Foreign institutional investment inflows into India -

FI investments are generally considered to be ‘hot money’, ie, they could get out of the country at the same speed at which they came into the country. On the other hand, large FII inflows also indicate that India is an attractive destination for global investors. In such a scenario, is the large scale FII inflow, good or bad for the Indian economy? This article also explores a second question as to where such FII investments into India have actually been channeled and the implications.

Dr Suresh Srinivasan
India has received a very high level of Foreign Institutional Investments (FII) inflow in the recent months; much higher than other emerging economies. Prior to the recession setting in, 2007 recorded a peak FII investment flow into the Indian stock markets, amounting to around Rs 80,000 crore. This steeply declined during 2008 while in late 2009 it picked up significantly; 2010 has finally seen the FII investments into the Indian stocks surpassing the 2007 levels. The second quarter of the current fiscal July to September 2010, alone, has seen an inflow of around Rs 50,000 crore.

Are FII and capital inflows healthy for the economy?
Over the recent past, India’s current account deficit has steeply widened. The current account balance is defined as the excess of imports of goods and services over exports; a high current account deficit primarily indicates that imports are far exceeding exports. A high level of capital inflows resulting from FII investments goes towards bridging this current account gap; if not for the FII inflows the current account gap could result in the Indian rupee steeply weakening. Hence, at the outset, such high levels of FII inflows are welcome, although they need to be cautiously managed. Why?

The primary concern from the high capital inflows is the ‘appreciating’ rupee which again has a tendency to negatively impact exports; the country’s products become uncompetitive in the international market. Further, reduced exports widen the current account gap and this becomes a vicious circle. Such large scale inflows of foreign funds into the economy create problems of excess liquidity, thereby exerting pressure on domestic inflation, a major problem which is already being battled by the Reserve Bank of India (RBI).

India’s current account deficit is now close to Rs 60,000 crore, reaching close to 3 percent of the GDP, after a gap of around two decades. Last time this deficit reached such high levels that it resulted in an economic catastrophe; however this time around analysts view this more optimistically. This is due to the fact that current account deficit means more imports as compared to exports, and imports generally comprise not only crude oil but also capital goods used in the economy which would go to generate further goods and services for exports. Larger imports of capital goods into the economy also signal the increased activity in industrial production which will subsequently result in increased exports, of course, with a time lag.

So, although FII investment flows into the country is good to the extent that it spurs investments in our economy. However, the negative effects this has on exchange rate and the resultant effect on the reduced exports could be a concerning factor! The Indian rupee has appreciated by around 5 percent during the last month alone, making India’s exports uncompetitive. Reserve Bank of India’s (RBI) concern is that that rupee value is being influenced more by capital inflows rather than an exchange rate born out of the real economic activity, being the difference between the imports and exports out of the economy. The industry in general, and more importantly the exporters, strongly feel that RBI may have to intervene into the currency markets more strongly to keep inflows under control, and thereby manage inflation and at the same time not to allow rupee to appreciate to such levels that it hurts exports. Other emerging economies like Brazil, Korea and Thailand have devised mechanism to selectively restrict capital inflows into their countries. Analysts point out that at deficit levels of 3 percent of the GDP, the government should focus more on how to reduce the deficit through improved exports rather than freely allowing FII and capital inflows that go to appreciate the currency which in turn negatively impacts exports, further widening the current account deficit.

Where have the FII funds been channeled into?
FII inflows have not gone into the traditional Sensex 30 companies or other large cap stocks, as one would generally expect. Analysing as to where such funds have largely been invested, it comes to light that a large part of the investment has been routed to the small and midcap stocks rather than the larger stocks; this has resulted in the Sensex moving up only by around 15 percent this year as compared to the earlier boom periods during 2007. FII investments have also been channeled into public sector stocks, which have been traditionally ignored; stocks of public sector companies like State Bank of India and Oil and Natural Gas Commission (ONGC) have hence performed much better than their private sector counterparts like ICICI Bank and Reliance Industries Ltd. FII’s have started to perceive larger value in such public sector stocks given their size and scale. They believe that such companies could unlock significant value in the future and hence have shown significant interest in such stocks.

Implications
Interest rates in the developed world are expected to remain low for more time to come and hence this will vouch for more FII investment flows into emerging markets and more specifically India. With this trend clearly emerging, the following seems to be the pain-points which the Indian regulators need to manage in the short term:

Assets prices, especially the stock prices and real estate, will continue to rise. India’s strong fundamentals are already priced in and any higher growth in the stock prices could potentially lead to an ‘asset bubble’.

The Price Earning (P/E) ratio of large caps has already moved towards 20, much higher than its historical average of 15. Unless restricted in some form or the other, rupee will continue to strengthen, which in turn will also have a negative impact on the exports, further widening the current account deficit.

In order to avoid another ‘asset bubble’, the government is slowly opening up measures to divert a part of FII inflows away from the equity markets; it has increased the limits of FII investments into the debt market. Now, FII can hold up to a maximum of $ 20 billion in Indian corporate bonds and $ 10 billion in government bonds.