Merrill Lynch's Holland: Worried about the current account deficit

Two years ago, the $190-billion (Rs 8,55,000- crore; the number is funds under management) CalPERS, also known as California Public Employees Retirement Scheme, the world's largest pension fund, trooped into India along with dozen other pension funds. At the time, CalPERS' entry-the company was a late entrant into India-seemed timely. Most Indian stocks were undervalued, the Sensex was trading at around 5,000, and with a price-earnings multiple of 15. In the two years since, CalPERS hasn't emerged a big investor in the Indian market. Still, its word does carry a lot of weight in the international investing community.

That should explain why the downgrade assigned by the company to India in its outlook for emerging markets in 2006 is worrying. It could indicate increasing concern among foreign investors about the Indian market's capacity to deliver returns from its current levels. At 10,800+ (Sensex), the market looks fairly valued with a P-E multiple between 17 and 18. The possibility of a downside from this level is certainly higher than that of an upside. Ergo, big foreign investors such as Citigroup, Merrill Lynch, JM Morgan Stanley, and DBS Asset Management have turned careful (see FIIs Are Sounding...) in terms of their India-strategy.

The California-based Condor Advisers Inc., for instance, has recently cautioned that rising oil prices will take India's current account deficit to unsustainable levels in 2006-07. The firm, which advises institutional investors such as hedge funds and mutual funds in the US, adds that "this deficit will prompt a large decline in foreign exchange reserves. The resulting exchange rate depreciation could spur significant foreign capital flight". Condor's 28-page report (price: $29) goes on to advise investors to reduce their emphasis on India over the next few months. "Current account is definitely a worry if the oil price shoots up to $80 or Rs 3,600 per barrel," says Andrew Holland, Executive Vice President, DSP Merrill Lynch, whose firm is also a bit cautious in its approach to the Indian market in the short run. "At the current level of around $50 or Rs 2,250 per barrel, we are not very worried." Merrill Lynch expects 2006 to be a year of consolidation with returns being flat to negative. Sushil Muhnot, CEO, IDBI Capital Market Services, agrees. "There are definitely concerns in the short run, but (in) the long term (the) India story is still intact." "Interest rates are going to play a big role," adds Michel Tilmant, Chairman, ING Group, with interest in asset management, insurance and banking in India. "Inflows into emerging markets will continue if there is a measured hike." Evidently, India isn't exactly the flavour of the month among foreign institutional investors (FIIs) that have pumped in over $25 billion (Rs 1,12,500 crore) over the past three years, and that have played a part in taking the market to its current high.

The Mind Of The FII

What's on the mind of investors in the US or Hong Kong? There are several things, ranging from valuation to liquidity to political stability and India doesn't exactly score high on most parameters.

A Relatively Expensive Market: The Indian market looks expensive when compared to its BRIC competitors like Brazil, Russia and China. Returns on D-street have been an impressive 72 per cent in 2003, 12 per cent in 2004, and 40 per cent in 2005. Today, India is among the most expensive markets to enter based on 12-month forward P-E multiple. "We believe that earnings will be less impressive than the growth enjoyed over the last couple of years due to impact on margins from high energy prices...," says Aberdeen Asset Management in a recent report. In effect, expected returns from the Indian market are lower now than they were in the past and FIIs seeking higher returns could turn their back on D-street.

RBI's Belated Liquidity Tightening Move: With credit-offtake soaring, interest rates are being pushed up. The Reserve Bank of India's move to raise interest rates marginally will directly increase the lending cost and could derail the consumption boom in the country. Globally, too, rates are on an upswing. According to analysts, the Fed (the us Federal Reserve) rates are expected to touch 5.0 per cent by July this year. "If the Fed rate moves up over 5 per cent, the impact on fund flows into emerging markets, including India, could be more adverse than we anticipate," says a report from ABN Amro. RBI could effect another measured hike in interest rates to keep pace with global rates and pre-empt any overheating in the economy. Given all this, some foreign investors, especially hedge funds, will not find India attractive since their borrowing cost has been gradually increasing. In contrast, several foreign investors are beginning to look at India's debt market.

A Zooming Current Account Deficit: Russia, Brazil, China, and several other emerging markets enjoy a current account surplus. India has only a deficit to show and one that is spiralling out of control. This could weaken the rupee. Consequently, any gains made by FIIs in the local market will also reduce in magnitude. Worse, if FIIs start pulling out and investing in other markets, foreign exchange inflows will reduce and that, in turn, will have an adverse impact on interest rates and the rupee.

No Local Money In Stock Market: If FII money moves out, the market could collapse. Domestic investors are always first to exit when there is turmoil in the market. Over two dozen mutual funds in India have been a consistent seller over the last three months (December-February). The funds are also not a force to reckon with on D-street. Between April 2005 and March 2006, their net investments in the market were Rs 11,709 crore as compared to a figure of Rs 45,794 crore for fiis. Mutual funds are raking in money through new offerings, but they face huge redemption pressures; much of the money being invested in new fund offerings is coming from investors who are churning their mutual fund portfolios in search of short-term gains.

Political Turbulence: India is ruled by a coalition; five states go to the polls this year; the ruling coalition's key allies, the communist parties are key contenders in two of these states; and that doesn't bode well for the stock market at all.

If India has something going for it, it is a GDP growth rate in excess of 8 per cent. For investors faced with slow-growth at home (if home is Europe, especially), that is a strong lure. Which could explain why the last word from FIIs in terms of investing in India seems to be, "pause and then continue playing".