Foreign Institutional Investors have been flowing to developing countries since the beginning of 1990s. Since then it has been attracting the attention of the thinkers in the field of finance and international economics to study the various dynamics of this fast emerging important component of international capital flows. Several research pappwers have been attapting to study the cause and effect of the flows by FIIs to developing countries. For research purpose the focus of this research has been those various research papers that addressed the various issues related to foreign capotal flows and FIIs. This section focus on the review of the available literature in this area.

Since 1990 till date several research studies have been undertaken on FIIs Flow in India. However their results have been mixed in nature and at certain time contradictory with each other also. Some of the major studies and their summarised findings have been discussed in the following pages:

Sen (1996) in her paper’’ the role of foreign capital in india ‘s security market boom’’ ,observed the shere price movements and tried to determine the rold of foreign capital and various economics factors. Such as gdp growth, change in interest rate,

Classens (1993) analyzed the return and diversification benefits of investing for an investor in an industrial country with emerging markets and barriers which prevent a free flow of funds. Study found that equity portfolio flows can be affected by efficiency of domestic stock market as well as market segmentation created by barriers. Investors’ perception and attitude may thus matter as much as formal barriers.

Chuhan (1994) analyzed portfolio “switching” behaviour by investors between different emerging markets. Study has found that institutional investors from Canada, Germany, Japan, United Kingdom (UK) and United States (US) have not contributed to the growth in portfolio investment in emerging markets (the countries where they have invested). These investors, who otherwise are major players in international capital markets, have approached developing countries’ securities markets with great caution. Institutional investors generally enter markets with significant liquidity, market capitalization and claim to have a longer time horizon in their risk return assessment than other investors such as performance based retail traders. Study concluded that any country that shows good track record in its reform process may expect to have a lower risk and e higher returns from portfolio investment, thus, consequently large portfolio flows are expected to go to such countries with “good” track records of liberalization, fiscal consolidation and regulatory reform than to those emerging markets that do not exhibit such a performance on sustained basis.

Gooptu (1994) undertook research on “Are Portfolio flows to Emerging Markets Complementary or Competitive’ He concluded that there is a competition between developing countries for portfolio investment from abroad. The study analyzed gross portfolio investment flows for a sample of eight emerging markets over the period of 1989 to 1993 using quarterly data. Four countries in each geographical region, namely, India, Indonesia, South Korea and Thailand in Asia while Argentina, Brazil, Chile and Mexico in Latin America have been examined. All of these countries have experienced large portfolio investment inflows in recent years. However, the gross portfolio flows to Latin America has been observed to be more significantly related to East Asia (Indonesia, South Korea and Thailand) than those to South Asia i.e. India in this study. According to the study, it is important for the policy makers in the developing economies to provide right signals to international capital markets in terms of economic and domestic institutional reforms to successfully compete with other developing economies to attract portfolio investment from abroad. Study found that to attract more private capital flows policy makers must continue to provide right signal to foreign institutional investors in terms of economic and domestic institutional reforms that attract portfolio investment from abroad. Study concludes that there is a need to continue for increasing pace of reforms in any given emerging stock market in order to maintain the steady portfolio flows to developing countries.

Agarwal (1997) found that world stock market capitalization had a favourable impact on the FPI in India. FII inflow depends on stock market returns, inflation rates (both domestic and foreign), and ex-ante risk. In terms of magnitude, the impact of stock market returns and the ex-ante risk turned out to be the major determinants of FII inflow.

Kumar (2001) investigated the effects of FII inflows on the Indian stock market represented by the Sensex using monthly data from January 1993 to December 1997. Kumar (2001) inferred that FII investments are more driven by Fundamentals and they do not respond to short-term changes or technical position of the market. This finding is in contradiction with the findings of Rai and Bhanumurthy (2003) who did not find any causation from FII to return in BSE using similar data between 1994 and 2002. However, Rai and Bhanumurthy have also found significant impact of return in BSE on NFI.

Pasricha, J. and U. Singh (2001) have analyzed the impact of FII’s investment on the Indian capital market. The study found that FIIs have remained net investors in the country except during 1998-99 and their investment has been steadily growing since their entry in the Indian markets. They are here to stay and have become the integral par t of the Indian capital market. Although their investment in relation to market capitalization is quite low, they have emerged as market movers. They have also found that the

market has been moving, in consonance with their investment behaviour. However their entry has led to greater institutionalization of the market and their activities have provided depth to it. They have also contributed towards making Indian markets modern comparable with the international standards. This has brought transparency in the market operations and simplified the procedures.

