EXCHANGE RESERVE,NEXUS IN INDIA
Department of Economics,
Jai Narain Vyas University,
Department of Economics,
Narain Vyas University, Jodhpur
Abstract: The foreign institutional investment had a very significant impact on
the domestic stock market and real economy since their arrival in India in 1993.
FII investment in India is responsible factor in determining foreign exchange
reserve in India. Fluctuation in FOREX, actually disturb the economic stability
through this paper we study the impact of FII on Foreign exchange reserve and
examine the causal relationship between these two factor. For this purpose
Granger Causality test is used with unit root test. Along with these test,
statistical tool are also used.
Foreign Institutional Investments (FII), foreign exchange reserves, FIIs Equity,
Granger causality test, RBI
Maintenance of Economic growth of the nation is always a challenge for
economic planner in India. The rupee slumped to a record low in late August
sparking India's biggest market turmoil since a balance of payments crisis in
1991. To remove this crises and to achieve faster economic growth, India has
opened its gate for foreign investor since Economic reform of India 1991, which
was witnessed a remarkable growth due to liberalisation of external capital
flows especially in the form of foreign institutional investment (FII), equity
investment. This has led to surge of capital inflow and strengthened Balance of
institutional investment had a very significant impact on the domestic stock
market and real economy since their arrival in India in 1993.FII means an entity
established or incorporated outside India which proposes to make investment in
India. They are registered as FIIs in accordance with section 2(f) of the SEBI
(FII) regulations 1995.
FII have emerged as an important
player in Indian Equity market in the recent past. FII and returns in equities
in Indian stock market had shown a drastic change in foreign exchange reserves
of India. The surge in foreign funds flowing into in equities coupled with
record NRI funds and dollar purchases by the Reserve Bank of
India (RBI) has
boosted the foreign exchange reserves to over $300-billionmark at the end of
March, which is the highest since December 2011. The latest RBI figures for the
week to March 28 show that foreign reserves jumped by $5.038 billion to $303.673
billion, the second highest in the 2013- 14 fiscal. The robust flow of dollars
into the country has strengthened the rupee, which breached the 60- mark for the
first time in eight months. RBI had been widely expected to build up its
reserves after the country was one of the emerging countries worst hit during
intense global market volatility last year because of its record high current
RBI had to sell dollars to
defend the rupee sending reserves to a more than three- year low in September
2013. Strong interest from FIIs in equity market also led to the addition of
FOREX reserves. Towards the year- end, FIIs interest
increased leading equity
markets to lifetime highs. During the April- March period, FIIs have pumped a
net amount of Rs 79,709 crore into the equity market. This was the fifth
consecutive fiscal year of inflow by overseas investors after they pulled out a
net amount of Rs 47,706 crore from the share market in 2008- 09. The rise in
reserves of $ 24 billion on a year-on-year basis is the highest since 2009. In
2009 RBI had added almost $29 billion to its reserves.
Foreign exchange reserves are now very close to the all-time high
level which was seen in the week ending September 2, 2011 at $320.79 billion.
However, despite reaching an all-time high in 2011, the year had ended at
foreign exchange reserves worth $ 296.69 billion in end 2011. In 2014 it was the
first time when RBI's foreign exchange reserves had ended above the $300 billion
mark. “If government bond limit is opened up, then FII flows will continue to
come,” said Jayesh Mehta.
FIIs generally invest in two ways:
investment could be in equity related instruments or up to 30% could be invested
in debt instruments i.e.70 (Equity Instruments):30 (Debt Instruments).
investment has to be made in debt securities only.
Foreign institutional investors (FIIs) bought shares Rs 4,157 crore (US$ 675.27
million) and sold equities worth Rs 3,148 crore (US$ 511.70 million) within the
first three days of January, 2014, according to data from Securities and
Exchange Board of India. FII equity investment in India is major topic of
discussion because it affects India’s FOREX reserve which takes into account the
volatile composition of balance of payment and endeavours to reflect the
“liquidity risks”. Thus it can be said that FII equities and foreign exchange
reserves of India has a cause and effect relationship. This relationship leads
an increase in the rate of economic growth during the period of 2008 to 2014 but
during this period FII equities outflow was also observed which had affected
FOREX Reserve of India , this outflow was the cause of global financial crises.
