Relationship between Foreign Portfolio Investment and Exchange Rate: The Case of India Using VECM Testing Approach

Abstract

India attracts a large sum of foreign investments every year. These foreign investments have a remarkable impact on Indian economy. Real economy is assumed to be affected by foreign investment through its constituents like exchange rate, foreign exchange reserves, economic growth, etc. Exchange rate movements are also believed to affect the foreign portfolio investment, especially foreign institutional investment coming to the country. The unit root test is applied to determine stationary of the time series data. Vector error correction model is applied to determine the dynamics of the relationship between foreign investment and exchange rate. The result shows that foreign portfolio investment, foreign direct investment, index of industrial production, interest rate and wholesale price index have a positive impact on the exchange rate (REER), that is, Indian rupee appreciates whereas import has negative impact on exchange rate in India that is, Indian rupee depreciates. In short, foreign portfolio investment in India may lead to rupee appreciation with several other currencies and their selling and disinvestment may lead to its depreciation.