A P: What are FIIs worried about?

Investors are anxious about the treatment of PSUs

The past week has been a truly tumultuous time for the Indian capital markets. What with the markets down intra-day more than 16 per cent and frozen shut for two hours last Monday.

This harrowing experience was the culmination of a month long decline with the markets having lost 23 per cent of their value at the bottom before stabilising over the last three to four days.

Given that the technical definition of a bear market is a decline of 20 per cent, one could be forgiven for wondering whether we had just completed one of the quickest bear markets on record in India's long history of capital markets.

While most people intuitively understood the nervousness of foreign investors brought on by the election outcome, many observers are taking the market recovery over the last three to four days to indicate that foreign investors have overcome their initial fears about the new government.

It is undoubtedly true that the appointment of Dr Manmohan Singh as the PM and P Chidambaram as the FM have calmed many nerves and even brought back memories of the initial heydays of reform in 1991-93.

However concerns on India still linger among the larger FIIs and it is a fallacy to assume that investors are sanguine. The worries are really two, one related to India's vulnerability at an asset class level and the second on PSU stocks.

The first worry on India is linked to fears about the entire emerging markets asset class. Over the last month the MSCI EMF(emerging markets free ) index, the most widely used benchmark for emerging market investors, has declined by 16 per cent.

This is the fourth worst one month decline in the entire history of the asset class, a 2.5-standard deviation event and the only decline of this magnitude not linked to an external crisis.

The other three declines of even greater magnitude were linked to the Russian debt default of 1998, Asian crisis in 1997 and 9/11 in 2001.

There is therefore tremendous short term uncertainty with respect to emerging markets and the ability of this asset class to recover in an environment of falling investor risk appetite and a flattening yield curve linked to a Fed tightening cycle.

In the above environment India is seen as especially vulnerable. It consistently shows up as one of the top three relative overweights in any survey of emerging market funds and has attracted over $10 billion in FII flows over the past 12 months(second highest in Asia).

India has clearly been in favour over the past six months or so and many new investors with very limited experience and knowledge of the country have entered.

These investors bought into the top-down country story, seeing India as the China of 10 years ago. Of this $10 billion FII inflow, fully 50 per cent entered after November, 2003 and is thus already out of the money.

Despite the above, over the past month of high volatility and investor nervousness, India has experienced the least outflow of any of the large Asian markets (only about $700 million).

Thus we have a market that is over-owned, where new investments over the past few months have been driven by inexperienced India hands (most of which is already under water) and which has had less than its share of outflows from the region.

If the emerging Asia asset class were to continue to weaken, then India looks very vulnerable indeed. What would happen if $2 billion were to flow out of India over the next couple of months? Does all the money invested in India currently really need to be there? Are all investors really taking a long term view of the country and its economic prospects?

Are all these new investors mentally prepared for the economic rhetoric of the Left, or the inevitable jockeying for power and political brinkmanship inherent in the initial days of any coalition. I have my doubts. Of course we could have a strong recovery in emerging markets over the coming months which would make these concerns less critical.

In terms of the new political dispensation, beyond fears of an inevitable slowing down of reforms as the new government finds its feet, the really big worry among investors is the treatment of the PSU sector.

Under the prior NDA government, there was a feeling among investors that PSUs were finally being allowed to run as commercial organisations with profit maximisation as their goal.

The oil companies were allowed to double and triple their profits and earn whatever return their assets could generate. Banks were allowed to do VRS schemes and strive to optimise their return on equity.

As a result of the above the PSU sector led the market over the past 12 months and attracted more than its share of foreign flows.

According to data I have seen, PSUs accounted for over 40 per cent of FII flows over the last 15 months(despite being less than 30 per cent of the BSE-100 index over this period).

These flows have also caused PSUs to be re-rated by over 100 per cent over the past 12 months from a P/E of 4.6 to 9.9. Over this same period private sector enterprises have been re-rated by only 30 per cent, P/E rising from 14.7 to 19.2. The numbers are even more stark when you look at them on a company by company basis.

ONGC for example used to trade at a P/E discount of 84 per cent to Reliance (at the peak), it now trades at a premium. Nalco used to trade at a P/E discount of 33 per cent to Hindalco, but now trades at parity.

Because of this significant re-rating, PSUs over the past 12 months have delivered about twice the return of the private sector, despite the recent crash in their prices. In fact nearly 50 per cent of the total increase in the market capitalisation of the BSE-100 has been contributed by PSUs. It goes without saying that most of the large PSUs are widely owned by international investors.

The fear now is that at a minimum, the Left will dilute the profit maximisation focus of these companies. Why allow ONGC to make a profit of Rs 10,000 crore the Left can argue, why not Rs 5,000 crore and increase subsidy on kerosene.

Why should SBI strive for a 25 per cent return on equity, if it means retrenching 20,000 people? Why cannot SBI be happy with a 20 per cent ROE and keep all its employees? Why should banks have a net interest margin of over 3 per cent? Why not increase the portion of mandated priority sector lending?

For a government with a serious fiscal problem both at central and state levels, an easy way to finance populism is to reduce the economic returns of the PSUs and redistribute this profit through subsidised goods and services.

Any such actions will obviously eventually hurt the fiscal side through reduced dividends and goes against the stated goals of the common minimum program of giving full managerial autonomy to profitable PSUs.

Investors are however still nervous, just look at the price action of PSU stocks over the last week. The statements made by the Left in this area do not help.

Do not forget also that till recently most PSU stocks were trading at the steep discounts mentioned above precisely because investors did not trust the government to be a sensible and economically rational owner. The onus is now on the government and its actions to prove these doubts wrong.

Even though the dream team of Dr Singh and Chidambaram have taken charge, foreign investors remain nervous. On the one hand the whole emerging markets asset class is under stress with India still to feel the pain, and on the other PSUs, the leader of the last bull run in India runs the risk of becoming pariah stocks again.