FII investments reach all-time high in September 2010

Foreign Institutional Investors are betting heavily on the India growth story. By the end of September, 2010, the FII investment in calendar year 2010 stood at US $ 28.5 bn, out of which US $ 18.4 bn were in equity while US $ 10.1 bn were in debt instruments.

Figure 1: FII Investments in Equity and Debt (Source: SEBI)

During 2010 the cumulative investments by FIIs in India, has already crossed the highest investments India has ever received in any calendar year. FIIs are the driving force in the market. During the month of September, Nifty has risen by 11.62%.

Figure 2: Total FII Investments (Source: SEBI)

2008 was the only year in which there was a net FII outflow. Inflows rebounded during 2009, almost reaching the 2007 levels. Inflows in 2010 are already 50% more than that received in the whole of 2009. The cap on FII investment in government & corporate debt was recently increased from US$ 20bn to US$ 30bn. A hike in the investment limit was necessary, as FIIs have already reached close to the existing limit of US$ 5bn in government securities & US$ 15bn in corporate debt. Net FII inflow into the debt market has grown over eight times from a little over US$ 1bn in 2009 to a more than US$ 10bn during the first nine months of this year. 

At the current rate FIIs inflows are on track to exceed US$ 40bn by the end of 2010.

Is The Market About To Top Out?

Never invest with the herd. More often than not, it is disastrous for your investments. No one can predict what the market will do; but one of the best indicators of a market top is when a so called perma-bear becomes a bull.

Is a tiger changing his stripes a sign of a market top?

It is certainly one of them. When a famously bearish analyst joins the chorus of bulls, it's time to be a little careful. One of the loudest contrarian voices, James Grant recently jumped ship.

James Grant is the editor of Grant's Interest Rate Observer. Among his books is "The Trouble with Prosperity." He is often referred to as a “perma-bear.” Reporters ring him up when there is a downturn in the markets. A glass half empty kind of guy. His recent article in The Wall Street Journal and newly bullish stance has caused a buzz in the US markets.

The Market Does What It Wants To Do

Sharp rallies are the rule in a bear market, not the exception. It is common for the market to rocket upward in an overall downtrend. Take a look at the following chart of the Dow Jones from 1929 – 1932.

During that time, there were seven major declines and six major rallies. The rallies ranged from 19% to as high as 101%. And in every case, investors probably thought the worst was over and a new bull market had dawned.

This rally has not been built on the foundation of improving fundamentals. There is still too much wrong with the economy to hope that a new bull market is beginning just yet.

What To Do?

Don't sell and exit the market. This rally could run much higher regardless of the fundamentals. Book 50% of your profits, set trailing stop losses and let the rest of your profits ride.

Is Irrational Exuberance Back In The Markets?

With market chaos abating the return of risk appetite in stock and lending markets is logical - up to a point. Markets probably overshot to the downside and some level of recovery is therefore only a return to a sensible middle ground.

But there are clear signs of an overshoot on the upside - an 'echo bubble'. Sensible analysis of stock prices for instance suggests that after the run-up of recent months, markets are clearly overvalued. A recent rash of IPO's (NHPC, Adani Power, Oil India), follow-on offers and QIP's (Axis Bank) and large bond issues can be seen as a return to business as usual.

Investors are also tired of talking about the macro issues. That's understandable given the return of a modicum of stability to markets. Yet the things that keep people awake at night are still the big macro concerns:

• Is the US consumer going to pull back further?
• Is a continuing downturn in commercial property going to undermine the credit recovery?
• Are bad things still lurking in the banking system?

The fact is that the foundations of a recovery are scarcely in place, yet the optimists are already looking for the lift to the new skyscraper's observation deck.

Will The US Dollar Decline In Value?

In theory, because of the huge amounts of dollars printed by the US Fed the US Dollar should weaken against all currencies. To some extent it has already happened. In the last 3-4 years as the US Trade and Fiscal deficits increased, the dollar did weaken.

From 2000 to 2007 the USD lost half its value with respect to the Euro. Refer the Euro-USD chart below:

This is exactly as per theory. But in the short run when investors seek to avoid risk they move into safe assets. So currencies like US Dollar, Swiss Franc appreciate in value. Similarly Gold gains when investors seek safety over returns. So in the last 6 months the dollar strengthened against other currencies.

In many respects India and US are remarkably similar. India has a huge fiscal deficit and is a net importer of goods. Last year India's Trade Deficit was over $100bn which as a percentage of GDP is worse than America !! This trade deficit was financed by foreign investors who bought Indian stocks and bond by the truckload. So, the rupee remained stable, when the stock market declined, the inflows dwindled and the rupee weakened.

India does not have Capital Account Convertibility. The Reserve Bank of India's official is to prevent sudden volatile movements in the currency markets. The RBI does not try to fight the trend; it tries to smooth out the volatility.

There was an article in the New York Times weekend edition about the US Dollar. Read the article here

Asphyxiation By Forex

India's phenomenal growth of the last five years was powered in large part by huge injections of cash and investment. Investment accounted for about 39% of the country's gross domestic product in the 2008 fiscal, up from 25% five years ago. At its peak, more than a third of investment came from abroad. At its peak, more than a third of investment came from abroad.

But in the last three months of last year, foreign loans and direct investment fell by nearly a third, to their lowest level in more than two years.

Source: Reserve Bank of India

The decline in foreign investment has taken a big toll on sectors like real estate, manufacturing and infrastructure. In the last quarter of 2008, the economy's growth rate plummeted to about 5.3%, the lowest in five years.

For 8-9% growth rate, private investment and low cost of capital is essential. The Government's Fiscal Deficit has ballooned to 10% of GDP. The Government is expected to borrow Rs 300000 crore this year compared to Rs 120000 few years ago. Such large borrowings will crowd-out the private sector and lead to an increase in interest rates.

Cutting subsidies, reducing the fiscal deficit and attracting foreign investment should be top of the 'To Do' list for the Government.

Capital Flows And The Financial Crisis

The latest issue of the The Economist has a great article on how America's huge current-account deficit and China's huge Current account surplus together created enormous global imbalances. A growing number of policymakers and academics believe that these lay at the root of the financial crisis.

To read more click here