The Hindu Business Line : Reduced FII flows are no threat

STOCK prices are on a high after two consecutive years of strong inflows from foreign institutional investors. Now market participants, especially retail investors, are a worried lot. They are now fretting about the possible impact of lesser foreign institutional inflows.

The threat of a sharp decline in stock prices post-Budget is now rearing its head. Although stock prices have bounced back strongly over the past week, warnings calls to stay away from equities still abound. These issues, however, should not overly perturb a long-term investor.

Over a longer term, profit performance, efficient resources management and corporate governance will influence sustainable returns more than excess liquidity created by overseas inflows.

Disinvestment and IPOs: The cumulative inflows from foreign institutional investors in 2003 and 2004 were of the order of about $15 billion. In the preceding years, annual inflows never topped $2.5 billion. Therefore, a link can clearly be established between the across-the-board rally in stock prices in 2003 and 2004 and the inflows from abroad.

Though FIIs buy predominantly into larger companies, investors who sell to FIIs re-invest their proceeds in other stocks, leading to a market-wide increase in values. In this context, substantially lower FII flows will certainly threaten valuations.

Will flows, however, decline at all? Reports suggest that cross-border flows may remain stagnant this year or may fall about 5 per cent.

There are also reports that suggest that although fund managers think the valuation of Indian stocks is on the higher side, the attractiveness of the Indian market has not declined.

There are also studies by foreign brokerages that speak highly of corporate governance in India relative to other Asian markets. This could cumulatively mean that strong flows into India will continue in 2005 as well.

The key to the quantum of inflows, however, lies in the disinvestment programme and capital mobilisation plans of Indian industry.

If the disinvestments programme is on track and the number of large companies that come out with public offers keep pace, then the quantum of flows from institutional investors will remain robust.

If, however, there is a lull in either the disinvestments programme or the pace of offers from large companies, then FII flows will be lower than in the two previous years.

Stock prices and flows: Even if the pace of disinvestments and listing of large unlisted entities slacken, stock market liquidity will be threatened only if FII flows decline sharply. If cross-border inflows are anywhere closer to $5 billion, the impact on liquidity will still be positive. Only FII flows, which are substantially lower than $5 billion can lead to substantial drop in liquidity.

Larger FII flows, on the other hand, does not mean that stock prices will keep going up. FII purchases alone do not necessarily lead to a sharp upturn in prices. For instance, consider April 2004. FIIs bought stock worth $1.6 billion.

The leading indices, however, stayed flat in April 2004. In contrast, FIIs bought only about half a billion dollars worth of stock in September 2004.

Stock prices ruled firm and edged higher by about 7 per cent. A monthly gain of 7 per cent can be considered significant. Stock prices can, as such, stay down despite firm flows from abroad.

Over the longer term, however, the key issue is not flows from abroad. The issue is about an increase in the level of household participation in the equity market. A marginal shift in the asset allocation pattern of household investors will flood the equity market with substantially large inflows.

The defined contribution pension plan introduced for new government employees and increased sales of unit-linked insurance plans could achieve just that. In such a backdrop, lower flows from abroad will not be missed at all.

Focus on fundamentals: Over a longer term, however, what matters is profit performance, and the efficient use of resources matters more than liquidity. The sustainable return from investments in equity is directly linked to profit growth.

Liquidity will only ensure that return from equities will be disproportionately higher than profit growth. If, however, profit growth of Indian industry is in double digits, then equities can generate superior returns to investors even without any re-rating of stock prices.

As such, continued investment in the equity market over the next decade still holds the key to building wealth.

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