portfolio flows

7/30/2019 Portfolio Flows

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Portfolio FlowsAnand SubramanianManager

RSM & Co.

SECTION 3 : MARKET TRENDS

Portfolio flows to India

India has witnessed over a decade of portfolio flows and wi th each passingyear, portfolio flows have gained in their significance and have played a keyrole in the overall Indian economy. Although investment by foreigninstitutional investors are typically synonymous with portfolio investmentsin India, investments in ADRs / GDRs and offshore funds are also includedin any analysis relating to portfolio flows. In this article we review the portfolioflows in 2002-2003, the key motives that drive portfolio investments andthe prerequisites to ensure a healthy rate of portfolio flows into India.

India — 2002 / 2003 in perspective

The year 2002-2003 was highlighted by significant events, both locally andinternationally that had a bearing on the Indian economy. Although thefailure of the monsoon had adversely affected the growth in the agriculturalsector, the growth in the industrial and services sector partly made up for suchshortfall. Further, with easing of interest rates and improved liquidity, therewas no adverse impact on performance of the corporate sector.

By end March 2003, cumulative portfolio investments totaled nearly US$16billion, which constituted nearly 11 percent of the country’s stock marketcapitalization. During the year 2002-2003, net flows were positive in allmonths expect during the months of June, October and March, with thehighest outflow being recorded in October 2002, in view of the tension

along the Indian border and subdued conditions prevailing in the Indianequity markets.

During the year 2002-2003, net inflows declined to Rs3,530 crores (US$ 735million) from Rs8,273 crores (1.72 billion) during the previous year. Assuch, although the Foreign Direct Investment (‘FDI’) and Foreign InstitutionalInvestment (‘FII’) in India were lower when compared to the earlier year, thenet capital flows were stable.

Foreign Investment(USD billion)

1998-99 1999-00 2000-01 2001-02 2002-03

432

1

0-1

FDI Portfolio Investment

G-112

Anand Subramanian is a manager with RSM& Co. He specialises in formulating entry

strategies for foreign companies that intendto establish a presence in India, structuringFII investments into India and advisingIndian companies on their outboundinvestments. Anand has also advised clientson joint ventures and strategic alliances, withspecific emphasis on the financial servicessector. Prior to joining RSM, Anand waswith Infosys and Arthur Andersen. Anandis a member of the Institute of CharteredAccountants of India and a Bachelor of Commerce from Bangalore University.



Most emerging markets faced difficulties in attracting portfolioinvestment as equity markets across the world continued to beunder pressure on account of multiple factors including, needfor greater structural reforms, geopolitical tensions and subduedeconomies in developed markets.

The Indian market continued to attract portfolio investmentson account of positive moves on the privatization programmeand a credible performance by the domestic industry. Indiacontinued to be one of the few emerging markets that attractedportfolio investment and this bodes well for India’s ability tooutperform other emerging markets in the coming year.

Amongst other emerging markets, Russia, Indonesia andThailand were some of the best performing emerging markets,with investors impressed by the pace of reforms in thesecountries. In contrast, markets like Brazil were hit last year byinvestor concerns about the country’s debt situation and thepolitical commitment to carrying out economic reforms, whilecountries like Philippines have completely fallen off the investormap due to a disappointing reform drive.

With portfolio investors weighing their returns based oncountry-specific factors, such as reform impulses, countries suchas India will need to do more than ever on the policy front andensure a sustained programme of reforms on the structural andeconomic sides of the economy.

Global view

In the 1990s, capital flows of public and private sector werebroadly equal at around US$60 billion. Over the next decade,private flows grew five fold to over US$300 billion, while publicflows almost halved. This fall was marked by liberalization of markets that made capital mobile. Further, the new liberalized

economy linked the fortunes of the developed and thedeveloping economies even closer, resulting in highercompetition for portfolio flows.

Another analysis by the World Bank on FDI and portfolioflows indicates that in 1980, flows of short-term debt toemerging markets amounted to US$30 billion. In the 1990,the figure was US$15 billion. From 1998, flows of short-termdebt turned negative. FDI inflows moved sharply in theopposite direction: from US$5 billion in 1980 to US$24 billionin 1990 to US$160 bil lion in 2000. Net portfolio investmenthas increased too, from about zero in 1980 to US$26 billion in

2000.In the current year, emerging economies should see a modestincrease in net private capital inflows. As per the Institute of International Finance, the net private capital inflows is expectedto be US$139 billion in 2003, up from US$110 billion lastyear, the lowest level in a decade. FDI, the biggest componentof private capital flows, is expected to fall slightly, from US$111bil lion in 2002 to US$109 billion in 2003, while investmentin bonds is expected to double on account of drastic fall inemerging market bond spreads.

In order to garner a higher share of the portfolio flows, India has

to make conscious efforts in l iberalizing the manner in whichqualifying entities can invest in India and by further deregulatingthe investment limits.

