Capital inflows: The perils of a bad neighbourhood

India’s strong medium-term growth outlook may not suffice for foreign capital to flow, as existing channels that bring global savings to India face turbulence

Neelkanth Mishra
Last Updated at October 3, 2022 22:14 IST

This appeared in the Business Standard on October 4, 2022 (link).

“Why will global savings not flow to India if India has such strong economic prospects?” is a question commonly posed when India’s balance-of-payments (BoP) deficit is discussed. This deficit, which has led to a sharp and continuing erosion of foreign currency reserves over the past six months, can be bridged by either slowing the economy down, or attracting more foreign capital. India needs foreign capital to sustain its growth rate, and the current global de-risking episode means slower inflows.

Tessellatum readers are familiar with “plumbing problems” that create distortions. For example, that Indian sovereign bonds (which are supposed to be risk-free) are cheaper than Indian equities (which are riskier) is not due to the rules of finance breaking down, but due to the pipes that carry savings to various investments. The challenge with global savings is similar, particularly with portfolio flows, where foreign portfolio investors’ (FPIs’) share of holdings of the BSE500 have fallen to decade lows.

FPIs now hold around $600 billion of Indian equities. Of this, mutual funds and hedge-funds (MFs/HFs) hold 68 per cent, sovereign wealth funds (SWFs) 16 per cent, pension and insurance funds 8 per cent, and others 8 per cent. SWF flows have very low volatility: They make allocations with a very long-term perspective, and not surprisingly, even during the heavy FPI selling seen from October 2021 to June 2022, they were still net buyers. Flows from pension and insurance funds are also less volatile. That said, the allocation of SWFs and pension/insurance funds to a country is often linked to its share of the global gross domestic product (GDP) and does not change very quickly. Over the past five years, SWF share of India FPI holdings has increased from 12 per cent to 16 per cent.

While MFs and HFs are two-thirds of FPI holdings, they accounted for three-fourths of FPI outflows that India saw between September 2021 and June 2022. To understand this better, we analysed monthly data on 6,300 such funds, which have total assets under management of just under $4 trillion. Despite their heavy selling of India, the India weight in their portfolio remained unchanged at 13 per cent, indicating that these funds were only trimming their India positions as their funds saw outflows.

The challenge here is that only 13 per cent of MF/HF holdings are through India funds. As much as 18 per cent are now through non-India Exchange Traded Funds (ETFs), which are passive, meaning that they allocate a fixed proportion of their assets to India. If the fund sees outflows, they will be forced to sell their Indian holdings too. The rest is through active funds that have Emerging Market (EM), Global or Asia mandates.

Despite the outperformance of India’s equities versus global equities over the past five years, the share of India-dedicated funds has in fact declined by 8 per cent points from 21 per cent in 2017. This appears to be due to fund-specific factors — outflows from some large India-dedicated funds may have been due to underperformance against their benchmarks or a change of fund manager. Some others had a large part of funds raised from one geography, and investors there may have become less positive on India. Even though idiosyncratic, these factors demonstrate the challenges of India developing as an asset class.

Promising as India’s medium-term growth story is, it is not easy for asset allocators globally to carve out funds specifically for India. At just over 3 per cent of global market capitalisation, India is currently too small to warrant such attention, and it is much more convenient to gain exposure through regional or global funds. In any case, the process of issuing mandates involves significant due-diligence and is time consuming. While there are some very successful India fund managers with strong and proven track records, they too are careful in the quantum of funds they raise, as deployment is not easy.

Thus, at least for the duration of the ongoing turbulence in the global financial markets, which may last several quarters (for reasons why, see last month’s Tessellatum: “Turbulence Ahead”), a large part of equity portfolio flows will be through regional or global funds. When investors lose confidence in global growth or that of larger EMs and pull money out of such funds, India is likely to see portfolio outflows too.

India’s benchmark weight in these funds is rising due to outperformance and new listings, but this is a gradual process. Funds can also be overweight India, meaning they allocate more to India than its benchmark weight, and data suggests that most of them are already. But they are unlikely to keep an overweight beyond a few per cent points owing to internal risk management guidelines. That India’s valuation premium to EMs is now well above 100 per cent, and at record highs, makes this even more difficult for them. Further, passive funds are gaining share (they have been nearly a third of incremental inflows since 2017), and their allocation to India must be at its benchmark weight.

That a resumption of portfolio outflows could keep equity markets pressured is less of an economic problem, so long as continued domestic inflows into equities prevent a steep correction, as appears likely. Such outflows could, though, increase the pressure on the BoP. The Reserve Bank of India using foreign currency reserves to offset such outflows is more justifiable (India’s reserves were anyway accumulated by sequestering excess inflows in the past) than in funding a current account deficit. However, when currency markets see volatility, it can be hard to segregate current account flows from capital account flows.

Other forms of capital flows, like foreign direct investment (FDI) or foreign loans are less affected by such plumbing issues, but they have their own challenges. A substantial portion of FDI in recent years was for private equity and venture capital investments, which, for understandable reasons, is slowing. FDI from global firms that are increasing their footprint in India can moderate too given the likely oversupply of goods globally. Further, a worrying takeaway from the recently released June quarter BoP was the jump in short-term foreign loans: These have increased by $27 billion over the past year. If these do not get rolled over due to global uncertainty, or a slowdown in trade, these will have to be paid back, worsening BoP pressures.

India’s healthy foreign currency reserves should help tide through this period of global economic volatility without significant turbulence. However, it would be unwise to assume that the pipes that move global savings can automatically and quickly readjust to provide India the dollars that it needs to sustain growth.