SECTION 3 : MARKET TRENDS Anand Subramanian

Manager RSM & Co.

Portfolio Flows
Portfolio flows to India India has witnessed over a decade of portfolio flows and with each passing year, portfolio flows have gained in their significance and have played a key role in the overall Indian economy. Although investment by foreign institutional investors are typically synonymous with portfolio investments in India, investments in ADRs / GDRs and offshore funds are also included in any analysis relating to portfolio flows. In this article we review the portfolio flows in 2002-2003, the key motives that drive portfolio investments and the prerequisites to ensure a healthy rate of portfolio flows into India. India 2002 / 2003 in perspective The year 2002-2003 was highlighted by significant events, both locally and internationally that had a bearing on the Indian economy. Although the failure of the monsoon had adversely affected the growth in the agricultural sector, the growth in the industrial and services sector partly made up for such shortfall. Further, with easing of interest rates and improved liquidity, there was no adverse impact on performance of the corporate sector. By end March 2003, cumulative portfolio investments totaled nearly US$16 billion, which constituted nearly 11 percent of the countrys stock market capitalization. During the year 2002-2003, net flows were positive in all months expect during the months of June, October and March, with the highest outflow being recorded in October 2002, in view of the tension along the Indian border and subdued conditions prevailing in the Indian equity markets. During the year 2002-2003, net inflows declined to Rs3,530 crores (US$ 735 million) from Rs8,273 crores (1.72 billion) during the previous year. As such, although the Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII) in India were lower when compared to the earlier year, the net capital flows were stable.
(USD billion) 4 3 2 1 0 -1

Anand Subramanian is a manager with RSM & Co. He specialises in formulating entry strategies for foreign companies that intend to establish a presence in India, structuring FII investments into India and advising Indian companies on their outbound investments. Anand has also advised clients on joint ventures and strategic alliances, with specific emphasis on the financial services sector. Prior to joining RSM, Anand was with Infosys and Arthur Andersen. Anand is a member of the Institute of Chartered Accountants of India and a Bachelor of Commerce from Bangalore University.

Foreign Investment

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1998-99

1999-00 FDI

2000-01

2001-02

2002-03

Portfolio Investment

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Most emerging markets faced difficulties in attracting portfolio investment as equity markets across the world continued to be under pressure on account of multiple factors including, need for greater structural reforms, geopolitical tensions and subdued economies in developed markets. The Indian market continued to attract portfolio investments on account of positive moves on the privatization programme and a credible performance by the domestic industry. India continued to be one of the few emerging markets that attracted portfolio investment and this bodes well for Indias ability to outperform other emerging markets in the coming year. Amongst other emerging markets, Russia, Indonesia and Thailand were some of the best performing emerging markets, with investors impressed by the pace of reforms in these countries. In contrast, markets like Brazil were hit last year by investor concerns about the countrys debt situation and the political commitment to carrying out economic reforms, while countries like Philippines have completely fallen off the investor map due to a disappointing reform drive. With portfolio investors weighing their returns based on country-specific factors, such as reform impulses, countries such as India will need to do more than ever on the policy front and ensure a sustained programme of reforms on the structural and economic sides of the economy. Global view In the 1990s, capital flows of public and private sector were broadly equal at around US$60 billion. Over the next decade, private flows grew five fold to over US$300 billion, while public flows almost halved. This fall was marked by liberalization of markets that made capital mobile. Further, the new liberalized economy linked the fortunes of the developed and the developing economies even closer, resulting in higher competition for portfolio flows. Another analysis by the World Bank on FDI and portfolio flows indicates that in 1980, flows of short-term debt to emerging markets amounted to US$30 billion. In the 1990, the figure was US$15 billion. From 1998, flows of short-term debt turned negative. FDI inflows moved sharply in the opposite direction: from US$5 billion in 1980 to US$24 billion in 1990 to US$160 billion in 2000. Net portfolio investment has increased too, from about zero in 1980 to US$26 billion in 2000. In the current year, emerging economies should see a modest increase in net private capital inflows. As per the Institute of International Finance, the net private capital inflows is expected to be US$139 billion in 2003, up from US$110 billion last year, the lowest level in a decade. FDI, the biggest component of private capital flows, is expected to fall slightly, from US$111 billion in 2002 to US$109 billion in 2003, while investment in bonds is expected to double on account of drastic fall in emerging market bond spreads. In order to garner a higher share of the portfolio flows, India has to make conscious efforts in liberalizing the manner in which qualifying entities can invest in India and by further deregulating the investment limits.

