The dilemma of being an FII in India: Only entry, no exits

Since we are told that two-thirds of India is under 35, it would be fair to assume that the majority of readers believe music began with Shreya Ghoshal, or Guns and Roses. But some from a certain generation will remember a rock classic from the Eagles, Hotel California. Don Henley’s wailing lyrics and the Felder/Walsh duo on lead made the song an all-time hit. Playing to a familiar loss of innocence theme, it remains the best ever evocation of a certain Southern California way of life - and the dark underside that came with it.

Now why go on about Hotel California? Well because part of the allegorical impact of the song came from the person who had the surreal experience of entering a luxury hotel he could not leave. Something like that may be happening with foreign institutional investors (FIIs) in Indian equities. They’re in, but there’s no out.

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**“Up ahead in the distance,**I saw a shimmering light”

Sometime in 1992, when they were first allowed in, the ferengs saw up ahead in the distance - a shimmering light. It was the light of India Shining. Their heads grew giddy, and their eyes grew starry. They stopped by - not for the night - , but for a generation.

The result, gentle reader, is that today with the market at its all-time high, total FII holding in Indian equities is close to $200 billion. That’s over Rs 13 lakh crore at current exchange rates. It’s also about a quarter of total market capitalisation.

Actually, if you take away promoter holdings and the government’s stake through “President of India” holdings in public sector companies, you’re left with something called the “free float”. Doing this is sensible as these holdings rarely change. FIIs hold about 40 percent of that “free float” (i.e.) non-promoter, non-government holdings in the Indian market.

These guys are the biggest game in town. Perhaps the only game.

A reasonable question to ask is what will happen if they come to sell. If they come to sell, someone will be required to buy from them, and take paper off their hands. That someone is usually the domestic institutional investor (DII) segment, which for all practical purposes is LIC. The other alternative is the public.

Both have issues. LIC buys less than Rs 40,000 crore a year, hardly a large sum compared with the FII holding. The public - that great saviour of the professional who wants to dump his holdings on them - is not present in the markets. Besides, the public, because of their flexibility on exiting, seems to have done better than the professionals. In India, the pros, particularly the mutual funds, are the dinosaurs because of their mandate to stay fully invested.

Consequently, there seems to be some tension, both in markets and in policy circles, about what will happen if FIIs do exit. The absence of countervailing buying power could result in the sort of huge market sell-off we saw some years back - a sort of 2008 redux.

But relax. The FIIs are not going anywhere. Both their belief systems and their investment patterns make them prisoners of their own device.

**“We are all just prisoners here,**Of our own device”

[caption id=“attachment_1040443” align=“alignleft” width=“380”]  Like the traveler in the Eagles hit Hotel California, FIIs cannot leave India, says Adil Rustomjee. PTI[/caption]

One is awe struck by the remarkable resilience of the FII belief in India. In fact, they have been net investors in India for 20 of the past 22 years since they were first allowed in. This is surprising considering that they are literally the worst investors in India, perennially buying at the top and getting cleaned out at the bottom. Part of the reason for this performance is that they’re fighting a secularly depreciating currency. Between 5 and 7 percent of annual folio returns disappear in currency conversion from rupees to dollars on exit, and long-term hedging against the rupee is simply too expensive.

Their patience is saintly, and commendable. One would have thought that, at some point patience is a finite commodity, even for a saint.

Never mind the fact that in 2008 with the Sensex at 8000, growth came in at 6.8 percent. Today, with the Sensex crossing its all-time high of 21,000, growth, according to the IMF, will come in at a little over half the earlier rate. Of course, earnings have grown in the intervening five years, but not by much. As a result, the market trades at a price-to-earnings ratio of 17 times trailing earnings, unusually high given the state of the real economy.

Never mind the macroeconomic imbalances, the ‘policy paralysis’, parlous factor markets for land and labor, a tottering financial sector, barely coherent monetary transmission, the creaky judicial system, the absence of even common sense regulatory economics, predatory tax authorities, the looting of natural resources, collapsing urban infrastructure, and the non-stop drip drip of scams, that are endlessly recounted in the media.

