The Foreign Institutional Investors (FIIs) infused a net amount of $ 5.12 billion (about Rs 25,212 crore) during February, taking the total for 2012 so far to $7.16 billion for the Indian stocks. 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 2011 and post one of the best returns in the last two decades . 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 2007 again in 2012? 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.
India may attract better portfolio flows this year. Various conducive factors are present that can encourage these flows. To begin, there is little risk to the long-term GDP growth in our country. Over the last 30 years, India's real GDP growth has averaged about 6.2 per cent. With little dependence on the western world for its growth, a slowdown elsewhere in the world will have little impact on India.
Domestic consumption continues to be key factor driving growth. Good monsoons and higher farm prices should keep the rural economy humming.
Those worried about inflation need to remember that, for India, this is not new phenomenon. In the early 1990s, India had grown despite the high interest rates and inflation. However, for FIIs coming into India with an 8-9 per cent GDP growth assumption, a 6.5 per cent growth could be a disappointment.
The second factor is that valuations of Indian stocks are attractive and earnings growth is good. If the price-to-earnings multiple of our market is considered, stocks are not as cheap as they were in 2003 or 2008 when valuations were less than 10x. If the euro crisis escalates further, we might see those kinds of valuations; however, at the current levels, given the current earnings growth rates in India, it is still attractive as it is below the long-term average of 17.6x. According to Bloomberg's consensus estimate, earnings is expected to grow 25.6 per cent in FY2012 and 16.8 per cent in 2013. Based on these growth estimates, valuations appear reasonable. While no one prefers the policy freeze in New Delhi, a rate of growth in GDP of 6.5- 7 per cent with more equitable growth is far better than a 9 per cent growth number with massive corruption.
57 In the first half of 2012, slowing inflation and lower economic activity would set the stage for the RBI to reverse its monetary policy by cutting interest rates and adding liquidity, thus improving investment sentiment.
As things stand today, foreign investors get to buy more Indian assets for the same dollar due to a weaker rupee. On a long-term basis, given the huge deficits in India, we are of the view that the rupee will depreciate. However, the 16 per cent depreciation in the rupee since August seems unwarranted. So there is a case for currency appreciation, which is positive for an FII. Year-to- date, the rupee has appreciated 7.6 per cent.
Shaky Beginning
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 2012, 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. There was a small increase in the number of Foreign Institutional Investors (FIIs) registered with SEBI. As on March 31, 2011, there were 1,722 FIIs registered with SEBI as compared to 1,713 a year ago, showing an increase of 0.53 percent during the year. There were 5,686 sub-accounts registered with SEBI as on March 31, 2011 as compared to 5,378 as on March 31, 2010, an increase of 5.73 percent
58 How „Hot‟ is Hot Money?
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.
FII Inflows & Their Impact
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 for FII inflows (or outflows) and the returns generated by
59 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. 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 5 per cent in February 2012. Similarly, they reduced it from 17.99 per cent to 11.37 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. 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. 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 2012.
60 As per belief FII investments in India will be driven by seven major factors that are listed below.
Liquidity
―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 3 trillion euros in Feb 2012 as quantitative easing (QE) exceeded the liquidation of credit facilities. So with quarter ending there is little room for further reduction in various credit facilities, the excess cash in the US banking system should stay close to a trillion euro throughout 2012. Even in euro area, liquidity is expected to remain at higher level till the second half of 2012. The amount of such excess liquidity in the euro area banking system is estimated to be €776.941 billion ($1.034 trillion) ie in European Central Bank (ECB)
In contrast to US Federal Reserve & ECB, is set to inject more liquidity into the banking system. This is evident from the recent policies by these governments.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 2012 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.
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 Indian
Government's 2012 economic survey has projected the economic growth at about 7.6% in the next fiscal 2012-13, up from 6.9% estimated in 2011-12 on the back of declining
61 inflation and softening interest rate. It expects the economic growth to further improve to 8.6% in 2013-14.. 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 Opportunity in Indian Companies
Although Indian market ranks among the top half of the costliest emerging markets, so certainly we are not cheap when trading. 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 2012 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.
62 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,in terms of interest rate policy, the US Fed announced no changes. It noted that the Fed funds rate would remain between 0 and 0.25 percent, and reiterated that it was likely to maintain this exceptionally low interest rate stance through late 2014. 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.
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. And now in 2012 when sensex is 17300 dollar index is back on 79.34. Dollar index actually measures risk aversion: when it declines, FIIs look at investing to riskier assets and vice versa.. 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 like what happened in last quarter of 2011
63 (The USD Index measures the performance of the US Dollar against a basket of
currencies: EUR, JPY, GBP, CAD, CHF and SEK)
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, 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.