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Sunday, February 18, 2007

FIIs, economy and the common man


We have been reading about the large investments being pumped into the stock market by foreign institutional investors (FIIs). The current levels are unprecedented. But what is the larger picture? Is the impact of the FIIs limited only to the stock market or do the institutions have a larger role in the economy? To be more specific, how do FII flows affect the common man?

Taking a closer look at the funds flow, FIIs bring dollars to India which get converted into rupees in the inter-bank foreign exchange market. As the supply of dollars increase, the law of demand-supply starts operating and the rupee appreciates vis-à-vis the dollar.

Appreciation of the rupee

So, other things remaining constant, higher FII flows would help the rupee to appreciate. This allows Indian consumers to import goods (which are priced in dollars) at a cheaper price. However, an appreciating currency also makes our exports uncompetitive in the global markets. As India is a developing economy, it would be beneficial to have a weaker currency, improve exports and, thereby, generate higher domestic activity.

Higher forex reserves

Under normal circumstances, the Reserve Bank of India (RBI), would try to stem the the volatility of the rupee by buying dollars and selling rupees. The excess dollars bought by the RBI would accrue to the foreign exchange reserves. For an emerging economy such as India a higher level of forex reserves affords financial and economic stability and reduces the vagaries of global capital flows.

So, higher foreign (dollar) inflows into India usually translate into more rupee liquidity in the system. This increases the money supply and facilitates easy availability of credit (loans) from banks (thus the frequent calls from telemarketers, offering all kinds of loans).

Invest and capture gains

Thus, we can conclude that higher FII flows also aid in lowering the cost of borrowings. On the flip side, as liquidity is high and banks become keen to lend money than accept it, the rates paid on deposits and bonds would decline. An investment strategy in such a situation is to invest in bond mutual funds and capture the capital gains on the bond portfolio arising from lower interest rates.

The easy availability of credit and the lower borrowing costs increase consumption demand for housing, durables, cars and real-estate. This higher demand often leads to greater public and corporate investments, resulting in higher economic growth. This, in turn, raises the prosperity level and the general standard of living. More jobs are created and wages also rise. Taxes are also lower.

However, as the amount of money in the system grows rapidly, the goods and services available may not grow at the same rate, leading to inflationary pressures (higher prices for goods and services) and reducing the purchasing power of consumers. Such inflationary pressures can push the central banks to hike interest rates.

Creating wealth

From a different perspective, if the FII flows are high (relative to the country's stock market capitalisation), the demand-supply equation comes into play once again and the market tends to rise rapidly, creating more wealth for the investor. This positive wealth effect also often leads to higher consumption and greater demand for other asset classes such as gold, real-estate etc., which, in turn, fuels economic growth and inflation. Higher FII flows can, thus, be seen to help create wealth through higher asset prices.

In case there is a sharp reversal of flows — the funds start flowing out — the conditions mentioned earlier would be overturned. Strong outflows would result in higher interest rates, lower demand and consumption, lower forex reserves, a weaker rupee and falling asset prices.

India's success story

Thus, FII flows do have a great impact even on the common man. The large inflows are often cited by politicians and media as proof that India is a success story and that global investors are flocking in their hordes. It should be kept in mind that the so-called `global investor' can be very fickle. He goes where he perceives profits. If the tide turns, he would be the first to flee with the profits.

A sharp reversal of fund flows could result in economic and financial instability. India was relatively immune to the Asian crisis in the mid-1990s as its integration into the global financial market was not so strong. It may not be so lucky the next time around. India also needs to focus on long-term flows in the form of foreign direct investment to sustain the economic reform process.