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Determinants of Foreign Institutional Investment in India

The role of Return, Risk and Inflation

Foreign Investment refers to investments made by residents of a country in financial assets and production method of another country. After the opening up of the borders for capital movement these investments have developed in leaps and bounds. But it had wide-ranging effects across the countries. It can affect the factor productivity of the beneficiary country and can also affect the balance of payments. In developing countries there was a great necessitate of foreign capital, not only to increase their productivity of labor but also helps to build the foreign exchange reserves to meet the trade deficit. Foreign investment provides a channel all the way through which these countries can have access to foreign capital. It can come in two forms: foreign direct investment (FDI) and foreign portfolio investment (FPI).

Foreign direct investment involves in the straight production activity and also of medium to long-term nature. Although the foreign portfolio investment is a short-term investment mostly in the financial markets and it consists of Foreign Institutional Investment (FII). The FII, given its short-range nature, might have bi-directional causation with the returns of other domestic financial markets like money market, stock market, foreign exchange market, etc. For this reason, understanding the determinants of FII is very important for any emerging economy as it would have larger impact on the domestic financial markets in the short run and real impact in the long run. The present study examines the determinants of foreign portfolio investment in the Indian context for the fact that the country after experiencing the foreign exchange crisis opened up the economy for foreign capital.

India, being a capital insufficient country, has taken lot of measures to attract foreign investment ever since the beginning of reforms in 1991. Till the end of January 2003 it could catch the attention of a total foreign investment of around US$ 48 billions out of which US$ 23 billions is in the form of FPI (Foreign Portfolio investment).

FII consists of approximately US$ 12 billions in the total foreign investments. This shows the significance of FII in the overall foreign investment programmed. As India is in the development of liberalizing the capital account, it would have noteworthy impact on the foreign investments and particularly on the FII, as this would affect short-term stability in the financial markets. For this reason, there is a need to determine the push and pull factors behind any change in the FII, so that we can frame our policies to influence the variables which drive-in foreign investment. In addition FII has been subject of intense discussion, as it is held responsible for intensifying currency crisis in 1990’s somewhere else.

The present study would inspect the determinants of FII in Indian context. Here we make an effort to analyze the effect of return, risk and inflation, which are treated to be major determinants in the literature, on FII. The projected relation (discussed in detail later) is that inflation and risk in domestic country and return in foreign country would adversely have an effect on the FII flowing to domestic country, whereas inflation and risk in foreign country and return in domestic country would have constructive affect on the same.

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