21

st
September 2010
Implications of FII inflows



Overview

The FII inflows this year have been robust leading to euphoric
conditions in the stock market. The Sensex and NIFTY crossed the
psychological levels of 20,000 and 6,000 respectively on the 21
st

leading to further conjectures on the future direction of movement
of these indices. Such increases have given rise to discussion on
the impact of these inflows on the stock indices as well as
exchange rates.

An analysis of data from January onwards shows that the
Sensex has a positive correlation with FII inflows and is
statistically significant though admittedly there are several
other factors that impact the indices.
o This holds for daily as well as fortnightly data.

However, when juxtaposed with the exchange rate, the picture
is not that clear and while it may seem that prima facie there
is reason to believe that the rupee should appreciate along
with the FII inflows, the relation over a longer time period
shows that this is not the case.
This is so because the trade deficit has been widening
simultaneously thus negating the positive effect of these
flows.
However, the future direction will be towards an
appreciation of the currency though conditions would be
held stable by the RBI.

The RBI may have to resort to sterilization of these funds in
case they do get out of hand, though the present scenario of
liquidity being scarce could defer this process.

Economic Studies
Contacts:

Madan Sabnavis
Chief Economist
91-022-6754 3489

Samruddha Paradkar
Associate Economist
91-022-6754 3407

Krithika Subramanian
Associate Economist
91-022-6754 3521


ECONOMIC UPDATE

2
Trends in FII inflows

FII inflows have been increasing quite rapidly in the last few months leading to the
build-up of optimism in the economy, as reflected by the Sensex. Cumulatively there
has been an inflow of nearly $ 25 bn up to September 17, 2010. Last year, the same
was around half at $ 12.2 bn. In fact, there has been acceleration in the last four
months starting June where $ 14.5 has come in.

The profile of these FII inflows is given in Table 1. For the entire period 63% has
come from equity, and this had increased to around 77% since June. An interesting
observation is that FII flows into the debt market have been lower than that in
equity. This indicates that the perception that higher interest rates in the country
would lead to excess flows into corporate debt may not always hold. The RBI has
been increasing rates since April before the Annual Policy and twice again in July
followed by the recent increase this month. The impact was witnessed in July and
September and was of a low order in August.

Table 1: FII inflows since January ($ mn)
FII inflows Equity Debt
Jan 1,690 -231 1,921
Feb 938 464 474
March 6,364 4,135 2,229
April 2,961 2,220 740
May -1,456 -1,989 533
June 2,197 2,099 98
July 5,431 3,777 1,654
Aug 2,839 2,404 435
Sept (17th) 4,015 2,937 1,078
Total 24,980 15,818 9,162
Source: SEBI


Table 2: FII inflows over three quarters ($ mn)
FII inflows Equity Debt
Jan-March 8.99 4.37 4.62
Apr-June 3.70 2.33 1.37
Jul-Sep 17 12.28 9.12 3.17
Source: SEBI

Table 2 provides information on the FII inflows across three quarters (last one is for
2.5 months). Quite clearly FII inflows have been highest in the last three months
after a lull in the second quarter. Higher inflows to India may be associated with
unclear growth prospects in the west (US has slowed down while Germany and UK
are upbeat) and unchanged interest rates signifying lower returns with the Fed, ECB,
BOE keeping rates unchanged. Funds seeking better returns have tended to move to
the Asian emerging markets in particular and India has received its share of funds
from this quarter. The higher interest rate regime in the country would also have
refueled their interest in this segment leading to an overall revival in this segment.



ECONOMIC UPDATE

3

Impact on stock markets

The perception is that stock markets are moved quite decisively by the FII inflows. In
the month of August, for example, the FIIs accounted for approximately 1/3 of the
transactions on the stock exchanges while mutual funds accounted for another 8%.
The information on the net FII flows into the equity segment as well as movement in
Sensex is juxtaposed in Table 3. It is normally held that FIIs being net purchasers
results in positive impetus on the stock indices while their net selling drives them
down. The Sensex, which crossed 20,000 on 21
st
September, after more than two
years, thus registering a new high has been increasing since June. Table 3 provides
the averages for the months to even out the aberrations during any time period.


Table 3: FII inflows ($ mn) and Average Sensex
FII inflows Equity Debt Sensex
Jan 1,690 -231 1,921 17,260
Feb 938 464 474 16,183
March 6,364 4,135 2,229 17,303
April 2,961 2,220 740 17,679
May -1,456 -1,989 533 16,844
June 2,197 2,099 98 17,300
July 5,431 3,777 1,654 17,848
Aug 2,839 2,404 435 18,177
Sept (17th) 4,015 2,937 1,078 18,947
Source: SEBI and BSE

To understand the relationship between these two variables two exercises have been
carried out: a coefficient of correlation analysis and simple linear regression analysis.
Table 4 provides the results of the same. The coefficient of correlation is reckoned
for daily and fortnightly data while the regression analysis looks at the relation on
changes (first differences) in the variables on a daily basis to ensure that the series
are stationary.

