Understanding FII investment
Business Standard, 2 Jan 2008
Fear of capital flows is, in part, rooted in their incomprehensibility. The process of removal of capital controls in India is leading to a buildup of empirical experience with financial globalisation. An examination of data about FII inflows into India yields fascinating explanations at the level of both macroeconomics and firm characteristics.
FIIs have convertibility on the equity market, and this is the most important single element of India's de jure openness. It is, hence, important to study FII flows. Between March 2001 and March 2007, the market value of shares owned by FIIs went up from $9.7 billion to $124 billion. What was going on here? What explains FII flows?
A fairly long time-series of monthly data for net FII inflows is now available. A problem with this time-series is that when inflows are expressed in million dollars per month, the values for the early years are very small when compared with recent values. In the statistical analysis, the recent values tend to dominate.
A key insight in analysing this data lies in rescaling FII inflows by the broad market capitalisation of the country. The market capitalisation of the CMIE Cospi index, which comprises all firms with a minimal degree of stock market liquidity, is the best choice for this purpose. The market capitalisation of Cospi is roughly Rs.63 lakh crore, so in today's units, an FII inflow of 1% of COSPI would correspond to Rs.63,000 crore rupees. Once this rescaling is done, four factors appear to affect monthly inflows:
- The first is currency expectations. The best measure of currency expectations in India is the deviation on the currency forward market from rational pricing. When the rupee is expected to appreciate, importers tend to not cover, and vice versa. In a typical market economy, this would not be an issue, because forwards pricing is done by arbitrage and arbitrage alone. But in India, RBI has peculiar rules that limit this arbitrage. As a consequence, the currency expectations of the market show up as forward prices which are `too high' or `too low'. The "CIP Deviation" is the error between the observed forward premium and the fair value. It is an effective measure of the market's expectations about rupee movement. We find that when the CIP deviation is high, FII inflows are bigger.
- The next factor is Nifty. When Nifty yields positive returns in a given month, FII inflows are elevated in the following four months (and vice versa). A month with 10% returns on Nifty induces additional inflows of 0.2% of Cospi market cap - roughly $3 billion - over the following four months.
- The third factor that matters is the P/E of Cospi. Foreign investors are deterred by a high P/E and vice versa. Foreign investors seem to be momentum investors (bringing more money into India in the four months after positive Nifty returns) but also value investors (bringing more money into India when the Cospi P/E is low).
- The fourth factor is the VIX: the implied volatility calculated from the option market on the S&P 500. This measures expectations of future volatility of the S&P 500. When future volatility of the S&P 500 is higher, less money comes into India, and vice versa.
Turning to firm level data, the first issue that merits focus is non-promoter shareholding. FIIs can only buy shares in the space that has been freed up by promoters. In recent years, promoters have increased their shares in many companies, which has actually reduced the space for FIIs.
This suggests a focus on FII ownership as a percentage of non-promoter ownership. Here, there is a two-part story. First, there appears to be a club of companies which have non-zero FII ownership. Firms which fail to make the grade on size, liquidity and corporate governance do not get into the FII club. Once club membership is secured, similar factors (size, liquidity, corporate governance) affect the proportion of non-promoter holding that is bought by FIIs.
The most interesting result of this exploration (slideshow, paper) lies in the extent to which it explains the dramatic change in foreign ownership of Indian equities from 2001 to 2007. To critics of financial globalisation, the upsurge of FII inflows into India is a fad, it merely reflects shifting fashions in financial globalisation. FIIs are seen as capricious, ignorant and untrustworthy.
However, careful modelling shows that the bulk of the change in foreign ownership (expressed as a proportion of non-promoter shareholding) can be explained based on changes in size, liquidity and corporate governance. In other words, the major reason why there has been an upsurge in FII inflows into India lies in the meritocratic story that the firms have gotten better. Conversely, policy makers and business leaders have the choice of fostering size, liquidity and corporate governance so as to retain and attract foreign capital.
The improvements in stock market liquidity are rooted in the successful reforms of the equity market which began from 1993 onwards and particularly the build-up of derivatives trading. This analysis suggests that we have to continue to strengthen stock market institutions, and put a strong focus on building SEBI into a top quality organisation, so as to be able to continue to grow stock market liquidity and thus bring a reduced cost of equity capital to smaller firms.
The improvement in profits of Indian firms is rooted in the strong performance of the macroeconomy. In a business cycle downturn, profits will go down, the firms will be smaller, and unchanged behaviour on the part of FIIs will generate lower ownership of Indian firms.
In the process of becoming a mature market economy that is integrated into financial globalisation, fear of the unknown is a key constraint. Macroeconomic and firm level data is now building up, which helps us understand FII inflows better. The monthly time-series of FII inflows (expressed as percent of the CMIE Cospi market capitalisation) is affected by rupee expectations, Nifty returns of the last four months, the Cospi P/E and the VIX. Firm level data analysis shows patterns involving size, liquidity and corporate governance that determine which firms are able to graduate into participation in globalisation. The bulk of the sea change in foreign ownership of Indian firms from 2001 to 2007 is explained by the sea change in firm characteristics over this period.
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