G-113

Net private capital inflows

(2003 forecast)
Europe 22% Africa / Middle East 4%

Asia / Pacific 49%

Latin America 25%

Indian context Various studies have indicated that portfolio flows into India have relatively low volatility compared with many other emerging markets. India has also not witnessed sharp portfolio outflows, and with the exception of 1998-1999, net inflows have been positive each year. In fact, domestic political events such as border tensions, or external shocks such as the Iraq war have tended to be mild and short lived, indicating to an extent the sustainability of the Indian economy. Today, FIIs account for over 10 per cent of the turnover on the Indian bourses and a whopping 50-60 per cent of the deliveries. This, in itself, has given FIIs considerable sway in the Indian capital market. With a bulk of FII funds (95 per cent) invested in stocks that comprise the key indices and half of it in the top five stocks that comprise the key indices, their influence on the performance of the stock market is immense. While the Government has continued its efforts to attract portfolio investment by offering various incentives and streamlining the regulatory and tax regime, it is important to note that most of the FII investment is also pinned on Indias weightage in crucial international indices such as the Morgan

Looking from a different angle, portfolio flows are also showing sings of following a reform-based investing approach, which is one of the main drivers in ascertaining country returns within emerging markets. In fact, most portfolio flows are to countries where the economic development is backed by increased sophistication in the financial and legal systems. In this context, emerging markets such as Russia, Czech Republic, Indonesia, Thailand and Hungary were amongst the best performing markets in the world, all powered by meaningful domestic economic reforms.
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Stanley Capital International (MSCI), which in turn will rally the FII interest in the country. This was particularly evidenced in the way the FIIs strengthened and pared their holdings in the Indian markets through 2002, taking cue from the MSCI weightages. Looking from a different angle, portfolio flows are also showing sings of following a reform-based investing approach, which is one of the main drivers in ascertaining country returns within emerging markets. In fact, most portfolio flows are to countries where the economic development is backed by increased sophistication in the financial and legal systems. In this context, emerging markets such as Russia, Czech Republic, Indonesia, Thailand and Hungary were amongst the best performing markets in the world, all powered by meaningful domestic economic reforms. There is hope that India will intensify its reform effort to positively differentiate its equity market in a more discerning environment. Further, given that India has started making a tangible dent in building its profile as a competitive hub for global industries such as outsourcing and manufacturing, it is important for India to ensure that other microeconomic blocks fall in place for a bigger India story to materialize. Determinants In the Indian context, some of the key determinants that have a bearing on portfolio flows in the past and in the coming year are highlighted below. Domestic economy India emerged as one of the fastest growing exporting countries in the world and the country witnessed the highest ever net invisible earnings in any year and ended the year with a surplus on the current account. The positive performance of the domestic economy had a significant influence in renewing interest of portfolio investments in India. Foreign exchange reserves The overall economic condition resulted in a record accretion in foreign exchange reserves, the third largest increase among the emerging market economies during 2002-2003. Incidentally, India is the sixth largest reserve holding country among the emerging market economies. The positive foreign exchange reserves were facilitated by net capital flows, particularly non-resident deposits and private remittances and non-debt creating capital including repatriation of past export

proceeds, which entail no future contractual obligation to service and are mostly non-reversible. Interest rate Interest rates came off substantially during 2002-2003 and this had a direct impact on corporate bottomlines and this also resulted in greater allocation of funds to equities compared to other fixed income avenues. Tax initiatives The Union Budget 2003 announced that dividends would be exempt from tax in the hands of a shareholder. Henceforth, dividends declared by an Indian company would not be liable to Indian taxes. However, the Indian company will be liable to pay 12.81% (including surcharge) dividend distribution tax. Further, long term capital gains arising on transfer of equity shares (held at least for one year) in a listed company, acquired between March 1, 2003 and February 28, 2004 would be exempt from tax. These initiatives were specifically targeted at resurrecting the Indian capital markets and attracting portfolio investments into India. Conclusion The year 2003 may witness moderation in investor appetite for emerging market assets, which could in turn affect the prospects of private capital flows to emerging markets, which is projected to decline to US$18.4 billion on account of outflows. However, portfolio flows have an increasing relevance from an Indian context and Indias ability to attract a higher level of portfolio flows would reflect Indias place in the pecking order among emerging markets and the level of sophistication of Indian capital markets. Other key policy measures of the Government, especially in liberalizing foreign investment in sectors such as, telecom, banking and insurance would be tracked closely, while the effect of the ruling of the Supreme Court on the tax implication of portfolio investments in India could have its own effect on the ability of FIIs to sustain their investments in India. Although private capital flows into emerging market economies have decreased significantly since the East Asian crisis, the Indian economy, which has been one of the most resilient performers amongst the emerging market economies should expect to receive much higher portfolio inflows in the coming years.

www.bseindia.com
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An intensive programme on securities market operations and stock exchange management through class room training, field visits, interactions with senior capital market professionals and also first hand experience of looking at the working of various operations, systems and procedures in securities markets. Highly useful and educative programme for officials of the emerging and transition economies. This programme held in Mumbai, is already attended by professionals from Oman, Kenya, Pakistan, Bangladesh, Sri Lanka, Nepal, Bhutan.
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