The effect of deregulation on FII flows and its impact on Indian capital market

Abstract

Indian capital markets in the last decade and a half have undergone tremendous change in terms of trading practices, technology, institutional maturity, corporate governance and regulation. They have become some of the most transparent and efficient markets in the world. India allowed FIIs to invest in Indian markets in September 1992 and since than more than 40 billion US dollars have found way to capital markets over a period of last 14 years. International portfolio flows are primarily driven by desire to reduce risk through diversification for the same expected return. These flows have also stated to be beneficial to the host country. Some of such benefits are: reduction in cost of equity, knowledge flows, strengthening corporate governance, improvement in market efficiency etc. These flows have some negative attributes also. They are said to be susceptible to herding behaviour and can lead to problems in management of balance of payments and monetary policy. This project studied some of the aspects of FII investment and capital markets. We found that the policy of deregulation had the desired expansionary effect on FII flows. The firm level analysis shows that such flows have a strong and positive relationship with market capitalization and measures of liquidity. In fact, it was observed that market capitalization as well as liquidity increased in those set of companies where FII investment increased from 2001 to 2005 as compared to companies where it remained low and stagnant. Most importantly, the same beneficial effect was observed on cost of equity capital. The cost of equity capital as measured through dividend yield also decreased disproportionately in case of increasing FII investment companies. However, no significant relationship was observed between FII investment and measures of volatility. These findings are important because the strong markets have been found to be linked to higher economic growth in decades to come in literature. To check the vulnerability of capital markets to sudden pull out of funds, it has been recommended that measures should be taken to increase domestic investor base household as well as institutional. Measures also need to be taken to strengthen the access, availability and accuracy of information pertaining to companies, industry and macroeconomic variables. The measures being taken to strengthen corporate governance and accounting standards need to be encouraged. Indian investors may also be allowed to invest abroad to act as countervailing force to FII pull out.