The Relationship between Dividend Payout Policy and Foreign Institutional Investment in India

Article
The Relationship between
Foreign Trade Review
48(4) 437–459
Dividend Payout Policy
©2013 Indian Institute of
Foreign Trade
and Foreign Institutional
SAGE Publications
Los Angeles, London,
Investment in India
New Delhi, Singapore,
Washington DC
DOI: 10.1177/0015732513504709
http://ftr.sagepub.com
Poulomi Lahiri
Abstract
This article tries to explore the link between dividend payout policy and for-
eign institutional investment (FII). Using panel data of 150 listed Indian com-
panies for the period 2001–2010, this article tries to explore the impact of FII
on dividend payout policy and vice versa. The outcomes indicate the FIIs, as a
whole, increase the chance of paying cash-dividend, but the marginal impact is
quite small in economic terms and also FIIs increase the probability of paying
more dividend payouts. Our analysis has further shown that the foreign insti-
tutional investors are attracted towards cash-dividend paying firms. Thus, our
study does not support the traditional agency cost problems but do support
the clientele theory. Our results further reveal that our firm-level characteris-
tics do support the free-cash flow theory and the pecking order theory firmly
but the maturity theory partially. However, the financial recession, which has
started since 2007, has shown its usual negative impact on the level of dividend
payments.
JEL: C23, C24, G30, G35
Keywords
Foreign institutional investment, dividend payout, panel probit estimation, panel
Tobit estimation, linear dynamic panel estimation
Introduction
One of the intriguing topics in financial economics is to explore the relationship
between ownership structure and firm’s financial policy. Under this broad topic
earlier researchers were interested in exploring the linkage between management
ownership and firm’s dividend payout policy. But, during the process of financial
Poulomi Lahiri, Doctoral-fellow, Institute of Development Studies Kolkata (IDSK).
E-mail: poulomilahiri@gmail.com

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438
Poulomi Lahiri
liberalization, academicians were more interested in exploring the relationship
between foreign investment and firm’s dividend payout policy.
One of the key elements of foreign investment is foreign portfolio investment
(FPI). Foreign portfolio investment can be of four types: (a) FIIs; (b) American
depository receipts (ADRs); (c) global depository receipts (GDRs); (d) offshore
funds and others (Reserve Bank of India [RBI]).
After financial liberalization, it is evident that FIIs play the major role in FPI.
The share of FII has increased in developed as well as in developing countries
(Kim et al., 2010) after liberalization.
In India, the absolute amount as well as share of FIIs has shown almost a
steady rise during this liberalization period except 1998–1999, 2002–2003 and
2008–2009 (RBI). Again, the share of foreign investors captured 23.85 per cent of
market capitalization in 2010 financial year (FY). FIIs held 13.82 per cent of
equity market capitalization in 2010 FY. Within non-promoter institutions, FIIs
held 54.52 per cent of total institutional holdings (NSE, CSO). On the other hand,
dividend payments followed a more or less stable path for most of the Indian
companies during the reform period (Kamat and Kamat, 2010).
Being larger shareholders and governed by improved legal rights, the foreign
institutional investors may influence the decision-making process (for example,
dividend payout policy) of the domestic corporate firms. Thus, in this context the
relationship between FIIs and dividend payout policy is a subject of great impor-
tance. Empirical evidence has shown mixed results. Empirical studies show either
positive, negative or no relationship between dividend payout policy and FIIs. In
this respect, most of the studies have been carried out in developed countries, such
as, US and UK, whereas for developing countries and especially for India this
study is almost untouched one.
Institutional investment is preferred for a number of reasons. First, institutional
investors are generally large shareholders. Being efficient and resourceful inves-
tors, foreign institutional investor may appoint some groups of experts who help
them in analyzing the financial health of the domestic corporate firms. Therefore,
institutional investors are more vigilant and better informed than individual inves-
tors. Second, in some countries like UK and US institutional investors may enjoy
either tax advantages or tax-exempted status over individual investors. Thus, the
advantages of institutional investment inspire many researchers to explore the
linkage between FII and dividend payout policy.
This potential linkage between dividend payout policy and FII can be explained
by several theories, such as, agency theory and signalling theory. These theories
have been discussed in the following literature review section.
This article addresses the following questions: (a) Do FIIs affect payout policy
of Indian corporate firms? Under such broad objective we would first like to
investigate whether FIIs induce Indian corporate firms to pay dividends? If FIIs
induce the Indian corporate firms to pay dividends, then by classifying FII into
higher foreign institutional investments (the foreign investors who own more than
5 per cent shareholding ratio) we would like to see whether FIIs as a whole, as
Foreign Trade Review, 48, 4 (2013): 437–459

