Foreign investors deserting Indian stocks

Let’s face it. Even after 65 years of independence, a large part of India’s economy still swings according to the whims and fancies of foreign capital.

The sharp fall in Indian stock indices is one such glaring example as foreign investors together pulled out billions of dollars in the recent months.

In the last three months or so, the Bombay Stock Exchange’s Sensex has plunged 2,463 points from 18,428 on February 21, 2012 to below 16,000 mark on Friday. And one of the major reasons for the fall was foreign institutional investors (FIIs) pulling out money.

If the first quarter of the calendar 2012 witnessed FIIs pumping huge money into the markets and inflating it, the next two months of the second quarter saw FIIs taking out funds from India.

In rupee terms, foreign investors pulled out Rs 1,100 crore from the domestic equities in April, while they sold shares worth a net Rs 665.76 crore during May, as per initial data from bourses.

If FIIs are running for cover, there are strong reasons for that. The fact that the mighty India growth story is waning is well established by the slowing economy.

The latest official figure showed that in 2011-12, India’s GDP growth has dropped to 6.5 per cent, and, even worse, the growth in the January-March quarter was only 5.3 per cent, lower than the most pessimistic projections. 

The falling value of the rupee against the dollar is another major reason why FIIs are cashing out.

The Indian rupee has fallen 21 per cent against the dollar since the beginning of 2012 and recently, touched an all time low of 56.63. The rupee is also the worst performer among all Asian currencies so far this year.

In any country, foreign investors get badly impacted if the local currency depreciates deep and fast because FIIs bring in dollar to invest and take back less of it when they sell.    

Value shock

Let’s take the example of the PSU giant, Coal India Ltd (CIL), which sold its shares in November 2010. The much sought after IPO was hugely oversubscribed and around 484 FIIs picking up a little over 209 million shares at the offer price of Rs 245 a piece.

At the then exchange rate of Rs 44.36 a dollar, each Coal India share was worth $5.52. But the fall of rupee has wiped out all gains for FIIs, though CIL shares quoted at Rs 321 or 31 per cent higher on BSE in rupee terms on Friday last.

If the FIIs were to sell shares at the Friday’s exchange rate of 55.59, each Coal India share would fetch roughly $5.77. Factoring in the interest cost of the last 18 months, FIIs have certainly lost money and any further fall in CIL stock price or fall in rupee will further enhance the loss.

If this can happen with a blue chip company like CIL, FIIs plight with other stocks is not difficult to gauge. Many stocks with large FII exposures have already hit their five-year lows where FIIs have lost up to 15 per cent of the value.

In dollar terms, several Indian stocks have never been cheaper in the past five years, not even when the Sensex was trading below the 9,000 mark in March 2009, pointed out a study.

Union KBC Asset Management CEO G Pradeep Kumar describes it as a reflection of reality in the broader market. “Coal India is not an isolated case. Whoever had invested in the first quarter (of 2012) would be nervous. The rupee volatility has come on top of market volatility.”
   
The declining value of rupee also means higher inflation as imported commodities like crude oil and petroleum products become costlier, which, in turn, fuels inflation making it difficult for RBI to cut interest rates.

Hostile policies

Other factors dampening the market sentiment are two tax provisions. One will change India’s tax laws to allow cross-border deals, similar to Vodafone’s purchase of Hutchison Essar, to be taxed retrospectively.

The other will target tax evaders, using the General Anti-Avoidance Rule (GAAR), to force investors to prove that registrations in tax haven countries are not intended solely to avoid tax.

Analysts view the provision (GAAR) as the government’s move to crack down on tax avoidance via Mauritius, the tiny island nation through which 40-60 per cent of foreign investment is routed. These issues have been lingering since the Budget 2012 announcement and dented market sentiments.

Lack or rather the absence of economic reform, thanks to the strong opposition even by the government’s allies like the Trinamul Congress, and large trade deficits are the other reason holding the investors back.

A Morgan Stanley analysis, for instance, warned that India faces a “high” risk of a “shock” in its balance of payments with a tumbling rupee. The avalanche of these negatives not only dented the interest of global investors, but domestic funds too have been quietly watching the oscillating markets, it has pointed out.

Though the Centre has deferred implementation of GAAR by a year, FIIs still do not want to take chances with India, whose credibility suffered maximum now due to its unpopular move of taxing firms retrospectively. Some segments of foreign investors like Europe’s largest listed fund 3i, CX Partners and Edelweiss Capital have taken action by shifting their earlier Mauritius-domiciled operations to Singapore.

“PE funds so far justified their presence in Mauritius as they enjoyed tax benefits there. But without those benefits, Singapore, with a substantial financial community, is a more convenient location,” says Mahendra Swarup, President of the Indian Private Equity and Venture Capital Association.

  But some feel that the Mauritius issue is overblown as those institutions running legitimate businesses are less concerned about the GAAR change. Says Choksey of KR Choksey brokerage, “It is those operating shell companies, often as fronts for powerful politicians or businesspeople, who should be really concerned, and will have to move on."

Market experts say exchange-traded funds and hedge funds are avoiding taking positions in India, as they would be the most affected by the implementation of GAAR.

The most glaring example is the shutting down of its hedge fund and ETF by Australian institutional investor Macquarie in April. It informed its clients that instead of trading in the Indian market, they would be trading the same Indian instrument at another bourse located in a foreign land.

Vineet Bhatnagar, MD of MF Global says that trading can shift back to India again. “Once there is clarity over tax laws, FIIs will shift back. The advantage of trading in India is that overall, there is deeper liquidity available due to local traders and arbitrageurs, which can help FIIs in various other strategies."

The implementation of GAAR would hurt hedge funds the most, then ETFs and P-note holders. As GAAR puts the onus on firms to prove that they are using a specific structure for a commercial purpose and not to avoid tax. Of course, the taxman can question the claims of companies and FIIs.

ETFs are vague structures, while P-notes were criticised for providing a perfect smoke screen for investors operating in a clandestine manner. After the Vodafone tax case, FIIs are worried over rules being changed with retrospective effect.

FIIs have been using P-notes to take exposure to Indian markets for nearly a decade now. Singapore is a tax haven for foreign funds. The low rate of personal and corporate income tax – only 20 per cent in Singapore – is a further sweetener for unregulated entities to trade on the SGX Nifty.

Often, a rise in trading volumes of Indian indices in foreign markets is viewed critically. Higher offshore volumes than the local market normally disturbs the equilibrium as domestic traders are at a loss, more so, when the Nifty index at NSE covers 23 sectors of the Indian economy and accounts for 60 per cent of the total market-cap of the underlying bourse.