Shifting Sands: Will FIIs Return To Indian Shores?

The Indian equity market currently grapples with a cloud of uncertainty, with volatility reaching its peak. FIIs have been consistent net sellers for months, offloading a significant ₹1.20 lakh crore in 2024 alone. This raises a critical question: Is this indicative of a fundamental shift in their view on the Indian growth story, or are they contending with temporary headwinds? Mandar Wagh delves into the potential reasons behind FII selling and explores when FIIs might return to India. 

While major global indices have been on a tear in 2024, scaling new peaks, India’s frontline indices have presented a more muted performance. 

Despite achieving record highs themselves, the Indian benchmarks have delivered comparatively modest gains of 3-4 per cent year-to-date. This stands in contrast to most other leading indices, which have clocked double-digit returns. 


 

The gain, though small, in the Indian equity market is a testament to the unwavering confidence of domestic institutional investors (DIIs). This stands in stark contrast to the behaviour of foreign institutional investors (FIIs), who have been net sellers. While FIIs remained optimistic on India even during the corona virus-triggered pandemic downturn, attracted by discounted valuations, their stance has demonstrably shifted now. Since 2021, they have been net sellers, offloading a staggering ₹1.20 lakh crore in 2024 alone, excluding a modest buying spree in March driven by expectation of better results around year-end financial performance. 

The FII Effect: A Double-Edged Sword for Indian Markets

The relationship between FII activity and equity market performance is an intricate dynamic. FII inflows serve as a catalyst for the market. As FIIs inject fresh capital, they become eager buyers, driving up demand for stocks. This increased competition pushes the share prices higher, creating an optimistic feedback loop that can fuel a bull run. However, FIIs are also known to be reactive to global market trends and risk appetite. If economic concerns or volatility rise, FIIs might become risk-averse and start pulling out their investments. 

This sudden outflow creates a wave of selling pressure, potentially triggering a correction or even a bear market as the share prices plummet. While FIIs undeniably play a significant role in short-term market fluctuations, their impact on long-term market performance is a topic of ongoing debate. Taking a closer look at the graph, a fascinating relationship emerges between FII activity and the performance of Nifty 500. Both seem to be tightly intertwined, moving in the same direction within a defined range. 


 

When the flows of FIIs increase, Nifty 500 tends to rise as well, suggesting that increased foreign investment boosts the Indian stock market. Conversely, when the FIIs pull out their investments, Nifty 500 typically dips, highlighting the influence of these international players on short-term market movements. This close correlation underscores the importance of monitoring FII activity for anyone interested in understanding the current state and potential future direction of the Indian stock market. 

A shadow of uncertainty hangs over the Indian equity market. FIIs have been net sellers for months, raising a critical question: Is this a fundamental shift in their view of the Indian growth story, or are there temporary headwinds at play? Let’s delve into both domestic and global factors that may be contributing to the pessimistic stance of foreign investors and explore how long they might persist in selling 

Unveiling the Reasons for FIIs’
Persistent Selling Streak

Retail Rush Fuels Rally, But Froth Warns —

Indian headline indices saw a respectable gain of around 25 per cent over the past year. However, the true story lies beyond the blue chips. The Mid-Cap and Small-Cap indices have witnessed a phenomenal surge, clocking in impressive gains of around 65 per cent each, reflecting broad-based market optimism. This robust growth is further underscored by the BSE reaching a milestone USD 5 trillion market capitalisation. It shines a light on the crucial role played by domestic investors, who have stepped up their participation.

In contrast, FIIs have been noticeably absent from the rally, with concerns about overvaluation being a major factor behind their continued selling activity. The recent remarks of Madhabi Puri Buch, Chairperson, Securities and Exchange Board of India, highlighting frothy valuations in the small-cap and mid-cap segments further amplified these concerns, leading to a heavy selloff. Adding to the cautious outlook, brokerage houses like Kotak Securities have warned of a potential period of consolidation in the Indian markets this year due to the prevailing rich valuations.

