“FIIs are selling, it is time to rush to the exit door”, “FIIs have bought Rs 4,000 crore worth of stocks on Monday, the sentiment is turning bullish” or “FIIs are waiting on the sidelines to see government’s action, stay invested” — remarks such as these abound in the Indian stock market and are a reflection of the influence that foreign institutional investors wield.
These overseas investors are far from a homogenous bunch and are a mix of foreign pension funds, insurance companies, mutual funds, hedge funds, exchange traded funds and so on. But they loom over the equity trading landscape in India through their holding of almost 19 per cent of the country’s market capitalisation.
More than a third of the daily turnover in the cash market and one-fifth of derivative turnover on the National Stock Exchange stems from FII transactions. Most of the reversal points in stock market in recent years have been accompanied by heavy buying or selling by this investor group.
It has, therefore, become imperative for investors to understand the factors that drive the FII fund flows into our country to gauge the direction of the equity market.
A correlation analysis (a statistical measure of how two variables move in relation to each other) between FII fund flow into India and various parameters such as rupee, stock market returns, macro economic performance and so on shows a strong link between FII flows and the movement of the currency and stock prices.
We have used data on FII flows as captured in RBI’s statement of international investment position.
But this linkage has weakened in 2012. With the ‘pull’ factor or the domestic environment turning weak, it is the ‘push’ factor or conditions in countries from which these flows emanate that is now taking over.
Rupee’s moves
The exchange rate movement can play havoc with returns of foreign investors. For instance, in calendar year 2011, when the Sensex lost 24.6 per cent, dollar denominated loss was a steeper 36.7 per cent due to sharp depreciation in rupee against the dollar in that year. In some years such as in 2007, a conducive rupee movement has bolstered returns of these investors.
It is, therefore, not surprising that the correlation between rupee movement and FII inflows was very strong, above 0.9 in the years between 2007 and 2011. The only exception was in 2010 when the correlation dipped to 0.7.
This strong relation is also a function of the fact that foreign portfolio inflows play an important part in shoring up the country’s balance of payment that, in turn, affects the fundamental value of the rupee.
This link, however, weakened in 2012 with the correlation declining to 0.28. Rupee was volatile through the last year and ended 3.5 per cent lower even as FIIs brought in $19 billion.
Stock price returns
It is a ‘chicken and egg’ kind of conundrum in the link between FII flow and equity market returns. While FIIs would bring in more money in rising markets and do the reverse in a falling market, equity prices tend to rally or collapse based on the actions of the FIIs. It is, therefore, not surprising that the average correlation between MSCI India Index and FII flows between 2006 and 2012 was strong at 0.94.
Money flowing into the Indian market also depends upon the performance of the market groups in which India is a member. For instance, strong correlation existed between FII flows into India and performance of the BRIC markets, Emerging Markets and the Asian markets (excluding Japan).
But this link is slackening a little. The correlation between fund flows received by Indian equities and performance of MSCI BRIC Index slipped from an average of over 0.96 prior to 2009 to 0.86 in 2012. Underperformance of Chinese and Brazilian equity markets in the last two years could partly account for this weakening link.
The correlation between FII flows and performance of MSCI Emerging Market Index and MSCI Asia ex-Japan Index also slackened in 2010 and 2011. But the link grew strong in 2012 with correlation of 0.96.
This trend corroborates the view that a chunk of FII money was channelled through emerging market and Asia ex-Japan funds in 2012.
Economic reading
The performance of the Indian economy does not move in tandem with FII flows since these flows would typically precede a reversal in economic conditions by a few quarters. Again, these investors judge this data in relation to the corresponding numbers from other countries. So what appears dire to us might be just fine to the foreign investors.
For instance, in 2012, even as the GDP growth (year on year) fell from 6.1 per cent to 4.5 per cent and industrial production growth declined from 2.7 per cent to -0.5 per cent, FIIs brought $19 billion into India. In 2010 too, even as economic growth stagnated and industrial production growth decelerated accompanied by wholesale price inflation growing at 9.45 per cent, foreign fund inflows hit a record $40 billion.
The drivers
While foreign investors do not appear too fazed by domestic economic data, the timing of these flows seems influenced by economic growth in US and Japanese economies. As the accompanying table depicts, in 2010, the receipt of copious inflow from overseas coincided with US economy moving from contraction of -3 per cent to 2.3 per cent growth. The Japanese economy also recorded similar turnaround in that year.
The same trend is seen in 2012. US economic growth increased by 0.4 percentage points and the Japanese economic growth increased by 2.5 percentage points in that year even as Indian GDP growth decelerated. This can partly explain the $19 billion brought in last year by foreign investors.
Why are the funds flowing into our country influenced by the economic growth in the US and Japan? The answer lies in the fact that a large proportion of investors who invest in these funds come from the US, Japan and the UK. According to CityUK, an organisation that promotes the UK as a financial centre, 46 per cent of investors in global pension, insurance and mutual funds hailed from the US. The UK and Japan were in second and third place, accounting for 8 per cent of the investors each. It, therefore, follows that the economic prosperity in these countries is needed to ensure a steady flow of funds into India.
Central Bank easing
Global liquidity is another factor that affects FII investment. And liquidity since 2008 has mainly been generated by the Central Banks of leading regions, including the US, European Union and Japan. It is easy to draw a link between the timing of the quantitative easing announced by the US Federal Reserve in 2009, 2010 and 2012 and the sudden spurt seen in FII inflows in those periods.
Investors also need to watch out for the interest rate movement in key countries such as the US and Japan. The Bank of Japan maintaining its policy rate below 0.5 per cent since 1995 has given rise to a vibrant yen carry trade wherein investors borrow money in Japan to invest in assets across the globe. This rate has been further lowered to 0.10 per cent since 2009. The Federal Reserve lowering its fund rate to 0.25 per cent since the first quarter of 2009 has resulted in similar carry trade in dollar as well.
Flows from tax havens
According to SEBI, 11 per cent of total assets of foreign institutional investors is currently held in the form of participatory notes or offshore derivative instruments. These instruments are issued by FIIs registered with SEBI to entities outside India. The opaqueness of these instruments led to misuse of this route by money launderers in the past. As most of the P-note holders are based in offshore tax havens such as Mauritius, the Government’s stance towards such investors has a significant impact on FII flows. It may be recalled that in the months following March 2012, when General Anti-Avoidance Rules were introduced in the Union Budget, FII flows dried up and revived only after implementation of GAAR was postponed. A benign government stance towards money flowing in from such sources is thus another factor that keeps these funds flowing.
lokeshwarri.sk@thehindu.co.in