Everybody knows that what matters for Indian equities are foreign institutional investor (FII) inflows. If you can predict whether FIIs will buy or sell, you can predict the direction of the benchmark Sensex index on the Bombay Stock Exchange. Small wonder then that a lot of effort has gone into understanding what determines allocations to emerging economies.
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The problem, though, is that most experts have been singularly unsuccessful in predicting fund flows. For instance, hardly anybody believed, in March 2009, that we had reached a turning point and that a tsunami of fund flows to emerging markets (EMs) would soon erupt. Similarly, after the announcement of the second round of quantitative easing in the US, a lot of people expected flows to emerging economies to increase. And now that the Indian economy is slowing and oil prices are rising, many find the return of FII inflows a bit difficult to understand.
Common sense tells us that there will be more than one factor behind capital flows to EMs. For instance, many analysts have pointed to the close relationship between the Sensex and the dollar index. When the dollar is strong, money flows back to the US. When it’s weak, EM equities are hot.
Yet a look at the dollar index shows it has been falling since January, though it’s only recently that fund inflows have resumed to the EMs. Also, it’s far from clear whether the currency effect is the result of funds moving in and out of markets, or whether the currency movement is what causes the fund inflow or outflow. I would think it would be the former.
What about the strength of the economy? One theory has it that fund flows are based on growth differentials and it’s the rebound in growth in the US that led to the recent sell EMs, buy developed market trade. If so, the bias towards developed markets should continue, at least relative to India, because the latest forecasts by International Monetary Fund (IMF) show US and European growth increasing in 2012, while gross domestic product growth in India moderates. So why has the Indian market suddenly started to do well again?
The theories that say push factors are more important assume that easy monetary conditions in the developed economies are responsible for the bulk of the fund inflows to EMs, as investors search for higher yields. Bond yields, for instance, went down dramatically in the US in the middle of last year, which led to outflows to EMs. On the other hand, the yield on the 10-year US treasury note hasn’t changed much in the last three months or so, yet fund flows have changed dramatically. Perhaps these factors are important only for long-term trends and short-term flows depend on valuations, the amount of cash with investors and the need for taking profits.
There are other, more important reasons for trying to determine the direction of capital flows. Too much of capital inflow can fuel inflation and force currency appreciation, leading to unpleasant consequences in the real economy. On the other hand, too much of selling by foreign investors could crash the markets and lead to a drying up of fund-raising options for companies, apart from problems in the balance of payments. So central banks and governments also have a big interest in monitoring capital fund flows.
The IMF’s World Economic Outlook, released a few days back, has an entire chapter on international capital flows. This is what it says: “The chapter’s findings suggest that capital flows are generally fickle—from the point of view of the recipient economy—and sensitive to AEs’ (advanced economies’) monetary policy changes, which are outside the control of domestic policymakers.”
Capital inflows are higher when global interest rates are low, when global risk aversion is low and when EMs are doing much better than advanced economies. But IMF also says common factors such as global or regional economic conditions explain only a part of the variation in flows, which means domestic factors in individual EMs too are important.
This is quite a change from the conclusions reached in last year’s Global Financial Stability Report, which said that global liquidity, or liquidity in the G4—Japan, the US, the Eurozone and the UK—was the most important factor. Indeed, IMF had then said that a 10% decline in global liquidity growth is associated with a 2% decline in the equity returns of what they call the liquidity-receiving economies, or EMs.
This time, IMF says both advanced and EM economies that are more financially exposed to the US face a bigger decline in net capital flows opposed to countries that don’t have that much of a direct exposure. So where does India stand as far as direct financial exposure to the US is concerned? Well, it’s far below China, Korea and Brazil, but it’s still ahead of Malaysia, Indonesia, South Africa, Russia, so tighter policy in the US is likely to affect India quite a bit.
The IMF study points out that “it is reasonable to expect that future US monetary tightening would be associated with a dampening of net flows to EMEs (EM economies).” The countries with a direct exposure to the US will be more affected, but the impact is smaller for countries with greater financial depth and strong growth.
If the IMF is right, while flows to emerging economies will shrink when the US starts to tighten policy, the Indian markets may not be much affected.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org