India: Case for better FII flows in 2012

There was widespread consternation when FII flows turned into a trickle in 2011. But the first month of this calendar has seen these investors return to Indian stocks with renewed vigour ($1.7 billion till date). What were the reasons for this slowdown and how is it going to be in 2012?

Recent trends

The global financial crisis in 2007-08 triggered strong portfolio capital flows into bonds of some advanced economies and outflows in emerging economies. Similarly, in the recovery period of 2009-10, capital flows into emerging economies were high as fund managers had easy access to liquidity. Factors that influence these flows can be attributed to a specific country/region that receives these flows (pull factors) and some to specific country/region that sends out these flows (push factors).

Some of the push factors could include policies that influence the liquidity conditions in economies that have capital. Risk appetite of the investors and relative opportunities among asset classes and countries are the other factors affecting capital flows out of a country.

Pull factors could be the macro framework of the country receiving the flows and the prevailing valuation of companies in that country.

So what happened in 2011?

High inflation caused by quantitative easing in the US and the euro crisis set the stage for a nervous 2011 and poor FII flows. Increasing interest rates in India also deterred foreign investors. With fiscal deficit remaining high, market participants feared that borrowing costs could remain high.

Policy paralysis, rising input cost and depleting margins also worried foreign investors. Flight to the safety of dollar saw the rupee tumble on fears over India's ability to fund its estimated current account deficit of 3 per cent of GDP.

Will India be attractive in 2012?

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.

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.

On the flipside, though the Indian market was among the worst performers, other emerging markets also witnessed deep cuts in 2011. In the BRIC pack, Indian market fell 36.5 per cent while Brazil lost 27.1 per cent, Russia 21.9 per cent and China 18.1 per cent. Money could flow to these markets also as bargain hunting begins.

Worsening euro crisis will also be detrimental to these flows. It will keep investors nervous and make them move to safer avenues of investment such as bonds.

Push factors in 2012

Another round of quantitative easing will help further inflows. This could be inflationary, but it may push further capital to India. While the exact quantum cannot be predicted, there is a strong case for better flows in 2012.

(The author is Director, Quantum Asset Management Co. Pvt. Ltd.. The views are personal.)

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