Review of Literature
There are tremendous studies that have been conducted so far in the
field whether the FII investment behaviour is reflected in the stock market and
or on Foreign Exchange Reserve, at various intervals of time. Many studies have
done across the world mainly related to effect of FII volatility across various
economy as well as Indian economy and the contagion effects of a financial
crisis with granger causality test in which work done by -
Rajput and Thaker state that no long run
positive correlation exists between exchange rate and Stock Index in Indian
context except for year 2002 and 2005. Badhani, (2005), examines the long
term and short-term relationship among stock prices, Dollar Rupee exchange rate
and net FIIs investment in India using monthly data from April1993 to March
2004. Study finds long term relationship between FIIs investment flow and stock
prices and between FIIs investment flow and exchange rate. However no long-term
relationship was found between exchange rate and stock prices. Study also shows
that exchange rate long term granger causes FIIs investments flow and vice
versa. It suggests that FIIs use positive feedback trading in respect to
exchange rate. BI-directional long term causal it was found between FIIs
investment flow and stock prices Takeshi (2008) reports unidirectional
Causality from stock returns to FII flows irrelevant of the sample period in
India where as the
reverse causality works only post 2003. The structural break of 2003 as
suggested by him and
other researchers was introduced in the current model and hence analyzed.Karimullah
(2009) examined the impact of FIIs equity investment behaviour in the Indian
stock market and found bi-directional causality between FII and stock return.
Garg and Bodla (2009) concluded that the rate of FII flows into the country
is governed by the performance of the domestic stock market and the foreign
investors’ expectations about this performance. Kumar Sundaram(2009)
in his paper, “Investigating causal relationship between stock return with
respect to exchange rate and FII: evidence from India” examine the causal
relationship between FOREX rate and FIIs in India. More recent work includes
that ofAnshuman, Chakrabarti and Kumar (2010) who bring high frequency
data and the powerful tools of market microstructure analysis to address these
questions. They find that the aggregate trading of FIIs dampens the volatility
of the Indian stock market. Furthermore, positive shocks in trading volume have
greater impacts than negative shocks, while trading between FIIs and domestic
investors increase volatility. IMF (2010)
includes an event study of the impact of capital control introductions on 37
“liquidity receiving” countries. The data is quarterly, and covers 2003:Q1 to
2009:Q2.Bose and Dipankar in their study attempted to estimate the
quantitative impact of certain regulatory policy decision related to FII
investment in India using the technique of intervention analysis of time series
econometrics. Dr. M. Venkata Subba Reddy, Mahammed Saleem(2013) ,in their
research paper examine the impact of FII’s on Indian Stock Markets. The
important result of their study is that foreign investment is determined by
stock market return. But foreign investment is not a major factor for the stock
market boom in India the FII are increasingly dominant in the stock market. The
fear of sudden outflow of foreign capital may be a trigger a third stock market
scam as most regulatory changes are being made only as a follow up of an adverse
Objective of the Study
attempt has been made-
To understand the different instrument of FIIs Equities in India
To analysis the trend of Foreign Institutional Investments (FIIs) in equities
(gross sale and purchase)
To examine the causal relationship between FII equities and FOREX reserves in
Collection and Research Methodology
To achieve the objective of the study, the secondary data will be
www.ozforex.com, for a period ranging from 2008 to 2014. Besides the
websites mentioned above various publications of SEBI, BSE, RBI & Economic
Political weekly, etc. will be used. The Data will be classified & tabulated
using Ms- Excel. Diagrams are used as statistical tool for data analysis and the
relation will be determined by using Granger Causality test taking monthly data
from 2008 April to 2014 March.
