7 Reasons Why FIIs Will Keep Pumping Money Into Indian Market

Foreign institutional investors (FIIs) have invested more than Rs 80,500 crore in 2009. For some, it may be just another factoid, but when we look at it from the perspective of the Indian equity market the massive inflow has far-reaching consequences. The inflow helped Indian equity market to turn around from the negative return of year 2008 and post one of the best returns in the last two decades - return in excess of 75 per cent! The last time we witnessed return in excess of 75 per cent was in 1991. That was mainly because the then Finance Minister and present Prime Minister Dr Manmohan Singh ushered in new economic policy of liberalization, privatization and globalization and creating euphoria that resulted in historic market returns. So will India be lucky to repeat the inflows of 2009 again in 2010? But before we come to that, we will try to understand the nature of FII investments and their importance in shaping the market direction and returns.

[INSERT_1] 

At the dawn of year 2009 we were staring at uncertainty in the global markets and also facing one of the worst corporate governance issues (Satyam Computers) in India. But as we stand at the dusk of 2009, we find most of the crises have blown away and although certain patches of uncertainty in the global recovery still remain, things are clearer than they were at the start of the year. Undoubtedly, this has helped attract record inflow of FII money into Indian equity market, despite 70 per cent fall in new registrations of FIIs in 2009 (see graph). In 2008, when market was down 53 per cent and FIIs pulled out about Rs 53,000 crore (USD 11.3 billion) from Indian market, 375 new FIIs got registered in India as compared to just 111 in 2009. At the end of November 2009, there were 1705 FIIs registered in India. One of the reasons for such low registration numbers might be that many of the hedge funds that were very active during pre-crisis time have either liquidated or significantly cut down their exposure to emerging markets and are still treading with caution. This means that the amount has been pumped by the existing FIIs only, which is also substantiated by the fact that registration of new sub-accounts has declined by 60 per cent. In 2009, only 475 new sub-accounts were registered as against 1,228 in 2008.

FIIs have fuelled rallies in stock markets across the world, but they have been also accused of fuelling volatility. If the past evidence of FIIs’ investing pattern in a different country is anything to go by, FIIs seem to be more sensitive to bad news than good news. This means FIIs are more cautious while investing than while withdrawing it. The explanation to this behaviour is that FIIs are risk-averse, which makes them react in a knee-jerk fashion to bad news. Moreover, they view every market as an asset in their global portfolio and, therefore, they tend to restructure and rebalance their portfolio dynamically across countries to minimize and maintain healthy returns on their portfolio. Even among FIIs it is investment through participatory notes (P-Notes), which is considered as prime source of ‘hot money’ and hence volatility. This is because there is little clarity on who the actual investors are and the source of their money. To keep tabs on this hot money, SEBI banned investment through P-Notes on October 17, 2007, resulting in crash of the benchmark Sensex and suspension of trading for an hour. But the latest SEBI figures suggest that supplies of this hot money are on the decline. In 2007, investment through P-Notes constituted 45.5 per cent of FIIs’ total assets under management, which has come down to just 16.21 per cent in 2009 (see graph). This is on the backdrop of SEBI lifting the ban on investment through P-Notes. The drop may be attributed to the fear of the regulator imposing the ban again.

One of the reasons for FII money seeking global investment avenues was the fiscal stimulus packages provided by governments across the world as also the lack of demand from the real economy. The FII money found its way to the different financial asset classes, including emerging markets. To understand how important and effective these FII investments are for Indian equity market, we analyzed data of last 117 months (from July 98) for FII inflows (or outflows) and the returns generated by BSE Sensex in the corresponding period. It was not surprising to find that Sensex had given positive returns only eight times despite negative flows from FIIs. In almost 70 per cent of the times, Sensex and inflows moved in tandem. Therefore, it is no coincidence that in the history of the Indian equity market the only time when Sensex and Nifty were closed due to upper circuit in May 2009 also happens to be the month when FII inflows were highest at Rs 20,607 crore.

[INSERT_2]

Now, let us check where all this money got parked. After the second quarter of FY10, FIIs have raised their stake in more than 200 companies. The sectors where they particularly evinced keen interest were construction, infrastructure and heavy engineering. These are also the sectors where demand has more to do with domestic consumption. These were also the sectors that suffered the worst last year due to credit crisis and got hammered on the bourses. So how do these fare in terms of returns as compared to the broader market and peers? We find that these outperformed, both sector-wise and company-wise. For example, HCC, Sobha Developers whose returns were 227 per cent and 223 per cent, respectively, between April-Sept. 2009 outpaced their respective indices by a wide margin. HCC, which is part of BSE 200 and Sobha Developers, which is part of BSE Realty are up by just 80 per cent and 174 per cent, respectively. Similarly, BSE Realty gave returns of 174 per cent as compared to 73 per cent by Sensex.

