I have received a lot of feedback questioning my assumption that foreign institutional investors (FIIs) have huge power over Indian equity markets and will ultimately force responsible governance from any political formation coming to power in May 2014.
The argument goes as follows: that even though FIIs own approximately $250 billion of Indian equities, that is less than 25 per cent of our market capitalisation and hence not something that can disrupt our economy. Many other emerging markets have even higher FII ownership. Why worry about FII outflows when we have only seen one episode of sustained outflows (2008-09), and that too was linked to the global financial crisis? It won't happen again on the scale (and size) needed to worry policymakers - so goes another strain of wishful thinking.
The above arguments may be partially correct, but they underestimate India's vulnerability.
The reality is that more than 51 per cent of our market capitalisation is held by promoters, both private sector and government. Given fiscal capacity and regulations, neither of these two groups can buy in an unconstrained manner. Thus, of the free float in Indian equities, FIIs own almost 50 per cent. If one were to take out another 15 per cent of the total market capitalisation, which is owned directly by retail investors and which also does not trade very frequently, then FIIs would own about two-thirds of the free float. You can see why they clearly call the shots.
FII ownership at $250 billion also dwarfs the total equity assets under management of our mutual funds (approximately $25 billion) and insurance companies (about $ 60 billion).
Besides, FII ownership is very concentrated, with 82 per cent of the FII investment in MSCI India stocks (an index of mostly large-cap stocks, 71 in total). According to CLSA, the share of funds dedicated to India within this pool is at an all-time low, with only about 11 per cent of the total FII ownership - the balance is with global and regional funds.
Now, why does all this matter?
Despite all the negative press and sentiment surrounding India, equity investors have been very kind to us and have given the country the benefit of the doubt. According to a recent Goldman Sachs report that studied the portfolios of the top 200 emerging market mutual funds, India was the single largest overweight for this group. The group was overweight by on average 300 basis points in India (almost 50 per cent higher than benchmark weight). India has been one of the biggest recipients of FII flows after 2009 (over $80 billion), with flows especially strong in the last couple of years. The FII ownership share of our equity markets has also risen by 500 basis points in the last two years.
However, we have to recognise that these investors do not have indefinite patience. If nothing concrete is done even after the elections to improve economic governance, many portfolio managers will throw in the towel and simply give up. Who is going to wait for another five years for India to get its act together?
In such a situation, even if four per cent of the existing stock of equity - or about $10 billion - were to flow out, we would be severely impacted. Who could buy it? This number is 40 per cent of our entire mutual fund industry in terms of assets under management. Remember that most mutual funds do not keep more than two or three per cent of cash, and no one has 40 per cent. Even insurance companies now complain of redemptions from equity; given the restrictions they have on investment allocation, they do not have much spare capacity to buy equities either. One must question how much capacity Life Insurance Corporation (LIC) has left to buy stocks, given that it has become the buyer of last resort for all government equity offerings.
We had a near run on the rupee when some $7-8 billion left our debt markets - what will happen when a larger number tries to exit equities? At least on the fixed income side, the government could keep bond yields in control to an extent, since there are many large players in those markets of a size and scale to match these outflows. There is no one for equities, with the possible exception of LIC - which can take the other side when FII outflows pick up.
Markets could easily drop 15 per cent to 20 per cent, and there would be serious disruption. Most of corporate India would lose access to equity funding. We would be a $2-trillion economy disrupted by a $10-billion outflow. It is sad, but true, that we have absolutely no institutional capacity in the country to handle even a minor outflow in percentage terms.
All this when only four per cent of our existing stock of equities were to exit. In the history of emerging markets, this is not unthinkable when investors lose interest in a country - especially when a country has already received more than its fair share of equity inflows and is sitting as the biggest overweight for many emerging market funds.
Remember also that almost 90 per cent of the equity money in India is held by non-dedicated India investors. They have no compulsion to be in this country; they may simply move money to another more hospitable investment destination.
In reality, what will happen is that this $10 billion will not exit - it will not be able to since markets will decline rapidly and liquidity will dry up. Markets will have to become cheap enough for either the selling to stop or a new set of investors to get attracted. Either way, it will imply a big fall in markets, and disruption in financial conditions.
This is a huge and scary vulnerability. We need to build up our domestic institutions to counter this threat. The only way to accomplish this is by first raising financial savings through positive real rates. Savers then have to be encouraged to take market risk and invest in equities. Globally, we have seen that the only way to move them in this direction is through tax breaks.
We also have to allow the distribution system to be incentivised to sell these products, be they funds or insurance. Currently, there is no viability for a non- bank distribution channel to work for creating these pools of equity capital. Regulators are right to worry about mis-selling, but surely a better balance can be struck between investor protection and distributor incentives to encourage capital market savings.
All this will take time, since domestic money will move into equities slowly. Till then we have to hope that our policymakers are aware of our vulnerability and do nothing to scare investors away. Like it or not, we are dependent on FIIs. There's no such thing as free lunch, but there is no contradiction in objectives either. Everyone is aligned in desiring policies that boost growth, employment and inclusion. Now if only someone were to deliver…
The writer is at Amansa Capital
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
