A cause and effect relationship between Foreign Institutional Investment Flows and Stock Market Returns. Vietnam case study

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

A CAUSE AND EFFECT RELATIONSHIP BETWEEN
FOREIGN INSTITUTIONAL INVESTMENT FLOWS
AND STOCK MARKET RETURNS
VIETNAM CASE STUDY
By

NGUYEN XUAN PHAP

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, August 2012


UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

A CAUSE AND EFFECT RELATIONSHIP BETWEEN
FOREIGN INSTITUTIONAL INVESTMENT FLOWS
AND STOCK MARKET RETURNS
VIETNAM CASE STUDY
A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

NGUYEN XUAN PHAP

Academic supervisor

Dr. DUONG NHU HUNG

HO CHI MINH CITY, August 2012


CERTIFICATION
“I certify that the substance of this thesis has not already been submitted for any
degree and have not been currently submitted for any other degree.
I certify that to the best of my knowledge and help received in preparing this thesis
and all sources used have been acknowledged in this thesis.”
NGUYEN XUAN PHAP

i


ACKNOWLEDGMENTS

I would like to thank all Professors at VNP, who have taught me initial
economics lessons as well as guided me to further research later.
I specially express my deep gratitude to Professor Doctor Duong Nhu Hung,
Lecturer at Shool of Industrial Management, University of Technology-Vietnam
National University HCMC. He has encouraged me to develop and complete this
thesis from the initial proposal with wholehearted guidance, useful advice that
enabled me to be patiently inquiring and more creative.
I owe so much my family and closed friends who gave me tremendous
support in life and study. Therefore, I take this chance to express my deep gratitude
to them all.
Finally, I pride myself for working very hard to finish this thesis. This seems
fruit of my studying at VNP with many obstacles that I have overcome with
determination and enthusiasm.

ii


ABSTRACT

Many previous studies has investigated the relationship between Foreign
Institution Investment (FII) and stock market return in emerging markets of Asia
such as Taiwan, Thailand, Korea, especially India with a lot of studies reseaching
this relationship. However, some of them investigated the relationship in mean, the
other focused on volatility. Wishing to have the combination research, with new
approach in econometrics like VAR, multivariate GARCH, I carried out the

investigation on this relationship that there has been no empirical study reseached in
Vietnam market so far. This thesis tried to investigate the relationship between FII
and the stock market return in Vietnam represented by Ho Chi Minh Stock market
(HOSE) in mean and volatility. Data are used from year 2004-2011 including the
two sub-periods of pre-crisis and during criris and found that FII caused the stock
market return in all periods in mean; the stock market return caused FII only during
crisis. Regards to volatility, there was no long-term effect between the two series.
FII had short-term effect to the stock market return, especially during crisis.

iii


ABBREVIATIONS

AIC

Akaike Information Criteria

ARCH

Autoregressive Conditional Heteroscedastic

BEKK

Multivariate model proposed by Baba, Engle, Kraft and Kroner

BSE

Bombay Security Exchange

FII

Foreign Institution Investment

GARCH

Generalized Autoregressive Conditional Heteroscedastic

HNX

Hanoi Stock Exchange

HOSE

Hochiminh Stock Exchange

NSE

National Stock Exchange of India

SIC

Schwartz Bayesian Information Criterion

SMR

Stock Market Return

VAR

Vector Auto Regression

VN-Index

Vietnam Ho Chi Minh Stock Index

iv


TABLE OF CONTENTS

Chapter I : INTRODUCTION ............................................................................................ 1
1.1. Problem statement .............................................................................................. 6
1.2. Research objectives ............................................................................................ 7
1.3. Research scope ................................................................................................... 7
1.4. Research questions ............................................................................................. 7
1.5. Thesis structure ................................................................................................... 7
Chapter II : LITERATURE REVIEW ................................................................................ 8
2.1. Theory background ............................................................................................. 8
2.2. Empirical studies ................................................................................................ 9
2.3. Conceptual frame work .................................................................................... 15
Chapter III : DATA SOURCE, RESEARCH METHODOLOGY AND
HYPOTHESIS .................................................................................................................. 16
3.1. Data source & variables.................................................................................... 16
3.2. Methodology..................................................................................................... 17
3.2.1. Unit Root Test ............................................................................................ 18
3.2.2. Granger causality test ................................................................................ 19
3.2.3. VAR BGARCH-BEKK (1,1) model ......................................................... 20
3.3. Hypotheses........................................................................................................ 25
Chapter IV : FINDINGS AND DISCUSSIONS............................................................... 27

