Wrong diagnosis, Dr Reddy

FII inflows are not the reason for the volatility in the Indian stock market

Apart from the comic-strip comedy that followed the Reserve Bank of India (RBI) governor Yaga Venugopal Reddy's comments on foreign institutional investor (FII) inflows, does his contention that these funds are responsible for volatility in the Indian markets hold water?

A look at the table on FII inflows into the Indian equity markets over the past decade shows that they have been net positive every year except for a small net outflow in 1998.

 

Net positive
Calendar year ($ million)	Net FII inflows into equities
1993	827
1994	2165
1995	1191
1996	3058
1997	1747
1998	-338
1999	1560
2000	1492
2001	2843
2002	764
2003	7591
2004	9188

Moreover, the inflows have continued to be positive despite US interest rates going up sharply in 1994, despite the tech meltdown, and despite the scams that have plagued the Indian markets.

It was only after the Asian crisis that there was a small outflow, and that soon corrected in 1999.

On the other hand, domestic retail participation in the country dropped over the decade, thanks to the numerous scams. With hardly any retail participation, and with few long-term players in the market, it's no wonder that FII flows act as the trigger for the markets.

But the remedy lies in expanding the retail market and allowing pension and provident funds to invest in the stock market, not in discouraging FII inflows.

Have FII inflows been responsible for inflation or upward pressure on the rupee? Inflation in India is largely supply-driven, with crude oil prices being a big determinant. At no stage during the past decade have FII inflows, via a rise in money supply, been responsible for inflation.

Also, since the RBI has intervened in the currency market, FII inflows have actually resulted in more liquidity in the money markets, which has helped bring down interest rates substantially. That is an unalloyed gain.

To be sure, our level of forex reserves may be very high, thanks to FII flows, but one way of correcting that would be to buy resources abroad to ensure raw materials and energy requirements for our industry.

Also, the FII investor is a different animal from the FDI investor, and putting hurdles for FIIs would not mean that FDI will increase. Our lack of FDI has more to do with our lack of competitiveness than tax policies.

And finally, one sure way to convert FII inflows into investment would be for the government to float infrastructure companies and get FIIs to invest in them. That's exactly what Chinese local authorities have done.

In short, we need to come up with ways to use FII money productively, rather than discouraging inflows.

Interest rates

ABN Amro's economics team has pointed out several reasons why interest rates have not risen higher, in spite of a record rise in credit. First, the government is borrowing much less from the market.

Among the sources of funding that replaced market borrowing were cash drawdowns, or the spillover of excess borrowing from last year, and a surge of investment in RBI bonds. Also, government expenditure was lower.

And although the cash drawdown will not be available in the second half of the current fiscal, that will be made up by higher small savings collections and investment in RBI bonds.

ABN Amro's chief economist, Abheek Barua, says he believes that market interest rates will remain at around current levels till the end of the current fiscal.

But Barua points out that the current liquidity is due to a "conjunction of one-off factors". Next fiscal, interest rates will rise sharply.

The reasons: the resumption of spending on infrastructure; a pick-up in government borrowing; depending of the capex cycle; higher US interest rates; and sluggish portfolio flows. The implications: corporates have a small window of opportunity to borrow cheap in the next three months.

Dena Bank: not a steeply priced issue

Dena Bank's net worth as at end-March 2004, after adjusting for revaluation reserves, was lower than its net non-performing assets. Six months later, the bank's net worth, excluding revaluation reserves, have improved, as has the net NPA percentage.

But book value after adjusting for non-performing assets and revaluation reserves would not be anything to write home about.

If earnings are adjusted for the proposed equity dilution, annualised earnings on the basis of the half-yearly results would be Rs 5.8 a share.

A price of Rs 27 per share doesn't look very steep seen from that angle, especially when one considers the fact that credit growth for the banking sector is going to be excellent.

However, bank valuations are usually made on an adjusted book value basis, which indicates that the Dena Bank stock price is based more on hope for the future than on the bank's current position, especially when net NPAs are still a high 7.85 per cent.

How valid are these hopes? Profits have been much lower, on a year-on-year basis, in the first half of the current fiscal, but that's mainly due to lower treasury profits. Advances growth is picking up, but net interest income fell in Q2 compared to Q1.

Operating profits were lower in Q2 than in Q1, and not all of that is due to lower "other income". Interest expended, as a percentage of interest earned, rose from 61.9 per cent in Q1 to 63.3 per cent in Q2.

Clearly, there's some pressure on margins and the bank will have to grow advances aggressively to counter it. The Rs 216 crore that the bank will raise will help it do that.