 

Of course, FIIs have not increased their stake in all the companies, they have also lowered their holdings in various companies, most of whom belong to media and entertainment. For example, FIIs have reduced their holdings in NDTV from 23.14 per cent to 18.76 per cent between April-Sept. 2009. Similarly, they reduced it from 17.99 per cent to 13.97 per cent in TV Eighteen during the same time period. However, when we calculate the returns of these companies in the same period we do not find that they have underperformed the market. For example, NDTV has moved up 88 per cent, while BSE TECK is up 74 per cent. Clearly, although FIIs are an important force that moves the stock market, they are not the only ones to influence it.

 

When we analyzed the FII investments in terms of company categorized by market capitalization, we came across a startling revelation that instead of choosing the large caps or Nifty companies, FIIs have instead shown more interest in small and mid cap companies like HDIL, Indiabulls Real Estate, 3i Infotech, etc. and this might be one of the reasons why returns of these indices had outperformed Sensex and Nifty. For example, CNX Midcap had given returns of 96 per cent between March-Sept. 2009 (exceeding the 66 per cent return given by Nifty).

Having established the fact that FIIs greatly influence the stock market, we will now try to understand the factors that determine the FIIs inflows and why they will invest in the Indian market in 2010. We believe FII investments in India will be driven by seven major factors that are listed below.

 

“Liquidity moves the markets, which in turn, attract more liquidity,” says Ambareesh Baliga, VP, Karvy Stock Broking and remains the single most important factor which determines the FIIs inflow.

 

We feel that global economy is still flush with liquidity and will remain at this level till second quarter next year. The excess cash in the US banking system has risen by USD 400 billion since March 2009 and has reached USD one trillion in December as quantitative easing (QE) exceeded the liquidation of credit facilities. With QE ending on Q1CY10 and little room for further reduction in various credit facilities, the excess cash in the US banking system should stay close to a trillion dollar throughout 2010. Even in euro area, liquidity is expected to remain at higher level till the second half of 2010. The amount of such excess liquidity in the euro area banking system is estimated to be euro 150 billion and this will remain till June 2010, after which it may recede after European Central Bank (ECB) stops providing unlimited liquidity and goes back to offering fixed amount at variable rates. In contrast to US Federal Reserve & ECB, Bank of Japan is set to inject more liquidity into the banking system. This is evident from the recent policies by these governments wherein Japanese government unveiled a 7.2 trillion yen (USD 81 billion) economic stimulus package and USA government decided to deploy no more than USD 550 billion from the Troubled Asset Relief Program, which was supposed to expire by December 31st if no action had been taken. Therefore, we believe liquidity will not be sucked out of the global economy in a hurry and part of this liquidity will definitely finds its way into Indian equity market.

 

Indian Growth Story
Liquidity and corresponding inflows is like a double-edged sword, and although it helps create wealth by better market returns, “it also creates bubbles in different asset classes, including art and paints” says Mohit Mirchandani, Head of Equity Investments, Taurus Mutual Fund. Therefore, high liquidity creates the problem of absorbing the high inflows with its side effects. But we feel this is not a big concern in case of India. “If the government goes for PSU divestment as planned, our market will become deeper and will absorb this extra inflows in 2010 and yet avoid much of its pitfalls,” says Mirchandani. Apart from this, many fresh issues are lined up, which will take care of extra liquidity. Fresh equity issuance (FPO/IPO/QIP) will continue over the next few quarters and will remain an important source of capital for the private sector till deleveraging is complete and credit growth improves and is incremental.
[PAGE BREAK]
"Bank credit-deposit ratios reach 65-70 per cent. This will attract inflows initially in the primary markets and also bring in more actively traded stocks into the secondary market universe for investments,” says V. Sriram, Head - Wealth Management, Centrum Broking. That apart, Indian economy is more dependent on domestic consumption, which contributes more than 60 per cent of the GDP. This makes it less vulnerable than those economies, which are more dependent on export sector and commodity cycle. The latest GDP growth figure for second quarter reiterates the confidence with the economy growing by 7.9 per cent. We believe that once the global recovery comes back on track, India’s GDP will accelerate further, giving more reasons for FIIs to be a part of the Indian growth story.

 

Diversified Opportunity
India offers a much more diversified market than markets such Russia, Brazil or even China. These economies are largely based on commodities like crude and less in terms of primary articles and products. India offers opportunities in IT, banking, services and the range of listed companies available in India is much broader than in Eastern Europe or Russia. However, Chinese market provides a much bigger size in financial and raw materials market, but India still offers more diversified stocks than any other emerging market to an investor. “India offers diversified exposure across various sectors covering consumers, industries, materials, financials, healthcare, technology, etc. and depending on the evolving economic outlook, one can definitely absorb flows in various pockets,” says V. Sriram. Moreover, India is less volatile than many emerging markets and more transparent to international investor community – something that would always give a premium over the long-term. Hence, long-term investors such as pension funds whose investment horizon is much longer (about 10-15 years) are also attracted.