4.1. Data and descriptive statistics .......................................................................... 27
4.2. Analysis results ................................................................................................. 32
4.3. Hypothesis testing and findings........................................................................ 41
Chapter V : CONCLUSIONS, POLICY IMPLICATIONS AND LIMITATIONS ......... 44
5.1. Conclusions ...................................................................................................... 44

v


5.2. Policy implications ........................................................................................... 44
5.3. Limitations ........................................................................................................ 47
References ......................................................................................................................... 49
Appendix ........................................................................................................................... 53

vi


LIST OF TABLES

Table 2.1: Liturature review summary ......................................................................11
Table 4.1: Descriptive statistics of FII flow and stock market return in three periods
of time .......................................................................................................................28
Table 4.2: The results of unit root testing for FII and stock market return in periods
considering intercept and trend in equation. .............................................................33
Table 4.3: VAR Granger causality between FII and stock market return ................35
Table 4.4: Bivariate GARCH(1,1)-BEKK model for FII and stock market return in
HOSE ........................................................................................................................37
Table 4.5: Result of hypothesis testing .....................................................................42

vii

LIST OF FIGURES

Figure 1.1 Deposited shares by years..........................................................................2
Figure 1.2: Percentage of deposited shares as proportion of registered shares per
year ..............................................................................................................................3
Figure 1.3: Listing Scale 2011 ....................................................................................4
Figure 1.4: VN-Index and Net trading volume of FII as proportion of the whole
market of HOSE ..........................................................................................................6
Figure 2.1: Causality between FII flows and stock market return ............................15
Figure 4.1a : The whole period graph with sub-period marks for monthly FII in
HOSE ........................................................................................................................27
Figure 4.1b : The whole period graph with sub-period marks for monthly stock
market return in HOSE..............................................................................................28
Figure 4.2a : The whole period graph with sub-period marks of monthly FII in
HOSE varied by season .............................................................................................31
Figure 4.2b : The whole period graph with sub-period marks of monthly stock
market return in HOSE varied by season ..................................................................32

viii


LIST OF APPENDICES

Appendix A: Unit root test ................................................................................................ 53
Appendix B: VAR Residual Normality Test .................................................................... 61
Appendix C: VAR Granger Causality .............................................................................. 64
Appendix D : Ljung-Box/Correlogram test ...................................................................... 77
Appendix E: Bivariate Garch model estimation from R-Plus .......................................... 83

ix


Chapter I : INTRODUCTION

Foreign Institutional Investment (FII) flows which are commonly known as
international portfolio flows, refer to capital flows made by individual and
institutional investors across national borders in creating an internationally
diversified portfolio. FII flows almost had not appeared until 1980’s. But following
a strong trend towards globalization, widespread financial liberalization and
implementation of financial market reforms in many countries all over the world
had actually led FII flows during 1990’s. According to Bekaert and Harvey (2000),
FII as a proportion of a developing country's GDP increases remarkably with
liberalization as through an integration of domestic financial markets with the
global markets, free capital flows from countries which are rich to those are scare in
capital in seeking of higher rate of return and increased productivity and efficiency
of capital at global level.
Vietnam stock market overview
In order to develop the country, Vietnam has been required to restructure the
economy to be more efficient and competitive. For this purpose, Vietnam had
demanded much more capital of investment. Thus, securities market establishment
in Vietnam is necessary to mobilize capital for the economy development. The
Prime Minister signed Decree No. 48/1998/ND-CP on July 10th 1998 about stock
and securities market and Decision No.127/1998/QĐ-TTg on July 11th 1998 to
establish the two

securities trading centers in Hanoi and Ho Chi Minh City.

