What determines capital inflows to India is a question that is of much interest to the stock markets, given their dependence on funds from foreign institutional investors
(FIIs). The International Monetary Fund’s (IMF) recent note on India has something to say about that. It says that IMF carried out an empirical analysis of fund flows to India to find out the determinants of FII and ECB (external commercial borrowing or foreign loans) flows. The results of their study show that: 1) a decline in global risk aversion—a proxy for which is the US Vix— increases FII flows to India; 2) investors seek markets showing positive momentum, but withdraw as valuations rise; 3) exchange rate volatility discourages both FII and ECB inflows; 4) ECBs are also influenced by the Vix, but are more sensitive to market capitalization and growth differentials and 5) interest rate differentials do not matter.
The last point should be an answer to those who worry that the Reserve Bank of India raising policy rates will lead to greater fund flows into the country. That’s because most of the portfolio funds coming into the country go into equities and debt market exposures are limited for FIIs.
The correlation of FII flows with the US Vix is also clear—recently, a spike in the Vix in February led to drying up of FII funds. But so far as valuations are concerned, the relationship may not be that clear-cut. For instance, it’s well known that the Indian market is expensive compared with others in Asia. Yet, if we look at the MSCI indices, the index for India (as on 19 March) is up 1.48% (in local currency terms) compared with a decline of 0.97% for the Emerging Markets Asia Index and 0.24% for the Emerging Markets Index. And if we take the one-year returns, there, too, MSCI India, with a return of 104.5%, comfortably outpaces MSCI Emerging Markets Asia at 61% and MSCI Emerging Markets at 57.6%. Other factors, besides valuations, also impact FII flows.
Graphic: Yogesh Kumar / Mint
IMF’s outlook for capital flows to emerging markets and to India is positive and the note says, “Historically, a low interest rate environment in advanced economies and strong growth in emerging markets have provided a powerful boost to capital flows to emerging markets.” It says that if the US Vix stays low, it could lead to another $10 billion (Rs45,500 crore) in FII and ECB flows. It warns, however, that “dedicated emerging markets equity funds are already overweight on India, suggesting that capital flows to India will depend on the continuation of the strong domestic recovery, as well as on global financial conditions”. The chart shows that IMF feels the huge portfolio inflows of 2009-10 are unlikely to be replicated in 2010-11 and 2011-12. Note also the sharp rise in foreign direct investment.
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