There is considerable unease among market participants in India about the growing role and power of the foreign institutional investor in driving the Indian capital markets and giving it direction.
The recent correction of 13 per cent only goes to underscore the point, driven as it was by a resetting of interest rate expectations in the US and a reduction in risk appetite globally.
Despite all the talk of mass redemptions and huge selling, FIIs sold less than a billion dollars, yet this was enough to force a 13 per cent correction.
What will happen if the FIIs actually bail and sell $3-4 billion in a short period? Given the quantum of equity flows into India over the last 2-3 years, a reversal of flows of this magnitude is quite possible.
India is now a mainstream Asian market and ranks right up there with Korea and Taiwan in terms of flows, liquidity and interest, and both these markets have seen outflows significantly greater than $2-3 billion at various points of time. So if it can happen there, why not in India?
Conventional wisdom in India is that such an outflow would immediately cause a market collapse, and hence the fear, but looking at evidence across Asia this is not necessarily so.
Take the case of Korea and Taiwan in 2005.
Taiwan saw huge inflows in 2005, attracting over $12 billion from foreign investors (the highest among all the Asian emerging markets). Despite this huge inflow, Taiwan is the worst-performing market in Asia year to date and the only one actually in negative territory (in local currency terms).
The reason for this poor performance is the continued and unabated selling from retail investors. Retail investors in Taiwan have been slowly and steadily reducing their domestic equity holdings and have become a structural overhang on the market.
Though down from a peak of 47 per cent in 1997, at 31 per cent, the share of equities as a percentage of household financial assets in Taiwan is still among the highest in the world. (In the US the ratio is at 16.3 per cent.) This ratio is likely to keep coming down and, until it normalises, is a huge headwind for the financial markets in Taiwan.
Korea is exactly the opposite case, wherein despite foreigners being net sellers of more than $6 billion year to date, the Korean market is the single-best performer in Asia this year.
The reason for this is once again domestic flows, with the increased flows here being on both the institutional side as well as retail. Rising pension allocations and equity savings plans are boosting asset managers' inflows, as institutions realise they have to raise equity allocations to maintain returns and retail investors work down their cash mountain.
Looking at both the above examples, it becomes clear that the behaviour of foreign investors is not the only determinant of market performance. Domestic investors, be they institutions or retail, are still the majority owners of the market, and they have the influence and ability to act as a counterweight to the foreigners.
In both Korea and Taiwan, it has ultimately been the domestic investor base that has driven the market, irrespective of what the foreigners have been doing, and this despite foreign ownership in both markets being higher than in India (41 per cent in Korea, 32 per cent in Taiwan).
Instead of being worried about the selling out of our companies and our losing sovereignty over our capital markets, the intellectuals should focus more on how to strengthen and deepen the equity cult in the country, rather than imposing ownership restrictions on the foreigners.
The question then becomes whether something similar can happen in India. Is our domestic fund management industry developed enough and deep enough to be able to override and compensate for the foreigners? My sense is that while we are not there yet, the signs are clearly visible that this will happen.
Take the institutional side first; it is to my mind inevitable that the rules for pension plans will get liberalised to permit them to invest significant chunks of their corpus in equity. With interest rates being where they are and the political compulsions to keep the promised rates of return on pensions and provident funds high, there is no alternative.
Increased flows and allocations to equity are inevitable because there is no other fiscally responsible path open to the government. Given the size of these pension and provident plans and their projected growth, this asset allocation change will be a very significant source of incremental domestic demand. A similar story can be painted for the insurance sector, which over time will also have to increase its investments in the capital markets.
As for the retail investor, their allocations to equity at less than 1 per cent of household financial assets are at an all-time low (were over 10 per cent in the 90s), and can only rise, more so given the decline and outlook for interest rates. Most competing investment alternatives offer you zero to negative real returns.
Chidambaram's recent tax changes, offering savers a single consolidated tax credit for any investment they make in savings products (be it debt or equity), should also over a longer term drive more flows into equity-oriented savings products. He has effectively levelled the playing field among competing investment alternatives from a tax incentive point of view.
The scrapping of capital gains taxes only reinforces all of the above and in fact tilts the scales towards equity. Combine all of the above with demographics and income distribution and the outlook gets only better.
I, for one, am convinced that the coming decade will be a period of huge asset growth for the domestic money management business, a sentiment which is slowly becoming conventional wisdom, given the number of foreign money managers desirous of setting up local operations. As this domestic industry develops, the power of the FIIs to dominate our markets will reduce. Market direction and sentiment will be set locally and not in New York or London.
For anyone worried about the power of the FIIs in India, they have to only look towards Taiwan and Korea to understand that ultimately in large sophisticated markets the domestic investor base is more important and powerful in determining the long-term trends.
The emergence of a strong domestic money management industry will be the next driver of the bull market in India, and this development or lack of it will be the real determinant of whether India is in a secular bull phase or not. The government and regulator must do all they can to encourage this development.