DSIJ Mindshare

Warming Up

Foreign Institutional Investors (FIIs) have been one of the most potent forces in the Indian equity market. After a blip caused by the Lehman crisis way back in 2008, FIIs were quite active in Indian equities in the two years that followed. However, 2011 wasn’t a great year on this front. FIIs, the most important faction that drives Indian equities, had lost interest in the market thanks to a host of macro-economic reasons. 2012 is panning out to be diametrically opposite to what happened in 2011, as the FIIs have rekindled their fancy for Indian equities.

A net of Rs 42000 crore has been invested by FIIs in Indian equities from the beginning of the year till 30th June, 2012. However, as always, just as they had begun to get a grip on the market, our own policy makers managed to scare them off (though only temporarily) by implementing the General Anti Avoidance Rule (GAAR) in the middle of March. A knee-jerk reaction to the ambiguity surrounding the tax provision led to some slowdown in FII inflows. The three months ending June 2012 saw a net outflow, though only marginal (at Rs 2000 crore).

Nevertheless, after the government issue some clarification on GAAR, FIIs have again resumed their shopping and have pumped in more than USD 1 billion in July 2012 till date. This is reason enough for us to reiterate what we had said in our Issue No. 4 (dated February 12, 2012) – ‘FIIs Are Set To Come In’.


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Who Matters?

It is a rather well-established fact that FII inflows have a strong correlation with the returns provided by the equity markets in which they invest. In case of India, this correlation stands at 0.4. What this effectively means is that if the equity market is outperforming, it is bound to attract smart money from FIIs.

There is another school of thought, though, which believes exactly the opposite. According to this, it is the FIIs that push up the market and generate positive returns.

To establish the actual relation, we, at DSIJ, regressed the monthly FII flows with the monthly returns of the BSE Sensex for the last 233 months. Our findings suggest that stock market returns are the cause and not the effect of FII inflows, and almost one-fifth of FII inflows are attributed to the returns generated by the markets.

If we look at the recent performance of the stock indices in India, we find that they have outperformed most of the emerging markets on a year-till-date basis, raising the hopes of better FIIs inflows going forward. This is best echoed in the improving performance of the MSCI India Index, which has gained a lot of strength over the past six months. Its rank among the 31 emerging market indices has improved from number 20 in the past one year to seventh on a year-till-date basis and an even better sixth spot in the past three months.

This outperformance has to be viewed in the background of the turbulence that the Indian macro-economic scene weathered in recent times. As though a stubborn inflationary scenario and widening twin deficits were not enough, we saw a series of downgrades that further exacerbated the situation. First, it was S&P that downgraded its outlook on India, and this was closely followed by Fitch. Another set of downgrades that hurt the market sentiment was the lowering of expectations on the GDP growth front by various international financial institutions and brokerage houses.[PAGE BREAK]

Outperformance under such circumstances reflects the resilience of the Indian equity market. The worst is behind us now, and the situation will only improve here on. In fact, there are various other compelling reasons that reinforce our conviction that the Indian market will continue to show its buoyancy. This, in turn, will attract more FII inflows. One of the primary factors, as we see it, is the rupee, which is bound to strengthen from here.

Rupee Depreciation: The Worst is Over

Last year (CY2011), FIIs lost more than local investors did, as they had to bear losses on account of the Indian rupee’s depreciation against the USD. The BSE Sensex fell by 25 per cent last year, whereas its performance declined by 36 per cent in dollar terms. The slide continued this year too, with the  rupee witnessing a fall since the beginning of the year to hit an all-time low of Rs 57.37 to a dollar.

In the past couple of weeks, the rupee has appreciated by four per cent from that bottom. This immediate strengthen in the currency was due to various steps taken by the RBI (See Box). However, long-term strength for the rupee will come from a structural improvement in the country’s current account balance.

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The Indian rupee became the worst performing currency among its Asian  peers last year, and one of the reasons for such underperformance was the worsening condition of the current account. India’s current account deficit (CAD) more than doubled to USD 78.2 billion in 2011-12 in absolute terms as compared to 2008-09, while it is at 4.2 per cent as a percentage of the GDP, almost twice that of 2008-09.

Nonetheless, things look set to change going forward. One thing that will definitely help is the decline in the price of crude oil, which is down by more than 20 per cent from its peak over the last few weeks. Some amount of calculation reveals that this will reduce the CAD as a percentage of the GDP for next year by around 100 basis points to 3.2 per cent, assuming that the economy grows at six per cent and that crude oil imports grow on a prorata basis next year. This will definitely provide some stability to the Indian rupee and will strengthen it.

According to an estimate by CRISIL, the rupee is likely to appreciate to around 50 per dollar by March-end 2013 from the current levels of 56.3 per dollar (as on June 29, 2012). This appreciation alone will provide a 10 per cent return to FIIs which are likely to invest now, and this looks quite attractive in the current scenario.

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Commodity Prices: A Decline Will Add To FIIs’ Returns

Not only are the crude oil prices coming down, but other commodity prices are also following suit. Most of the commodities that are a part of the Dow Jones-UBS Commodity Index have seen their prices decline on a year-till-date basis. Out of the total list of 88 commodities that trades in DJUBS commodity index, 52 are trading lower than where they were at the start of the year. This downturn seems to be more acute if we consider the data for the past one month, where 64 commodities have witnessed a decline in their prices. On an average, commodity prices have fallen by 3.5 per cent in the past one month.

One of the reasons for such a fall is the deceleration of the world’s largest commodity-consuming country, China. It has been rightly said, “As China goes, so go commodities”. The demand for steel, copper and other industrial metals drops significantly if the Chinese economy slows considerably. This is because these materials are used heavily in construction, which would be at a risk due to the weakness in the Chinese real-estate market, as also because China often accounts for some 40 per cent of the global demand for these materials.

