AN EMPIRICAL STUDY OF FOREIGN CAPITAL WITH REFERENCE

TO RUPEE VOLATILITY IN INDIA

Author : Abhishek Pande

Institute : Orange School of Business

ABSTRACT

The rupee has lost almost a fourth of its value against the dollar in last one year. This fall has

created a chorus of demands from industry as well as sections of the political establishment

that the Reserve Bank of India (RBI) should step in and use its foreign exchange reserves to

stabilise the value of the rupee.If the rupee falls, it is bound to impact the price of the

commodity even if it is being procured locally. Thus, volatility impacts the entire economy,

not just large importers or exporters.So far, managing volatility and the associated currency

risks has been a function of the RBI.We are already seeing this trend emerging with

management and audit committees of companies across the board, not just importers and

exporters, spending more time in assessing rupee volatility and finding ways to mitigate

them.

Keywords – foreign direct investment,foreign institutional investment,volatility.

JEL Classifications : E4,E5,E6

INTRODUCTION

Higher current account deficit and high inflation tend to go hand in hand. This itself is less of

an issue for global investors, provided we can maintain growth. If we are able to push growth

up even to the 7%, global capital flows will return and this will bolster the rupee. To do this,

what we need is a more open market access to a wider, exchange-based system of hedging

risks. The present restrictive system leaves too much onus on RBI.In the long run, the only

way to control volatility as well as stop the rupee from falling further is to open up our

economy further and do away with controls on FDI in sectors like insurance and multi-brand

retail.It not only helps bridge the current account deficit but also does not add volatility to the

markets. But, most important, it adds productive capacity, new technologies and new

expertise that further helps the growth of the economy.

REVIEW OF LITERATURE

Theoretically, a direct linkage between exchange rate volatility and macroeconomic variables

of any country is described, but empirical investigation shows that there is no consensus

about it because of mixed pattern of results found in those studies. Adubi et al. (1991)

evaluated the impact of price volatility and exchange rate volatility on agricultural trade flow.

Bleany et.al. (1999) analyzed through a model that if exchange rate of developing countries is

pegged to exchange rate of developed countries, the inflationary expectations in developing

countries may be reduced. Frey (1999) investigated the impact of short run volatility of

exchange rates on the volume of exports. Cooper (1999) compared the scope of different

exchange rate choices availed by rich and developing countries. Liwang (2000) studied the

impact of exchange rate volatility on flow of international trade. Kawai et al. (2001)

discussed conceptual and empirical issues relevant to exchange rate policies. Larrain et al.

(2002) put light on the question of which exchange rate arrangement middle income countries

should adopt.Esquivel et al. (2003) described the exchange rate volatility of G-3 countries.

Rollemberg et al. (2004) emphasized the relationship between alternative exchange rate

regimes and the different concepts of money and the role of the market as an economic

regulator. Zhang (2005) reviewed China’s foreign exchange reforms and analyzed their

impact on the balance of trade and inflation. Maskey (2006) reviewed the patterns of

economic shocks affecting the SAARC member countries.

FOREIGN CAPITAL INFLOWS

The government needs to start building a political consensus on such pending FDI issues such

as insurance and pensions.When faced with hardship, the instinctive reaction of most

policymakers and regulatory authorities is to clamp down and levy additional controls. It may

seem counter-intuitive, but what is really needed is more openness and transparency.Global

linkage and dependence of the economy is now a challenge for all policymakers.To benefit

from these, we need to go beyond the halfway house that the economy now finds itself

into.India’s decision to allow overseas companies to own as much as 51% of retailers selling

more than one brand will help curb inflation rate in some way.

Providing a stable and predictable macroeconomic environment is a challenge and the need to

reduce fiscal deficits both at the Centre and in the states to stabilise the debt-GDP ratios at

sustainable levels is a tough task.

RUPEE VOLATILITY AND FDI TRENDS IN INDIA

The relative rate at which the price of a security moves up and down is called volatility.

Volatility is found by calculating the annualized standard deviation of daily change in price.

If the price moves up and down rapidly over short time periods, it has high volatility. If the

price almost never changes, it has low volatility.

Rupee-dollar exchange rate

FDI is regarded as a potential catalyst for raising productivity in developing host countries

through the transfer of technology and managerial know-how, and for facilitating access to

international markets (World Economic and Social Survey 2012).

There are two routes through which FDI can take place in India :

1. Automatic Route

2. Government Approval Route

Foreign individuals or enterprises may take FDI in the form of acquiring shares of existing

Indian company, establishment of a new subsidiary with 100% share, joint venture, and

collaborations or by establishing new branches or expanding existing ones. FDI investment is

a long-term relationship with domestic company by participating actively in the management

of affairs of that company. So in essence, FDI in all these cases, results either in setting up of

new units of business or acquisition of controlling authority by acquiring major share in

equity capital.

