QE Does Not Drive Portfolio Flows Into India

Conventional wisdom has it that quantitative easing (QE) leads to deluge of capital flows into emerging market economies and are generally positive for risk-on assets. The focus of this piece is the impact of QE on Indian stock market.

While the impact of QE1 was clearly positive for the Indian stock market, it is important to realise, however, that mere perceived causality does not imply that necessarily one leads to the other.

Performance of NIFTY (Equity Index of National Stock Exchange or NSE)

Source: National Stock Exchange (NSE) of India and Federal Reserve Board

As mentioned earlier, QE1 did lead to Indian stock markets virtually doubling from its low. However, QE2 failed to have the desired effect.

Similarly, while the portfolio investors became more active post QE1 (total net inflow during the two year period post QE1 was north of USD 75 billion), there was an overall net outflow till Aug’12 post QE2.

Net FII Inflow (USD billion)

Source: RBI, FRB

In the same vein, while the INR appreciated fairly strongly post QE1, it moved the other way post QE2.

Movement of INR/USD

Source: Haver Analytics, USD

So, why is the reality different from perception? It has to do with differing macroeconomic fundamental of India over the period.

India’s GDP And Capital Formation

Source: Haver Analytics, FRB

Inflation And Interest Rate

Source: Haver Analytics, FRB

Before the global financial crisis erupted, India enjoyed a period of high and sustained growth. Capital formation also remained quite strong. As the financial crisis resulted in a slowdown in global growth, Indian economy also felt the heat. However, the economy recovered fairly quickly and regained the strong growth momentum as domestic demand recovered fast, aided by falling inflation and a fast pace of easing by India’s central bank (RBI). However, all these period of high growth had its toll as India hit a structural bottleneck and inflation started to rise – led by rising global prices of commodities (including oil) and domestic food price. Rising inflation induced RBI to embark on a tightening mode. However, RBI was not only slow to react, even the pace of their tightening was much slow for comfort, which resulted in inflation and inflationary expectation galloping away. And then when RBI realized their folly, they moved way to fast but by that time the harm was already done and inflation continued to remain at elevated levels. High inflation and high interest rates had its toll on the economy as domestic demand started to suffer. Thus, by the time QE2 started, the economy was slowing down while inflation jumped to near double digit mark. Not surprisingly, the impact was muted. The problem was further exacerbated as Indian political environment worsened and policy paralysis gripped the country. Unending stream of populist expenditure and worsening global environment meant that high dual deficit (fiscal deficit at 5.8% of GDP and CAD at 4.2% of GDP during FY12) pulled down the economy even further.

Input And Output Inflation

Source: Office of Economic Adviser

Not just the macro factors, even corporate performance reflected the broader equity market performance. As input inflation started to fall, strong domestic demand ensured better pricing power and hence corporate bottom-line remained healthy, resulting in improved stock market performance. However, by the time QE2 came into existence, input inflation was up again, while continued demand destruction meant much weaker pricing power for the corporate. This resulted in stable output inflation and hence worsening corporate bottom-line.

Now that QE3 has been announced, there is no reason to believe that this will induce additional flow of fund into the stock market, simply because there will be more liquidity in the system. What will drive the flow of liquidity will be the overall macro as well as micro fundamental. Fortunately, the QE3 coincided with a stream of positive policy announcements by the government of India though the political environment hasn’t improved sufficiently. Also, on the positive side, corporate bottom-line is showing distinct signs of improvement – all of which explains recent inflow of portfolio investment and improved stock market performance.

7 Responses to "QE Does Not Drive Portfolio Flows Into India"

  1. IvyMumbai   October 5, 2012 at 6:33 am

    Much has been made of the “burst of reforms” unleashed by Finance Minister Chidambaram in recent weeks. The stock market has rallied and animal spirits it seems are back. The market is now at 21 times earnings (trailing twelve month free float adjusted as per the National Stock Exchange). Once more the mood swings violently. More interestingly the India VIX , the fear index is at 3 year lows of 15. This is usually an indicator of complacency, and historically such lows have signified a massive sell off. My two bit as an Ivy educated fund manager in Bombay who was worked internationally on structural adjustment programs.

    In reality, the reforms amount to bureaucratic tinkerings with percentages – of a sort that only tax mavens and accountants can comprehend. Witholding taxes go down by a percentage point or two. FII margin percentages change. Service tax percentages for insurance companies change. Now an attempt's been made to increase the percentages foreigners can hold in insurance and pensions. (This last will never pass through Parliament given the unanimous opposition to it). Blah Blah Blah.

  2. IvyMumbai   October 5, 2012 at 6:35 am

    The Indian economy, in fact, requires Parashurama’s ax and not the surgeons scalpel. The reference is to the mythical woodcutter of Indian mythology who wields a massive axe when needed.

    The government had no choice but to unleash this wave of beaucratic tinkering and percentage change and call it “reform”. It is trying to keep the capital markets buoyant because it needs to sell or “chipkao” (ie stick as we say in the business) close to Rs 50,000 crores worth of equity. This will, with other measures like spectrum auctions, hopefully plug the budget deficit a little by March. More crucially it will also free up resources for massive election giveaways in next March’s budget. This is especially needed if the Food Security Bill – Mrs Gandhi’ s chosen strategy for reelection – is to be passed.

  3. IvyMumbai   October 5, 2012 at 6:35 am

    Real reforms for India will not happen for a long time. These include financial sector reform, and an end to the financial repression signified by the statutory liquidity ratio. Privatization of the banking system that’s put an end to the ridiculous spectacle of 75 % of the banking system being owned by the government in a market economy. Bankruptcy and exit laws will have to be introduced. Labour market liberalization and the freedom to hire and fire labour will have to be allowed.

    The collapsed state of Indian cities will have to be addressed by building 30 to 40 cities each with a population of 4 to 5 million to accommodate massive rural urban migration. Land acquisition which is impossible now will have to be addressed. This list does not even include the sector changes required in power and fertilizers and real estate, and so on and so on.

    None of this is happening ever it seems.

  4. IvyMumbai   October 5, 2012 at 6:36 am

    The government will in all likelihood fall in December, during the winter session of Parliament. Elections will take place in May as India needs the school system for a general election. This will allow the Opposition the chance to deny the government’s attempt to pass a budget full of sops and giveaways. The February budget will consequently be a vote on account.

    This scenario will suit all parties except the Congress and hence it will happen.

  5. IvyMumbai   October 5, 2012 at 6:42 am

    The logical conclusion also is that this is the high point of the markets move this year. India has gone from having the most incompetent FM (Pranab) to the most cunning FM (Chidambaram). The later is deliberately doing all he can to talk up markets to implement his plan. There is little need to oblige him and his plans of using the stock market as a financing vehicle by buying high and losing ones hard earned capital. Sell all trading positions.

  6. Harry   October 9, 2012 at 6:39 pm

    I'm sorry but this piece is just going round and round in circles. Also, please check your spelling and grammar.

  7. RKARYA   October 17, 2012 at 4:35 pm

    the impact of QE3 would be nominal as the present valuation are what the future growth is projected, which further depends on the reform getting materialised. the materialisation of the reforms is not so easy as the government is attacked from all sides.