Mumbai: To borrow a phrase from table tennis, India is two games down against China. Much of the media attention at home has been focused on the sparring between India and Pakistan. But in the important area of trade and markets, there has been trouble further north, with China notching up two major victories in quick succession.

First, there is a thawing of China’s trade relations with the US, with reports suggesting that the two countries will announce a deal that ends their trade war soon. In contrast, India’s trade relations with the US took a wrong turn, with the latter withdrawing duty benefits provided to certain Indian products earlier this month.

Around the same time, MSCI increased the weights of China shares in its highly popular indices, which means that more money will chase those stocks vis-a-vis stocks of other emerging markets (EMs). Foreign brokerage house Jefferies has estimated a net outflow of $9.17 billion from India as a result, from both passive and actively managed funds (ETFs) (see chart above).

Increasing the inclusion factor for China’s A-shares would lead to a recalibration of the MSCI indices in three stages. As a result, weights of many emerging markets will come down. The worst hit will be South Korea and Taiwan, as their weights would sharply decline. India, too, will feel the heat, with its weight in the MSCI EM index estimated to decline by 50 basis points to 8.3% by November.

One basis point is one-hundredth of a percentage point.

“The world is moving to passive index investing. If we are not part of global indices, we will not get adequate flows, no matter who is the fund manager," said Nilesh Shah, managing director of Kotak Mahindra Asset Management Co. “If we don’t take corrective action, China’s weight will keep on increasing. We have to take multiple actions to increase weights. For instance, we have to get the unlisted part of India listed on the bourses."

While the impact of the MSCI index change is yet to play out, China has already been the beneficiary of huge fund flows into its markets. The monthly fund-flow tracker report of Kotak Institutional Equities Ltd based on emerging portfolio fund research (EPFR) data shows inflows of around $33 billion into China in the 12 months till January 2019, mostly driven by flows into exchange-traded funds. In India’s case, funds tracked by EPFR pulled out $6.5 billion in the same period.

Some analysts argue that the silver lining for India is its strong domestic fund inflows. “As the impact of the MSCI index change is spread over three quarters, this can be easily absorbed if the markets are positive. This is the kind of money that is coming through SIPs," said Andrew Holland, chief executive of Avendus Capital Public Markets Alternate Strategies Llp.

SIPs are systematic investment plans of mutual funds.

But while monthly Mutual Fund SIP flows have been steady at around 8,000 crore in the last couple of months, there have been outflows from other funds. As such, overall net inflows into domestic mutual funds fell to 5,122 crore in February, compared to a monthly average of 10,594 crore in 2018. And while headline numbers suggest that foreign portfolio investors (FPIs) are back with a bang into Indian markets in February, the fact is that a large chunk of these was related to a block deal involving shares of Kotak Mahindra Bank Ltd.

Some analysts are still concerned about India’s high valuations. “Despite the recent underperformance of Indian equities relative to North Asian peers, Indian equities are still overvalued relative to Asia, excluding Japan," said Manishi Raychaudhuri, Asia-Pacific head of equity research and Asian equity strategist at BNP Paribas, in an email. “Besides, India’s consensus earnings estimates continue to decline, and even after such declines, earnings estimates in some sectors appear overstated to us. We are currently neutral about India in our Asia excluding Japan Model Portfolio."

For now, China has the attention of foreign investors. A Bloomberg report last week said two China-focused ETFs attracted inflows of more than $100 million each in a single day. “Positive news on trade and economic stimulus are also boosting Chinese stocks," the report added.

That just shows global investors in funds benchmarked to the MSCI indices are busy with plenty of rejigging, which can cause the dragon to soar higher.

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