However, till July 20th 2000, the Ho Chi Minh City Securities Trading Center was

officially opened and then was changed into Hochiminh Stock Exchange (HOSE)
on August 08th 2007 (Hochiminh Stock Exchange, 2011).The Hanoi Securities
Trading Center (HASTC) was put into operation on 08th March 2005 and officially
changed into Hanoi Stock Exchange (HNX) on 24th June 2009 for listing and

1


transaction only stocks of companies with charter capital less than VND 30 billions
(Hanoi Stock Exchange, 2011)
Figure 1.1 below shows us the increasing trend of deposited shares by years.
DEPOSITED SHARES BY YEAR
25000
20000
15000
10000
5000
0
2006

2007

2008

2009

2010

2011

Millions of shares

Figure 1.1 Deposited shares by years
Sources: Vietnam Securities Depository. (2012). Annual report. Retrieved August
30, 2012, from />
Obviously, deposited shares remarkably increase in the three years from
2008. This also shows the corporation equitization process increasing during crisis
in according with government policy to reconstruct corporations in which the
equitization is required for more effectiveness.
Besides, we can see the trend of deposited shares as proportion of registered
shares per year for the whole Vietnam stock market in Figure 1.2 as follows;

2


% DEPOSITED/REGISTERED SHARES PER YEAR
1

0,8
0,6
0,4
0,2
0
2006

2007

2008

2009

2010

2011

% DEPOSITED/REGISTERED SHARES PER YEAR

Figure 1.2: Percentage of deposited shares as proportion of registered shares per
year

Sources: Vietnam Securities Depository. (2012). Annual report. Retrieved August
30, 2012, from />
The ratio reach to the highest point around 0.7.It means that remaining 30
percent of registered shares haven’t been deposited yet. These shares which are
often held by state shareholders, financial institutions, members of management
board are not ready for transaction during defined period of time.
Up to now, numbers of listing stocks in HOSE and HNX have been 353 and
394 respectively. However, considering the size and trading volume, HOSE is much
bigger than HNX. In year of 2011, numbers of transacted shares in HOSE and HNX
are 8,280,645,959 and 7,943,573,441 with the equivalent amount of VND 159,144
billion (Hochiminh Stock Exchange, 2012) and VND 95,847 billion (Hanoi Stock
Exchange, 2012) respectively. This means that the trading volume of HNX is
around 60.2% proportion of HOSE. While foreign trading in HOSE and HNX is
VND 57,294 billion and VND 4,497 billion respectively equivalent to 36% and 4.7
% of total trading of each corresponding exchange market. Moreover, in terms of
amount, foreign trading in HNX is only 7.8% proportion of HOSE. Therefore,

3

foreign trading activities in HNX are not really remarkable compared to those in
HOSE and their effect to HNX is less important than to HOSE. Hence, the effect of
foreign trading in HOSE should be considered and HOSE with its dominance can
be used as representative for the whole stock market of Vietnam for investigating
foreign trading activities and the causality between FII and stock market return.
Actually, there are some kinds of securities transacted in HOSE such as
stock, bond and fund certificate. However, company stock has a big scale in the
market. Thus, in this study only stock transactions in HOSE can be used for
calculation.
Figure 1.3 shows the listing scale in HOSE at the end of 2011.

1,870,00
6,23
Stock
Bond

Fund Certifcate
Others
91,91

Figure 1.3: Listing Scale 2011
Sources: Hochiminh Stock Exchange. (2012). Listing summary. Retrieved January
15, 2012, from />
4


FII in Vietnam
FII takes part in the Vietnam stock market in kinds of individual or
institutional investor that usually has been known as foreign fund. To date, the fund
invests in Vietnam mainly in the form of investment company or investment fund