Chakrabarti (2002) made an empirical investigation to see the inter relationship between FIIs flows and equity returns in India in the Indian context. Following the Asian crisis and the bust of info-tech bubble internationally in 1998-99 the net FII declined substantially by US$ 61 million. Using the monthly data between May 1993 and Dec. 1999, Chakrabarti (2001) found that FII flows and stock returns are strongly correlated in India. The entire sample period was sub-divided into Pre-Asian Crisis and Post-Asian Crisis period to capture the impact of the Asian crisis on the net FII inflows. The study found that there appears to be significant differences in the nature of FII flows before and after the Asian crisis. In the pre-Asian crisis period any change in FII found to have a positive impact on the equity returns ( FIIs acted as independent variable and other variable like return acted as dependent variable). But in the post-Asian crisis period it was found the reverse relation existed that is the change in FII was mainly due to change in equity returns ( where FIIs acted as dependent and other variables like return acted as as independent variable). It was also found that FIIs did not have any informational disadvantage in comparison with domestic investors in India, since the US and world return were not significant in explaining FII flows. Besides, changes in country risk ratings for India did not appear to affect the FII flows. The beta of the Indian market with respect to S&P 500 index seemed to affect the FII flows inversely, but the effect disappeared in the post-Asian crisis period. Thus there appeared to be significant differences in the perception of FII flows before and after the Asian crisis. In the post-Asian crisis period i.e. from 1998 onwards, returns on the BSE National Index became the sole driving force behind the FII flows.

Eun & Rensick (2002) observed that international portfolio Investment has been growing rapidly in recent years due to (a) deregulation of financial markets (b) introduction of new investment vehicles such as international mutual funds, country funds and internationally cross listed stocks which allow investors to achieve international diversification without incurring excessive costs. Despite sizable potential gains from international diversification, investors allocate a disproportionate share of their funds to domestic securities displaying the so called home bias. Home bias is likely to reflect imperfection in the international financial markets such as excessive transaction/information costs, discriminatory taxes for foreigners and legal/institutional barriers to international investments.

Mukherjee et al(2002) ,in their paper explored the relationship of foreign institutional investment (FII) flows to the Indian equity market with its possible covariates based on a daily data-set for the period January 1999 to May 2002. The set of possible covariates considered comprises two types of variables. The first type includes variables reflecting daily market return and its volatility in domestic and international equity markets as well as measures of co-movement of returns in these markets (viz. relevant betas). The second type of variables, on the other hand, are essentially macroeconomic ones like exchange rate, short-term interest rate and index of industrial production (IIP)—viz. variables that are likely to affect foreign investors’ expectation about return in Indian equity market. Their results show that: (1) FII flows to and from the Indian market tend to be caused by return in the domestic equity market and not the other way round; (2) returns in the Indian equity market is indeed an important (and perhaps the single most important) factor that influences FII flows into the country; (3) while FII sale and FII net inflow are significantly affected by the performance of the Indian equity market, FII purchase is not responsive to this market performance; (4) FII investors do not seem to use Indian equity market for the purpose of diversification of their investment; (5) return from exchange rate variation and fundamentals of the Indian economy may have influence on FII decisions, but such influence does not seem to be strong, and; finally, (6) daily FII flows are highly auto-correlated and this auto-correlation could not be accounted for by the all or some of the covariates considered in their study. They stated that, policy implications of the findings are that a move towards a more liberalized regime in the emerging market economies should be accompanied by further improvements in the regulatory system of the financial sector. their results additionally suggested that in the case of India (and other countries having thin and shallow equity markets) the prime focus should be on regaining investors’ confidence in the equity market so as to strengthen the domestic investor base of the market. Once this is achieved, a built-in cushion against possible destabilizing effects of sudden reversal of foreign inflows might develop. Only then would it be possible to reap fully the benefits of capital market integration.

Batra A (2003) in their study on ‘The Dynamics of Foreign Portfolio Inflows and Equity Returns in India’ used both daily and monthly data in order to understand the trading behaviour of FIIs and returns in Indian equity market. It was found that there is strong evidence of FIIs chasing trends and adopting positive feedback trading strategies at the aggregate level on a daily basis. However there is no evidence of positive feedback trading on a monthly basis. The results of our analysis also indicate that foreign investors have a tendency to herd together in their trading activity in India. The trading behaviour and biases of the FIIs do not appear to have a destabilizing impact on the equity market.