Despite all this, the FIIs believe. In fact, they believe more than we do. And they stay on. This is remarkable and needs examination. It is indicative of an act of faith more than anything else.

A belief system is at work here. There is a belief in something called the “India growth story”. Earnest, pretty, papihas in the media are often heard asking hardened businessmen and seasoned portfolio managers “Sir, do you believe in the India growth story”. To this, the answer usually was a resounding ‘yes’. Nowadays, it’s a more guarded ‘yes’.

It’s actually a little like someone being asked if they believe in God. The stock answer of the respondent should be that it’s a private affair - so go to hell. The above mentioned hardened businessmen and fund managers don’t have that luxury on national television, so they play along and say “YES, I BELIEVE”.

The need to believe in India is seen as imperative, and as urgent as the need to believe in God. It seems almost as though the “India growth story” has a religious dimension to it. This is not surprising, considering the religious fervor that pervades day-to-day life in India. The use of the word “believe” is the key. It presupposes doing business in India is an act of faith, instead of an act of reason.

Presumably doing business anywhere is not an act of faith, but an act of reason. But that normal rule doesn’t apply here. Or perhaps in India, it is as much an act of faith, as an act of reason.

India has become a little like Russia. Fyodor Tuitchev, Russian minor poet, famously once said “You can never understand Russia with the mind. You can only hope to believe in her.” Something like that seems to be going on here too. Perhaps one cannot understand India with the mind. In India, it seems, one can only believe.

This belief by FIIs in the “India growth story” is still rock solid, and despite mounting evidence to the contrary. Consider Blackstone, a private equity fund, regarded as the epitome of smart money. The track record - on the part of their portfolio that is publicly available - is actually an embarrassment, but I will, for reasons of professional courtesy, not go into that here. Or take Ford on the foreign direct investment (FDI) side. Remember these guys invented modern assembly line manufacturing, and they are considered a paragon of excellence in automotive engineering and marketing. After 18 years in India, mind you this is almost a generation, Ford has this to show for it - a 2 percent market share and almost 2000 crores in accumulated losses. Old Henry Ford must be turning in his grave at these numbers.

The above scenario is being repeated countless times. In fact, other than three complexes in the economy-the healthcare/pharma/hospitals, the shampoowallas / saboonwalas (FMCG), and the IT/BPO/KPO space - it remains the norm. But it is being swept under the carpet. Remember, this is a country where appearances have to be maintained above all else. Sometimes it seems that the rest of the country - outside these complexes of excellence - is a banana republic.

The “India growth story” also gets married to that most dangerous of beliefs - belief in the long run. In the long run, as the clich from Keynes goes, we’re all dead. It appears that most investment rationalisations carry this belief. Various reasons are given for this belief in the long run - the demographic dividend, the hugh domestic market, a rising middle class, and so on. The future, for these reasons, is always on the distant horizon, a horizon that itself keeps receding as we advance. The present may be a mess, but the future on that horizon is always glorious. If only we could reach it.

The problem is that both interest rates and the cost of doing business in India are so high, that belief in the future starts getting expensive very quickly. Remember the interest rate is also the opportunity cost of capital. It’s what you would have made elsewhere, say in a bank, if you never made the investment. 100 invested by Ford at 10 percent would have been up almost six times in a little over 18 years. Instead it’s gone down to a third, perhaps even less. Of course, the exchange rate complicates matters a little, but the example still holds.

At a 10 percent cost of capital, the opportunity cost of believing in the future is very high. That horizon needs to be reached very quickly.

In fact, a case can be made that there is no future over that horizon. The future comes in a series of present moments. When you count 4, 5, 6, 7, to reach the future you need a unit of 1 to count. That unit of 1 is the present. Thinking about the future without regard to the present, is like trying to count without that unit of 1. It is this realization that is yet to strike the FIIs.

Belief in the “India growth story” - and waiting for that distant horizon - cannot be the full account though. There is something else going on here. Investment patterns and strategies are at work too.

