What Causes FII Outflows and Inflows?

When Do FIIs Pull Out Funds From Emerging Markets?

• Strengthening of the U.S dollar

The U.S dollar has strengthened since the U.S Federal Reserve’s 2021 announcement to hike interest rates by 2023. As a result, FIIs have been liquidating a significant chunk of their holdings in developing and emerging economies like India to gain more liquidity to invest in the U.S markets.

• Tightening Liquidity

There is less liquidity in the system with central banks such as the Bank of England and the U.S Federal Reserve reducing bond purchases. At the same time, interest rates are starting to rise.

Anticipating tighter Fed policies, FIIs tend to pull funds out of risky assets like emerging markets (EMs) like India and invest in developed markets instead.

• Rising Inflation

Central banks respond to rising inflation by increasing interest rates. A hike in interest rates shrinks company profits. As a result, investors are reluctant to pay high valuations and start pulling money out of EMs.

What Causes FII Inflow?

• Global liquidity and the macro environment are the two crucial factors that drive FIIs to invest in EMs.Global liquidity is a significant element that decides the FII inflow into EMs. The liquidity rises when central banks reduce short-term interest rates. With money readily available, companies can better mobilise funds and are more willing to invest in EMs.
  
  
• The macro-environment of EMs also plays a significant role in fund inflows. When the economy is strong and the valuations are attractive, the country will have a higher allocation in the EM basket. Thus, it will stimulate fund inflow from FIIs.

Read more about Foreign Direct Investment

Impact of FIIs on the Indian Stock Markets

• Market Volatility

The investment decisions of FIIs have profound impacts on the Indian stock markets and the economy in general. To begin with, FIIs are a primary cause of stock market volatility. A healthy flow of FII increases the Indian capital market index. Likewise, a drop in FII flow decreases the Indian capital market index. 

• Inflow in Market Instruments

FIIs also bring funds into the stock market and the resulting inflow of capital spurs financial innovation. In addition to this, FIIs contribute to the development of hedging instruments and improve market efficiency. Moreover, FIIs help impart stability to India’s balance of payment. 

FIIs play a crucial role in shaping the course of developing or emerging economies. Here’s see how:

• FIIs ensure a healthy inflow of equity capital, which, in turn, improves capital structures and bridges investment gaps.
• FIIs boost financial market competition and align asset prices to fundamentals.
• FIIs improve capital markets, aiding financial innovation and economic development.
• By contributing their understanding of a firm’s operations, financial analysts and asset managers constituting FIIs improve corporate governance.

However, most developing countries place limits on the total value of assets and the number of equity shares an FII can hold in that particular country. It helps restrict the influence of FIIs on the financial markets and the possibility of damage in case of mass outflow. In India, the overall investment ceiling is 24% of the paid-up capital of Indian companies and 20% for public sector banks. 

The Bottom Line 

Developing economies attract the highest volume of FII activities. Further, the dynamic growth of EMs presents attractive opportunities for foreign investors compared to developed economies.

India being a growing economy, the country draws FIIs that form a vital part of the backbone of the Indian capital market. However, to understand the importance of FIIs in the Indian market scenario, it’s pertinent to identify what makes FIIs pull out funds and invest.