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Dividend Payout Policy and Foreign Institutional Investment
439
opposed to higher foreign institutional investments, or both, play an important
role in increasing the level of dividend payouts because in many countries foreign
investors who own more than 5 per cent shareholding ratio are only considered as
foreign institutional investors (Kim et al., 2010). Finally, we want to see from the
reverse side—(b) whether dividend payout policy affects the inflow of FII. In
other words, do foreign institutional investors prefer those Indian companies
which pay high dividend payouts?
Using balanced panel data for the period 2001 FY to 2010 FY on firm-specific
variables of 150 listed Indian corporate firms from Capitaline database and also
using macro-variables, such as, inflation, interest rate and real effective exchange
rate from RBI database, this article examines the potential linkage between divi-
dend payout policy and FII.
Our results show that the FIIs may increase the chance of paying dividends
payouts. Instead of higher foreign institutional investments, the FIIs itself may
increase the chance of paying more dividend payout ratio of the firms. Hence, FII
does influence dividend payout policy. On the other hand, foreign institutional
investors are more attracted towards dividend paying firms, no matter whether
they belong to low or high group of dividend payment. Thus, dividend payouts
affect FII.
The rest of the article is arranged as follows. In the second section we discuss
the literature review of the study. In the third section we discuss the data descrip-
tion and sources, our database and variables to be used. The fourth section incor-
porates empirical analysis and the fifth section includes concluding remarks.
Literature Review
Theoretical Issues
Over time, several theories have explored the linkage between dividend payout
policy and FII. Among them, agency theory suggests that being large shareholders
and also governed by strong legal laws of domestic countries along with practis-
ing effective and enhanced monitoring facilities, foreign institutional investors
may prevent managers of the domestic firms to reduce the over-investment or bad
investment problems by forcing the domestic firms’ managers to formulate effec-
tive dividend payout policy. So, effective payout policy, strong legal protection
along with direct or indirect monitoring activities may mitigate the agency cost
problem (Easterbrook, 1984; Jensen, 1986; La Porta et al., 2000). Thus, in order
to address agency cost problem the free-cash flow hypothesis suggests higher
foreign institutional investment should force the domestic firms to pay more divi-
dends and higher dividend paying firms may also attract FII.
Signalling theory advocates that under the situation of asymmetric informa-
tion, firms may use dividend as a signal to convey the information of the current
and future prospect of the firms. Under asymmetric informational situation firms
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Poulomi Lahiri
will pay dividends in order to attract foreign institutional investors. Under signal-
ling theory, a positive association between dividend payout policy and foreign insti-
tutional investors is expected (Allen et al., 2000; Jeon et al., 2011). But sometimes
it has been seen that under asymmetric informational situation dividend and institu-
tions act as substitute signalling devices. In that case signalling theory predicts a
negative relation between dividend payout policy and FII (Short et al., 2002).
Asymmetric informational theory assumes that the agency or the signalling
theory arises out of the conflict between managers (controllers) and shareholders
(outside) (Bhattacharya, 1979; Jensen, 1986; Miller and Rock, 1985). But, in
India, this agency cost problem takes place between large controlling owner-
managers and minority shareholders (Sarkar, 2010). In India, foreign institutional
investors are investors as well as equity holders of those respective...