which have been established by foreign investors in third countries offering tax
advantage like the British Virgin Island or Bermuda and then open investment
accounts in Vietnam as a foreign portfolio investor. In the past three years, more
than 8,100 institutional investors and individuals abroad have opened trading
accounts in Vietnam. In 2010, there were 289 organizations and 950 foreign
individuals are granted trading codes, up 25.5% and 6.7% compared to 2009 (
Nguyen, 2011). At the end of 2011 accounts of foreign investors were 15,569
including 1,724 organizations and 13,845 foreign individuals (Vietnam Securities
Depository, 2012). Number of investment funds operating in Vietnam is quite large,
about more than 400 funds, while fund established within the country is too small,
only 23 funds with small size of capital as well.
FII has flown into Vietnam with big proportion but after the first half of the
year 2008 this FII decreased in the context the financial crisis widespread all over
the world. Figure 1.4 below shows us the situation. Moreover, it shows that FII
varied a lot with a big difference between the two periods before and after the year
2008. Compared to the first period with high variation, FII in the second period
varied more slightly. However, in this period FII has made the peak and the base
point of net trading volume in June and November of 2008 respectively. We might
explain this situation as profit making activity of foreign investors when the stock
market return turned down over several consecutive months from October of year
2007 till June 2008. Hence, they increased buying in April, May and June then
increased selling during months later, reaching a negative net trading volume from
November of year 2008.

5


1000

30

800

20

600

10

400

0

200

-10

0

-20

VN-Index
FII
proportion of overall trading volume %

40

Thg1…
Thg6…
Thg1…

Thg4…
Thg9…
Thg2…
Thg7…
Thg1…
Thg5…
Thg1…
Thg3…
Thg8…
Thg1…
Thg6…
Thg1…
Thg4…
Thg9…
Thg2…
Thg7…
Thg1…

1200

Figure 1.4: VN-Index and Net trading volume of FII as proportion of the whole
market of HOSE
Sources:

1.1. Problem statement
FII flows, often referred to hot money with short-term and speculative
character, are extremely volatile compared to other forms of capital flows. Foreign
portfolio investors who come in when they can gain money in market and leave it
right away when they recognize impending trouble hence destabilize the economy
of the host country. Moreover, securities market of Vietnam is small and immature

whereas the foreign funds are now so big, possibly to dominate the capital market.
Hence, there may be the potential of that FII capital flies out of Vietnam market,
drive the prices down sharply thereby induce considerable instability in the Vietnam
stock market.
However, the issue of whether FII flow affects stock market return or in a
contrary direction is still on controversy. An analysis of the direction of causality to
understand the possible effect of volatility of FII flow on the domestic financial

6


market and economy is important from the viewpoint of policy makers.
Nevertheless, this issue still remains unresolved.
1.2. Research objectives
 The empirical study aims to determine the causal relationship
between FII flow and the national stock market return.
 Examine the role of FII flow in the stock market of Vietnam.
1.3. Research scope
This study just focuses on Ho Chi Minh Stock Exchange (HOSE) only to
determine the relationship between FII flow and stock market return because HOSE
can represent to Vietnam stock market due to the large size of HOSE in capital as
well as bustling foreign trading activities.
1.4. Research questions


Does FII flow cause the stock return and/ or vice versa?



Does FII flow volatility have short-term or long-term effect on the

stock market return volatility and/or vice versa?

1.5. Thesis structure
Accordingly, the remainder of the paper is organized as follows. The next
chapter deals with literature review while the third chapter shows the data source,
research methodology and hypothesis. Chapter four discusses the findings of the
case study. Finally, conclusions, policy implications and limitations are presented in
chapter five.

7


Chapter II : LITERATURE REVIEW

2.1. Theory background

The theory says that local investors comprehend about local financial market
more than foreign investors, leading to a positive feedback trading by foreign
portfolio investors. A positive feedback trading strategy leads to buy or (sell)
decisions following a rise (or fall) in stock prices thereby brings more FII inflows
into the market. Conversely, the behavior of selling (or buying) while the stock
prices are rising (or falling) is considered as a negative feedback trading.
Accordingly, local investors who are owing to the advantage of information may
trade in stocks in response to some new inside information and cause a price
variation, and then this variation in price may lead to FII flows due to foreign
investors’ positive or negative feedback trading. In such cases, local investors are
considered as information traders with insights about the firms of which stocks they
would want to buy and foreign investors are considered as positive or negative
feedback traders who observe and trade stocks following the trend of the market.
Besides, Bikhchandani and Sharma (2001) gave out a theory regarding positive or