FIIs Investment in Equities and its Instruments
FIIs are required in the nation because FIIs
contribute to the foreign exchange inflow as the funds from multilateral finance
institutional and here FDIs are insufficient. FIIs are helpful as it cuts the
capital cost and cheaper the global credit, increases domestic saving and price
in the Indian market. Investment made by FII in equities has improved the
structure of capital market and financial sector. Total investment by FII in
equities since January 2014 has risen to about Rs 28,979 crore ($ 4.78 billion).
FII uses following routes to invest in equities-
Securities in the primary and secondary
market including shares which are unlisted, listed or to be listed on a
recognised stock exchange in India.
Units of schemes floated by the Unit Trust of
India and other domestic mutual funds, whether listed or not.
Following are the Entities through which FII can invest in equities in India
Entities who propose to invest their proprietary funds or on behalf of “broad
based” funds (fund having more than twenty investors with no single investor
holding more than 10 per cent of the shares or units of the fund) or of foreign
corporate and individuals.
are the foreign entities / funds for FII:
Insurance Companies / Reinsurance Company
Foreign Central Banks
Foreign Governmental Agencies
Sovereign Wealth Funds
International/ Multilateral organization/ agency
University Funds (Serving public interests)
Endowments (Serving public interests)
Foundations (Serving public interests)
Charitable Trusts / Charitable Societies (Serving public interests)
following entities proposing to invest on behalf of broad based funds, are
Asset Management Companies
Institutional Portfolio Managers
Trustee of a Trust
of the above mentioned types are described below:
Pension funds: It manages pension and health benefits for
employees, retirees, and their families. FII activity in India gathered momentum
mainly after the entry of CalPERS (California Public Employees’ Retirement
System), a large US-based pension fund in 2004.
Mutual funds: In this type of fund ,
pools money from many investors are collected and invests it in stocks, bonds,
short-term money market instruments, or other such securities.
Investment trust: These
trusts are closed-end funds and are constituted as public limited companies.
Investment banks: These are financial institution which raises
capital, trades in securities and manages corporate mergers and acquisitions.
They earn profit from companies and governments through purchasing and selling
securities in capital markets (both equity, debt)
Hedge funds: Every hedge fund has its own investment
policy which is the type of investments and the methods of investment it
undertakes. Many hedge funds investments in India were facilitated by global
investors borrowing at near zero interest rates in Japan and investing the
proceeds in High interest markets like India.
University Fund: It consists of the University’s endowed
trust funds or other funds of a permanent or long-term nature and external
Endowment fund: It is a transfer of money or property
donated to an institution, usually with the stipulation that it be invested, and
the principal remain intact in perpetuity or for a defined time period.
Insurance Funds: These funds includes all types of life
assurance and insurers pension plans, both single premium and regular premium
policies by foreigner in investment.
Charitable Trusts or Charitable Societies: Charitable trusts
(unlike private or non-charitable trust) can have perpetual existence and are
not subject to laws against perpetuity. They are wholly or partially exempt from
almost all taxes.
equity investments are limited by SEBI/RBI in following way-
FIIs on its own behalf, s not invest in
equity more than 10% of total issued capital of an Indian economy
Investment on behalf of each sub account
shall not exceed 10% of total issued capital.
For the sub- account registered under foreign
companies /individual category, the investment limit is fixed at 5% of total
These limits are within overall limit of
24%/49%/74% or the sectoral caps, as applicable and prescribed by government of
India/ Reserve Bank of India.
Must adhere to disclosure/ compliance
requirement in the SEBI (substantial acquisition of share and takeovers,SAST)
regulations and the SEBI (insider trading).
