FII effect on rupee

Even as stock prices were falling pell-mell on Thursday afternoon most market participants had their eyes glued to the movement of rupee. The Indian currency declined 2.6 per cent to hit a 28-month low of 49.57 against the dollar.

Rupee movement has a very high correlation with stock price movement in India. This is explained by the fact that foreign institutional investors (FIIs) are the largest group of investors in the Indian stock market and their buying and selling has a big influence on domestic stock prices.

FIIs tend to track rupee movement closely as the returns they make on their Indian holdings can be affected significantly by currency movements.

For instance, the Nifty returned 0.51 per cent in the last one month and domestic investors would have broken even on their Nifty investment. FIIs investing in Nifty would, on the other hand, have lost 6 per cent in the same period largely due to currency movement if they were from the US.

FIIs from other countries too would have made losses but to a lower extent as the rupee has been depreciating against most major currencies, including the yen, euro, pound and Australian dollar over the past month.

It is, therefore, not surprising that FIIs would track rupee closely and their outflows would accelerate in a scenario of rapid currency depreciation.

The stance of FIIs has an equally strong impact on the movement on the Indian currency. On days when Indian stocks witness a sell-off, the rupee too depreciates on fears that FIIs could be moving out of Indian stocks. The situation is the reverse on days when Indian stocks rally.

The fact that our current account deficit is financed mainly through foreign portfolio flows and India's forex reserves of $316 billion is largely built through FII inflows, could explain the influence that these flows have on the rupee's direction.

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