“Good night said the nightman
We are programmed to receive”

The saintly patience of the FIIs towards the country’s current situation may have a simple explanation. Perhaps they just don’t care about the country’s performance on the real side of the economy! India it seems, is programmed to receive capital, and they are programmed to send it. To see this counterintuitive result requires some knowledge of portfolio strategies.

The fact is that most FIIs are asset allocators who are looking for the benefits of international diversification. They are not stock pickers or market timers. The investment problem for them is primarily an asset allocation problem. Because they enjoy absolute capital account convertibility, they can invest anywhere in the world. For every 100 in capital available to invest, the big decision is whether to put 2 or 3 in India. Remember though the actual amounts are in hundreds of billions of dollars, and not a 100. At the margin, therefore, the move from 2 to 3 (or its reverse) for every 100 is huge.

To understand this, see that there are four sources of FII money. They come primarily from global equity funds (GEFs), global emerging market equity funds (GEMs), Brazil/ Russia / India / China funds (BRICs) , and India dedicated exchange traded funds (ETFs). The global nature of the funds decreases as we move from GEFs to ETFs (i.e.) from left to right along the acronyms. The percentage allotted to India increases from negligible in the case of the GEFs, to 100 % (say) in the case of an India dedicated ETF. Notice also that the first three are all asset allocators. Only the last are India dedicated, and therefore, market timers. Most of the funds entering India is, therefore, asset allocation money.

For FIIs, the world’s their oyster as they enjoy absolute capital account convertibility (CAC). Indians by contrast don’t enjoy the benefits of CAC. The RBI imposes - and then fiddles with - a series of monetary limits on how much Indians can invest abroad. Besides the tax implications are unfavourable. As a result most Indians have virtually zero international diversification in their portfolios. They’re 100 % invested in India, and stuck with the country, whether they like it or not.Hence, the difference in obsession levels.

Domestic investors seem so obsessed with the Indian market, that the fact that FIIs don’t share that level of obsession and pour in money at any level, strikes them as puzzling. It’s not so strange. The FIIs don’t care. There’s always a bull market in some part of the world. The ferengs are more interested in that next bull market somewhere, and in achieving the benefits of international diversification.

This results in a peculiar form of equity market dynamic unique to India. Bouts of international liquidity due to “quantitative easing” lead to massive infusions of cash in western banking systems. Some of it chases yield in riskier asset classes like equities or emerging market equities. This leads to asset allocation to the four fund types outlined earlier. This in turn leads to asset allocations to India in certain proportions. Remember, most of these guys are asset allocators not stock pickers. So the standard instruction is to buy the companies constituting the national stock index of the country the allocation is made to. As a result, most of this money goes into the Sensex 30 (or the Nifty 50).

This also accounts for the heavy outperformance of companies in the stock indices. Remember there are over 2,000 actively traded stocks, but all the action is in the handful of index components. The remaining counters are a side show.

This results in the baffling situation witnessed today, that of a steadily rising market with steadily deteriorating fundamentals. The domestic segment - mainly LIC - sell into this rising market and and “cross” the FIIs (ie) they sell when FIIs are buying. This pattern of DIIs crossing FIIs repeats itself again and again, and is not insignificant. It also results in the absurdly hypocritical situation of domestic fund managers babbling about how much they also believe in the “India growth story” despite the fact that they, as a group, are selling heavily!

More technically, and this is something finance professionals will appreciate. The FIIs get to reduce portfolio risk (betas) because of the ability to diversify internationally. DIIs and the domestic public don’t have that luxury. The only way they can reduce risk, is by going to cash. This they do by selling to the FIIs.

Also, as often happens in markets, there is just enough rationality to justify irrationality. Most FII money goes into the frontline index stocks as outlined earlier. It so happens also that more than half the index consists of the three complexes mentioned earlier - health care, software / business services, and consumer goods. Companies in these sectors are doing very well for themselves, thank you very much, either because of comparative advantage due to a favourable exchange rate, or because the domestic markets for their products are huge. This provides the rationality to this otherwise bizarre situation. These companies are growing with healthy bottom lines. The valuations - mainly the price earnings multiple expansions because of this liquidity flow - are therefore easier to rationalise.