Equity Investment Pattern in India
India’s capital account has been liberalized over the year to
attract long-term, non- debt creating capital inflows. For this purpose, FIIs
were allowed In India to invest in equity since1992. The investment pattern of
FIIs equity in India has been changed over a period of time. As FIIs invested
around Rs 79,709 crore (US$ 13.23 billion) in the country’s
in 2014, according to data released by the Securities and
Exchange Board of India (SEBI).FIIs invest in equity is done through the
sale and purchase. Their sales and purchase have fluctuated drastically during
2001 to 2014. It can be observed with the help of following table. TABLE -1
EQUITIES IN DIFFERENT FII
EQUITY IN RS. CRORE
Table 1 given above presenting the gross sales and purchase of
FII in financial year from 2001 to 2014 especially in equities. From 2001 to
2006 FIIs gross purchase had increased from 45,780.90 to 4,61,487.97 Rs crore
in Equities but their purchase had increased to 5 lakh approx in 2007-08 but
after this period there it was observed that FIIs gross purchase had decreased
and come to 5,55,674.30 Rs crore ,at the same period FIIs gross sales also
decreased from8,53,832.80 Rs crore to 6,02,375.00 Rs crore in 2008-09 due to
which net investment in equities become negative or we can say that FIIs
withdrew their shares from Indian stock market ,that outflow of FIIs from India
was the adverse effect of global financial crises ,but it can be observed that
after this period in 2009 -10 FIIs gross purchase had increased but their sales
is continued to declined. But it had improved the total purchase while sales in
equities had declined .From 2009 equity investment performance had improved
as net inflow in equity increased to1,17,648.10 Rs crore from -46,700.70 Rs
crore. After this period fluctuation can be observed in FIIs gross sales and
purchase which was directly affecting the investment pattern of FIIs is equities
.Chart 1 also depicts the same fluctuation in FIIs gross sales / purchase
and net investment in Equities during 2001 to 2014 which affected Indian capital
market adversely as well as positively.
Chart 1 : FII Equity
investment in India
of X variable on Y variable in case of non-stationary series creates problem. To
solve such a Problem an alternative test of stationary that has recently
become popular known as the :
Unit Root Test
A unit root test is a feature of processes that involve
through time that can cause problems in statistical inference involving time
series models. A linear stochastic process has a unit root if 1 is a root of the
process’s characteristic equation. Such a process is non stationary. If the
other roots of the characteristic equation lie inside the unit circle- that is,
have a modulus less than one then the first difference of the process will be
stationary. It use the following model
Yt = Yt-1 + ut ......................................(1)
Where ut is the stochastic error term that follows the
classical assumption, namely , it has zero mean Constant variance δ2, and is non
auto correlated. Such error is known as white noise error term .now if the
coefficient of Yt-1 is in fact equal to 1 , we face unit root problem which can
e solved by running regression as
Yt = pYt-1 +ut ......................(2)
Find that p= 1 , means stochastic variable has unit
root in time series thus unit root in time series is known as random walk.
Random walk is as example of non-stationary time series. Thus non stationary
time series is often expressed as
∆Yt-1 = (p-1)Yt-1 ...........................................(3)
= δYt-1 +ut
=β1+ δYt-1 +ut
= β1+ β2t + δYt-1
+ut where δ= (p-1)
Thus it is formed null hypothesis which is δ= 0. Under
the null hypothesis that p=1 the computed t statistic’s critical value have been
tabulated by Dickey and Fuller test. If null hypothesis that p=1 is rejected
(time series is stationary) , t (student ) test is used . In simplest, we
estimate a regression like ( equ 2) , divide the estimated p coefficient by its
standard error to compute the Dickey Fuller statistic thus with the table null
hypothesis will be rejected. And series become stationary after first
differencing then the series is to be integrated of order 1(equ 3)
Granger Causality Test
The granger causality test is a statistical
hypothesis test for determining whether one time series is useful in forecasting
another. ordinarily , regressions reflect “mere” correlation but granger
causality in economics could reflected by measuring the ability of predicting
the future values of a time series using past values of another time series .
that the Granger test finds only “ predictive causality”
A time series X is said to granger cause Y
if it can be shown, usually through a series of t-test and F-test on lagged
values of X ( and with lagged values of Y also included ), that those X values
provide statistically significant information about future values of Y. Thus
here X variables are EQUITIES and Y variables are FOREX reserves.
Causality Test Equation for FII (Equity) and
FII=α0+ α1 FIIt-1+...
