International Capital Flows and Financial Market Dynamics: Empirical Evidence from the Indian Stock Market

Abstract

During the 1990s, the world economy had witnessed many ups and downs of capital inflows and outflows due to financial crisis and economic turmoil. The rising international capital flows were very attractive from the year 2000, until the global financial crisis 2008. The changing pattern of capital flows does not depend only on external but also internal country characteristics and fundamentals. Since the global financial crisis, wide-ranging cross-border capital flows into G20 nations, including inflows from both G20 countries and non-G20 countries. But they have partly returned to pre-crisis of high tide-lines. They are main below the average level, on a percentage to GDP basis, for the G20, over the past decade. This is nothing but the dilemma of risk. So, the investors’ always treat the U.S and some developed market as a safe bucket for investment. Due to lack of understanding regarding emerging markets opportunities or inadequate ability to efficient investment, it is a greater task to quantify the share of both developed and developing countries out of G20 countries.
International capital flows have remained a controversy and puzzle among the existing variety of flows. Both theoretical and the empirical literature on international capital flows have been a topic of argument among the researchers and policy makers. After the liberalization episode, international portfolio capital flows were introduced in the Indian financial market. The existing literature gives a mixed result for international capital flows and its impact on financial market development including macroeconomic situation. In the recent scenario, international capital flows pass through different phases due to financial crisis and many ups and downs in the world economy. It is very important to study the liquidity situation of financial market, international capital flows into G20 countries and its contagious interaction between liquidity, efficiency and returns across the global financial market. Existing literature discusses the total flow from U.S to G20 countries including India, but very few studies focus on gross flows, net flows from U.S to India and its impact on liquidity and returns on Indian stock market. However, U.S is treated as a dominating country due to its monopoly policies and regulation towards the global financial market integration. But the question arises, how far U.S policy affects emerging country’s financial markets like India? This gives space for a study. The Impact of U.S policies on global financial market efficiency is also a threat in the present situation. The existing economic theory talks about the Push and Pull theory in an economy. The previous studies specifically emphasize on the impact of different types of flows on financial market efficiency and returns. But the relation between push approach and pull approach and its role in financial market efficiency and returns are missing in prior studies. The assessment of capital flows to exchange rate and current account performance is rarely studied in the context of global monetary policies.
The present study uses variety of econometric tools for the empirical analysis. For the first objective, Pedroni and Kao’s cointegration test are used to identify the existing cointegrating vector among variables. Fully Modified Ordinary Least Square Method (FMOLS) and Dynamic Ordinary Least Square (DOLS) were used to find out the elasticity estimation of the variables. To find out the cross-country specification result, ARDL/PMG model is used. For second objective, a Vector Error Correction Model (VECM) has been x chosen for this study as it allows identification of long and short term relationships between variables. In estimating the cointegration, first we have checked whether each of the series is integrated of the same order. Integration of a time series can be confirmed by the standard Augmented Dickey-Fuller test and Phillips-Perrons unit root tests. The number of cointegration ranks ‘r’ is tested with the maximum eigen value and trace test. The maximum eigen value statistics tests the null hypothesis that there are ‘r’ co-integrating vectors against the alternative of ‘r+1’ co-integrating vectors. The trace statistics tests the null hypothesis of no co-integrating vector against the alternative of at least one co-integrating vector. The asymptotic critical values are given in Johansen (1991) and MacKinnon et al. (1999). For third objective, Vector Autoregressive (VAR) method, impulse response function and variance decomposition technique are employed to examine the short-term dynamics and casual relationship between variables. Before estimating the VAR model, the unit root test was used to examine the stationary properties of the variables. In this study two unit roottests, viz. Augmented Dickey Fuller (ADF) tests and Phillip Perron’s (PP) test have been conducted to examine the stationarity properties of the variables. Finally, for the fourth objective, again VECM framework is used to analyze the relationship between the log of stock prices and the log of output.
From all the above analysis, it is very clear that foreign investors tend to channelize rather than dry-out liquidity from domestic market. Hence, our analysis finds little support from the correlation that, at the time of adverse environment, foreign investors can destabilize the domestic market. As the cross-country specification result indicates, India, one of the emerging countries among the total 18 high market capitalization countries, is having positive causality from flows to both domestic market liquidity and returns with significant coefficient. Also we establish that domestic market efficiency is having long-run association between foreign capital flows from U.S to India. Both the variables, foreign net flows and the “liftoff” episode (quantitative easing episode), have direct influence on Indian domestic financial market. The volatility pattern of U.S Fed rate and foreign capital flows interaction with domestic financial market, presents statistically significant result with netflows but not with Fed rate. Our results significantly reciprocate the present scenario of tremendous increase in capital out flows due to taper talk and QE phase 4. So the empirical result signifies that in Indian capital market both pull factor and push factor works for capital flight. But real financial situation statistically justifies that “push factor approach” (declaration phase of U.S fed rate) has greater impact than “pull factor approach” (REER, Inflation). We can conclude that outflows don’t cause depreciation of exchange rate. It implies that capital flows to a country does not enhance the capital account to full extent; rather it helps to maintain the reserve. This study has not found any huge contribution of foreign capital flows to output growth (IIP) but the contribution is positive so far as the fills up of the gap between savings and investment is concerned.