A scenario of FII selling is possible

FIIs have not abandoned India despite years of poor policy-making. They may, however, trim exposure substantially if they are unhappy with the 16th Lok Sabha

A fellow columnist at Business Standard, Akash Prakash of Amansa Capital, recently pointed out that India was very vulnerable to selling by foreign institutional investors (FIIs). As he said, FIIs controlled roughly two-thirds of free-float market cap with concentrated holdings in the 70-odd Indian stocks, which are part of the Morgan Stanley Capital International (MSCI) Index.

In value terms, Prakash estimates the FIIs own roughly $250 billion equity. That's about thrice as much as the Indian mutual funds ($25 billion) and the insurance companies ($60 billion) combined. If the FIIs sold in serious fashion, domestic counter-parties lack the deep pockets required to absorb the sales. Prices would therefore, crash.

In Prakash's opinion, this gives FIIs the clout to enforce some discipline on the new government taking charge in May 2014. My guess is, India's politicians and even finance ministry, Securities and Exchange Board of India (Sebi) and Reserve Bank of India (RBI) officials don't see the threat quite as clearly. There would have to be an actual run on Indian equity before the establishment woke up to the possibility of a run on equity!

A scenario of FII selling is clearly possible. Is it likely? After all, the FIIs have not abandoned India despite years of poor policy-making and mismanagement. They may however, trim exposure substantially if they are unhappy with the 16th Lok Sabha. A 10 per cent cutback for example, would mean selling about $25 billion at current prices.

My guess is, under normal circumstances, even a sell-off of 10 per cent or more is not a likely scenario. A major sell off could only be triggered by extraordinary events. For example, there may be heavy selling if there's huge deterioration of macro-economic indicators for some reason. Or perhaps, a big terrorist attack, a natural disaster, or a hung parliament with no possibility to stitch a working government together.

In the long run however, smaller sell-offs are more or less guaranteed at some stage. Emerging market investment history shows that there have been big capital outflows at some point from every market. The FIIs don't need to abandon India to trigger a bear market. If they just reduce exposures by about five per cent, they might trigger a bear market.

Sustained FII selling to the tune of $10 billion (Prakash's estimate) may be enough to overwhelm potential domestic counterparties. This would be less than five per cent of FII holdings. And, sooner or later, selling on this scale is bound to happen because FIIs rebalance portfolios. As and when it does happen, there will be a sharp correction.

Obviously, $10 billion is a moveable target. Right now, the DIIs may be incapable of dealing with $10 billion worth of selling, which means that this would be enough to force the market into deep correction. A year later, DIIs may be capable of dealing with $10 billion.

But the principle would remain valid. If there is sustained FII selling, there would be a tipping point beyond which domestic buyers would no longer be able to absorb offered shares. Prices would drop sharply if that point was hit. Markets could freeze up beyond that point.

It is very difficult to make an exact quantitative assessment of any such tipping point, or to gauge the extent of correction that may be triggered by a lot of FII selling. But it would not be a difficult situation to diagnose if it it does happen. The underlying causes of the selling would also be known. Money cannot be moved on this scale, or equity offered, without setting off alarm bells. An investor would just have to wait until any such bear market blew over and hope that policymakers took the right decisions. One trigger point for such a market could be a hung post-election scenario mentioned above. Another is a possible sovereign rating downgrade, which is still on the table if the macro-economic scenario going into the second half of 2014-15 is unsatisfactory.