Trivedi & Nair (2003) in their study on ‘Determinants of FII Investment Inflow to India’ concluded that any investments, either domestic or foreign, would depend heavily on the risk factors. Hence, while studying the behaviour of FII, it is important to consider the risk variable. But it was only Trivedi & Nair who considered this factor in their study in 2003. Further, they have decomposed it (risk) into realized risk (observed) ex-ante and unexpected risk. Ex ante risk is an observed component and is negatively related to FII. But the relationship between unexpected risk and FII is obscure. Hence, one needs to separate the unobserved component from the realized risk while examining the impact of risk on FII.

Gordon and Gupta (2003) in their study on ‘Portfolio Flows into India: Do Domestic Fundamentals Matter’ conclude that given the huge volume of investments, foreign investors could play a role of market makers and book their profits, i.e. they can buy financial assets when the prices are declining thereby jacking-up the asset prices and sell when the asset prices are increasing Hence, there is a possibility of bi-directional relationship between FII and the equity returns.

Bose and Coondoo (2004), examined the impact of the FII policy reforms on FII portfolio flows to the Indian stock markets. They tried to assess the impact on FII flows of several policy revisions related to FII investment during the period January 1999 to January 2004, through a multivariate GARCH regression model. Using techniques of time series intervention analyses they incorporated the effect of each individual policy intervention in a model that includes the two most important covariates of FII flows to India, namely stock market (BSE) returns and past FII flows. The range of policies considered encompasses liberalization policies as well as restrictive ones taken to assure stability of flows. Their results strongly suggested that liberalization policies have had the desired expansionary effect and have either increased the mean level of FII inflows and/or the sensitivity of these flows to a change in BSE return and/or the inertia of these flows. On the other hand, interestingly, the restrictive measures aimed at achieving greater control over FII flows also do not show any significant negative impact on the net inflows; we find that these policies mostly render FII investments more sensitive to the domestic market returns and raise the inertia of the FII flows.

Griffin and Nardari (2004) in their study titled ‘Are daily cross-border equity flows pushed or pulled’ found that foreign flows are significant predictors of returns for Korea, Taiwan, Thailand and India, indicating that foreign investors are buying before market index increases. Increasing trends of FIIs inflows can act as a predictor for upward trend in the value of index or vice versa. FII and Stock Index show positive correlation, but fail to predict the future value. They also found that contemporaneous flows are positive and highly significant in India.

Batra, A. (2004) has analyzed the trading behaviour of FIIs and the impact of their trading biases upon stock market stability. Author found that there is strong evidence that FIIs have been positive feedback investors and trend chasers at the aggregate level on a daily basis. But there is no evidence of positive feedback trading on a monthly basis. The results also indicate that foreign investors have a tendency to herd together in their trading activity in India. The trading behaviour and biases of the FIIs do not appear to have a destabilizing impact on the equity market.

Pal, P. (2004) found that FIIs are the dominant players in the Indian stock market and their impact on the domestic market is growing. Trading activity of FIIs and domestic stock market turnover suggest that FII’s are becoming more important at the margin as an increasingly higher share of stock market turnover is accounted for by FII trading. They have emerged as the most dominant investor group in the domestic stock market in India. The study also shows that the FIIs are the most dominant non-promoter shareholder in most of the sensex companies and they also control more tradable shares of sensex companies than any other

investor groups. He also found that even sharp changes in sensex do not necessarily indicate a significant alteration of actual shareholding pattern of different investor groups even in the sensex companies. As far as the real economy is concerned, the stock market has a very limited role to play.

David and Steil (2004) viewed that the macroeconomic factors like current account surplus, accretion in foreign exchange reserves, appreciating domestic currency and higher interest rates have been responsible for an increase in FII inflows to an emerging country.

Kumar SSS (2005) in his study on ‘Role of Institutional Investors in Indian Stock Market’ examines the ‘pulling’ and ‘pushing’ role of Foreign Institutional Investors in Indian stock markets. He finds using granger causality test that the market movement can be explained using the direction of the funds flow from these investors.

Sandhya et al. (2005) attempted to relate the kind of foreign capital flow and stock market volatility. In their research they tested the existence of price pressure and feedback trading hypothesis to study the correlation between returns and contemporaneous flows of fund and the evidence of market efficiency. Their major finding was that the unexpected flows have a greater impact than the expected flows on the stock indices. They did not detect any evidence regarding momentum or contrarian strategies

being employed by FIIs.

Mohan, T.T. (2005) concludes that the crossover funds in the emerging markets are only a small component of global portfolios and hence they are less vulnerable to fluctuations to returns arising from changes in economic conditions in emerging markets. He also found that, in India, over the past decade FIIs have displaced domestic mutual funds in importance in the equity market. Their shareholding in the sensex companies is large enough for them to be able to move the market. The volatility in por tfolio inflows to India

has been modest compared to other emerging markets. The real problem caused by variations in FII inflows from year to year is not stock market volatility but difficulties posed in management of money supply and the exchange rate.

