Do Domestic Institutional Investors (DIIs) Neutralize the Impact of Large Reversal by Foreign Institutional Investors (FIIs)? Recent Evidence from Indian Stock Market

Abstract

FIIs and DIIs are the two dominant investment categories in the Indian stock market with enough clout to move the market. Inflow of FIIs is crucial for an emerging economy like India. At the outset, it attracts foreign capital to finance economic growth. Inflow of Foreign capital through FIIs is also expected to enhance liquidity in the stock market by widening the investor base and thereby improves the functioning of the secondary market. Hence, the flow of FIIs is expected to indirectly contribute to the economic growth (Lee, 2007). However, on the flip side, they are considered to be voracious, erratic investors that often profit from destabilizing financial markets of host countries. Batra (2003) observes that FPIs are considered to be driven by animal spirits rather than rational investment decisions. Hence, they have often been blamed for large reversal of capital from countries in times of crisis leading to herding behavior in other investors, particularly, domestic institutional investors (DIIs). As a result, these flows tend to make financial markets vulnerable and may end up landing the country in a crisis (Rakshit, 2006). To neuralisze the destabilizing nature of FII trading, it is critical to have powerful DIIs that would provide a cushion against this adverse effect of FIIs. However, this function of DIIs depends on the relationship between FIIs and DIIs. Therefore, the present paper attempts to understand the relationship between foreign institutional investments (FIIs) and domestic institutional investors (DIIs) in India, using the most recent high frequency data. The study finds that FIIs and DIIs follow a different trading strategy in the market. Importantly, the study shows that DIIs negatively affect the FII flows, whereas they are not affected by the FII flows. This suggests that DIIs indeed act as a cushion against the significant withdrawal by FIIs, thereby maintaining stability in the stock market.

Keywords: FIIs, DIIs, Stock Market

JEL Classification: G1