The fickle nature of FPIs: Business Line 25th February 2019

ndia must avoid constant tinkering with investment norms as they act as a deterrent to foreign portfolio investments

Foreign portfolio investments are now viewed as an integral part of the balance of payments even though it is understood that these flows are fickle unlike FDI. There has been an attempt to provide more leg-room for operations and steps have been taken by the regulators to allow foreign portfolio investors more scope in the debt market — both government and corporate debt as well as equity — to boost their flows.

At the same time, there have been occasions when P-Note and DTAA (double taxation avoidance agreements) issues have been brought up to avoid round-tripping of money coming through this channel. How important are these flows and can the government really determine the quantum that comes in? And how important is the pull factor in terms of policies in attracting such funds?

Foreign portfolio investment in the country currently stands at around $435 billion or ₹30.9 lakh crore. The flows, however, have not been consistent over the years and have witnessed a fair degree of volatility.

After the financial crisis, FPI flows increased till FY13 after which there was a slowdown for a year before increasing again in FY15. Subsequently, there was a slowdown in flows, and while FY18 was a good year with $21.5 billion, it was still much lower than what it was in the early part of the decade. What’s interesting is that until FY11 it was equity which dominated and in FY12 it was evenly distributed between the two segments. Equity started dominating again, but in FY15 debt accounted for almost $27 billion of the $45.7 billion. It was negative in the next two years and became significant in FY18 with $18 billion. Hence, there has not really been any pattern in such investment.

The high inflows into India were mainly due to the excess liquidity in the western economies, when quantitative easing (QE) programmes were pursued by the US Fed, ECB, Bank of England and Bank of Japan at different points of time.

While the central banks started buying non-government securities in return for cash, the institutions were able to deploy that cash in the emerging markets which led to a high infusion of dollars which also helped to strengthen currencies. India was not insulated and gained a lot from such flows. Curiously, the quantitative programme was put in place to revive domestic economies but the funds got invested elsewhere.

Taper tantrums

The so-called taper tantrums which started in 2014 led to the reversal of the QE that gradually reduced the bond purchases which was a prelude to increasing interest rates. As the rollback of QE started, funds available for investment came down and the inflows slowed down. This available quantum of funds is the critical factor that influences FPI inflows into the country which is quite beyond the control of the government.

The interest in the debt segment has been varied for the investors. The regulators have provided enough scope for FPIs to operate in both the G-Sec and corporate debt segments. In the case of G-Secs and SDLs it has been fixed to the o/s (outstanding) amount, which lends some degree of automaticity to the available limits. But this limit has not been utilised fully. For the debt market slice, the utilisation levels have come down from March 2018 to February 2019. Quite clearly the debt market is less attractive.

The reasons are two-fold and related. The Fed has increased rates and signalled possibilities of further hikes. The 10-years paper has become more attractive this year with yield at around 2.7 per cent while it crossed 3 per cent when the trade wars made them more attractive.

The dollar will strengthen as the trade wars intensify and with the Fed still thinking of hikes, albeit reduced in number, these markets are attractive. Further with the dollar strengthening, the exchange risk becomes another factor to be borne in mind which lowers the real return for an investor in the Indian market. The other factor is the direction of movement of interest rates in India.

Falling interest rates

With the RBI virtually signalling that it will only be lowering interest rates, this will mean that bond yields will decline, making the market relatively less attractive.

On the equity front, FPIs will be evaluating both the returns offered in different markets and also the regulatory norms while making their investment decisions. The constant tinkering of rules regarding the quantum of investments in companies and the limits cause uncertainty and that is the last thing investors want.

This is so because if the investor is long in stocks then any change in rules will result in changes in the portfolio and can lead to losses which are avoidable. This is why FPIs are always interested in markets which have stable regulatory regimes. With FPI flows becoming more whimsical in the last few years with negative numbers being witnessed twice in the last four years, dependence on such funds will reduce. The market, however, has still been resilient with domestic funds offsetting the FPIs’ pull-out. But from the point of view of exchange rate management, FPI is still important and the correlation with these flows works almost on a daily basis.

Hence it is important not to resort to constant changes in tax laws or investment norms as they cause upheaval, especially given that India is an emerging market which is on the investment radar of FPIs.

With the reservoir of investible funds drying up, having restrictive laws can be a deterrent. But regulation is only a facilitator. Factors such as available quantum of investible funds, interest rate differential, pricing in equity markets, etc., are more important.