FII Inflow and Indian Equity Market

INTRODUCTION

Since the liberalization in 1992-93 FIIs have played an imperative role in shaping our Indian economy. As we are growing, we now have a symbiotic relationship with the FIIs. The FIIs invest in our equity market because we are a second most fastest growing economy and our equity market is outperforming because FIIs are the major investors which are attracted. After the setback of Sub-prime crisis, Lehman brothers’ bankruptcy, and crash in the Indian market in January 2008, two and a half years from then on 21st September 2010 Nifty has once again crossed the 6k level and Sensex breached 20k level. Indian equity markets are again confident as FIIs have invested heavily in the past few weeks, specifically in September. There are many reasons why FIIs are investing heavily in Indian equity markets. They do so because we have the ability to produce goods and provide services at a lower cost also the Indian companies have tremendous growth potential inside as well outside India. The mergers and acquisitions of the MNCs by the Indian companies in recent, has proved our mettle to the world. The population of India signifies that we have never ending demand unlike developed countries where the demand is less than the supply. The purchasing power of Indian consumers has also increased during the past few years.

The FIIs are also betting on a second quantitative easing (QE-II) by the US to create jobs. Since this will mean more liquidity, global investors and overseas exchange-traded funds are taking positions before fresh money starts chasing stocks. India is one of the best-performing markets and they don't want their portfolios to underperform so obviously we are the first choice for the FIIs to put in their money. The month of September has brought pleasure for all the investors as FIIs have already started investing in our equity market. We have shown this with the help of the following FII data table and the S&P CNX Nifty daily chart.

Quantitative Easing

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. Central banks tend to use quantitative easing when interest rates have already been lowered to near 0% levels and have failed to produce the desired effect.
For example, in introducing its QE program, the Bank of England bought gilts from financial institutions, along with a smaller amount of relatively high-quality debt issued by private companies. The banks, insurance companies and pension funds can then use the money they have received for lending or even to buy back more bonds from the bank. The central bank can also lend the new money to private banks or buy assets from banks in exchange for currency. These have the effect of depressing interest yields on government bonds and similar investments, making it cheaper for business to raise capital. Another side effect is that investors will switch to other investments, such as shares, boosting their price and thus creating the illusion of increasing wealth in the economy.

The major risk of quantitative easing is that although more money is floating around, there is still a fixed amount of goods for sale. This will eventually lead to higher prices or inflation. Also Quantitative easing runs the risk of going too far. An increase in money supply to a system has an inflationary effect by diluting the value of a unit of currency. If devaluation of a currency is seen externally to the country it can affect the international credit rating of the country which in turn can lower the likelihood of foreign investment.

Effect of QE (II) By Federal Reserve on Indian Equity Market

It has a very crucial effect on Indian equity markets as second quantitative easing would yield positive results for the Indian stock market. As we mentioned earlier, India is amongst the best performing markets and a hot spot for FIIs to invest money. FIIs have also started taking positions before the stock prices move up. This has helped Nifty and Sensex to breach the level of 6000 and 20000 respectively. And now with all the festivities coming up it is expected that this level may sustain and we can soon see Sensex at 21k level.

What if there is no QE (II)?

If there is no second QE then it may force the FIIs to take the money out, which they have already started investing in Indian stock market. This may have adverse effect on our booming stock market which is expected to reach 21k by this Diwali. Also, the earnings of Indian companies may be subdued due to a higher base effect. If inflation stays high, RBI will be forced to raise rates again and if a contractionary monetary policy is issued then that would further worsen the situation. So we can say that nasty global surprises can come from anywhere in coming weeks.

USA is also trying to pressurize china to revalue the Yuan which is right now undervalued. China deliberately undervalues its currency by as much as 25% to 40% to give Chinese companies an unfair trade advantage, hurting US exports and job prospects. US lawmakers have pressed this issue for years with little success, but it appears to be gaining momentum now and bipartisan support, six weeks before the congressional elections in which the high unemployment rate is the top issue.

The proposed legislation would essentially treat China's "undervalued" currency as an export subsidy and allow the Commerce Department to impose countervailing duties to offset the undervaluation.US companies applying for the duties would have to show they have been injured by China's exchange rate practices. If this bill is passed then there may be no need for the second quantitative easing.

Would the market fall?

The market may fall because of sudden withdrawal of funds by the FIIs and also the absence of big local investors is a worry. The DIIs are taking money out of the economy for almost 3 months now because they don’t want to repeat the same mistakes they did in 2008. It is the time to tread cautiously as no one wants to fall for the rosy picture created by the stock markets. Unlike 2007-08, MFs and insurance companies are not big buyers this time. If FIIs sell, there will be little local support. The long IPO pipeline can trigger selling by investors who need the money to invest. Anecdotal evidence suggests that retail investors have not yet entered in a big way. Also, leveraged positions in single stock futures are lower than what they were during the previous market peak. This could be because there is still fear settled in the market after what happened in January 2008.

What support it may get at that time?

Clearly the Indian market has done exceptionally well this year. The index is up almost 14% in local currency terms, and in US dollar terms it is almost up by 16%. There has been a huge surge of foreign fund inflows in the Indian equities. We have had about close to $15 billion flowing into the Indian equities market, which is about 60% more than what we had last year.

At this juncture with Sensex at 20000, it looks like it is going to hit a bit of a resistance. The PE multiples for the Indian stock market, the 2010 earnings are trading at probably about 19 times and 2011 earnings are probably trading at about 16 to 17 times. That is relatively high compared to the MSCI Asia ex-Japan index which is probably trading at about 13.5 for 2010 and about close to 11.5 for 2011. So the Indian markets are trading at a premium. Probably we could see a little bit of a pullback, but the long-term picture is still very positive for India.

Also many stocks are still quoting at substantially lower price earnings, or P/E ratio, than the levels recorded when the index scaled 20K for the first time in October 2007. The P/E mismatch could mean investors are valuing the companies more reasonably than in the past or that the stocks are grossly undervalued, particularly where the difference is huge, according to analysts.

Blue chip stocks led by the Reliance group and heavyweights from telecom and infrastructure sectors have underperformed the broader market due to short-term concerns over their prospects which prompted investors to shift focus to sectors with high growth visibility. As most of these companies are established with strong fundamentals and good management background, analysts feel long-term investors may find their valuations with prices of the current market outperformers becoming more and more expensive.
Out of the 192 regularly traded A-group companies, more than 100 are currently quoting at a lower PE multiple than in 2007. GMR Infrastructure, Indiabulls Real Estate, DLF, Bharti Airtel, Ideal Cellular, L&T and Reliance Industries are some of the notable examples of this phenomenon. So these “A” listed companies would definitely provide a crucial support for the market in the time to come.

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