Colour of FII money

There is widespread belief that foreign institutional investors (FIIs) are pulling money out of India and thus causing erosion in the value of the rupee.

This is definitely true of debt, with the FIIs pulling out around $3.2 billion in fixed income assets this calendar. But these investors have, at the same time, displayed remarkable equanimity with their equity investments, pumping in $12.5 billion into the country's share market so far this year.

Some might point out that even in equities, there was an FII outflow of around $1.8 billion in June and $1 billion in July.

But while there was a pull-out in June, FIIs were actually net buyers in July if we make adjustments for their stake sales in the very enticingly-priced Hindustan Unilever open offer.

FIIs puzzle

This is not the first time that foreign investors have acted in this bewildering manner.

A similar behaviour was observed in 2011 too, when FIIs shrugged aside a host of negatives and remained invested even as the Sensex declined 24 per cent. Net FII outflows were a mere $358 million in that year.

The above observed attachment to India stocks is hard to understand in some way. It is the concern over the US Federal Reserve's tapering its liquidity infusion programme, leading to reduced foreign portfolio flows to emerging market including India, that has been a major cause of FII exodus from the country’s bond markets over the last two months.

But then, the same argument ought to be applicable to equity investments as well. After all, the returns to FIIs on equity investments, too, would have reduced with a sliding currency, as seen in recent months.

India’s macro environment has also been far from conducive. GDP growth is at a decade’s low, industrial production is contracting, there is a notable slowdown in investment, consumer price inflation is showing no signs of declining and the current account deficit is threatening to run out of control.

The corporate score card is not too inspiring either, with both revenue and earnings growth contracting rapidly.

One argument that was being forwarded earlier in favour of India was its relatively superior economic growth led by domestic consumption.

But both slowing domestic consumption and low real GDP growth now have placed India in a position of weakness vis-à-vis its emerging market peers.

Numbers do not add up

The strong inflows into India also contrast starkly with other emerging markets in Asia such as Indonesia, Thailand, South Korea and the Philippines, which have received meagre flows so far in 2013 with some even recording net outflows.

While all these economies are in the same league as India in struggling with slowing economic growth and high inflation, foreign investors nevertheless appear to be more ‘tolerant’ towards India alone.

One way to solve this conundrum would be to look at the source of the FII money. FIIs are not a homogenous lot: They represent a bunch of global pension funds, insurance funds, wealth managers besides mutual funds and ETFs who invest in countries across the globe.

Their allocation to a country would vary according to their perception of the prospects of the country.

According to EPFR Global, a global fund-flow database provider, India-dedicated funds — which raise money overseas for investing into Indian equity — recorded net outflows of $951 million in the first three months of 2013. Yet according to SEBI, FIIs have net purchased $10 billion in the same period.

India-focused exchange traded funds listed overseas have also recorded pull-outs so far this year. WisdomTree India Earning Fund recorded net outflow of $53 million — that is about 7 per cent of the fund’s market capitalisation — since the beginning of this year.

Another India-focused ETF, Ipath MSCI India Equity too saw an erosion of 3 per cent of its assets so far this calendar.

Some of the inflow could have been routed through Global Emerging Market funds, Asia ex-Japan Funds or BRIC Funds. Since India is part of these groups, the fixed apportioning of funds within member countries could have resulted in some money coming to Indian equity from these sources.

A quick calculation reveals that $3-4 billion could have been received through the GEM and Asia-ex-Japan funds in the first four months of this year. While hedge funds, sovereign wealth funds and other wealth management funds could have brought in another $2 billion, the $12.5 billion of inflows is still not completely accounted for.

Why are FIIs staying put?

Understanding this gap in FII flows will also answer the question about why the pull-out is so mild this year and in 2011. A significant proportion of the unaccounted portion of the FII inflows could be round-tripping money that is entering the country camouflaged as FII money. This money might not be free to move out at will.

The market regulator, SEBI, has put in a series of measure over the years to clean up this route. The participatory note route was sanitised after the clampdown in 2007. SEBI, in 2010, directed entities with multi-layered structures investing out of offshore centres to change their business structure.

This made many FIIs cancel their registration then. Action was also initiated against a couple of big FIIs such as Societe Generale and Barclays Capital for not disclosing the right information in 2010.

But these measures have clearly not been sufficient to stop the misuse of the FII route.

How else would one explain the fact that foreign portfolio flows dried up soon after former Finance Minister Pranab Mukherjee proposed including General Anti-Avoidance Rules (GAAR) in the 2012 Budget and the flows miraculously revived once his current successor P Chidambaram postponed the implementation of GAAR.

These rules would have given Indian tax authorities the power to question the source of funds routed into Indian markets from offshore tax havens.

So a large chunk of the $138-billion investment of FIIs into India could actually belong to Indians. In a lighter vein, this ensures that our market and the economy are not at too great a risk of a collapse caused from FII pull-out.

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