top of page

Effect of Foreign Capital Flows on Indian Stock Market Returns

Introduction


In this paper, we aim to examine the effects of foreign investment flows on the Nifty50 prices – the benchmark index on the National Stock Exchange (NSE). The foreign investment flows in India predominantly consist of Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII).


Foreign investments entail the inter-country exchange of capital flows. They refer to investments made by residents of a nation in another nation’s assets, which assist in boosting the foreign exchange reserves to help meet trade deficits. FDI flows represent international transactions involved with direct investment within a period of time. These are measured in USD and as a share of GDP.


In this article, we have presented three unique perspectives on how foreign capital flows affect stock market return. First, we explore the positive impact and the driving factors which enable this. Second, we put forth the results from excessive capital flows into the country and lastly, we observe the effects of the global financial crisis.


Positive impact of Foreign flows on Nifty 50


Through multiple studies, it has been observed that as the FII inflows increase, there is an increase in the Indian stock market prices. This positive correlation can be explained as follows - the returns on the stock market will be higher if more people want to buy stock rather than sell it. In economic terms, if the demand for a stock is more than the supply, it leads to a rise in the stock prices and this gradual increase leads to higher stock market returns. If India attracts more foreign investments, it means that more and more people are investing in the country’s stocks leading the demand for them to increase. The healthy inflow of capital leads to an improvement in capital structures and helps in bridging the gaps in investments.


Shrikanth, M. and Kishore B. (2012), explained a cause and effect relationship between the Indian capital market and foreign institutional investment, where the main motive of FIIs was to maximize returns, and minimize risk, keeping investment liquidity intact. Their results showed that net FII inflows positively impacted the Indian stock market.


Negative impact of Foreign flows on Nifty 50


Functioning:


Now, we shall explore the negative impacts of foreign flows on Nifty 50 through a small mathematical exercise as follows:

Since,

Demand = Supply,

We get:

Exports + Capital Inflows = Imports + Capital outflows

On rearranging:

Current account + Capital account=0.

where the current account is equal to [Exports - Imports] and capital accounts are equal to [Capital Inflows - Capital outflows].


This implies that an increase in the current account will lead to a decrease in the capital account and vice versa. Consequently, high capital inflows (capital account surplus) are accompanied by large trade deficits (or current account deficits). Thus, we can see how excessive capital inflows can impact the economy through the lens of the consequences of trade deficits in the economy.


Consequences:


Unemployment: As capital inflows increase, domestic manufacturers are replaced by foreign manufacturers, rendering the former bankrupt. This gives rise to an increase in unemployment in the home country. It further leads to a decrease in the GDP, which consequently leads to a decrease in profits of the domestic consumers, and their overall income decreases. As a result, their capacity to invest decreases, resulting in a fall in the stock market returns.


Debt: In an attempt to combat rampant unemployment, the government initiates unemployment benefits, social security schemes, and food stamps. These factors increase the government debt.


Low Savings Rate: Since income is either saved or consumed, high inflow of foreign capital decreases interest rates and credit standards. Increasing capital inflows leads to higher consumption, which contributes to decreasing the savings rate. As the savings rate is lower, people have a lesser incentive to invest, which in turn, has a negative impact on the stock market returns. Tying all the above factors together, we see how an increase in FII can have a negative impact on the stock market returns.


In conclusion, the effect of foreign national flows can be either positive or negative. It depends on the interplay between high capital inflows and how it also leads to higher trade deficits. When the former is higher, we witness a positive relationship and when the latter is higher, we witness a negative relationship. The positive effects present themselves in the form of higher growth rates and better investment prospects while the negative effects result in a low savings rate, increased debt, and growing unemployment rates.


(Written by Ashisha Bishoyi & Arushi Kapoor and Edited by Anoushka Gehani)




Comments


bottom of page