Foreign portfolio investors continue to flee India. Cumulatively, they have withdrawn $22 billion from India in the current calendar year. This can be seen as a sign of India’s loss of investment appeal in the eyes of investors. A more positive, probably more realistic, view would be that India is paying the price for registering the largest net inflow among its Asian peers over the past three years (of $40.5 billion), and thus accumulating higher valuations.
Vast pools of savings roam the world, seeking to maximize returns. Emerging markets offer much faster growth of economies and businesses, providing rich choices. This is the case, when things are normal. In times of uncertainty, emerging markets present a double risk for external investors. First, their economies may be more vulnerable to bad news than the economies of developed countries; second, their currencies could experience a sharp depreciation, which would reduce the return in dollars.
Today, the global economy is experiencing extreme volatility, fueled by two different sets of factors: the recovery from the pandemic and the war in Ukraine and the escalation of geopolitical tensions.
As the world recovers from the pandemic, the extra-loose monetary and fiscal policies that had been adopted, especially in the wealthy world, must be reversed. This process was accelerated by unexpectedly strong inflationary trends.
Policymakers in the rich world had bet on a steady recovery from the pandemic and focused on recalibrating demand to control inflation – remember the slogan, transitory, the US Fed used to describe rising inflation. inflation for much of 2021. This did not take into account an uneven recovery from the pandemic, resulting supply disruptions and supply-limited inflation.
Even as growth resumed and unemployment fell, particularly in the United States, supply bottlenecks emerged in unexpected quarters, such as a shortage of truck drivers, a shortage of containers for transporting goods from China to the rich world, a shortage of port handling capacity and blockages in China. . Then came the energy shock. The winter turned out to be extra long and extra cold, increasing the demand for gas for heating in North America and Europe. Some unplanned interruptions in gas capacity led to a sharp rise in gas prices, even as the OPEC oil cartel decided to regulate production to keep prices high.
Inflation dashed hopes that it would be transitory, and the US Fed and Bank of England moved to raise rates. The European Central Bank is also preparing to raise its rates.
When interest rates rise in the rich world, the risk-free yields of the rich world’s public debt rise. Large investment pools with a mandate to generate a certain risk-adjusted rate of return on their corpus reduce the risk of deploying their funds by reallocating a portion of the relatively riskier deployment in emerging markets to countries’ government debt. wealthy which now offers a higher rate of return.
This process involves reverse capital flows from emerging markets to the United States and Europe. This puts pressure on the exchange rates of currencies in emerging markets. The greater the likely depreciation of an emerging market currency, the higher the local currency return that deployments must generate to achieve the previous dollar rate of return. This means the withdrawal of certain instruments and a redeployment towards the country of origin, rather than towards higher yielding assets in the emerging markets themselves, because this higher yield could be associated with a higher risk than what the investor wishes.
It is to this mix that we must add the war in Ukraine. This gave inflation a boost – with the prices of food, oil, gas, metals and fertilizers directly affected. But the most important factor is greater uncertainty. Uncertainty translates into higher risk, and therefore a greater incentive to flee to the safety of the internal market. Since the United States is the largest source of cross-border capital, more capital has returned to the United States than anywhere else. As a result, the dollar strengthened against all major currencies.
On top of that we see Xi Jinping’s Zero Covid strategy disrupting global production, cities in China where key parts are fully shut down to contain the virus. This adds to shortages, inflation and general uncertainty. The net result is yet another flight to security.
Given that India has received more capital than other Asian countries and recorded higher valuations due to both these inflows and strong inflows of domestic funds in capital markets, India is now registering proportionally larger outflows as funds seek better value in other emerging markets.
The Sensex price-to-earnings ratio fell to 22, much more reasonable than the 30s where it had been for some time. But that’s high, compared to 13 for the Jakarta composite index, for example. This explains why the funds that left China, following the Covid lockdowns there, went to Southeast Asia rather than India on the scale expected.
The silver lining is that when the uncertainty subsides, funds could come back, driving valuations up. India remains the best growth prospect in the world, despite all the shortcomings too visible for observers, for the next few years.