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Foreign institutional investors (FIIs) have had a huge role in pushing stock prices in India to record levels over the past 16 months.

In 2020-21, FIIs bought $37 billion worth of Indian stocks net of selling. This was the highest investment ever since FIIs were allowed in the 1990s. Nevertheless, since April, FII investments in Indian stocks have slowed down to a trickle. They have invested just $176 million between 1 April and 5 July.

What explains this slowdown in FII investment? A simple answer might lie in the fact that stock prices at their current levels don’t justify the expected earnings of companies. During 2021-22, the price-to-earnings ratio of companies that constitute the Sensex has been at 32.3. This is the highest it has ever been. The price-to-earnings (PE) ratio is the stock price divided by the company’s earnings per share over the past 12 months.

The PE ratio of Sensex stocks has been rising year on year since 2012-13. This means that the stock prices have been rising at a much faster pace than the earnings of companies. Another way of looking at this is that companies’ earnings haven’t materialized.

Nevertheless, that stock prices don’t justify past or expected future earnings has been well known for a while. So, it isn’t just a 2021-22 phenomenon. What’s happening here? Why have FIIs stayed away from Indian stocks in 2021-22?

The answer might perhaps lie in the following chart. It plots the money deposited by banks with the US Federal Reserve through the reverse repo window during 2021.

Flush with cash
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Flush with cash

As of 30 June, the money deposited with the US central bank through the reverse repo window reached an all-time high of $992 billion or close to a trillion dollars. As of 2 July, the latest data available, it stood at $731 billion.

This is the excess money in the financial system of which banks currently have no use. Hence, they are depositing it with the central bank. In technical terms, banks are lending money to the Federal Reserve, and the central bank is paying them a certain rate of interest on this lending. Earlier, this rate of interest was 0%. But this was increased to 0.05% as of 17 June.

The fact that banks are ready to deposit such vast amounts of money with the Federal Reserve at such a low rate of interest tells us that they have no use for this money. Thus, the funds deposited with the central bank is essentially taken out of the financial system. This is rather ironic because the Federal Reserve is pumping money into the financial system at the same time.

In its latest monetary policy statement in June last month, the Federal Reserve said that it would continue buying bonds worth at least $120 billion every month. The Federal Reserve does this by printing money and buying bonds from banks and other financial institutions. When it does so, banks and other financial institutions get this money. As a result, the money in the financial system goes up, pushing down interest rates. At lower interest rates, the hope is people will borrow and consume more, and companies will borrow and expand. This will push up economic activity and, in the process, economic growth.

So, at one end, the Federal Reserve is pumping in at least $120 billion every month into the financial system. But, on the other hand, it had pumped out $731 billion through the reverse repo window as of 2 July. This is close to six months of money printing carried out by the Federal Reserve ($120 billion multiplied by six, which equals $720 billion), if the central bank printed $120 billion every month and not more.

One interpretation of this is that the Federal Reserve now wants to go a tad slow on the easy money policy it has been following since 2008, when the financial crisis broke out, though it is not saying so in a direct way. But its actions reveal its preference.

Much of this money has been printed since January 2020. The Federal Reserve balance sheet size stood at $4.17 trillion at the beginning of 2020. It now stands at $8.08 trillion. The Federal Reserve has printed money and pumped money into the financial system by buying different bonds from banks and other financial institutions. In the process, the size of its balance sheet has more or less doubled.

Some of this easy money found its way into stock markets worldwide and drove up stock prices to way beyond levels their current or expected future earnings would justify.

To conclude, stock market investors don’t wait for things to happen. They discount for possibilities. It seems that FIIs are currently discounting that the Federal Reserve will go slow on its easy money policy in the time to come. If that happens, the easy money going around in the system will come down. And if that happens, stock markets globally won’t continue to be at as high levels as they currently are.

Given that, the FII investment in Indian stocks has been next to nothing in 2021-22.

Vivek Kaul is the author of Bad Money.

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