negative feedback of mutual funds in financial market: Behavior of investors who
reconstruct their portfolio due to a sudden rise or a fall in share prices, should be
called a positive or negative feedback behavior of buying at high then selling at low
price or buying at low then selling at high price.
The contrarian theory of flows affecting contemporaneous and future stock
market returns coexists. Froot, O'Connell and Seasholes (2001) showed that
international portfolio flows led price changes. The acceptable explanation for the
reverse direction of causality from FII flows to stock market returns is the 'herding
behavior' of foreign investors. According to Park and Sabourian (2011), herding
behavior is in which agents switch behavior from buying to selling or in the
contrary direction, following the crowd. These herders act against their own
information and make their investment decisions based on the other traders’

8


decisions. Information externalities have conditioned rational herding to occur.
Accordingly, rational herding happens when agents’ own information is less
efficient or never revealed to public (Redding, 1996) because it is covered by
information of other traders’ observed decisions. Moreover, phenomenon of mutual
investors who watch the other investors’ behavior for trading is considered herding
behavior (Bikhchandani & Sharma, 2001).
2.2. Empirical studies

In 1990’s and 2000’s, several studies have researched the cause and effect
relationship between FII flow and domestic stock market return but the results have
been mixed in nature. Malarvizhi and Jaya (2009) studied the impact of FII flow to
the Indian stock market (National Stock Exchange NSE was used for
representative) and found that there was a unidirectional causal relationship
between FII and stock market return (the return of Niffty Index) where FII caused

the stock market return but not the reverse. In contrast, Brennan and Cao (1997)
found a positive correlation between FII flow and stock market return. This positive
relationship is explained due to information disadvantage of foreign investors and
then they trade as momentum traders. Evidence from causality tests conducted by
Mukherjee, Bose and Coondoo (2002) suggested that FII flows to and from the
domestic market tended to be caused by returns in the domestic equity market but
not in a contrary direction. Gordon and Gupta (2003) indicated that lagged domestic
stock market return had a negative effect to FII flow.
Subsequently, by using daily data, Bose and Coondoo (2004) found light
evidence of bidirectional causal relationship between return on the stock index of
Bombay Security Exchange (BSE) and FII net inflow. Chakraborty (2007) used
monthly data obtained from BSE and employed pair-wise Granger causality test to
investigate the causal relationship between FII flow and stock market return in
India. They have found the evidence of bidirectional causality between FII flow and
stock market return, whereas FII flow is more caused by stock market return. While
Babu and Prabheesh (2008) employed VAR approach, Granger causality test and

9


data on daily basis from NSE, they have also found the existence of bidirectional
causal relationship between FII flow and stock return in India stock market,
whereas FII flow is more driven by stock return. Lai, Low and Shiu (2008) studied
in TSE1 , tried using pair-wise Granger causality test and found the same result that
FII tends to be a momentum trader and conversely, they can predict the stock return.
Jo (2002) employed a combination of Two Stage Least Squared and ARCH
models to show that FII flows induced a greater volatility in market compared to
domestic investors in Korean stock market. Pavabutr (2004) used modified
GARCH(1,1) to identify the impact of FII flow to stock return volatility and found
the evidence of that foreign net flow has positive effect on market volatility. Rai

and Bhanumurthy (2004) used the monthly data for the period started from January
1993 to November 2002 to examine the effect of stock return, risk in the stock
market and other real factors on FII flows into India. To capture the asymmetric
effects between the good and bad news which induce volatility in returns, in turn
causing volatility in FII, they employed TARCH model. The result shows that the
stock return in India is the main driving force to FII and foreign investors react
more strongly to bad news than to good news. They also recommend that
stabilization of stock market volatility would attract more FII. However, the reverse
causal direction running from FII to stock return has not found. Chauhan and Garg
(2010) used the daily data from April 1st, 2001 to December 31st, 2009 and
employed Granger causality test, VAR model, Wald test, Impulse Response
Function to identify the investment behavior of various institutional investors. FII’s
are found to be engaged in the positive feedback trading activities and causing
volatility in Indian stock market.
Briefly, we can summarize the relevant empirical studies as table 2.1 below;