RESEARCH DESIGN

The main objective of the present study is to quantify the affect of foreign capital inflows,

which include FDI and FII’s on economic growth of India. India has been receiving

significant amount of foreign capital via these routes after India liberalised its policy

regarding foreign capital.Thus the reference period for the present study has been chosen

from 2006-2012.Different researchers have under taken various studies to examine the impact

of foreign capital on the economic growth. Most of the studies have focused on the impact of

foreign direct investments on economic growth.Foreign Institutional Investors (FII’s) and

Foreign Direct Investment (FDI) have emerged as an important component in various

developing countries including India.Thus the relationship of Indian economic growth has

been studied with reference to FDI and FIIs investments flows. Consequently rupee volatility

has been taken as dependent variable and FDI and FIIs investment flows have been taken as

independent variables. Total 17 observations over the period of study 2006–2012 have been

used for analysing the relationship. The data for the study have been taken from the

Handbook of Statistics on Indian Economy published by Reserve Bank of India.

EMPIRICAL ANALYSIS

In order to judge the contribution of various components (FDI and FIIs) of foreign investment

on rupee volatility in India, Ordinary Least Square (OLS) method of regression analysis has

been applied using the annual data of Rupee Volatility (RV), FDI and FIIs. Symbolically, the

impact of FDI and FII on Rupee Volatility of India under OLS may be expressed as follow.

RV = β1 FDI + β2 FII + ε …………………. (i)

In this regression equation RV has been presented as dependent variable and all other

variables as independent or predictor variables. Here, in this regression equation:

RV – Rupee Volatility

FDI – Foreign Direct Investments

FII – Foreign Institutional Investments

β1 – Regression coefficient to measure the change in rupee volatility with change in FDI

β2 – Regression coefficient to measure the change in rupee volatility with change in FII

ε – Error term

Table 1.Regression analysis explaining the variations in RV of India during the period

2006-2012 ( no of observations =17)

Model Unstandardized

Coefficients β

Standard

Error

Standardized

Coefficients

β

t Significance

FDI 11.236 1.317 .899 9.263 .000

FII 6.668 2.645 .244 2.450 .022

R2 = 0.846

Adjusted R2 = 0.851

Dependent variable in model = Rupee Volatility

Independent variables : FDI and FII

The beta values or coefficients indicate the strength of relationship between independent

variable and dependent variable. These regression coefficients have been used to construct an

OLS equation to test the relationship of each independent variable with dependent variable.

The model equation has been estimated on the basis of quantitative data for the entire

variables from financial year 2006 to financial year 2012. The total number of entered

observations is 17.

As visible from Table 1, the beta coefficients for FDI and FII have been found to be

significant. As per the result of Multiple Regression method, the following multiple

regression equation has been developed:

RV = 11.236 FDI + 6.668 FII………………………. (ii)

Positive regression coefficients of independent variables indicate a positive relationship with

the dependent variable. R2 known as the coefficient of determination, measures the

proportion of the total variation in dependent variable by the presence of all independent

variables simultaneously. So the model is statistically significant in the case of Indian

environment as it is explaining 86% variation in rupee volatility of Indian economy. Adjusted

R2 value is another measure of the success of the model. Adjusted R2 in this case is 0.851,

which means 85% of the variance in rupee volatility can be explained by the independent

variables jointly.

Table 2 shows the overall significance of the model. The value of the F-Statistic at 46.605 is

significant at 1% level of Significance. So model developed using the Multiple Regression is

statistically significant.

Table 2.Model Summary and analysis of Variance (ANOVA)

Model Sum of squares Df Mean square F Statistics Significance

Regression 6215779963500 2 3107889981749 46.505 0.000

Residual 933600437611.9 14 66685745543.6

Total 7149380401112 16

Predictors : FDI,FII

Dependent variable : Rupee Volatility

RECOMMENDATIONS AND CONCLUSION

In charting a roadmap for rupee consolidation, we need to be mindful of the quality of fiscal

adjustment —which is to weed out unproductive expenditure and protect, if not enhance,

growth-promoting foreign players.Also the optimistic view is rupee's recent weakness against

the dollar will likely be short-lived as it is due to global factors and India's economy remains

strong.It is widely acknowledged that current account deficit is by far one of the most binding

constraints to accelerating growth.Given its fiscal compulsions, the Government should

mobilize its resources by promoting the influx of FDI and FII’s in the country.In order to

support recent reforms,the RBI should cautiously relax regulatory norms.These include

higher exposure norms in respect of single borrowers and borrower groups, permitting

foreign players to invest in Infrastructure Debt Funds (IDFs) and to enter into infrastructure

financing.

REFERENCES

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Economic Growth: Further Evidence From Four Asian Countries (1970–1998). Journal of

Asian Economics, Vol. 15, Issue 2: 399–413.

[4] Moshirian, F. 2008. Globalisation, Growth and Institutions. Journal of Banking and

Finance, Vol. 32, Issue 4: 472–479.

[5] World Economic and Social Survey, Financing for Development, Department of

Economic and Social Affairs. 2005. United Nations.