Asset Reallocation amid Emerging Market Volatility — The reallocation of assets is like rebalancing a seesaw. It involves strategically adjusting your portfolio’s mix to manage risk and return. This could mean diversifying for overall stability, reducing exposure to emerging markets, or capitalising on promising opportunities. The reallocation of assets has prompted some risk-conscious investors to consider withdrawing from emerging markets such as India. This could lead to short-term volatility as FIIs unwind their holdings. However, history has shown that these corrections can present opportunities.

FIIs Shun Sectors with Cloudy Future — While Indian companies have largely reported positive earnings with healthy revenue and profit growth, certain sectors continue to grapple with headwinds, keeping them out of favour with FIIs, who remain cautious about these sectors. Based on NSDL data, a significant portion of selling activity is concentrated in sectors like finance, IT, construction, oil and gas, and FMCG. FIIs have significantly reduced their holdings in the financial services sector, including major players like HDFC Bank, Kotak Mahindra Bank, IndusInd Bank and Bajaj Finance. 

Market experts predict that the return on assets (ROA) will gradually decline due to ongoing margin pressures and slower loan growth, as loan-to-deposit ratios remain tight. Additionally, analysts anticipate limited improvement in credit costs, as the peak of the asset quality cycle has passed. HDFC Bank has fallen out of favour due to its less-than-attractive results post-merger, as the bank’s higher borrowing costs and lower-yielding loan book have negatively impacted the merged entity’s margins.

The FMCG sector has been hit with weak sales and lacklustre profits due to rising expenses. Similarly, the performance of IT companies in fiscal year 2024 points towards a cautious approach for the upcoming fiscal year. Uncertainties surrounding the future growth outlook of these sectors have led to FIIs reducing their stake. FIIs dumped stakes in leading companies like AU Small Finance Bank, Kalyan Jewellers, PVR Inox and Zee Entertainment, with reductions of 5-9 per cent each compared to the previous quarter.

Political Uncertainty Ahead of Lok Sabha Elections — Burned by past experiences, FIIs remain particularly cautious during periods of political uncertainty. The memory of the 2004 Lok Sabha elections, where the unexpected victory of the UPA coalition led to a 15 per cent plunge in the BSE Sensex in a single day, serves as a stark reminder of the potential market volatility triggered by political shifts. This aversion to risk compels FIIs to prioritise stability, and any hint of uncertainty regarding future policies or economic reforms can prompt them to pull back from investments.

As the Lok Sabha election results approach, the market is poised to closely monitor the developments. The current ruling government is targeting majority seats, and failing to achieve this could lead to a market correction, according to experts. Conversely, a strong mandate in favour of the current government is expected to bolster market resilience, particularly with Prime Minister Narendra Modi promising significant reforms within the first 100 days of a new term. 

The low voter turnout and unclear predictions of the election results have fuelled market anxiety. This jittery sentiment was reflected in Nifty VIX, considered a ‘fear gauge’, which skyrocketed by more than 100 per cent in the last month, highlighting investors’ fear and anticipation of sharp price swings. This heightened volatility, fuelled by election uncertainty, has caused FIIs to take a wait-and-see approach, putting a hold on new investments.

The U.S. Factor
Rising concerns over inflation have pushed the U.S. Federal Reserve to adopt a more hawkish stance. This translates to keeping interest rates ‘higher for longer’ than previously anticipated, delaying any potential cuts. This shift has sent shockwaves through the global markets, particularly impacting emerging economies like India. Foreign investors, who typically seek higher returns associated with lower interest rates, are rethinking their strategies. The situation presents a delicate balancing act, where the Federal Reserve’s actions target inflation but could unintentionally trigger temporary setbacks in emerging markets dependent on FII investment.

