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Business News/ Money / Personal-finance/  Growth prospects may attract foreign portfolio investment
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Growth prospects may attract foreign portfolio investment

Equity markets in India struggle when FPI inflows dry up. But improved growth may prevent this

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Bloomberg

Fresh equity inflows will likely swing due to expected earnings recovery in September, although India’s higher growth prospects and volatility in China should limit outflows, according to a recent report by Bank of America Merrill Lynch, What if capital flows stall?

Foreign portfolio investment (FPI) inflows are critical for both equity and debt markets. Equity markets typically struggle when FPI inflows dry up if valuations are rich. The government securities (g-secs) market will find it difficult to clear in the absence of fresh FPI inflows. That said, the Reserve Bank of India (RBI) will need to conduct open market operation (OMO) purchases to inject reserve money rather than OMO sales to prevent any hardening of yields. On balance, the RBI is expected to hold 60-65 per dollar.

Here are a few things to watch for in the coming months.

Earnings are key

There is a downside risk to Bank of America’s FPI equity inflow forecast of $15 billion for financial year (FY) 2015-16. Fresh inflows will likely be based on an earnings recovery in September even as chances of growth recovering in India and volatility in China limit outflows. The S&P BSE Sensex’s profit growth is forecasted to recover mildly to about 4% in the June quarter from -0.1% in March on a stand-alone basis. On a consolidated basis, this comes to 0.3% in the June quarter from a fall of 6.4% in March. An upside surprise in reforms—such as passage of goods and services tax in Parliament’s present monsoon session—could also support markets.

Equity markets typically swing when FPI inflows dry up if valuations are rich. Equities do not appear cheap given the Sensex 1-year forward price-to-earnings will climb to 17.3 times, well above the 14.5 times average, if consensus FY16 Sensex profit growth forecasts are downgraded to 15% from 23%. Stalling or reversal of capital flows at this point could, therefore, result in a Sensex correction.

RBI OMO to hold yields

The FPI debt investor under-owns India and may be more than willing to buy g-secs as long as the RBI is seen to cut rates. There is sufficient appetite for debt FPIs to play India’s falling rate cycle that the RBI could use to rebuild foreign exchange reserves. After all, the rupee tends to depreciate when the import cover, now 9.3 months, slips below the eight-month level. We expect the RBI to cut 50 basis points more with consumer price index inflation set on under-6% by January 2016. The timing will depend on rainfall and market pricing of the expected September US Federal Reserve rate hike.

Debt FPIs have invested in quasi g-secs (counts under the $51 billion corporate bond limit) as the $30 billion foreign institutional g-sec limit is filled up. This poses a risk if there is an emerging market sell-off in anticipation of a Fed hike. It is expected that the RBI will increase the limits by $5 billion after the first Fed rate hike in September or in August if the Federal Open Market Committee sounds dovish on 29 July.

Foreign exchange

RBI is likely buy at 62 per dollar levels and sell $15 billion to defend 65 per dollar levels. Over the past two years, with the RBI now recouping foreign exchange reserves, import cover has increased to close to 10 months. As a result, the rupee has outperformed its peers.

Three event risks

Portfolio inflows will likely swing on three event risks in September-October. First, will the Fed hike in September as many expect it to? Second, will the September earnings in India stage a recovery? Finally, what will the Bihar poll results mean?

Edited excerpts from Bank of America Merrill Lynch’s report, What if capital flows stall?

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Published: 29 Jul 2015, 06:31 PM IST
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