Written by Neelkanth Mishra | Updated: Oct 30 2012, 06:47am hrs
(This was published in the Financial Express: link)
What one does not understand, one distrusts. FII equity flows into India continued for the last two years even through a sharp deterioration in economic fundamentals. The trickle turned into a flood recently as the government started to bring reforms back on the agenda. Inability to explain flows has caused much hand-wringing, and scurrilous explanations have been attempted.
This is surprising, as over the last two decades inflows have been the norm, and outflows rare. Outflows, in fact, have coincided with periods of global economic uncertainty, not when Indian fundamentals changed. Between 1994 and 2003, when the Nifty in dollar terms remained unchanged, earnings growth slowed to a trickle and the rupee fell by a third, FII equity inflows added up to $50 billiona royal sum even now.
So what explains this unending stream of flows The answer, we believe, lies in an economic identity: that for any country the current account (primarily the trade balance in goods and services) and the capital account (sum total of all inbound and outbound capital flows) must add up to zero. India, for example, has a current account deficit (CAD); to sustain, it must have a capital account surplus or else the currency falls and the CAD shrinks. Similarly, countries with a current account surplus must be capital account deficit, i.e. invest their surplus capital in some other country.
Put simply, capital flows and trade flows are two sides of the same coin: as global trade has risen over the past two decades, so have global capital flows. Some years ago, the US was three-fourths of global CAD, and not surprisingly was the destination of most of the capital flows as North Asia and Europe bought US debt in unprecedented amounts. Ben Bernanke, in a famous 2005 speech, attributed the rising US CAD to a Global Savings Glut.
In the last five years, the direction of flows has changed: US share of global CAD has shrunk and that of emerging markets has risen dramatically. Not just India, but Latin America, Turkey, South Africa and Eastern Europe have all seen increases. As one would expect, they have also seen a surge in capital inflows. As these economies are not as open to capital flows as, say, the US or Japan, these flows have been primarily in equities.
Just as the pressure of attracting capital flows is a matter of grave concern for Indian economic observers, countries with large surpluses (for example: China, oil exporters) have the challenge of deploying their hard-earned capital productively. They have therefore created formal mechanisms for this:
the Sovereign Wealth Funds (SWFs). As per the SWF Institute, these currently manage over five trillion US dollars of assets (about 7% of world output).
Assuming a set fraction of their respective surpluses continue to get deployed in these funds, assets can keep growing by $300-400 billion every year. For these funds, allocation to particular asset classes (like equities) is usually a fixed proportion: a survey suggests it is 11-12% for emerging market (EM) equities. Thus, not unlike Systematic Investment Plans that are recommended for retail investors, $35-50 billion can keep flowing into EM equities every year.
Over the past 15 years, about one-fifth of FII equity flows have come to India, far in excess of its weight in various global indices. In fact, among BRIC countries, only China and India have seen inflows cumulatively. This could be strategic diversification by commodity exporters, hedging themselves by investing in their customers! While we have no evidence of this line of thinking, it seems quite obvious, for example, that it is in the interest of the middle-eastern oil exporters that Indians keep buying oilif not, how will they sustain jobs in their own countries
Thus, $7-10 billion of FII flows can keep coming into Indian equities every year just from SWFs, so long as global trade flows continue (remember that FII equity outflows from India only happen at times of global uncertainty). Given the now obvious gambit of the developed world pushing away capital flows so as to contain their own CAD and create jobs locally, the weight of EM equities in long-term funds (SWFs, pension, insurance funds) may rise further. After all, SWFs must at least beat domestic inflation, and yields on developed market sovereign bonds are now no longer sufficient.
This does not, of course, mean that Indias CAD becomes automatically sustainable: there is never a free lunch. The sustainability of CAD in a country depends on whats causing it: investment or consumption. If investment is strong, there are continuing opportunities for foreign investors (FDI or bank loans: there are limits to how much can keep coming in through the narrow window of FII equity flows), but if purely for consumption, such avenues dry up. In such a case, the rupee takes a knock every once in a while, like it did last year.
The form of these flows has long been assumed to be passive index-tracking investments through ETFs. These deliver the strategic purpose of allowing the investor country to benefit from broader market growth with low management fees. Data, however, suggests that the share of ETFs in FII equity flows into India has peaked. Anecdotally as well, it seems SWFs are entering through actively managed funds: such flows track earnings growth. One should not therefore assume that the equity markets will touch new highs: as seen in the past, in the absence of earnings growth, the broader market may still languish despite FII inflows.