Foreign Institutional Investors

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FOREIGN INSTITUTIONAL INVESTMENTS AND THE INDIAN STOCK MARKET K.S. Chalapati Rao, K.V.K. Ranganathan and M.R. Murthy* To facilitate foreign private capital flows in the form of portfolio investments, developing countries have been advised to develop their stock markets. It was suggested that these investments would help the stock markets directly through widening investor base and indirectly by compelling local authorities to improve the trading systems. While the volatility associated with portfolio capital flows is well known, there is also a concern that foreign institutional investors might introduce distortions in the host country markets due to the pressure on them to secure capital gains. In this context, this paper seeks to assess the importance of foreign portfolio investments in India relative to other major forms and to study the relationship between foreign portfolio investments and trends in the Indian stock market during the past four years. Introduction The character of global capital flows to developing countries underwent significant changes on many counts during the 'nineties. By the time the East Asian financial crisis surfaced, the overall size of the flows more than tripled. It stood at US$ 100.8 bn. in 1990 and rose to US$ 308.1 bn. by 1996. The increase was entirely due to the sharp rise in the flows under private account that rose from US$ 43.9 bn. to 275.9 billion during the same period. In relative terms the percentage of private account capital flows increased from 43.55 to 89.55 per cent (Table 1). Simultaneously, the Official Development Assistance (ODA), declined both in relative and absolute terms. All the main components of the private account capital transfers, namely, (a) commercial loans, (b) foreign direct investments (FDI), and (c) foreign portfolio investments (equity and bonds) (FPI) recorded significant increases. Portfolio flows increased at a faster rate than direct investments on private account. As a result, starting with a low level of 11.16 per cent, the share of capital flows in the form of portfolio investments quadrupled to reach 37.22 per cent in 1996 reflecting the enhanced emphasis on private capital flows with portfolio investments forming the second important constituent of the flows during the 'nineties. In this process multilateral bodies led by the International Finance Corporation (IFC) played a major role.1 Following the East Asian financial crisis, initially there was a slow down followed, by a decline in private capital flows. While bonds and portfolio equity flows reacted quickly and declined in 1997 itself, loans from commercial banks dropped a year later in 1998. Decline in FDI was also delayed. But the fall in FDI was quite small compared to the other three major forms of private capital flows. While flows on official account increased, following the crisis, they continue to constitute only a small portion of the total flows. Thus, starting with the resolve by the developed countries to provide one per cent of their GNP as developmental aid, the industrialised world preferred to encourage private capital transfers through direct investments instead of official assistance [Goyal, 1980, Pp. 843-50; Goyal, 1982].2 The declining importance of official development finance is attributed to budgetary constraints in donor countries and the optimism of private investors in the viability of the developing countries [World Bank, 1998, p. 5].

K.S. Chalapati Rao, M.R. Murthy and K.V.K. Ranganathan are Principal Researchers in Institute for Studies in Industrial Development, Narendra Niketan, Indraprastha Estate, New Delhi - 110 002. This study is an outcome of the project Global Capital Flows and the Indian Stock Market sponsored by the Indo-Dutch Programme on Alternatives in Development (IDPAD). The authors wish to thank S.K. Goyal, the Project Director, and Biswajit Dhar and B.P. Sarkar for their comments and useful suggestions. The usual disclaimers apply. [Since...
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