αL FII t-L +β1 Forex t-1 +... βL
Forex t-L +et ...... (1)
Forext-1+... αL Forex t-L +β1
FII t-1 +... βL FII t-L +et.....
L in the above equations indicates lag length
of the variable. Null Hypothesis Ho: b1 = b2 = … = bL = 0; and Alternate Hypothesis
HA: P1 ¹ bL ¹ o. In equation 1 null
hypothesis is forex does not granger cause FII and in equation 2 is FII does not
granger causes forex. Rejection and acceptations of null hypothesis is based on
F statistic value if, the F - statistic obtained are less than the critical F
value. In such case the alternate hypothesis is rejected meaning that one
variable does not granger causes another variable and its vice versa.
Empirical Result of the Study
Table 2: Unit root test of stationary (null
hypothesis is : series is non-stationary)
Series Stationary at level
*critical value at 1%level of significance
** critical value at 5%level of significance
*** critical value at 10%level of
From the table given above it can be observed
that the result of unit root test applied in forex series in level are tested
and found that ADF test statistic is lesser negative than the 1% ,5%,10% level
of significance, it means null hypothesis can be accepted. But on the other hand
FII equity is stationary because it is equal and more than all level of
significance. But when forex is tested with 1 difference, series become
stationary because its ADF test statistic becomes -7.902346 which is more than
the critical value of all levels of significance. It means now null hypothesis
can be rejected in both the variables that there is no unit root.
Result of Granger Causality Test
Null hypothesis : FIIs equity does not
granger cause forex( Independent)
not granger cause FIIs equity (Independent)
estimated in all three equations are lesser than the critical value at 5% and 1%
level of significance which are 3.25 and 5.21 , 2.88 and 4.42 , 2.67 and 3.97 in
eq 1, eq 2 and eq 3 respectively. Because of this estimation null hypothesis
cannot be rejected means null hypothesis accepted in all three cases explaining
that FII equity does not granger cause forex as well as Forex does not granger
cause FII equity. Thus here we cannot reject null hypothesis in favour of
alternative hypothesis. Hence it can be concluded with the above estimation that
neither increase in foreign exchange reserve influence FII investment pattern in
Equity nor increasing activities of FIIs in equity affecting foreign exchange
reserve in India .But if we increase the lags in test, there may be a
possibility of granger causality in both the variables.
On the basis of above research, it can be said that investment made by FIIs in
equity has significant impact on Indian stock market as well as on economy. FII
investment mode in Indian stock market has increased even after global financial
crises (2008-09). Before this period, FII’s gross sale and purchase was at high
rate but to the crises their sale and purchase in equity have affected, which
was responsible for huge outflow of equity share of FIIs and net investment
became negative as -46,700.70 Rs crore. But after 2008-09 FIIs in equities was
increased as well as their investment instrument in India was also increased
because of which India becomes more stable and faster growing economy in the
Through this paper it can also be understood that FIIs invest in two
ways in the nation which are broad base fund and foreign funds. And their %
share in equities which are limited by SEBI. Here in this paper, various
instruments of FIIs in Equities were also discussed through which we have
understood the various type of funds used by FIIs to invest. Beside all we have
also examined causal relationship between FII equity and FOREX reserve, for that
Augmented Dickey Fuller unit root test was used and result was found that FII
series were stationary at level while FOREX series were stationary at 1
difference. Thus null hypothesis was rejected but null hypothesis was not
rejected in granger causality test as for the period April 2008 to March 2014
Forex does not granger cause FII (equity) . Hence it can be concluded that
foreign exchange reserve in India is increasing but less affected by FIIs
investment in equities.
Thus it can be said that foreign
institutional investment in India is increasing as India has become suitable
destination for foreigners to invest as they were not affected by global crises
during 2008-09 and continued inflow of FII was observed after this period which
was helpful for India to recover its status from recession during business cycle
and in future this channel can raise Indian stock market and more and more
Foreign reserve in the nation. Strong interest from FIIs in equity market
may also lead to the addition of forex reserves.
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