Dynamics of FII flows and stock market returns in a major developing country: How does economic uncertainty matter?

• Author: Aviral Kumar Tiwari,Shawkat Hammoudeh,Muhammad Shahbaz,Sangram Keshari Jena
• Date: 01 August 2020
• Published date: 01 August 2020
• DOI: http://doi.org/10.1111/twec.12830

World Econ. 2020;43:2263–2284. wileyonlinelibrary.com/journal/twec

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2263

© 2019 John Wiley & Sons Ltd

Received: 8 November 2018

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Revised: 11 May 2019

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Accepted: 30 May 2019

DOI: 10.1111/twec.12830

ORIGINAL ARTICLE

Dynamics of FII flows and stock market returns in

a major developing country: How does economic

uncertainty matter?

Sangram KeshariJena1

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Aviral KumarTiwari2,3

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ShawkatHammoudeh4

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MuhammadShahbaz5,6

1ICFAI Business School, Hyderabad, India

2Rajagiri Centre for Business Studies, Kochi, India

3Montpellier Business School, Montpellier, France

4LeBow College of Business Drexel University, Philadelphia, PA, USA

5School of Management and Economics,Beijing Institute of Technology, Beijing, China

6COMSATS University Islamabad, Lahore Campus, Lahore, Pakistan

KEYWORDS

economic uncertainty, FII flows, stock market return, wavelet coherency and phase difference

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INTRODUCTION

The importance of foreign capital in general and in the context of emerging markets in particular can-

not be overlooked. Capital inflows to emerging markets impact the investments and subsequently the

productivity of the firms and growth of the economy (Converse, 2018). India, being the fastest grow-

ing economy and holds the potential to drive global growth (IMF), would require large capital to

support this growth. As of September 2017, India has been the third largest receiver of foreign capital1

in the form of foreign institutional investment (FII).2

Although capital flows follow higher return op-

portunities, the benefits of those flows to the recipient countries can also be manifold including the

development of financial markets, which in turn fosters the financing of projects in underdeveloped

sectors with a lower cost of capital, thus stimulating consumption and raising the growth potential of

the economy through more efficient allocation of resources.3

This connection between economic

growth and development of financial markets in the form of long‐term causality has empirically been

1 Source: Bloomberg database and compiled by Economic Times Intelligence Group until September 21, 2017.

2 The SEBI (FII) Regulations (1995) define foreign institutional investor (FII) as an institution established or incorporated

outside India which proposes to make investment in securities in India and registered as FIIs in accordance with Section 2 (f)

of the SEBI (FII) Regulations of 1995.

3 The 21 April 2011 IMF Staff Discussion Note on Policy Responses to Capital Flows in Emerging Markets.

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JENA Et Al.

validated.4

However, on the flip side, at times a surge in capital flows not only poses policy challenges

for countries in the form of higher inflation and excessive appreciation of the exchange rate, but also

jeopardises the financial stability manifested in sharp movements in asset prices.5

That is why, it is essential to understand the dynamics between FII flows and stock market for

a far‐reaching financial decision‐making involving investment, risk management and policymaking.

For policymakers, it is essential to understand the dynamics over a period of time and simultaneously

at different time scale for short and long‐term policy initiatives. As far as portfolio management is

concerned, these time‐varying and frequency‐varying features have significant practical implications.

The time‐varying co‐movement signifies risk exposure of assets and the associated diversification

benefits that unfold over time which requires the periodical attention of portfolio managers to incorpo-

rate such effects into portfolio returns and risk management. On the other hand, the frequency‐varying

co‐movement helps investors in assigning the effective allocations of assets to their distinctive in-

vestment horizons by considering the co‐movements at the corresponding frequencies. Although the

literature is abundant with studies on the relationship and causality between the two variables, those

studies are mostly either in time or in frequency domain, which may partially satisfy the need of the

stakeholders (e.g., Dhingra, Gandhi, & Bulsara, 2016; Hiremath & Kattuman, 2017). However, the

relationship between stock market and FII flows evolves over different time and frequency domains

describing a particular phenomenon of the financial market such as a volatile, momentum and trend

reversal at each time scale. Thus, the associated ambiguity between stock markets and FII flows entails

a further study in the Indian context, which is critical for policymakers, regulators, traders and portfo-

lio managers at different frequencies over a period of time.

As far as India is concerned, the country has a full (partial) convertibility in the current account

(capital account). Our study is related to the capital account segment of the balance of payments

(BoP) of the country. To achieve a full convertibility in the capital account, it is required that macro-

economic parameters be stable supported by transparent macroeconomic policy measures. Again, the

unrestricted mobility of capital due to full convertibility brings in the benefits of foreign investment,

but the flipside is that it causes a massive destabilisation of the financial market in particular and the

economy in general due to huge flows in and out of the country. In the aftermath of the financial cri-

sis, although international capital flows were blamed for the systemic financial instability, the crisis

should not be the reason for restricting them keeping in mind the benefits of FII investment for eco-

nomic growth for the recipient country and for providing international diversification opportunities

for investors. Instead, the crisis calls for regulation of financial institutions backed by macroeconomic

policy measures for achieving financial stability. Further, the importance of macroeconomic policy is

also reinforced in the aftermath of the 1997–98 Asian crisis because any initiative towards liberalising

the capital account will increase exchange rate risk and financial instability in the absence of strong

macroeconomic policymaking and financial regulations (Milne, 2014). Although a few measures in

the form of capital controls could help limiting financial instability (Eichengreen, 2001; Eichengreen

& Leblang, 2003), there is no substitute for sound macroeconomic policies (Xafa, 2008). In addition,

the economic policy uncertainty is often reported in the news as a major headwind for both the FIIs

and the stock markets affecting their role in stimulating economic growth.

Thus, for a proper trade‐off between pursuing domestic economic goals and simultaneously elim-

inating financial instability from international capital flows requires capital market integration through

4 In the context of India (see Tiwari, Mutascu, Albulescu, & Kyophilavong, 2015), for 36 African countries (see Ngare,

Nyamongo, & Misati, 2014), in Belgium (see Nieuwerburgh et al., 2016), for Portugal (see Marques, Fuinhas, & Marques,

2013) to name a few.

5 See Dhingra et al. (2016) for the destabilising effect of the FII outflows. See also Poshakwale and Thapa, (2011) on how the

stock market becomes more sensitive to global shocks because of the FII flows.