The Indian economy, which is predominantly a consumption-based economy, benefits a lot from the fall in commodity prices. There is lot of evidence suggesting that whenever commodity prices fall, the Indian equity market tends to relatively outperform the other emerging markets.

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Falling commodity prices help India Inc. in two ways. The first is the reduction in the cost of raw materials. For the quarter ending March 2012, the bottomline of India Inc. increased by just five per cent on a yearly basis, and one of the reasons for such a dismal performance was a 21.45 per cent rise in the cost of raw materials. As they constitute 41.3 per cent of sales, any fall in commodity prices will directly boost the bottomline of the companies. It will also help bring down the interest cost, as funds tied up in the working capital cycle will be reduced once the commodity prices come down.

A fall in commodity prices will also help in easing inflation, which has remained above the comfort zone of the RBI for more than 18 months now. Basic metals, chemicals, textiles and fuel, whose prices have seen a sharp correction in the last couple of months, have a weightage of almost 45 per cent in the overall commodities used to calculate headline inflation, i.e. the wholesale price index (WPI). Therefore, we can expect some moderation in inflation in the coming months. This will give the central banker scope to take some much-needed assertive action in its next meeting on July 31 by cutting key policy rates. All of this means an improved performance from the corporate sector, which is a natural force of attracting FIIs to the Indian market.

Policy Paralysis: Small Ticket Reforms On The Cards

The government’s policy inaction and decisions like the implementation of the GAAR remained one of the top reasons for FIIs shying away from the Indian equity market. Such inaction was more due to the impact of the coalition dharma rather than the unwillingness of the government to push reforms.

However, now that Dr Manmohan Singh has taken over the reins as Finance Minister (FM), the market has become more hopeful on the economy front as he is perceived to be more adept at handling such situations. His early comments regarding the need to revive the “animal spirit” to boost  investment and to provide much-needed clarifications on proposals to tax foreign investments also points toward more assertive policy action.[PAGE BREAK]

Some of the recent actions of the government indicate that it is coming out of the policy amber. The statements by some of those at the helm (including the PM) suggest that we may see some decisive action shortly. Some steps have already been taken in this direction, such as the hiking of fuel prices and the awarding of road projects by the NHAI and state agencies.

The government has also used the GOMS and EGOMs to push the allocation of spectrum for telecom companies through via the auction route, as also coal block allocation (Mahan and Chhatrasal blocks) for infrastructure projects. Moreover, it has stepped forward to soothe the frayed nerves of foreign investors by providing clarifications on the proposals to tax foreign investments from April 2013 onwards.

Therefore, we believe that once the presidential elections slated for July 19 are over, we can expect a more investor-friendly policy environment that will help revive the choking investment cycle. This, again, will bring in the FIIs by the hordes.

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Global Uncertainties: Emerging From The Mayhem

It was not just the domestic factors that were dissuading the FIIs from investing in India. The global economic conditions have not been conducive for FII inflows either. Europe is in a spiralling debt mess, China is slowing down a bit, and the US too has not surfaced from its problems. These factors have really impacted the flows, as investors were in search of safer havens.

Nevertheless, we can see some light at the end of the tunnel. Recently, the European Central Bank (ECB) reduced the reference rates by 25 basis points, a move that was largely expected. What surprised many, though, was a cut in the deposit rate to zero per cent and the way this decision was taken in a unanimous manner. The 25 basis points cut in the deposit rate to zero per cent was mostly aimed at incentivising banks to redeposit less with the ECB and to lend more to each other as well as to the economy.

The reason for our guarded optimism on the European front also comes from the pledge of creating a Europe-wide banking supervisor (involving the European Central Bank) before the end of the year. Another factor that adds to the cheer is the fact that the Germans have yielded to the move, which will allow bailout funds to go straight to the banks instead of the governments.

Apart from the Eurozone, which contributes almost a quarter of the world GDP, the next big economy, the US, has maintained its status as a relatively safe haven and fears of a recession there have receded. China, the world’s second largest economy, is also signalling that its economy will not have a hard landing. Unlike the Eurozone, China is in a much better position to deliver fiscal responses. The Chinese authorities will hence use an array of measures across bank lending, infrastructure spending as well as policy rates to bring back growth in the second half of CY12. However, growth will be below double-digits and at a slower pace in order to avoid structural imbalances.

Therefore, we believe that the global situation is not as grim as it is being painted, and as the situation improves, it will help FIIs to look at emerging markets again to park their funds.[PAGE BREAK]

Conclusion

Overall, it seems that factors like rising input costs, high interest burdens, deteriorating balance of payment conditions, forex losses and uncertain global economic conditions, which led FIIs to shun the Indian equity market in the past one year, are showing signs of improvement. This will definitely help the Indian market to better the FII inflows in the second half of CY12 from what it received in the first half. Moreover, the FII inflows trends over the past 10 years suggest that a major chunk of these flows come in during the last four months of the calendar year. Even the current month’s inflows provide hopes of accelerating FII inflows going forward.

In addition to all the factors discussed, the Indian equity market’s attractive valuations on an absolute basis is also helping, as it is trading at its lowest in the past 10 years barring the post-Lehman crisis period. We also believe that we will not see any significant earnings downgrades like those we saw in FY12, wherein the earnings growth forecast started at 14 per cent and ended with just three per cent growth.

However, not all the all sectors and companies are looking equally attractive. It has been observed that FIIs have a strong tendency to add to their existing positions before they buy in new stocks. Hence, look out for those stocks where FIIs are increasing their stake and companies whose fundamentals are intact. In the current economic environment, it would be a wise proposition to have a stock-specific approach to investment.

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