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Home / Opinion / Views /  Departure of foreign portfolio investors needn’t worry us unduly

Foreign portfolio investors continue to flee India. Cumulatively, they have taken out $22 billion from India in the current calendar year. It is possible to rue this as a sign of India losing investment appeal in the eyes of investors. A more positive, probably more realistic, view would be that India is paying the price for having seen the largest net inflow among Asian peers over the last three years (of $40.5 billion), and thus having built up higher valuations.

Large pools of savings scour the world, looking to maximize returns. Emerging markets offer much faster growth, of economies and businesses, thus providing rich pickings. That is the case, when things are normal. In times of uncertainty, emerging markets pose a double risk for external investors. One, their economies might be more vulnerable to bad news than developed country economies; two, their currencies could see sharp depreciation, lowering the return in dollar terms.

Today, the global economy sees extreme volatility, fed by two different sets of factors: recovery from the pandemic and war in Ukraine and enhanced geopolitical tensions.

As the world recovers from the pandemic, the extra-loose monetary and fiscal policies that had been adopted, particularly in the rich world, have to be reversed. This process has been accelerated by unexpected vigour in inflationary trends.

Rich world policymakers had been banking on a steady recovery from the pandemic and focusing on recalibrating demand to control inflation — remember the catchphrase, transitory, that the US Fed used to describe the uptick in inflation over much of 2021. This did not take into account uneven recovery from the pandemic, resultant disruptions to supply and supply-constrained inflation.

Even as growth revived and unemployment fell, particularly in the US, supply bottlenecks turned up in unexpected quarters such as a shortage of truck drivers, shortage of containers to carry goods from China to the rich world, shortage of port handling capacity and lockdowns in China. Then came the energy shock. The winter turned out to be extra long and extra cold, increasing the demand for gas for heating in North America and Europe. Some unforeseen outages of gas capacity resulted in a sharp rise in gas prices, even as the oil cartel OPEC decided to regulate output to keep prices high.

Inflation dashed hopes that it would be transitory, and the US Fed and the Bank of England decided to raise rates. The European Central Bank is poised to raise rates as well.

When interest rates go up in the rich world, risk-free returns on rich-world government debt go up. Large investment pools with a mandate to generate a certain risk-adjusted rate of return on their corpus de-risk their fund deployment by reallocating a share of relatively riskier deployment in emerging markets to rich-world government debt that now offers a higher rate of return.

This process entails reverse capital flows from the emerging markets to the US and Europe. This puts pressure on the exchange rates of emerging market currencies. The higher the likely depreciation of an emerging market currency, the higher the return in local currency the deployments there must generate, to turn in the earlier rate of dollar return. That means withdrawal from some instruments and redeployment back to the home country, rather than to higher-reward assets in the emerging markets themselves, because this higher reward could be associated with risk higher than the investor likes.

It is to this mix we have to add the Ukraine war. This has given a fillip to inflation – with food, oil, gas, metals and fertilizer prices directly impacted. But the bigger factor is greater uncertainty. Uncertainty translates into higher risk, and thus a greater incentive to flee to the safety of the home market. Since the US is the biggest source of cross-border capital, more capital has returned to the US than anywhere else. As a result, the dollar has strengthened against all major currencies.

On top of this, we see Xi Jinping’s Zero Covid strategy disrupting global production, cities in China where key parts are made shut down entirely to contain the virus. This adds to shortages, inflation and general uncertainty. The net result is a further flight to safety.

Since India had received more capital than other Asian countries and seen higher valuations as a result of both such inflows and vigorous domestic fund inflows into capital markets, India sees proportionately larger outflows now, with funds seeking better value in other emerging markets.

The Sensex price-earnings ratio has come down to 22, a whole lot more reasonable than the 30s where it had stayed for some time. But this is high, compared to 13 for the Jakarta Composite Index, for example. This explains why funds that moved out of China, following the Covid lockdowns there, went to Southeast Asia rather than to India on the scale that was expected.

The plus side is that when uncertainty settles down, funds could swing back in, pushing valuations up again. India remains the brightest growth prospect in the world, despite all the shortcomings all too visible to observers, for the next few years.

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