Rai and Bhanumurthy (2006) in their study on ‘Determinants of Foreign Institutional Investment in India’ studied and analyzed the determinants of foreign institutional investment in India using monthly data from January 1994 to November 2004. The study revealed the positive association of FIIs investment with return on BSE Sensex, inflation in US (home country) ; and negative association with inflation in India (host country), return on S&P 500 index, ex-ante risk on BSE and ex-ante risk on S&P 500 index. Thus empirical estimates seems to be perfectly in consensus with the proposed theoretical model, except for ex-ante risk in US stock market, which adversely affects the FII flow to India. This could be due to the dominant position of US stock market. However, the ex-post risk neither in US nor in India affected FII inflow to India. Study also did not find any causation running from FII inflow to stock market returns in BSE as it was found by some existing studies (Gordon & Gupta, 2003). Study concluded that stabilizing the stock market volatility and minimizing the ex-ante risk would help in attracting more FII inflows. Otherwise there would be adverse impact of non-fundamental factors on FII behaviour which in turn would affect the real economy in the long-run. They further studied the impact of news on FII flows and found that the FIIs reacted more (sell heavily) to bad news than to good news.

Saji kumar (2006) in his study titled ‘FII vs. Sensex: An Emerging Paradigm’ analyses the performance of Sensex in terms of market Capitalisation. movement of Sensex, Returns on Sensex, trade turnover and Sensex P/E ratio and found out that they are significantly related to the surge in FII’s inflows. The behaviour of returns on Sensex and volatility has been more stabilizing due to external inflows and the fluctuations are largely due to withdraws by the domestic equity holders during the period considered.

Rakshi(2006) studyon FIIs conclude that FIIs inflows have actually imposed certain burdens on the Indian economy. Sudden increases and decreases in FIIs in India have raised several issues regarding the real implications of FIIs. The impact of FIIs can largely be observed at: (1) stock market (2) exchange rate and (3) forex reserves. Numerous studies examine the relationship between stock markets and FIIs, but some gap has been observed in the literature related to dynamic interaction between FIIs and the equity market. The recent plummet and surge in inflows warrants a fresh investigation to shed light onto the issue of causality between FIIs and equity markets. The present study is an attempt to examine the static and dynamic relation between FII and stock returns in Indian. To be more specific, this paper detects the direction of relationship between FII and market returns. Second, in the case of interdependence, we check the dynamic relation of FII flows to the lagged values of market return and vice versa. Finally, the paper also appraises the existence of positive feedback trading hypothesis in Indian equity market.

Singh (2008) in his study on ‘FII Investment Flow and SENSEX Movement’ concluded that there are many variables which contribute to the positive growth of the stock market. FIIs investment is considered to be one of the biggest push after the economic fundamentals got stronger. The liberalisation of the FII flows into the Indian Capital Market since 1993 has had a considerable impact on Indian stock market.

Babu and Prabheesh (2008) in their study on ‘Causal relationships between Foreign Institutional Investments and stock returns in India’ concluded that the FII investments in India are more stock returns driven. Perhaps the high rates of growth in recent times coupled with an increasing trend in corporate profitability has imparted buoyancy to the stock markets, triggering off high and thereby leading to return chasing behaviour by the FIIs.

Chakraborty (2007) undertook study on ‘Foreign Institutional Investment Flows and Indian Stock Market Returns: A Cause and Effect Relationship Study’. The empirical investigation of the direction of causation between FII flows to India and Indian stock market returns over the time period from April 1997 to March 2005 has revealed that FII flows are caused by; rather than causing the national stock market returns. However, the Indian policy makers must adopt a cautious approach while further liberalizing the FII policy by instituting in-built cushion within the system against the possible destabilizing effects of sudden reversal of FII flows.

Rajput & Thaker (2008) in their study on ‘Exchange Rate, FII and Stock Index Relationship in India’ concludes that in globalized world, exchange rate, FII and Stock Index are important economic variable and reflect underlying strength and stability of business and an economy. Earlier study findings have revealed positive, negative and mixed relationship amongst those variables. They measure the relationship and its predictive power for the period ranging from January 2000 to December, 2005, in the light of third generation reforms in India. Using simple correlation and regression analysis it is found that no long run positive correlation exists between exchange rate and Stock Index except for year 2002 and 2005. FII and Stock Index show positive correlation, but fail to predict the future value.