Table 4: Statistical Analysis
Relation examined Results
Coefficient of correlation between FII equity flows and
Sensex (daily)
0.46 (t=6.81)
Coefficient of correlation between FII equity flows and
Sensex (fortnightly)
0.61 (t=2.98)
Regressing Sensex on FIIs (first differences) R-square: 0.18
Constant: 11.46 (0.94)
FIIs: 0.34(6.18)

The coefficient of correlation is quite strong indicating that high levels of FIIs are
associated with high levels of Sensex with the coefficients being significant. The
regression analysis, which is a simple linear one, indicates that around 18% of
variation in the Sensex may be attributed to changes in the FII flows, with the
coefficient being significant. As it involves a single variable, the results should be
interpreted with caution as there are other factors which affect the Sensex which are
not captured due to the absence of numeric data on these variables such as
economic numbers and expectations, sentiments, corporate developments,
ECONOMIC UPDATE

4
international factors, political scenario etc which are not amenable on a daily basis to
numeric representation.

This relationship is significant as during this entire period, the other major
institutional entity, i.e. mutual funds have been net sellers in the secondary market
to the extent of Rs 16,000 cr up to August, of which Rs 10,000 cr have been sold in
the current financial year.


Impact on exchange rate

The large inflows of FII fund into the economy has been held chiefly responsible for
the rapid appreciation in the value of the rupee. In the last 15 days the rupee has
strengthened (though not continuously) from around Rs 47/$ on Aug 31
st
to Rs
45.61 as on 20
th
September. However, it must be pointed out that FII inflows are
just one component of foreign exchange transactions in the country which could
influence the exchange rate. Data on other flows are not available with high
frequency. The trade deficit for instance as may be observed in Table 5 below has
been high at over $ 10 bn a month consistently since April. This would negate the
strength of FII inflows considerably.

For the period January to September 17
th
, the coefficient of correlation between the
exchange rate and FII inflows was -0.06 (t=0.79) while on a fortnightly basis was
0.05 (t=0.194). This does not show any relation between the two which is also
reinforced by the regression analysis of first order changes in exchange rate on
changes in FII flows. The coefficient of determination is low at 0.045 with the
coefficient for FIIs being -0.00017 (t=2.8).

The Table below also shows that on account of the trade deficit, on a monthly basis,
the movements in the forex reserves have been fluctuating considerably. In fact in
months such as July when the forex reserves increased by nearly $ 9 bn, the rupee
had declined marginally on an average basis as the trade deficit had widened further
by almost $ 2.5 bn.

Table 5: FII inflows, forex reserves, trade balance and Exchange rate ($
mn)


FII
inflows Rs/$
Trade
balance
Forex
reserves
Jan 1,690 45.93 -9,288 256,362
Feb 938 46.33 -9,461 253,991
March 6,364 45.52 -9,210 254,685
April 2,961 44.53 -11,164 254,773
May -1,456 45.80 -11,292 247,951
June 2,197 46.56 -10,554 249,628
July 5,431 46.84 -12,929 258,551
Aug 2,839 46.57 -13,600 256,648
Sept (17th) 4,015 46.51 - 257,569
Sources: SEBI, RBI and Ministry of Commerce



ECONOMIC UPDATE

5

Implications for the economy

1. Higher FII inflows have shown at times tendencies to strengthen the rupee
and continued flows could make the appreciation swifter. So far this year
nearly $ 16 bn has come in which in rupee terms would be around Rs 75,000
cr. The RBI will have to keep a closer watch and weigh its options here to also
protect the interests of exporters. This is significant given that exports have
been growing at a brisk pace this year.
a. The future flow of these funds would continue to depend on global
economic developments and policy stances taken by various monetary
authorities. Going by the present size of flows, the aggregate net
inflows could cross $ 30 bn if this momentum is maintained.
2. Growing trade deficits would provide a check on the rupee appreciation in the
medium term. While exports have been growing rapidly, imports have risen at
faster rates thus exacerbating the deficit. The recent restrictions put by some
of the US states on outsourcing could restrict the growth of invisibles in the
form of software receipts. Therefore, this cushion may not be available to the
same extent.
3. There are implications on the monetary front. As of August end, growth in
deposits has been tardy with an increase of Rs 1.77 lkh crore as against Rs
2.46 lkh crore last year (over March). Money supply growth has also been
sluggish between April and August at 4.1% (5.6%). The higher FII funds
should impact liquidity positively by increasing deposits and credit.
a. The FII inflows should be increasing money supply through the forex
assets of the banking system. However, the RBI will have to monitor
these flows if they continue to grow at the same rate and would have
to consider sterilization of such flows through the issuance of the MSS
bonds to absorb these funds.
b. However, given that deposits are not rising, these funds could be used
to fund credit growth.
c. Currency holding up to August end had increased by Rs 54,790 cr as
against Rs 13,679 cr last year. It is expected that higher deposit rates
should move them into the banking system which can be deployed for
credit by banks.












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Disclaimer
The Report is prepared by the Economics Division of CARE Limited. The Report is meant for providing an
analytical view on the subject and is not a recommendation made by CARE. The information is obtained
from sources considered to be reliable and CARE does not guarantee the accuracy of such information and
is not responsible for any decision taken based on this Report.