Study of factors affecting the flow of portfolio funds into India

Abstract

Portfolio investment flows are becoming increasingly important for emerging markets like India. They are affected by a variety of factors, like interest rate differentials between the home country and the country of investment, structural factors, equity markets and overall outlook for the country where investment is targeted. They also tend to affect macroeconomic parameters of the recipient country like money growth, exchange rates, inflation and so on. Portfolio flows sometimes can also have a negative effect on the recipient country especially in times of crisis as has been exemplified in the Asian Currency Crisis in 1997. FII investments are sometimes termed as “hot money” in this context1; it is this aspect of the flows that worries policy makers and the central banks of emerging nations. Portfolio flows can be quite volatile and at the slightest possibility of trouble, these flows can reverse and get out of the emerging country. This could cause the currency of the recipient country to crash and set off a chain of events that can eventually snowball into a crisis. It is with this in mind that in India, the capital account liberalization measures have been introduced slowly and with a lot of caution by the Reserve Bank and this has served the country well and warded off any major crisis like the Asian Crisis or those in the Latin American countries. Nevertheless, in an emerging market like that of India, these flows have an added importance and help drive factors like liquidity in the equity markets. And in the last couple of years, FII flows have increased significantly and a systematic study of the causes and effects is in order for the Indian context. The following sections will attempt to document some of the studies that have been performed on this topic and will try to analyze the factors affecting the flows and the corresponding policy impacts in an Indian context.