Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Friday, 4 January 2013

The "Foreign Hand" in Indian Equities

My month long sojourn in India led to lots of observations, ideas and experiences which I shall write about in due course. Although it was rewarding from both a professional and personal standpoint, overall it led to a tempering of the optimism I felt for the country’s prospects. There has been a palpable ebbing of ebullience over the past year since my last visit. However, not so much for foreign institutional buyers of Indian equities as the graph below shows (something which I have touched upon earlier as well).

Source: SEBI, www.moneycontrol.com

So why are foreigners rushing where locals fear to tread? The first explanation is that of investors blindly running away from zero yields and low returns in the western world. But BRIC mutual funds have posted outflows of $1.65bn according to Bloomberg. Some of flows have gone into ETFs but those have been mainly directed at Brazil and China not India. This implies that the FII inflow into India is due to focused ('smart') investors rather than retail ('dumb') investors. However, this makes the inflow all the more puzzling since the India story is in tatters as GDP growth has collapsed to 5.3% and the current account deficit reaches new highs. This growth rate will be unable to absorb the expected 63.5 million people which are expected to enter the workforce over 2011-16. A fractured, out-of-touch and increasingly corrupt polity has ensured an environment of policy stasis (for the FDI in retail drum beaters see this). Unemployed youth and a moribund economy serving the elite is a toxic combination. Therefore either the 'smart' investors are showing the same combination of greed and hubris that they have demonstrated over and over again through various Latin American crises, East Asian crisis, Russian default, etc. or there is another  more conspiratorial explanation.

The second explanation is that FII inflows are nothing but undeclared Indian wealth being poured back through various tax havens. The problem with this is that the biggest recipient of undeclared wealth is real estate and land in India. Equity is not favoured since value creation for the shareholder takes a backseat to political meddling or owner-manager ambitions as most listed companies are either government owned or run like fiefs by individuals/families who started them. Therefore for this to be true, the owners themselves have to be clandestinely acquiring shares in their companies through the FII route. This again seems improbable because there is no need for them to increase exposure to their own enterprises.

On balance of probability, FII inflows are likely to be foreigners trying to make a fast buck without appreciating the reality facing India. Over the last seven years FIIs have invested close to 4 trillion rupees into the Indian stock market (Graph below). 

Source: SEBI, www.moneycontrol.com

At current exchange rates it is equivalent to roughly 7% of total market capitalisation and 16% free float capitalisation (assuming a trillion dollar market cap at USD/INR rate of 55 and ratio of free float to total is the same as that for BSE-500, i.e. 45%). By investing on such a scale FIIs have created their own momentum which has also validated their investment thesis begetting a virtuous cycle. Usually the trouble with this sort of investing is that everyone believes that they can be first in and first out but very few manage that feat. The eventual denouement will be messy unless a political miracle happens to ensure that reality matches expectations.

1 comment:

  1. Good analysis. There is a much more muted version of this going on in the private markets in India. Having no mark-to-market model there, it takes a lot longer to figure out whether an investment strategy is working or not. However, there are several instances of investors rushing en masse into one market and assuming that other will mark them up in future rounds.