Sumanjeet (2009) studied Foreign Capital Flows into India .he stated that existing studies reveals that the huge surge in international capital flows since early 1990s has created unprecedented opportunities for the developing countries like India to achieve accelerated economic growth. International financial institutions routinely advise developing countries to adopt policy regimes that encourage capital inflows. Since the introduction of the reform process in the early 1990s, India has witnessed a significant increase in capital inflows. The size of net capital inflows to India increased from US $ 7.1 billion in 1990-91 to US $ 108.0 billion in 2007-08. Today, India has one of the highest net capital inflows among the EMEs of Asia. Capital inflows, however, not an unmitigated blessing. The main danger posed by large and volatile capital inflows is that they may destabilize macroeconomic management. As evident, the intensified pressures due to large and volatile capital flows in India in the recent period in an atmosphere of global uncertainties has posed new challenges for monetary and exchange rate management. He concluded that undertaking more economic reforms is not easy but has to be done: the government can either manage the process or competitive forces will bring it upon us in a lopsided manner. The ball is in the government’s court. Countries that permit free capital flows must choose between the stability provided by fixed exchange rates and the flexibility afforded by an independent monetary policy.

Bansal And Pasricha (2009), studied the impact of market opening to FIIs, on Indian stock market behavior. India announced its policy regarding the opening of stock market to FIIs for investment in equity and related instruments on 14th September 1992. Using stock market data related to Bombay Stock Exchange, for both before and after the FIIs policy announcement day, they conducted an empirical examination to assess the impact of the market opening on the returns and volatility of stock return. they found that while there is no significant changes in the Indian stock market average returns, volatility is significantly reduced after India unlocked its stock market to foreign investors.

Kumar and Gupta (2010), in their study on ‘FII Flows to India: Economic Indicators’ concludes that the trading by the FIIs in the Indian stock market is registering sharp hike every year but their net investment is often registering negative growth rate. It can be said here that they are much interested in making short-term profit by trading in the market. Their investment is equity oriented which accounts around 95 percent of the total investment. It has also been found that share of FIIs cumulative investment in the total market capitalization is below five percent and share of trading by FIIs in the total stock market turnover is around 17 percent. Though enjoying a lesser share in the stock market, the FIIs have emerged as the big custodian in the Indian capital market.

Towards the end-1990s, especially after the outbreak of economic crisis in South East Asian countries, issues such as volatility of the ‘hot’ capital fl ows and their impact on the recipient country, problems relating to contagion etc. have increasingly occupied the centre-stage of academic research. Subsequently, many policy makers and economists became skeptical not only about the benefi ts of free fl ows, but also viewed uncontrolled capital fl ows as risky and destabilising. Krugman (1998) underlined the problem of

moral hazard in fi nancial intermediaries and noted that it can lead to over-investment at the aggregate level, overpricing of assets and vulnerability of such economies to fi nancial crises. Subsequent studies (e.g. Dabos and Juan-Ramon (2000)) concentrated on the

intricate relationship between capital fl ows and fi nancial markets. The recent literature has acknowledged the risks associated with the capital fl ows and indicated that the most effective way to deal with capital infl ows would be to deepen the fi nancial markets, strengthen fi nancial system supervision and regulation, improve capacity and implement sound macroeconomic / fi nancial sector policies. These actions will help in increasing the absorptive capacity and resilience of the economies and fi nancial systems to the risks associated with large and volatile infl ows. To quote Mohan (2009), ‘It is a combination of sound macroeconomic polices, prudent debt management, exchange rate fl exibility, the effective management of the capital account, the accumulation of appropriate levels of reserves as self-insurance and the development of resilient domestic fi nancial markets that provides the optimal response to the large and volatile capital fl ows to the EMEs. How these elements are best combined will depend on the country and on the period: there is no ‘one size fits all’’

Since the beginning of 2000s, empirical studies have concentrated on capital fl ows in India and its impact on domestic macro variables. In this context a study by Dua and Sen (2005) found that the real effective exchange rate is cointegrated with the level of capital fl ows, volatility of the fl ows, high-powered money, current account surplus

and government expenditure. The results reported by Trivedi and Nair (2000) indicate that the returns and volatility in the Indian markets emerge as the principal determinants of FII investments. D’souza (2008) noted that the difference between the capital fl ows to India

as compared with other EMEs are that (a) they are associated with a deteriorating current account position rather than improving one and (b) the extent of fi nancial outfl ows have only partially offset the capital infl ows. The author also notes that capital fl ows in India have been associated with a buoyant stock market and a rise in investment and interest rates in the economy.