Indian context

Various studies have indicated that portfolio flows into Indiahave relatively low volatility compared with many other emergingmarkets. India has also not witnessed sharp portfolio outflows,and with the exception of 1998-1999, net inflows have beenpositive each year. In fact, domestic political events such asborder tensions, or external shocks such as the Iraq war havetended to be mild and short lived, indicating to an extent the

sustainability of the Indian economy.

Today, FIIs account for over 10 per cent of the turnover on theIndian bourses and a whopping 50-60 per cent of the deliveries.This, in itself, has given FIIs considerable sway in the Indiancapital market. With a bulk of FII funds (95 per cent) investedin stocks that comprise the key indices and half of it in the topfive stocks that comprise the key indices, their influence on theperformance of the stock market is immense.

While the Government has continued its efforts to attractportfolio investment by offering various incentives andstreamlining the regulatory and tax regime, it is important to

note that most of the FII investment is also pinned on India’sweightage in crucial international indices such as the Morgan

Net private capital inflows(2003 forecast)

Europe22%

Africa /Middle East

4%

Latin America25%

Asia / Pacific49%

G-113

Looking from a different angle,

portfolio flows are also showing sings

of following a reform-based investing

approach, which is one of the main

drivers in ascertaining country returns

within emerging markets. In fact,

most portfolio flows are to countrieswhere the economic development is

backed by increased sophistication in

the financial and legal systems. In

this context, emerging markets such

as Russia, Czech Republic,

Indonesia, Thailand and Hungary

were amongst the best performing

markets in the world, all powered by

meaningful domestic economicreforms.



Stanley Capital International (‘MSCI’), which in turn will rallythe FII interest in the country. This was part icularly evidencedin the way the FIIs strengthened and pared their holdings inthe Indian markets through 2002, taking cue from the MSCIweightages.

Looking from a different angle, portfolio flows are also showingsings of following a reform-based investing approach, which isone of the main drivers in ascertaining country returns withinemerging markets. In fact, most portfolio flows are to countrieswhere the economic development is backed by increasedsophistication in the financial and legal systems. In this context,emerging markets such as Russia, Czech Republic, Indonesia,Thailand and Hungary were amongst the best performingmarkets in the world, all powered by meaningful domesticeconomic reforms.

There is hope that India will intensify its reform effort topositively di fferentiate its equity market in a more discerningenvironment. Further, given that India has started making atangible dent in building its profile as a competitive hub for

global industries such as outsourcing and manufacturing, it isimportant for India to ensure that other microeconomic blocksfall in place for a bigger India story to materialize.

Determinants

In the Indian context, some of the key determinants that havea bearing on portfolio flows in the past and in the coming yearare highlighted below.

Domestic economy

India emerged as one of the fastest growing export ing countriesin the world and the country witnessed the highest ever net

invisible earnings in any year and ended the year with a surpluson the current account. The positive performance of thedomestic economy had a significant influence in renewinginterest of portfolio investments in India.

Foreign exchange reserves

The overall economic condition resulted in a record accretionin foreign exchange reserves, the third largest increase amongthe emerging market economies during 2002-2003.Incidentally, India is the sixth largest reserve holding countryamong the emerging market economies. The positive foreignexchange reserves were facilitated by net capital flows,

particularly non-resident deposits and private remittances andnon-debt creating capital including repatriation of past export

proceeds, which entail no future contractual obligation to serviceand are mostly non-reversible.

Interest rate

Interest rates came off substantially during 2002-2003 andthis had a direct impact on corporate bottomlines and this alsoresulted in greater allocation of funds to equities compared toother fixed income avenues.

Tax initiatives

The Union Budget 2003 announced that dividends would beexempt from tax in the hands of a shareholder. Henceforth,dividends declared by an Indian company would not be liableto Indian taxes. However, the Indian company will be liable topay 12.81% (including surcharge) dividend distribution tax.

Further, long term capital gains arising on transfer of equityshares (held at least for one year) in a listed company, acquiredbetween March 1, 2003 and February 28, 2004 would beexempt from tax.

These initiatives were specifically targeted at resurrecting theIndian capital markets and attracting portfolio investments intoIndia.

Conclusion

The year 2003 may witness moderation in investor appetite foremerging market assets, which could in turn affect the prospectsof private capital flows to emerging markets, which is projectedto decline to US$18.4 billion on account of outflows. However,portfolio flows have an increasing relevance from an Indiancontext and India’s abili ty to attract a higher level of portfolioflows would reflect India’s place in the pecking order among

emerging markets and the level of sophistication of Indian capitalmarkets.

Other key policy measures of the Government, especially inliberalizing foreign investment in sectors such as, telecom,banking and insurance would be tracked closely, while the effectof the ruling of the Supreme Court on the tax implication of portfolio investments in India could have its own effect on theability of FIIs to sustain their investments in India.

Although private capital flows into emerging market economieshave decreased significantly since the East Asian crisis, the Indianeconomy, which has been one of the most resilient performers

amongst the emerging market economies should expect to receivemuch higher portfolio inflows in the coming years.

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