Most stock market commentators are extremely optimistic and attempt to find a silver lining to every bad news. If rupee crashes, they see value in tech stocks, if rupee gains, they turn bullish on importers. If monsoon is erratic, construction stocks are called a screaming buy; monsoon is good, agri input players are set to speed forward.
Continuing in similar vein, the view being parroted by many analysts and fund managers in recent times is that foreign portfolio investors (FPIs) will plough in more money into emerging markets, including India, in 2019. The argument is that as advanced economies slow down and markets in developed economies correct, portfolio investors will increase allocations to emerging markets.
The concerns about foreign portfolio outflows is not misplaced since these investors have been fuelling the market over the last three decades. If we look at the FPI inflow data since 2000, they have been net sellers in only three years — 2008, 2011 and 2018. The inflows were especially copious between 2009 and 2014 as global central banks began pumping money to avoid recession.
It can be argued that the dependence on FPI flows is reducing of late with net investments by mutual funds and insurance companies surpassing their foreign counterparts’ since 2014. While that is correct, MFs and insurance companies are long-term investors and do not churn their portfolios frequently, unlike FPIs. With 16 per cent share in daily cash turnover and around 12 per cent share in derivative volume, FPIs are able to influence trading in the Indian stock market to a large extent.
But to assume that portfolio flows in 2019 will reverse because of the threat of slowdown in advanced economies is too simplistic. One, ongoing monetary tightening by global central banks is shrinking the global pool of investable surplus. Two, there is a structural decline in portfolio flows into India due to clamp-down on inflows through low-tax jurisdictions. Three, the rupee is among the more vulnerable EM currencies due to India’s external imbalance. FPI flows are, therefore, likely to remain erratic this year too.
Slowdown pangs
Global stock markets have witnessed a steep erosion in stock prices in the last quarter of 2018 led by fears of growth slowdown. After robust growth in the second and third quarter of 2018, the US growth is expected to settle down to more sedate 2.5 per cent in 2019 as the momentum provided by the fiscal stimulus fades.
If the UK exits the European Union without a deal, it is likely to adversely impact the country as well as the foreign companies operating out of the UK. China is already facing the heat of the trade war, with the IMF revising China’s growth lower to 6.2 per cent in 2019 from 6.6 per cent in 2018.
It’s obvious that the prospects of Indian exporters will also diminish if the growth slows down or plateaus in other larger economies. Such slowdown can also impact global investment fund flows, which are typically stronger in periods of healthy economic growth, when investors’ ability to take risk are higher.
The assumption that growth slowdown in advanced economies will make investment flow in to EMs is therefore erroneous as emerging economies will also be impacted by such slow down. Of the global investable funds pool, more than half the funds belong to investors from the US. If the US slows down, the surplus of these investors reduces. Another factor to note is that global surplus is shrinking due to monetary tightening by Fed and other central banks.
Global tightening
The Fed is resorting to monetary policy normalisation through two routes. One, it has begun raising the Fed funds rate that had been moved close to zero following the sub-prime crisis; after the latest hike, the fund rate stands at 2.5 per cent. Besides this, the Fed is also tightening its balance sheet by not reinvesting a portion of the securities issued as part of the quantitative easing programmes.
The European Central Bank has also ended its bond purchase programme and could consider a rate hike in the second part of 2019. The Bank of Japan, the other central bank that is pumping stimulus funds, is tapering its asset purchases and has increased the effective ceiling on 10-year bond yields slightly.
It is an open secret that the era of cheap money, from 2009 to 2015, has led to asset price inflation across the globe. As money becomes more expensive, de-leveraging is the natural outcome as the carry trade loans get repaid.
According to IMF’s Global Financial Stability Report published in October 2018, the impact of US monetary policy normalisation on portfolio flows to EMs has been greater than expected in 2018. EM stocks and bonds witnessed outflows of close to $35 billion from April to September last year.
The report estimates that there could be a further drag on portfolio flows of about $10 billion by the end of 2019 due to Fed’s interest rate hikes. Additionally, with the pace of Fed’s balance sheet contraction to hit its maximum in the fourth quarter of 2018, flows could further reduce by $40 billion in 2019.
There are many who are hoping that there will be no further Fed rate hikes, given the threat of slowdown and with Trump breathing down Powell’s neck. Even so, the Fed balance sheet tightening will continue and the effect of that will impact portfolio inflows.
Also, continuing trade war and geopolitical tensions will keep risk-aversion at elevated levels in 2019. Funds typically move away from riskier EM assets in such conditions.
India-specific factors
Besides, there is a structural shift taking place in Indian foreign portfolio inflows. With growing intolerance towards tax avoidance through low-tax jurisdictions, implementation of many of the BEPS (base erosion and profit shifting) guidelines by India, phasing out the tax advantage enjoyed by investors from Mauritius and implementation of General Anti Avoidance Rules, black money round-tripping using the FPI route is now coming down.
This is evident from the falling value of outstanding p-notes.
Estimates suggested that at least a third of the foreign portfolio flows into the country belonged to Indians. FPI inflows are expected to shrink as these flows reduce. India is moving in the right direction in protecting the country from the risk of heightened portfolio outflows by increasing the participation of domestic investors and reducing dependence on foreign investors in the equity market. Increasing domestic participation in bond markets is another area that needs more attention.