What will make foreign investors return to India

We investors in India are looking at the alarming rate of foreign portfolio flows going out of India and are at worried that this constant outflow is affecting sentiment and markets are in a perpetual state of anxiety regarding them. We take a closer look at the impact of foreign portfolio flows and the impact on the Indian equity market

The “FII” era began in the ‘90’s

Post the liberalization in the Indian economy and the ensuing opening of the Indian capital market foreign portfolio flows began their entry into Indian equity markets. There were a few institutional investors, and mutual funds were yet a very small portion of the total pie. From the base year of 100 in 1979 to approximately 3,085.20 at the end of 1996, the BSE SENSEX grew at a compounded annual growth rate (CAGR) of 22.35% over the 17-year period[1]

From the advent of the FII’s, typically, overseas pension and retirement funds with a long term horizon started investing in equity stocks in India. A study indicates there was significant correlation between FII inflows and the market performance over a period of time[2]. While this study is limited in its scope and years of observation, anecdotal evidence also suggests that there is some impact of foreign flows on market performance. However in recent times the correlations have been reducing. As a significant portion of investors now include domestic mutual funds, we also are at a 15 year low in foreign portfolio ownership in Indian equities

So where do we go from here. Has taxation been the cause of unpopularity and the tinkering may ensure a return of flows?

Indian tax laws have seen significant adjustment over the years following the liberalization of the Indian economy and taxation alone was never an incentive nor a disincentive for investment. The government has from time to time encouraged the small investor by having a very low level of taxation to equity investors in the past and at one time had 0% capital gains tax and had no taxation on dividends of any kind.

However, the largest mass of investors has entered the capital markets after the imposition of long term and short-term capital gains as well as on taxation on dividends! A recent study by Motilal Oswal Mutual Fund[3] indicates a substantial shift of India household savings that preferred physical assets to now holding significant share of capital market assets. However, they compare still very low to developed as well as some emerging markets in Asia.

However, at a time that India appears to have missed the AI bus, is facing intense inflationary headwinds being exposed to a high dependence on imported crude to propel its economy and worried about the impact of rising rates on foreign investor sentiment, this may be a quick fix.

[1] https://www.voronoiapp.com/investing/45-years-of-Sensex-Returns-4718

[2] https://www.researchgate.net/publication/342881411_Impact_of_FII_on_Stock_Market_in_India

[3] https://www.motilaloswalmf.com/motilal-oswal-edge/articles/indias-evolving-capital-markets-structural-growth-and-transformation

But will it endure beyond the announcement?

Foreign portfolio flows have been notoriously unpredictable

• Given the choice that global investors have across markets does a change in taxation alone move them to significantly allocate more capital to India?

• Potential upside in other markets driven by the “AI” play as well as other trends will always be more of a factor for global allocators

• Apart from the taxation level, ease in operation and entry and exit barriers also bear upon an investment decision

Domestic flows will be key in the continued buoyancy in the markets and any change in taxation for domestic investors will be indeed as welcome and possibly more enduring. At the end of the day interest rates, growth rate expectations and actual earnings growth have a longer term bearing on stock market valuations than tax rates

Earnings growth and economic expansion remain long term drivers of investor interest

While different markets remain popular among global investors for various reasons, the India growth story is unique among them all and a sustained investment over a period is likely to yield handsome dividends.

Global investors have a slew of factors in their sights, and they continue to adjust their portfolios accordingly. So, the tinkering (if any at all) in the capital gains tax regime for FPIs may prove to be a short-term sentiment booster if at all. Making investment easier and allowing for smooth entry and exit will remain a far more tangible goal to achieve

The proverbial pot of gold at the end of the rainbow may yet prove to be elusive for some more time

Happy investing!