Foreign institutional investors have been active in India for over 10 years. India and Taiwan are the two key emerging markets that require foreign investors to register with the securities regulator and restrict their ownership in companies. India has gradually liberalised to foreign institutional investors.

This article analyses the net flows of foreign institutional investment over the years, it also briefly analyses the nature of FII flows based on research, explores some determinants of FII flows and examines if the overall experience has been stabilising or destabilising for the Indian capital market.

The table summarises the net foreign institutional investment flows over the last ten years.

The annual net flows have been positive over the entire period which included major disruptions in international financial markets such as the Mexican crisis, Asian crisis, Russian crisis, the bursting of the bubble in technology stocks and terrorist attacks on the US.

The annual net flows turned negative only in 1998, primarily due to the uncertainty that prevailed after India tested a series of nuclear bombs in May 1998 and the imposition of economic sanctions by the US, Japan and other industrialised countries.

Investors anticipated that this could trigger a foreign exchange crisis in India.

The average net annual flows over the last ten years (till 2002) were about $1.5 billion. The net FII flows this year so far is $3088 million, double the long-term average. The volatility of flows ( as measured by standard deviation) has been modest.

This is at odds with popular assertions that foreign investors are fair weather friends and tend to accentuate market disruptions.

There is some merit in that argument especially with respect to the Asian crisis as foreign investors became the infamous channel between falling markets and falling currencies.

Anecdotal evidence suggests that though there are over 508 registered FIIs, most of the activity is concentrated around less than 50 FIIs. We do not have data to test the depth of activity of the registered FIIs.

Two key issues are of relevance while analysing FII flows: stability and contagion due to the process of institutional investment.

The major concern among policymakers is that if foreign inflows are instrumental in driving returns and higher returns lead to greater inflows, the result is a positive feedback process.

The trouble with positive feedback process is that when there are outflows it can lead to a spiral of lower returns and greater outflows.

By this process, foreign investment inflows can become a source of instability. This is especially true in markets where local institutions such as mutual funds, insurance companies and pension funds are not well developed.

Statistically, there must be bi-directional causality between flows and returns to support the claim that there is a positive feedback process.

Using stock returns based on the NSE index and net foreign institutional investment flows, there is no evidence to statistically support the positive feedback process.

One of the standard models in finance is the capital asset pricing model.

Despite its imperfections, it is one of the best tools available to investment managers. From a stock perspective, the implication of this model is that the non diversifiable market risk is the important risk and a stock's riskiness is measured by its vulnerability to market risk.

This sensitiveness is known as beta and higher the beta, the greater is the risk and hence the greater are expected returns.

Extrapolating this analysis to the world of global stock market investments and fund managers will be rewarded only for the non-diversifiable global market risk, as measured by the sensitivity of the individual market to the changes in the global market.

Past research has shown that investors allocate capital as a two-step process, in which they first decide the portion to invest in emerging markets and then in the next step decide how to allocate to individual developing country markets.

Statistical analysis using simple regressions reveals that the sensitivity coefficient of the Indian market returns (measured by MSCI India index) to the world market returns ( measured by MSCI all country returns) is very small compared to its sensitivity to the emerging market returns (measured by emerging markets free index ).

This is a marked deviation from the behaviour predicted by CAPM, which would require investors to compare individual markets only to the world market.

Thus, foreign institutional investors have made the Indian market more sensitive to the developments in other emerging markets than to the world market index.

In simple terms, if the emerging markets asset class is pulled down by some disruption in one market, then the Indian market will also go down with it.

The determinants of portfolio flows can be broadly classified into two groups. External 'push' factors and domestic 'pull' factors.

External push factors are interest rates in developed markets, which determine global liquidity conditions and business cycle conditions in industrialised countries that drive investment opportunities.

The domestic pull factors are domestic macroeconomic factors and market performance. Research done by two International Monetary Fund economists (Gordon and Gupta -- IMF working paper, Jan 2003) find that external factors (LIBOR rates and emerging stock market returns) and domestic factors (lagged stock market returns and changes in credit ratings) are significant factors in determining the foreign institutional investment flows to India.

There is a strong element of seasonality as the first quarter has a positive effect on flows related to anticipation of budget and reactions to the specific opportunities arising from it.

One of the very interesting and robust results from this research is that the past stock market returns have a negative effect on future FII flows.

This would imply that foreign investors are very conscious of valuations and therefore may not be responsible for creating asset price bubbles.

One of the factors ignored by this research is the unique regulatory issue for foreign institutional investors, who are expected to take delivery of the securities.

On the National Stock Exchange, only 14 per cent of the traded value results in actual delivery.

Another issue which merits attention is how sensitive are foreign institutional investors to an increase in prices of a small group of stocks, a concentrated rally.

The addition of these new factors still confirms the earlier research results on the negative effect of past returns on future inflows.

We also find that the past global emerging market performance has a positive effect on future foreign inflows to India. The ratio of NSE market capitalisation to total market capitalisation, an indicator of the concentration is negatively related to future FII inflows.

So a sustained rally in the top 50 stocks will discourage future inflows. In terms of the relative quantitative importance, we find that domestic factors are more important than external factors.

India has always been a stock pickers market. Foreign investors are not chasing returns in the Indian market; to the contrary they seem to be bargain hunters.

The dominance of domestic factors over external factors in determining foreign investment inflows must allay the fears that these flows can be destabilising.

The only caveat here is that given the robust nature of flows this year, we do not know if there has been a fundamental change in the way foreign institutional investors have evaluated India, given the favourable macroeconomic situation.