Will FII money now start to flood emerging markets?

For now, everyone is switching to cash or gold. Over the next few months though, as the dust settles on the storm in the financial markets, foreign institutional investors (FIIs) are likely to look at all the options that lie in front of them.

If your mandate is to invest in global equities, what are your options?

US and Europe are likely to slip into a recession as growth prospects look weak. The S&P downgrade of US sovereign debt simply reaffirms the fear. American companies are sitting on $1 trillion worth of cash that gives zero returns. If economies in the developed world slow, consumption slows and vice-versa.

“Composite leading indicators (CLIs) for June 2011, designed to anticipate turning points in economic activity relative to trend, continue pointing to a slowdown in activity in most OECD countries and major non-member economies,” said the Organisation for Economic Corporation and Development (OECD) in a release on Monday. Emerging markets as an asset class have already grown significantly in importance. In 2010, according to The Economist , emerging markets accounted for 52 percent of the global gross domestic product in purchasing power parity terms. They accounted for over 50 percent of the inward foreign direct investment, motor vehicle sales (22 percent in 2000), oil consumption and exports (27 percent in 1990).There is very little to ignore anything here.

This has prompted a few to say that a deluge of capital could hit emerging markets over the next few months.

“The economies among the emerging markets universe will see a deluge of capital once the initial uncertainty subsides,” says Sandeep Sabharwal, head of portfolio management services at Prabhudas Lilladher in his blog .

“As such I would give around a couple of months for people to absorb the new reality and subsequently money flow to EMs (emerging markets) should be very strong,” he adds.

“This is already happening and will be accentuated,” said Krishna K Gupta, general partner in Massachusetts-headquartered Romulus Capital, told Firstpost earlier.

Gul Tekchandani, who has been a career fund-manager and now advises local and foreign investors, believes that FIIs would come back soon. He believes that rich individuals overseas and in India have not gone anywhere and would tap growth opportunities. “I do not see a flood but in a couple of months, foreign fund flow into India could be good,” he told Firstpost.

For the calendar year 2011, the FIIs have put in $2.4 billion in Indian equities so far. The bulk of this money came into India in July 2011, when the FIIs injected $1.8 billion in Indian equities. This was higher than Korea, Thailand, Brazil and Indonesia. They were net sellers in South Africa and Taiwan.

The fund flow in India is strong despite the fact that the BSE Sensex has fallen 18 percent since January 2011.

Sabharwal argues that the fall in share prices was due to risk aversion since November 2010 when shares in economies with high inflation were sold.

Going forward, he thinks that the inflation in India would come down rapidly as commodity prices ease.

Major foreign stockbroking firms are not speaking about any dramatic flood of money into emerging markets like India; they are playing down any significant negative impact on the Indian economy.

Deutsche Bank argued in a morning note on Monday that India is less affected by any potential slowdown in the developed world since exports account for only 18 percent of GDP. In comparison, exports account for 30 percent of the Chinese economy and 57 percent of South Korea’s.

Bank of America-Merrill Lynch, a US-based investment bank, advises investors to ignore inevitable chatter about India’s ’external vulnerabilities’ as the world becomes a more and more volatile place. “In our view, the RBI has as sufficient fire power to fend off contagion as any other emerging market,” the bank said in a note.

A deluge of money could inflate assets across emerging markets. Sabharwal thinks that the ability of a country to absorb strong flows without the worry of inflation depends on capital formation. This can happen only when investment activity surges.

Many have called for the Indian government to step on the gas as far as economic reforms are concerned. To that end, the Indian government has already made some noises. The government has cleared urea price decontrol, revised diesel prices, cleared large foreign direct investment (FDI) transactions and is on the verge of opening up FDI in multi-brand retail.

Sabharwal also pointed out that there are many road projects that the National Highway Authority of India or NHAI has begun to award. “This is both an opportunity and a challenge for India,” he added.