Foreign fund inflows are critical to India’s growth story, be it for infrastructure or stock markets. Although Finance Minister Pranab Mukherjee has taken a number of steps to increase the foreign fund inflow, given the current macroeconomic conditions in India and the uncertainty over crude oil prices, there is a need for foreign institutional investors (FIIs) to bring in more funds. Parul Saini, executive director, RBS Asia Securities, Singapore, tells Malini Bhupta about some of the key concerns of foreign investors and what this year’s Budget proposals mean to them. Excerpts:
The finance minister has come up with a number of proposals to attract more FII inflows into India. Will these measures work?
At present, FII concerns centre around inflation, financing India’s current account deficit, the recent policy inaction and the impact of high crude oil prices on India’s current account and fiscal deficit.
Inflation seems to be tapering off owing to a slowdown in food prices, but it remains significantly above the normal level of around 5 per cent. Maintaining the excise duty at 10 per cent should help avoid upward price pressures on the margins from a Budget perspective. However, given the significant increase in crude oil prices, any upward revision of diesel prices will have a considerable impact on inflation.
India’s current account deficit is primarily being financed through portfolio flows rather than foreign direct investment (FDI). The Budget did not offer any specific measures to boost FDI inflows.
The finance minister reiterated his commitment to financial sector reforms in the Budget. Several large projects have been given environment clearance recently. This does suggest that the government is getting “back to business”, which is a positive.
We estimate that with every $10 increase in crude oil price, India’s current account deficit increases by 50 basis points and the fiscal deficit rises by 20 to 30 basis points (because of the current subsidy on LPG, kerosene and diesel). There is little that the government can do about crude oil prices. However, moving to a cash transfer system for LPG and kerosene could help reduce the subsidy burden linked to LPG and kerosene, and introduce some demand elasticity.
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The limit for FII investment in corporate bonds (with residual maturity of over five years) has been raised to $25 billion. How do you see FIIs reacting to this? Will this create more depth in the country’s corporate bond market?
The government is moving in the right direction to fund India’s infrastructure needs. It has also reduced the withholding tax for notified infrastructure debt funds. That said, we do think it will take some time for this increased limit to be filled. According to market participants, the earlier increase of $5 billion (which was announced in late September) in the limit for infrastructure bonds has hardly been taken up by FIIs. So it may take time for the $20 billion increase in the limit to significantly attract inflows.
This apart, given the residual maturity of over five years, FIIs will need to get comfortable with the credit risk of the issuing entity. Apart from that, project-specific infrastructure bonds would also carry an execution risk. Introducing a transparent and streamlined land acquisition policy will help reduce land-acquisition related execution delays.
Besides, a number of other issues need to be resolved: a clear definition of the bonds eligible for this increase, the introduction of credit default swaps (CDS) for hedging the credit risk and more liquid longer-term swaps (more than 10 years) to hedge the interest rate risk for longer-duration infrastructure bonds.
How do you see these measures impacting India? Does the Budget meet your expectations?
India’s current account deficit of three to 3.5 per cent needs to be financed through foreign capital flows. So, further opening up the capital account to foreign investors is a positive from a funding perspective, especially for financing infrastructure.
Maintaining the excise duty at 10 per cent is definitely pro-growth. This apart, an adjusted capital expenditure (adjusted for revenue grants to states for asset creation) would represent 24 per cent of total budgeted expenditure, up from around 10 per cent in 2009, which reflects the focus on infrastructure creation. The commitment to financial sector reforms is positive, as is the plan of a transition to cash transfers instead of market price distorting subsidies.
On the fiscal deficit front, the finance minister has committed to reducing it to 4.6 per cent from 5.1 per cent in 2011, which is definitely a positive. However, it may be difficult to deliver on this target. Looking at FY2012, we think it may be hard to meet the 4.6 per cent fiscal deficit target. First, this does not take into account any subsidy payments to oil marketing companies for under-recoveries in FY2012; the Rs 20,000 crore under-recovery compensation is for the fourth quarter of FY2011. If crude oil stays above $100 per barrel, and retail product prices are not raised, the under-recovery bill could add 70 basis points to the fiscal deficit.
Second, there is a risk of slippage in the expenditure targets even if you were to exclude budgeting for subsidies.
Finally, tax revenues may disappoint if GDP growth lags the 9 per cent assumption; our chief economist, Sanjay Mathur, believes non-agriculture GDP growth is peaking. Also, gross tax revenues are expected to represent 10.4 per cent of GDP in FY2012, against 10 per cent in FY2011 (per RE) and 9.5 per cent in FY2010. Although the tax net is being widened, this expected buoyancy in tax capture may be optimistic since most tax rates have been maintained.
Foreign investors will now be able to invest in unlisted bonds of infrastructure companies with a minimum lock-in period of three years. Will this mean more funds for India’s capital-starved infrastructure sector?
The minimum lock-in period of three years may be a constraint for a number of FIIs. Infrastructure-focused FII funds may be the target audience for these special purpose vehicles (SPVs) since they would be more comfortable gauging the credit and execution risks, and will, therefore, factor in the liquidity risk inherent in these unlisted bonds.
What kind of inflows will India see this year, compared to last year's $29 billion?
We don’t specifically forecast FII equity flows. That said, we do expect a moderation from the $29 billion of inflows India saw last year and we think inflows would be in the ballpark of around $10 billion.
It is believed that this year FIIs will rotate funds to developed markets. What can India do to stem the fund outflow?
From a policy perspective, clarity on the timing and final form of the Goods and Services Tax, tangible progress on the cash transfer programme for better targeting social spending, financial sector reform and FDI into multi-brand retail will be the positives for investor sentiment.
This year's Budget has proposed to allow foreign nationals to invest in mutual funds. What kind of response is this likely to generate?
I do not think this will lead to a significant increase in foreign equity inflows into India. Foreign retail investors already have access to India-dedicated mutual funds run by FII managers. This proposal may shift funds from India-dedicated funds to domestic mutual funds but may not result in a significant increase in the total amount of international retail funds allocated to India.
How do you see Indian equities performing this year, given that the third-quarter performance was not the best show that India Inc put up?
We expect Indian equities to end up flat for the full year — as such, an upside of around 10 to 11 per cent from the current level, which is not compelling enough to be aggressively buying Indian equities at these levels.
Do you think chinks are appearing in India’s growth story and what can the government do to plug these gaps?
I think the key issue is whether the Indian economy can grow at 8.5 to 9 per cent-plus levels without overheating, given the structural supply constraints in infrastructure, skills and agriculture. Moderating growth to a slightly lower trajectory so that the supply side catches up may not be a bad idea.