Niti (2004) “Indian Financial System: Reforms, Policies and Prospects”, New Century Publications,
3

New Delhi (2004), p.144-145.

4
Avadhani V.A.(2006) “International Financial Management”, Himalaya Publishing House, p. 469.
5
Biswas Jaydeep (2007) “Emerging Equity Markets: A Cross Country Time Series Study”- The ICFAI Journal
of Applied Finance – Vol.13, No.7, July, 2007, p.53.
6
Reddy B.B., Ramanaiah M.V., Reddy B.P. (2008)- “Foreign Institutional Investors and Indian Stock Market”-
The Journal of Business Studies – Vol.5,January 2008, No-9- (Department of Commerce, University of Kerala)
p.53.

www.rbi.org.in
www.capitammarket.com
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