1

Taiwan Security Exchange

10


Table 2.1: Liturature review summary

Author
(year)

Period &
frequency of

Market

Methodology

Key variables

Findings

data

Brennan and

1989:1-1994:4

Cao (1997)

Quarterly

EMEs2

OLS

-FII( net purchases in

SMR causes

quarter t expressed as

FII

a proportion of the
average absolute
level of net purchases
over the previous four
quarters)
-SMR3 (local Indices)
Jo (2002)

1995:1-2001:12 Korea

TSTL(two

-FII (Net purchase

FII flows

Daily

Stage Least

amount)

induces a

Squares)

-SMR (KOSPI 4)

greater

ARCH model

volatility in
markets
compared to
domestic
investors

Mukherjee,

1999:1-2002:5

Bose and

Daily

India

Coondoo

Pair-wise

- FII (net investment

FII flows are

Granger

as a proportion of the

caused by

causality tests

size of market

returns in the

capitalization)

domestic

- SMR (BSE Sensex)

equity market

(2002)

2

Emerging Market Economies of 16 countries
Stock Market Return
4
Korea Composite Stock Price Index
3

11

and not in a
contrary
direction
Gordon and

1992:9-2001:10 India

Gupta (2003) Monthly

OLS

-FII equity flows as a

Lagged

Impulse

percentage of market

domestic SMR

Response

capitalization on the

has a negative

Function

BSE

effect to FII

- SMR (BSE Sensex)

flow

and lag series
Bose and

1999:1-2004:1

Coondoo

Daily

India

GARCH(1,1)

(2004)

-FII net equity flows

Light evidence

- SMR (BSE Sensex)

of

-Dummy variable

bidirectional

(policy intervention)

causal
relationship
between return
on the stock
index of BSE
and FII net
inflow

Rai and

1993:1-2002:11 India

TARCH

-FII(net purchase

-The SMR in

Bhanumurth

Monthly

(threshold

amount)

India is the

ARCH)

- SMR (BSE Sensex)

main driving

GARCH(1,1)

-Inflation

force to FII.

y (2004)

-Stabilization
of stock
market
volatility
would attract
more FII. The

12


reverse causal
direction has

not been
found.
Pavabutr

1995:1-2002:5

(2004)

Daily

Chakraborty

1997:4-2005:3

(2007)

Monthly

Thailand Modified

-FII(net trading

FII has

volume)

positive effect

- SMR (TSE 50

on market

Index, FB 25)

volatility.

Pair-wise

-FII (net FII flows as

Bi-causal

Granger

a proportion of the

relationship

causality tests

preceding month's

between FII

BSE market

flow and

capitalization)

SMR, whereas

- SMR (BSE Sensex)

FII flow is

GARCH(1,1)

India

more caused
by SMR
Babu and

2003-2007

Prabheesh

Daily

(2008)

India

VAR

-FII (net equity

The existence

approach,

purchase)

of

Granger

- SMR (S&P CNX

bidirectional

causality test,

Niffty of NSE)

causal

Impulse

relationship

Response

between FII

Function

flow and
SMR, whereas

FII flow are
more driven
by SMR

13


Lai, Low and 1994:6-2002:1
Shiu (2008)

Taiwan

Daily

Pair-wise

-FII (ratio of net

SMR causes

Granger

purchase to total

FII and vice

causality tests

shares outstanding)

versa

- SMR (TSE)
Malarvizhi

1999:4-2009:3

and

Monthly

India

Jaya(2009)

Pair-wise

-FII(net purchase

Unidirectional

Granger

amount)

causality from

causality tests

- SMR (S&P CNX

FII to SMR.

Niffty of NSE)

Chauhan and

2001:4-2009:12 India

VAR model,

-FII( ratio of gross

FII’s are found

Garg (2010)

Daily

Granger

buying to selling )

to be engaged

causality test,

-MF5( ratio of gross

in the positive

Impulse

buying to selling)

feedback

Response

- SMR (S&P CNX

trading

function,

Niffty of NSE)

activities and

covariance

causing

decomposition

volatility in
Indian stock
market

5

local Mutual Fund

14