The impact of second generation FDI reforms on the stock market development in India

Abstract

The Governments took a series of initiatives as a measure of second-generation reforms in Foreign Direct Investment (FDI). The FDI reform initiatives had started since 1991 as foundation of Indian economy and the governments over the period contributed to emerge India as destination for Foreign Direct Investment in the world. These reforms played an important role in capital formation in stock markets and developments in the economy. This paper attempts to study the impact of second-generation economic reforms in FDI and its impact on Stock Market Development (SMD) in India. This paper uses a multivariate unrestricted VAR (Vector Autoregression) model to investigate the impact of the reforms in FDI on the development of stock market in India. The study used the quarterly data of FDI inflow, exchange rates and terms of trade (Exports/Imports) from 2004 to 2017 to find the long run impact of FDI reforms on the SMD. The SMD is the ratio of stock market capitalization to the Gross Domestic Product (GDP) of the country. The study uses the unrestricted VAR to generate impulse responses to find the impact of one standard deviation innovation change in one variable on other. Further, Unit Root Test, Granger causality test statistics and variance decomposition (VDC) respectively have been applied to identify variables stationarity, the causality and percent change in variance due to one standard deviation innovation in other variable. The findings of the study conclude that there were structural breaks in the data during 2007Q1 and 2011Q1 due to US financial crisis that lead to high volatility in the Indian stock market. Further, finding concluded that there is a bidirectional causality between foreign direct investment and the stock market development. Finally, study revealed that FDI and terms of trade are also having a bidirectional causality where shock in terms of trade brings a change of 25.15 percent in FDI inflows.