The month of March is just about 2/3rd way through and foreign portfolio investors (FPI) have already infused close to $3 billion into Indian equities on a net basis. This is a stark departure from the trend in previous months. In fact, between October 2016 and February 2017, the fears of the negative effect of demonetization and expectations of a hawkish Fed policy had led to FPIs withdrawing nearly Rs.80,000 crore ($12 billion) from debt and equity put together. If that did not have an impact on the equity index levels, it was largely because of the strong inflows that markets received from domestic institutions.
The question, therefore, arises if the sudden turnaround in FPI buying in equities is a signal of a changing trend or merely a flash in the pan. There are four broad reasons why we believe that the shift in FPI trend may be real and decisive.
Fed has been more dovish than expected.
In the Fed meeting on March 15th, the focus of the FOMC was to ensure that it does not give an overly hawkish message to the global markets. While the Fed did hike rates by 25 bps and guided for another 50 bps rise this year, it is lower than what the markets had anticipated. That will surely be interpreted as a dovish signal. A dovish signal means that treasury yields will not harden as much as expected. The fear that FPIs will rush out of emerging market assets and into US treasuries may not be really founded. The risk-off trade may not be that attractive and therefore FPIs will once again come back into emerging markets like India in search of alpha.
India has moved fast from demonetization to remonetization.
This was one of the big concerns for the FPIs when they started withdrawing funds in November last year. The fear was that demonetization will crunch liquidity in the system and put undue pressure on the financials of Indian companies. It was also expected that the demonetization drive will significantly suppress IIP and the overall GDP growth. Fortunately for the Indian economy, what happened was nothing so serious. While IIP did take a temporary hit and GDP lost about 50 basis points in growth, the pain seems to be temporary. The way IIP has recovered after remonetization commenced in January, also gives confidence that the sharp recovery in Q4 of the current fiscal and the two first quarters of the next financial should be much sharper than expected. This puts the Indian economy and the Indian corporate sector on the cusp of much higher growth and will benefit the markets substantially.
Political continuity and economic certainty.
The big boost for the FII flows came largely from the outcome of state elections. The opinion polls had already predicted an improved performance by the ruling BJP. But what actually transpired was beyond all expectations. BJP swept the states of Uttar Pradesh and Uttarakhand and managed to form governments in the states of Manipur and Goa. This victory is critical for 3 reasons. Firstly, it means that the government gets much greater heft in the Rajya Sabha by 2018. Hence, the opposition parties may now think twice before stalling bills in the Upper House. Secondly, the outcome will be seen as a vote for demonetization and that will impel the government to persist with its economic reforms program. Lastly, this will also be seen as a precursor to the 2019 general elections and it substantially improves the prospects of the BJP in the next general elections. This will be a big relief for FPIs who were keen on the continuity of the reforms process.
Eventually, it all about the rupee.
Typically, when FPIs invest in India, they look at two things: the underlying fundamental attractiveness of earnings and the strength of the rupee. For FPIs a weakening rupee means that what they earn in the equity markets gets diluted due to dollar losses. To overcome this problem, most FPIs prefer to wait and watch in the sidelines when they expect the INR to weaken. That is exactly what happened in the last couple of months post demonetization. The INR, which is already overpriced in REER terms, weakened closer to the Rs.69/$ mark. Most analysts were predicting the INR to weaken to around the 72/$ levels to create equilibrium. That impelled FPIs to wait till the INR weakened further. However, what happened subsequently was exactly the opposite. The INR strengthened sharply to around the 65/$ levels, leaving most FPIs ruing over the missed opportunity. Obviously, now the FPIs will not want to lose out opportunities by waiting in the sidelines any longer. In fact, FPIs are getting reconciled to a stronger rupee and that will anyway suit them as it will help them protect their gains in dollar terms. Probably, the strength in the INR has been one of the key reasons for the revival of interest from FPIs.
So, the March FPI flows may not exactly be a flash in the pan. It could be indicative of an underlying shift in FPI sentiments with respect to India. How much it translates into genuine FPI flows into India is something only time will tell!