Foreign Portfolio Investment

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Draft Paper Submitted for the Annual Conference on Development and Change Mission: Promoting Development in a Globalized World, Sao Paulo, Brazil, November 18 – 20, 2006

Foreign Portfolio Investment, Stock Market and Economic Development: A Case Study of India Parthapratim Pal

Abstract

The objective of this study is to examine the impact of Foreign Portfolio Investment on India’s economy and industry. As FPI essentially interacts with the real economy via the stock market, the effect of stock market on the country’s economic development will also be examined. The findings of this paper show that the perceived benefits of foreign portfolio investment have not been realized in India. From the results of this study it can be said that the mainstream argument that the entry of foreign portfolio investors will boost a country's stock market and consequently the economy, does not seem be working in India. The influx of FIIs has indeed influenced the secondary market segment of the Indian stock market. But the supposed linkage effects with the real economy have not worked in the way the mainstream model predicts. Instead there has been an increased uncertainty and skepticism about the stock market in this country. On the other hand, the surge in foreign portfolio investment in the Indian economy has introduced some serious problems of macroeconomic management for the policymakers. Uncertainty and volatility associated with FPI have not only reduced the degrees of maneuverability available to the policymakers but have also forced them to take some measures which impose significant fiscal cost on the economy. Though this study focuses on India and draws policy implications based on the Indian experience, the results and policy implications of this study can be used to draw lessons for other developing which are at the same or similar level of development.

Contact Details Parthapratim Pal
Email: parthapal@gmail.com Participant CAPORDE 2001, Fellow GEM2003

1

Foreign Portfolio Investment, Stock Market and Economic Development: A Case Study of India Parthapratim Pal I. Introduction In 1992, India opened up its economy and allowed Foreign Portfolio Investment (FPI) in its domestic stock markets. Since then, FPI has emerged as a major source of private capital inflow in this country. The objective of this paper is to examine the impact of Foreign Portfolio Investment on India’s economy and industry. As FPI essentially interacts with the real economy via the stock market, the effect of stock market on the country’s economic development will also be examined. In the current global economic scenario, it is important to address these issues because of a number of reasons. During the late 1980s and early 1990s portfolio investment emerged as an important form of capital inflow to developing countries. The importance of portfolio investment to developing countries has come down after the East Asian crisis of 1997. However, unlike most other developing countries, India is still more dependent upon FPI than Foreign Direct Investment (FDI) as a source of foreign investment. For the period 1992 to 2005, more than 50 percent of foreign investment in India came in the form of FPI. Given such high dependence of the Indian economy on FPI, it is important to asses whether and how FPI has contributed to the economic development of the country. Secondly, the spate of financial crises since the late 1990s have repeatedly highlighted that the current global financial architecture, with its emphasis on speculative capital flows, can seriously disrupt the economic prospects of a developing country. For these countries, insulating the economy from the uncertainties of short term capital flows can impose serious fiscal costs on the economy. It can also make the management of external economy difficult by reducing the policy options available to the policymakers in developing countries. It is important to investigate these aspects of FPI in...
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