Destabilising flows

The record foreign portfolio flows have lifted the equity benchmark indices to life-time highs and pushed bond yields to 16-month lows, but there is a negative underside to this. Foreign investors have ploughed in money, expecting the new government to speed up economic growth, increase corporate earnings and ensure currency stability. While the $12 billion received from the beginning of this year until the Lok Sabha election verdict could have been largely in the nature of speculative bets taken by hedge funds and other short-term investors, the $28 billion received after the BJP took charge at the Centre shows that FIIs are betting on a superior performance by the new government. Any disappointment on this front can make this money reverse direction.

Indian stocks markets are not deep and liquid enough to absorb such burgeoning flows from overseas investors. Daily trading on our exchanges is concentrated in the top-200 stocks with just 100 stocks accounting for more than three-fourth of the turnover. With foreign investor demand percolating to other more illiquid stocks with lower public holding, their stock prices have surged to unreasonable levels. The stretched valuation of the mid- and small-cap stocks is a fallout of this demand-supply imbalance. There are also indications that money that is entering our markets in recent times could be of a short-term variety. Issue of participatory notes — that are used by overseas investors who do not wish to register with the Securities and Exchange Board of India to invest in Indian stocks and bonds — hit a six-year high in August. A glance down the list of stocks that have witnessed an increase in the holdings of foreign investors also emits disturbing signals. Many stocks with very poor fundamentals have recorded a significant jump in foreign holding. Given that foreign investors already own 40 per cent of the freely traded stocks in the country, any further increase in foreign holding will further expose our market to short-term volatility.

The bond market too is currently facing a similar threat. About two-third of the foreign flows received after the elections were into debt. The bout of volatility witnessed in this segment last year shows that the current limits on FPI investments in bonds do not necessarily protect this segment from short-term shocks caused by sudden outflow of FPI funds. The central bank should maintain the current limits on FPI investments in debt instruments. Also the Reserve Bank of India should not be in a rush to make India a part of the Emerging Market Bond Index. While this will lead to higher flows, the attendant risk of removing all restrictions on fund flows is one that we cannot afford to take at this juncture.

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