FII Trends: Net investments Surge in India

Summary

*FIIs were net buyers in 2007

*Inflows have surged multifolds since Sep 2007; surge in inflows coincides with the reduction in short-term rates by the Fed

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Foreign Institutional Investors (FIIs) were net buyers in Indian markets in 2007. According to the data published by Securities Exchange Board of India, FIIs have made a net investment (in both Equity and Debt) to the tune of $36.2 billion ($33.1 billion in Equity and $3.1 billion in debt), for the first 11 months ending November 2007. This is substantially higher in comparison to the $8.9 billion invested in 2006.

Though net investments were positive over the past three years, a closer observation at the trend indicates a different picture. During the first 8 months of the current year, only a fourth of the $36.2 billion was invested, while the remaining was invested in the last three months (see chart). FIIs invested in both Equity and Debt markets during this period. Interestingly, this coincides with the reduction of short term interest rates by the Federal Reserve. Since September 2007, Fed has pared interest rates by one percentage point in order to protect the economy from falling into recession. Reduction in interest rate, appears to have induced investors to move money into the Indian markets.

Madhan Gopalan

The author, currently based at Louisville, Kentucky, is a Global Equity Research Manager with Ness, USA. The views expressed in this article are his and not necessarily of his employer. He can be reached at gmadhan72@yahoo.com

Federal Reserve's Juggling Act

In my post dated April 4th (American New Home buyers can wait), I had indicated that the Federal Reserve will be forced to ease the interest rates if the housing market crisis continues. This is what appears to be happening in the US economy. Between September and now, driven by an economic slowdown in the wake of housing market crisis coupled with rising oil prices, Fed has lowered the short-term interest rates by 100 basis points (one percentage point).

The Outcome

When Fed lowers its interest rates, a string of things starts to unfold.

1) Investment and consumption expenditure increases – Propelled by lower lending rates offered by commercial banks, businesses get into the expansion mode by making sizeable investments. In addition, big ticket consumer items that are generally purchased through financing also surge, as retail loans (e.g. auto loans) becomes relatively cheaper

2) Dollar falls – When interest rate plummets (relative to other countries), Investors preferring higher returns move their funds to countries with a higher interest rate. When money moves out of the US, people sell dollars and buy other currencies say the Indian Rupee or the Chinese Yuan. With less dollars demanded, the value (price) of the dollar drops in the Forex market

3) Exports surge – A decline in the price of dollar means that foreigners only have to pay less (than before) to buy US made goods and services. Consequently, foreigners buy more goods produced in the US.

4) A multiplier process unfolds – Increase in expenditure results in an increase in income, which in turn augments the consumption expenditure. This enhances the aggregate demand, resulting in higher Real GDP and inflation rate.

The Juggling Act

Fed’s decision to increase the money supply (by paring the interest rates) to avoid an economic slowdown has a trade off, in the form of inflation. A cursory look at the CPI, an index that tracks the price level of key commodities, stands testimony to this. Inflation, since September 2007 has steadily increased both on a sequential basis and on a year-over-year basis (see table).

Now, Fed’s choices are caught between a rock and a hard place. Fed has limited incentives to pare the interest rates further, given the surge in inflation rate. Why? If Fed lowers the interest rate further, the rising inflation would pose a huge risk to growth. For instance, between 1975 to 1977, Fed continued to increase the quantity of money supply to accommodate increasing oil prices. This pushed the inflation stratospheric levels. However, when the OPEC cartels pegged up the price of Oil again in 1979, Fed didn’t react. Though this action curbed the inflation rate, the US economy went into a deep recession.

On the other hand, Fed will also find it hard to increase the interest rates, given the state of economy. Why? An increase in interest rate, at the current juncture, will prolong the economy’s recovery. Fed must be closely monitoring the supply-demand situation in the economy. It would be interesting to see how Fed nudges the economy into the growth path, concurrently keeping the inflation under control.

Madhan Gopalan

The author, currently based at Louisville, Kentucky, is a Global Equity Research Manager with Ness, USA. The views expressed in this article are his and not necessarily of his employer. He can be reached at gmadhan72@yahoo.com