The Securities and Exchange Board of India (Sebi) curbs on participatory notes (PNs) have gone a long way in helping the Union government cope with copious inflows.

In the seven trading sessions since 26 October, the day the curbs became effective, foreign institutional investors (FIIs) have brought in all of $115 million (Rs452 crore) into the Indian markets, after netting off sales. This includes the net long positions FIIs took in the futures market. This is a far cry from average net inflows of about a billion dollars a day after the US Fed cut rates in late September.

Also, FII participation in the derivatives market has fallen to 7% since the ban on participatory notes with derivatives as underlying.

Their share of turnover was in double digits in the past few months, peaking at 26% in the week before Sebi’s curbs were made effective.

Although Sebi has categorically stated that the move was to increase transparency and not to curb inflows, funds coming through the FII route have been impacted. It’s interesting that the markets have risen despite the drop in foreign flows since the PN curbs. The markets’ view seems to be that the impact is only temporary and once the foreign investors who are left out get their registration, flows from those sources would resume.

Needless to say, it remains to be seen whether the India story remains as attractive at that time as it is currently.

Meanwhile, flows into offshore India-dedicated funds continue to be strong.

Such funds tracked by EPFR Global have had inflows of $1.4 billion in the six weeks since the Fed rate cut, second only to the $1.9 billion collected by China funds, EPFR data collected by Citigroup Inc. reveals. Prior to the Fed rate cut, India funds had witnessed year-to-date net withdrawals of $2.2 billion.

In the week until 31 October, the first week since the PN curbs, India funds saw net inflows of $206 million, in line with the average weekly inflows since the Fed rate cut.

Even regional Asia (ex-Japan) funds have seen record inflows of $10.9 billion on a year-to-date basis, with about 36% of this coming in just the past six weeks. Some of these funds will also flow into the Indian markets. While these traditional sources of fund flows would continue into the Indian markets, some other sources such as hedge funds have been cut off, and this seems to have led to the drop in FII participation.

Meanwhile, the number of FIIs registered has increased to 1,133, from 1,125 on 26 October, the day the PN curbs became effective. The number of sub-accounts, on the other hand, has gone up from 3,454 to 3,478.

Living with low inflows

The irony is, despite the slowdown in FII net inflows, the rupee continues to appreciate against the dollar.

That’s clearly an indication that there’s more to the level of the rupee than FII flows. With the dollar weakening against all currencies, there’s no reason for the rupee to be unaffected. However, with the Reserve Bank of India (RBI) continuing to intervene in foreign exchange and with muted inflows, the rupee appreciation is likely to be slow and steady.

At the same time, bond yields have been moving up on concerns about the impact of the increased cash reserve ratio and fears that the cap on market stabilization bonds is likely to go up and RBI will intervene aggressively to mop up liquidity.

Further, more and more anecdotes are getting published and aired about job losses in sectors such as textiles, auto ancillaries and leather. All of this means just one thing—capital inflows are on the government’s radar. And if capital inflows slow down, liquidity too will evaporate, which could result in higher interest rates.

For instance, if curbs are tightened on external commercial borrowings, then corporates will be tapping the local banks for funds, with the result that the credit-deposit ratio could increase. That’s why investors will do well to avoid the interest-rate sensitive sectors, such as automobiles and real estate.

On the other hand, the rising level of protest against the rising rupee also means that beaten down sectors such as IT should see some bounce.

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