This paper examines the implications of capital account liberalization on the stability of capital markets in India captured in terms of two indicators, the market liquidity indicator and market volatility from 1993-94 to 2007-08. The empirical analysis, after controlling for other variables affecting the stability of capital markets, shows that capital account liberalization; particularly foreign portfolio investment liberalization has not contributed significantly to market liquidity whereas it has contributed significantly to increased market volatility. These results are particularly relevant since India opened its financial markets to Foreign Portfolio flows at an earlier stage of its reform process much before the development of domestic financial markets unlike the sequencing pattern flowed by most countries that were undergoing similar process of liberalization. Further, these results have important policy implications since the choice of an attitude towards full capital account convertibility in India has become a debateful issue.
Table of Contents
1. Introduction
2. Research Problem and Relevance
3. Preliminary Trends
4. Estimation Procedure and Results
5. Conclusion and Policy Implications
6. Appendices
7. References
Objectives & Research Themes
This paper examines the implications of capital account liberalization on the stability of capital markets in India, specifically analyzing the impact of foreign portfolio investment (FPI) on market liquidity and volatility between 1993-94 and 2007-08.
- Analysis of the relationship between capital account liberalization and market stability.
- Evaluation of liquidity and volatility indicators in the Indian stock market.
- Assessment of the sequencing of financial market reforms in India.
- Quantitative investigation using vector error correction models.
- Discussion on the necessity of completing domestic financial sector reforms.
Excerpt from the Book
1. Introduction
With the wave of financial globalization in the developing countries, most developing countries have started removing the restrictions on capital account transactions. Theoretically, capital account liberalization will result in a lower cost of funds due to diversification ,an increase in the supply of capital, an expansion in the size of the market, improved liquidity, improved market depth and increased efficiency in allocation of investments (Bekaert and Harvey, 2000; Bekaert et al. 2001).As an open economy allows for cross-border capital flow, capital account liberalization provides an additional mechanism through which shocks to the economy are offset, thus leading to lower income stream and asset price variability (Wu, 2006).However, in an economy where information is asymmetric, markets do not behave as predicted by standard competitive models, and liberalization could lead to episodes of capital flight, and asset market volatility (Stiglitz, 2000). Thus theoretically the implications of capital account liberalization on the stability of capital markets¹ is not clear.
Empirical studies and country experiences in this regard give mixed evidence and show that the results depend on country specific characteristics (Bekaert and Harvey 1997, Levine and Zervos, 1998; Aggarwal et al. 1999; Kim and Singal 2000, Bekaert et al. 2001, Kaminsky and Schmuckler 2003, Edwards at al. 2003, Claessens et al, 2006; Dhir, 2007etc).
Summary of Chapters
1. Introduction: This chapter provides an overview of the theoretical impacts of financial globalization and capital account liberalization on emerging economies.
2. Research Problem and Relevance: This section details India's policy shift towards a more convertible capital account and outlines the specific objectives regarding FPI and market development.
3. Preliminary Trends: This chapter presents empirical data on capital flow compositions and provides a comparative analysis of Indian stock market indicators against global benchmarks.
4. Estimation Procedure and Results: This section describes the construction of policy indices and the application of vector error correction models to determine the impact on market stability.
5. Conclusion and Policy Implications: This chapter synthesizes the study's findings, arguing that domestic reforms should precede full capital account convertibility.
6. Appendices: This section includes detailed technical explanations of the indices, filters, and statistical tests utilized in the empirical analysis.
7. References: A comprehensive list of academic sources and policy documents cited throughout the research.
Keywords
Capital account liberalization, portfolio flows, financial stability, market liquidity, market volatility, India, financial sector reforms, foreign portfolio investment, FPI, stock market development, vector error correction model, macroeconomic variables, economic growth, capital controls, emerging markets.
Frequently Asked Questions
What is the core focus of this research?
The research investigates the relationship between capital account liberalization and the stability of Indian capital markets by analyzing liquidity and volatility trends from 1993 to 2008.
What are the primary themes discussed?
The central themes include the liberalization of foreign portfolio investment, the sequencing of financial reforms, the impact of capital flows on stock market dynamics, and the role of domestic macroeconomic factors.
What is the main research question?
The study seeks to determine whether capital account liberalization—specifically FPI liberalization—has contributed to the stability or increased volatility of the Indian stock market.
Which scientific methodology is employed?
The author employs quantitative empirical analysis, specifically constructing policy indices and utilizing vector error correction models to examine co-integration and causal relationships.
What is addressed in the main body of the work?
The main body covers a literature review, descriptive statistics on capital flows, detailed econometric modeling of stock indices (Sensex and Nifty), and a discussion on policy implications.
Which keywords best characterize this work?
Key terms include capital account liberalization, financial stability, market volatility, market liquidity, FPI, and financial sector reforms.
How does the author explain the sequencing of reforms in India?
The author notes that India opened its markets to FPI early in the reform process, potentially before domestic financial sector reforms were fully consolidated, which differs from the standard sequencing patterns seen in other emerging economies.
What conclusion does the author draw regarding market liquidity?
The study finds that while liberalization was intended to improve liquidity, the evidence suggests it has not significantly contributed to doing so, but has played a role in increasing market volatility.
Does the author support full capital account convertibility for India?
The author suggests that a phase-by-phase approach is preferable and emphasizes that domestic financial sector reforms should be completed prior to full capital account convertibility to ensure stability.
- Quote paper
- Faculty Associate Lekshmi R Nair (Author), 2011, Capital account liberalization and stability of capital markets in India, Munich, GRIN Verlag, https://www.grin.com/document/179832
