Tracing FII flows

Vikas Khemani | Updated on November 17, 2017

As we approach 2013, the outlook appears to be improving on several fronts.

GDP growth at a low of 5.1 per cent, Current Account Deficit (CAD) in the high 3 per cent realm, the rupee hovering at around 54 to a dollar and stressed corporate earnings — logically speaking all these factors should make for a pretty dismal scenario. Under these circumstances, fund flow from foreign institutional investors and hence the markets should be depressed.

Why then are the Indian markets up almost 30 per cent from the lows of December last year and FII fund flow at around $22 billion in the secondary market, at a high? Do the markets and the FIIs know something that all of us are missing out on? Or are they being overly optimistic?

Neither actually. What is happening over the course of last 12 months is that the sentiment concerning the Indian markets has undergone a sea change. Around this time last year, the Government seemed paralysed and unable to deal with the worsening macro-economic situation. Despite the efforts of the Reserve Bank of India (RBI), inflation was proving to be sticky, interest rates were high.

The Union Budget in March 2012 also introduced General Anti-Avoidance Rules (GAAR) which proposed to impose tax on the gains of FII investments routed from tax havens. This came as a big jolt to the market as a significant value of Indian stocks is held via P-Notes. Within 3-4 months of the announcement, the value of Indian securities held via P-Notes fell around 38 per cent.

FIIs also shifted their trading base from tax havens such as Mauritius to avoid any repercussions. Stability emerged, however, with the subsequent postponement of GAAR, which then led to revival in the P-Note participation. The calm, however, did not last long. As European debt crisis escalated and India’s balance of payments deteriorated, the rupee witnessed a very steep fall. This created further uncertainty with regard to inflation (through currency weakness) and foreign currency borrowings of the corporates.

With the change of guard at the Finance Ministry, though, things began to stabilise. Over the last few months, the Government has initiated a slew of politically difficult measures to turn around the business and market sentiment. These included hike in fuel prices to contain fiscal slippages, liberalising capital account to improve Balance of Payments situation, making progress on SEB debt restructuring and coal prices pooling, hiking FDI limit in multi-brand retail, and very recently, introducing direct cash transfers for government welfare schemes. These measures suggested that Government is becoming serious about arresting the economic downturn.

As we approach 2013, the outlook appears to be improving on several fronts. Externally, high frequency indicators from the US and China are showing an improvement and this, along with INR depreciation, offers hope for India’s exports. Besides, the tail risks arising out of Europe have also receded with the ECB’s more explicit intervention.

Enhanced QE3 will mean more funds flowing into the emerging markets and among these, India’s attractiveness continues to remain strong. Brazil’s commodity-focused economy has slowed down to near standstill. China is also slowing and there are additional concerns because of the political transition. Russia over the last few years has become an economy heavily focused on energy exports and has been losing focus among investors due to high concentration of sector risk. The only other emerging nation of comparable size that continues to be attractive to FIIs is Indonesia.

Domestically, the economy seems to be bottoming out. Government is shedding its earlier inertia. The RBI, too, seems more inclined to reduce interest rate now than six months ago. These measures may support cyclical recovery in the economy, although lingering issues in several sectors such as power, mining, etc, will continue to be a drag on the economy. On corporate earnings side, the pace of downgrades has slowed substantially and valuations are not rich, especially in view of the fact that India’s relative growth prospects are still attractive. These factors will be supportive of capital flows in the coming year. We foresee continued flows from hedge funds and long-only fund as the governments’ reforms get on track and economic outlook improves. However, since ETF flows are highly driven by the momentum of the market, they may see more subdued participation with markets nearing all-time high levels.

The one critical risk which can upset the momentum in 2013 is political risk. If the reforms surge slows down or stalls because of a political crisis, the markets could react adversely. But if the last few months are any indication, the likelihood of that happening is remote.

(The author is President & Co-Head – Wholesale Capital Markets, Edelweiss Financial Services)

Published on December 15, 2012

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