Sustained capital outflows from the capital market have unnerved the stock markets and led to a weakening of the rupee amid rising inflation across the globe. With the US Federal Reserve set to hike rates further, outflows are likely to continue, putting pressure on the Indian currency.
Why is capital flowing out?
Foreign portfolio investors (FPIs), which own around 19.5% of the market capitalization, have pulled out Rs 42,000 crore in June so far, taking the total outflows to Rs 260,000 crore ($ 33 billion) since October 2021. The FPI sell-off is being attributed to the tightening of monetary policy by the US Fed which has been on a rate hiking spree to control inflation. Other central banks, including in Britain and the Eurozone, are following suit.
“Relatively high valuations in India, rising bond yields in the US, an appreciating dollar and concerns regarding the possibility of a recession in the US triggered by aggressive tightening are factors behind FPIs’ pullout,” said VK Vijayakumar, Chief Investment Strategist at Geojit Financial Services.
When the global economy took a hit, central banks across the world slashed interest rates and announced liberal monetary policies. While this helped the economies recover and led to higher consumption, the surplus liquidity in the financial system led to inflation. This is why central banks have started tightening monetary policies and hiking interest rates. In India, inflation surged to an eight-year high of 7.79% in April, prompting the RBI to hike the repo rate by 90 basis points to 4.90%.
How does it impact the markets and the rupee?
The pullout is dampening sentiment in equity and forex markets. The benchmark Sensex has plunged by 16% from the October 2021 high of 62,245.43 to 52,266.72 on June 23. The impact of FPI selling on markets is visible, with increase in volatility and declining equity prices. While this selling by foreign investors has been absorbed by domestic investors led by domestic institutional investors (DIIs) to a large extent till now, fund flow from retail investors and domestic institutions has slowed down of late. Between November 2021 and June 2022, DIIs have invested a net of Rs 2,84,488 crore (over $ 37 billion) in Indian equities, providing some counterbalance. Experts say, however, that the retail flow and DII inflow is weakening now, and the markets could weaken further if the FPI outflows continue.
India’s foreign exchange reserves have fallen $ 46 billion in the last nine months to $ 596.45 billion as on June 10, 2022, mainly due to the dollar appreciation and FPI withdrawals. The rupee has plunged 7.3% to an all-time low of 78.30 / 32 against the dollar. Rupee depreciation is never good for the overall equity market, and foreign investors pulling out can result in a decline in stocks and equity mutual fund investments. Foreign investors generally keep away when the currency is declining and interest rates are rising in the US and developed markets.
Analysts said a lower rupee against the dollar keeps import bills higher, pushing inflation even higher than it is now. Higher inflation is detrimental to the overall market. If the rupee does not strengthen, FPI outflows will continue, which is another negative. A strong dollar is good for export-oriented companies, but bad for import-oriented industries such as oil, gas and chemicals. With the dip in the rupee, oil imports and other imported components will get costlier, which will further lead to higher inflation. Travelers and students studying abroad will have to shell out more rupees to buy dollars from banks. People are directly impacted by the rupee fall as fuel prices shoot up.
How do FPIs operate?
In times of global uncertainty, foreign investors embrace a risk-off trade, meaning they move money from risky assets such as equities and add more of bonds and gold. When interest rates rise in the US and other advanced economies, they withdraw money from emerging markets such as India and invest in the bonds in their domestic markets. The 10-year US bond has shot up from a low of 0.54% in July 2020 to over 3.30% now.
“The global investing scenario has been plagued by risk-off trade since October 2021, as central bankers hinted at policy tightening with inflation moving from being ‘transitory’ in nature to somewhat of a medium-term headache. This aided the bond trade globally as yields started to become attractive, nudging investors to allocate a higher portion towards Fixed Income as an asset class, ”said an Axis Mutual Fund report. The rise in global yields is not good news for Indian stocks and investors. The FPI sell-off has led to a decline in the valuation of top-500 companies, with some of them losing 15-20% in the last 9 months.
How big are they in India?
FPIs are the largest non-promoter shareholders in the Indian market and their investment decisions have a huge bearing on the stock prices and overall direction of the market. Holding of FPIs (in value terms) in companies listed on NSE stood at Rs 51.99 lakh crore as on March 31, 2022, a decrease of 3.36% from Rs 53.80 lakh crore as on December 31, 2021, due to the sustained sell-off since October 2021.
FPIs hold sizeable stakes in private banks, tech companies and big caps like Reliance Industries. The US accounts for a major chunk of FPI investments at Rs 17.57 lakh crore as of May 2022, followed by Mauritius Rs 5.24 lakh crore, Singapore Rs 4.25 lakh crore and Luxembourg Rs 3.58 lakh crore, according to data available from the National Securities Depository Ltd (NSDL).
Will the rupee fall further?
The rupee has continued to depreciate beyond the general expectation of a gradual weakening despite the RBI selling dollars from its forex kitty to stabilize the currency. At current dollar-rupee spot levels, year-end forward pricing has moved above its projection of 79 per dollar by end-2022, a Bank of America Securities report said. “We believe the risks are still skewed towards more depreciation for the rupee as the fundamental outlook has deteriorated further primarily due to higher oil and other commodities. We have adjusted our projection higher from 79 currently to 81 per dollar for year-end 2022. We, however, see the RBI’s strong reserves as a mitigating factor against tail-risks, ”it said.
The rise in US inflation, rate hike worries and the stock market fall are weighing on the rupee sentiment. On the other hand, more rate hikes by the Fed will lead to higher outflows from foreign portfolio investors.
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What should investors do?
If FPIs continue with the outflow and there is a dip in retail and DII participation, which market participants have noticed over the recent past, the equity markets may witness further correction. However, while other markets may correct further from current levels, experts say that investors should stick with their existing investments in domestic equities.
“Even as weakness is likely to continue in the markets, investors should not look to redeem their holdings in the current market. “They should stay with them as a rebound in economic activity, which is on the way and could gather momentum over the next one to two years, would result in revival of the markets going forward and thereby gains for investors,” said the CIO with an asset management company. He further said investors should not go for lumpsum investments and should instead continue with the systematic investment plan mode.