Mumbai: Not just the Indian markets but the Indian economy, too, has been extraordinarily dependent on foreign portfolio inflows. Record net inflows from foreign institutional investors (FIIs) were seen in 2012 and in the first quarter of the current year. They have supported the stock market and allowed us to get away with a massive current account deficit so far without too much damage. They have bought vast quantities of Indian equities despite rampant selling by local investors. They have propped up the tottering rupee. Their faith in the prospects of the Indian economy has been remarkable and their belief in Indian companies extraordinary. They have continued to pump in funds in spite of a dramatically weakening economy, high and persistent inflation, faltering company profits and looming political uncertainty. But the FIIs’ astonishing patience with the Indian market finally seems to be wearing thin.
The government knows very well that FIIs are the last remaining bulwark of the economy. After becoming finance minister, P. Chidambaram lost no time in holding a series of roadshows with foreign investors abroad to hardsell the rather tarnished India story.
Initially, the series of reform measures taken by the government did help turn sentiment around. The reforms happily coincided with promises of unlimited liquidity by the US Federal Reserve, the European Central Bank and the Bank of Japan, which greatly diminished tail risk in the markets.
The inflows into India were also helped by the removal of the Damocles’ sword of a rating downgrade. There was a feeling the economy had bottomed out, inflation was coming down and the Reserve Bank of India would finally start to cut its policy rate. All these factors propelled the S&P BSE Sensex from around 17,300 at the beginning of last September to highs of over 20,000 by mid-January.
Those hopes, however, have been dealt a blow by recent data. The HSBC Composite Output index, based on the purchasing managers’ surveys for manufacturing and services, shows that growth in private sector output is the slowest since October 2011. Food inflation continues to haunt the central bank, which has said it sees limited scope to cut rates further. Hamstrung by tight liquidity, banks have been reluctant to pass on the rate cuts to borrowers. Rating agencies say they expect corporate downgrades will continue to outnumber upgrades this fiscal. Auto sales have plummeted. Bank credit growth is decelerating. The index for the core infrastructure industries has recently shown a contraction. Not only is a recovery not in sight, but there’s also the possibility the economy may not have reached the bottom.
The dismal macro numbers are mirrored at the corporate level. Brokerages now expect March quarter profits after tax for the Sensex companies to contract from a year ago. A recent Bank of America-Merrill Lynch report said earnings downgrades are likely to continue in the current fiscal year. The report estimates 2013-14 earnings growth of the companies that make up the Sensex at a mere 8-9%, slightly higher than the 5% growth for 2012-13. With the forward price-earnings ratio for the Sensex at around 14 for 2013-14 and if earnings growth comes in at a mere 8-9%, the price-earnings multiple doesn’t look cheap.
All these concerns have resulted in the MSCI India index underperforming its peers in the last three months. Moreover, there are hopes that consumer deleveraging in the US is almost over, which has led to money flowing out of emerging markets into the US.
The Indian government has enthusiastically adopted the view that boosting asset prices will lead to a revival of animal spirits and a recovery in the real economy. After all, this has been the policy of the central banks in the advanced economies, the Bank of Japan’s “shock and awe” easing being the latest example. The difference is that it’s not lack of demand that is holding back growth in India, but structural supply-side constraints. Higher asset prices, animal spirits and monetary easing can do little to address problems such as land acquisition, or the lack of power, or coal or gas. And to top it all, political risk has worsened.
To be sure, there are a few positives. The trailing price-earnings multiple for the Sensex is now at its lowest since August last year. Commodity prices, including crude oil prices, have fallen, which will help keep inflationary pressures at bay and allow the central bank to cut rates. The onset of the slack season for bank lending and renewed spending in the new fiscal year by the government will increase liquidity, allowing banks to pass on rate cuts. Lower inflation and lower gold prices could lead to household savings coming back to banks, again boosting liquidity. And, of course, global liquidity will be abundant.
But the risks are very high. If FII inflows slow, funding the current account deficit will be a huge problem, the rupee will depreciate, imports will become costlier, companies that have borrowed abroad will get into trouble, monetary easing will go out of the window. The economy will go into a tailspin.
Anirudha Dutta, a former research head with a foreign brokerage, says that one reason India received so much money last year from FIIs was because they were worried about the slowdown in China. Now that a new leadership is in the saddle there, the risk is that the money will rotate out of Indian markets to China. Moreover, the very high inflows in the past few months increase the probability that the same pace may not be maintained going ahead. And finally, even if structural reforms are undertaken, the problem is that their results will take time to show up.
Given all these, would not investors prefer to wait and watch the political situation rather than risk their money? That is the worry that has started to plague the Indian markets, after data showed that FIIs no longer seem to be pouring in funds with gay abandon.