## Tuesday, June 06, 2006

### Interplay between capital flows and the domestic financial system

Ila Patnaik and I recently did a paper on the broad subject of capital flows. It's a `background paper' for a World Bank project, and catering to the needs of the project has meant that it's a bit diffused. Ila wrote about this in Financial Express today.

The paper does three new things. First, it does a new classification of India's debt position, and finds that things are quite different from what we have traditionally thought. Second, it sniffs at daily data on FII inflows to look for lead/lag relationships with Nifty. Third, it does a preliminary examination of firm level data on the determinants of FII ownership. There are a few other interesting components of the paper, if you are interested in the broad subject of international economics and finance.

1. I happened to see both columns - Ila's and your's - today. When I read the columns, I wondered if both Ajay Shahs were the same and it was you, the blogger!

Your conclusions, from Ila's column, with regards to FII were very interesting. I suppose your paper will not subside the recent political rhetoric about markets.

2. A combination of data and sophisticated statistical techniques may show that FII activity may not be the real cause of stock market movements/volatility. But I wonder what is the impact that FII inflows/outflows have had on "sentiment" (in a behavioural finance sense). Afterall information about fellow market participants and their behaviour should be part of the information needed for prices to be established. Consider this:

-The anchors and experts who appear on channels like CNBC or NDTV Profit go on and on about FIIs, analyzing all their activities to death.

-The finance minister and officials keep appearing on television repeatedly giving "assurances" to FIIs about the "long term fundamentals of India"

-RBI/SEBI keep churning out omniously titled reports about FIIs and their impact on volatility and are regularly backed by soundbites (on television) by political leaders from the Left.

-Economic and Political Weekly keeps publishing regular articles/papers by economists warning India about the "experiences" of countries like Mexico/SE Asia with FII flows.

The point I am making is that the attention given to FIIs and the way the debates concerning their importance takes place in a context that fully ignores the analysis of the kind that appears in this paper. Because of which I see no reason for a retail investor (or even a fund manager) to not beleive that the markets moves up and down because of FII flows.

3. I am aware there is a lot of confusion about FIIs. But I think the best thing that we can aspire to do is dispassionate thinking.

How about this arbitrage strategy: to buy Indian equities on the day after data comes out about a large sale by FIIs (which ought to spook dumb people when they see this data).

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