This is not even a two-tier market as some commentators aver. It is more like a creamy layer of 20 or so companies, with the rest of the 2,000 languishing.

“You can check out any time you like
But you can never leave”

Recall, however, that the source of all this is those “bouts of international liquidity”.

World markets are moving to vast tides of liquidity being unleashed through the US Fed, the European Central Bank, the Bank of England, and the Bank of Japan. Most of these central banks take turns in picking up the slack. For the moment the big daddy is the Fed, now under new management. Uncle Ben has given way to Auntie Janet.

This “quantitative easing” and balance sheet expansion by bond buying - by about $1.5 trillion just in the Fed’s case - has never been attempted on this scale before. Ergo, the ending - the taper - has also never been attempted before.

What will make it end? And when will it end?

A prosaic reason includes an improvement in US economic conditions to the point where the taper has to start. Just the gradual ebb of the liquidity - and its tapering off - should cause the tide at the margin to reverse.

This reversal in international liquidity brought about by the end in the Fed’s bond buying will almost certainly result in the asset allocation process outlined earlier going into reverse. When this happens the flows into the above mentioned funds, and their consequent allocation to India will fall off.

Markets will then sell off as flows turn negative. The chattering classes will point to deterioration in economic fundamentals, but that cannot be the cause because that has already happened. One cannot imagine things getting worse from here.

If that does happen, and the FIIs leave, there is simply not enough countervailing buying power available. Recall that even a small 10 percent reduction in FII holdings in India means a net sell of Rs 130,000 crore. As mentioned earlier LIC invests just Rs 40,000 crores a year. So a 10 percent reduction in net FII holdings will require over three years of LIC buying to absorb! The other alternative source of buying - the public - is non existent in the markets.

Hence the allegory with Hotel California. The FIIs must be feeling a little like that traveller in the song. They simply cannot leave India. They face the classic dilemma of the small time speculator who has taken a large position in a thinly traded small-cap stock. The small time speculator’s very buying takes the stock up. His exit will take it down - on himself. The FIIs face the same predicament. They cannot sell because their selling will take the market down on themselves.

These guys, therefore, cannot leave. If they did, it would be 2008 redux. After selling heavily at the bottom the last time, they’ve learnt their lesson it seems.

This also results in the deadly and dangerous “cat and mouse” game with LIC and the DIIs. Both sides cross each other almost exactly, on a daily basis in the markets, i.e. FII buying is exactly offset by DII selling, and vice-versa. On a monthly basis, the pattern is even more noticeable. They have crossed each other for 33 of the past 36 months. The crossing is quite remarkable. When the FIIs sell, they are selling just enough to make sure that LIC can absorb. This is a classic pattern of distribution in a market. Anything more and the market will crack.

Notice the irony and paradox when compared with foreign direct investment (FDI). FDI - the money that goes into land and buildings and factories - was supposed to be stable. The FII portfolio money was supposed to be “hot”, i.e. running away at the first sign of trouble. Now this is all ulta. Judging from the news reports, it’s the FDI money that’s leaving through the Wal-marts, and Mittals, and Poscos. But the FII money is staying. Another paradox in a country teeming with them.

The FIIs are not going anywhere. Both their belief systems and their investing patterns have left them prisoners of their own device.

Conclusion

And if the above analysis is garam hawa and they do leave, as the great taper of QE3 plays out? Well then guys, it’s all over. And you might as well git home, read Asterix comics, and go to sleep next to Manibehn. And oh yes. Before that, - since we’re on the Hotel California theme - don’t forget to help yourself to the pink champagne on ice.

[caption id=“attachment_1206281” align=“alignleft” width=“224”]  Adil Rustomjee[/caption]

Adil Rustomjee is an investment advisor in Mumbai. Sensible comments are welcome at a_rustomjee@hotmail.com