Volatility caution

The data clearly show that net FII inflows to the Indian stock market are far out of proportion to the country's weighting in the Morgan Stanley Capital International (MSCI) index.

Apart from China and Korea, India was the biggest recipient of foreign portfolio inflows in Asia last year. What's more, the proportion coming India's way has been rising every year.

Does this indicate the long-awaited de-linking of the Indian market from other emerging markets?

In other words, is the India story getting big enough to stand out from the generic emerging market story? There are a number of straws in the wind that point to such an outcome.

First, there's the anecdotal evidence. Investment bankers have been pointing for some time now to the appetite for Indian stocks among investors in the US.

Roadshows showcasing Indian companies have standing room only, a fact underscored by the attendance at the finance minister's meeting in New York.

Confirmation is available not only from the figures of FII investments, but also from the rapid increase in the number of FIIs being registered with Sebi.

India is also increasingly being looked at as a destination for foreign direct investment, and reports indicate that the amount of FDI coming into the country in FY 05 could be very much higher than hitherto.

And finally, of course, the BPO and IT services stories continue to showcase India's capabilities to the rest of the world. So far as portfolio flows are concerned, the latest reports are of Japanese funds coming into the country.

Investment bankers say that dedicated India funds are being raised in Japan, which could be a sizable additional source of inflows.

Japanese savings rates are among the highest in the world, and it has been almost a decade since Japanese institutions began to actively invest in emerging markets to improve returns and diversify out of Japanese financial assets under liberalised investment regulations, particularly after the Japan Pension Fund Association sanctioned emerging markets as a distinct asset class in mid-1996.

It is becoming likely, therefore, that funds flows to India (both portfolio as well as FDI) will increase as the potential of the country becomes clearer to foreign investors.

Nevertheless, while that will be the secular, long-term trend, there can be many ups and downs in the near term. That is not only because of the cyclical nature of markets, but because there are distinct classes of foreign investors, with different time horizons.

Apart from FDI, which of course is practically permanent, there are investors like the pension funds which look at investments over 10 or 15 years.

What's more, they serve as a steady incremental source of funds. At the other extreme are the hedge funds, which have grown immensely in the past few years, thanks to lax monetary policy in the US.

The carry trade of hedge funds (borrowing cheap in the US to invest in higher-risk assets) is vulnerable to both higher US interest rates as well as a stronger dollar""and both these scenarios look more likely now than before.

The amount of this short-term money is large enough to ensure that volatility will remain high. In short, while the India story is certain to pull in funds over the longer term, that doesn't mean Indian markets will not be buffeted by volatility, caused by global turbulence, in the short term.