Dynamics of FII flows and stock market returns in a major developing country: How does economic uncertainty matter?

We apply the wavelet coherency and phase difference methodology to explore the nature of the relationship and the direction of causality between foreign institutional investment (FII) flows and stock market returns across time and frequency domain for the fast‐growing Indian economy. Since both variables are affected by economic uncertainty, we have estimated the partial wavelet coherency and the phase difference to discern the impact of economic uncertainty on the dynamic relationship and causality between those variables. Both the FII flows and the stock market return move together during the periods of the global financial crisis and the European sovereign debt crisis without any causality in the short run, but the stock market leads the FII inflows in the long run. However, in the bull market the stock market Granger causes the FII inflows both in the short run and in the long run. Nonetheless, economic uncertainty drives the co‐movement and also masks the causality effect between those two variables. Thus, the results require policymakers to set out a transparent economic environment to reap the benefits of FII flows. As far as the FII outflows are concerned, profit booking and economic uncertainty drive the relationship and the causality in the short run. Hence, policymakers and portfolio managers should be concerned about FII outflows in the long run, while in the short run, it is a normal trading activity.