[INSERT_1] 

Although Indian market ranks among the top half of the costliest emerging markets, so certainly we are not cheap when trading at around 15 times the forward earnings. But when we speak of these stretched valuations, it is mainly related to broader market indices like Sensex and Nifty and earning multiples of companies on those indices. “But if we scratch the surface and look at mid caps and small caps, there are many companies which are available at very cheap price. The year 2010 will be more of stock-picking rather than sector-specific. So, there might be some scrips which might go up to 300 per cent, while the market may stay range-bound,” opines Mirchandani. Moreover, till now it was the government spending (either directly through stimulus packages or indirectly through doling out money through 6th Pay Commission) that has been the driving force of recovery but now what will take the market forward is the investment cycle and capacity utilization which is slated to accelerate next year, though it will remain below the pre-crisis level. Nonetheless, it will translate into better growth numbers for India Inc. We believe that there is still scope of upgrading of corporate earnings in certain pockets, which will take care of some of the concerns on higher valuation.

Carry Trades
Other important factor in India’s favour and which is attracting FII inflows is the relatively higher interest rate. The current near-zero interest rate in the USA and Japan as against the 4-5 per cent in the Indian market gives rise to a strategy called 'carry trade', which involves borrowing in lower yielding (US dollar or Japanese yen) assets and investing in higher yielding assets (rupee) and pocket the difference. Ideally, whatever gain one would have expected from this strategy should be negated by the expected movement in exchange rate, but so far the strategy has worked profitably on an average. Going forward, we do not find any compelling reasons to justify the reverse of dollar carry trade. In addition, the US Fed is expected to hold its interest rates at its current range of 0.0-0.25 per cent until the end of Q3 of 2010, after which it may embark upon a slow process of policy normalization with slight increase of 0.5 per cent during the last quarter of 2010. Other major central banks such European Central Bank and Bank of Japan are expected to follow suit. Till the time differential interest rates remain at these levels and other things remaining equal, we can expect the flow to continue. According to one of the studies, the size of dollar carry trade has increased to USD 500 billion in first half of 2009 and yen carry trade grew to one trillion dollar between 2004 and 2007.

[INSERT_2]

US Dollar Index
The movement of dollar index, a measure of the performance of the US dollar against a basket of currencies including the yen and euro is one of the most important factors which will shape the future FII inflows. It has been observed that there is inverse relationship between dollar index and Sensex (see graph). Therefore, when Sensex hit its low on March 9th, it was no coincidence that dollar index too hit its high of 89. From there, Sensex started its ascent and touched high of 17,360 on December 24, 2009, whereas dollar index declined to 77.89 after hitting low of 74.26 on November 25, 2009. Dollar index actually measures risk aversion: when it declines, FIIs look at investing to riskier assets and vice versa. Some of the market observers feel that the dollar index has bottomed out and is poised for a rally in 2010. It is evidenced by the recent rally of dollar by 4.8 per cent from its recent low of 74.26. It is still premature to come to any conclusion about the future course of dollar index and jury is still not out, but it is worth mentioning that despite such ascent of the dollar, Sensex has continued its climb. Therefore, it appears that somehow the two have decoupled as of now. In addition, the US dollar, after loosing ground to most of the major currencies throughout 2009, resurrected after the Dubai crisis. We feel that this was partly due to investors playing safe rather than sorry. This may also be explained by investors’ tendency of taking away profit from the table as the year draws to a close.

 

Political Stability
India being the largest democracy in the world definitely inspires confidence in the Indian economy. This also reduces the risk premium of the country from the FIIs’ perspective. The FIIs’ confidence got a further boost after May 2009 general elections,
[PAGE BREAK]
which gave a clear mandate to the Congress party and ushered in the Manmohan Singh government once again. This was cheered by the market and for the first time Sensex and Nifty hit the upper circuit. This led to the return of risk capital into Indian equity market. Recognizing the importance of FIIs to the Indian stock market, the government has played its own role and Finance Minister has constituted a working group to recommend changes in the existing policies so as to attract more portfolio investments. The Finance Minister has also gone on record stating that as of now there is no need to tax capital inflows, which as a policy has been adopted by some of other emerging markets. Last, but not the least, India’s democratic polity would always enable a premium over the long term.

 

To conclude, the world recognizes that India and China will provide the growth impetus for the global economy, but what differentiates India is its peculiar demographic dividend which will last longer than many emerging economies, its political system and new vigour in India Inc. to take on the challenges of global competition. Therefore, we believe that the FII inflows will remain intact over the long term, although we might see some temporary blips occasionally.