The U.S. 10-year bond yield has emerged as a beacon for foreign investors seeking a safe haven with attractive returns. This yield, which represents the annualised interest paid on a 10-year U.S. Treasury bond, has become increasingly attractive compared to similar bonds offered in other countries. This attractiveness stems from two factors: first, the relative safety and stability associated with the U.S. government bonds, and secondly, the potential for higher returns compared to other low-risk investment options available globally. The surge in yield enticed foreign investors to shift their assets towards U.S. bonds, potentially leading to increased demand and further price appreciation for these securities. It is one of the reasons foreign investors are fleeing the Indian market in search of global opportunities.

Mauritius Maze: Tax Treaty Tweaks Hit FII Flows
Recent tweaks to the India-Mauritius tax treaty have emerged as a key factor behind FIIs pulling out of the Indian market. The crux of the issue lies in retrospective taxation. Previously, the treaty allowed investments routed through Mauritius to avoid capital gains tax in India. This was attractive to FIIs, who could invest in India while minimising their tax burden. However, the Indian government felt this practice led to lost revenue and introduced retrospective tax changes. These changes essentially removed the tax exemption for Mauritius-based entities if the underlying investments originated from India. This has caused uncertainty and potential tax liabilities for FIIs, prompting them to re-evaluate their investments in India.

Dragon’s Resilience and Gold Rush
The recent outperformance of the Chinese markets has posed a challenge for FIIs in India. While the Indian market has experienced some stagnation, the Chinese markets have surpassed most developed and emerging markets. International financial institutions have expressed confidence in China’s economic outlook, citing a series of targeted macro-policies in sectors like real estate that will continue to yield results. They also anticipate a further sizeable inflow of long-term foreign capital into China’s stock markets. The allure of higher returns in China could entice foreign investors to shift capital, causing short-term volatility in India.

In addition, China has been augmenting its gold reserves as part of a strategy to diversify its foreign exchange holdings away from the U.S. dollar. Such actions by major economies like China can sway the global market sentiment. If China’s moves are interpreted as a pivot away from dollar assets, it can have far-reaching repercussions for global investment flows. The rise in China’s gold acquisitions could be interpreted as a signal of potential global financial instability, prompting investors to re-evaluate their risk exposure.

In the event of heightened expectations of currency instability, global investors may adopt a risk-averse stance. It may lead to FIIs decreasing their exposure in emerging markets, including India, in favour of safer havens like gold. In essence, while there isn’t a direct causal link between China’s gold acquisitions and FIIs divesting Indian assets, the interconnectedness of global financial markets implies that significant actions by major economies can create ripple effects. These effects can influence investor sentiment and trigger broader shifts in investment strategies, including the behaviour of FIIs in the Indian markets.

FIIs’ Homecoming: Awaiting their Return to India
If the Federal Reserve successfully tackles inflation, it could be a game-changer for leading global markets, including India. Lower inflation paves the way for potential interest rate cuts, which can be a shot of adrenaline for economies. This prospect cautiously fosters optimism regarding a potential boost in investor confidence and economic activity. Also, FIIs recently demonstrated heightened engagement in Indian markets, making net equity purchases totalling ₹4,671 crore in a single day following the Reserve Bank of India’s announcement of its approval for the highest-ever surplus transfer of ₹2.11 lakh crore to the central government. This development propelled domestic indices to achieve record highs.

It has reinstated confidence that robust economic reforms, budgetary announcements and government initiatives under the newly elected administration will once again attract FIIs to India, which has long been viewed as an attractive investment destination. Adding to the optimism, both domestic and foreign investors are anticipating a robust political mandate. If this materialises, strong predictions suggest a significant bullish run in the Indian markets, further amplifying India’s allure as an appealing investment destination. The current government’s emphasis on infrastructure development, self-reliance and moving towards a ‘developed’ India highlights a visionary approach to the country’s comprehensive development and self-sufficiency.

This focus has significantly boosted key sectors such as infrastructure, railways, defence, automobiles, semiconductors and renewable energy. Additionally, inclusive development has empowered sectors like MSMEs, banking, financial services, education and skill development. If the current government continues in power, these sectors are expected to experience renewed confidence, potentially accompanied by multiple new announcements. These efforts are likely to attract foreign investors, positioning India on its path to becoming the world’s third-largest economy