Foreign Investments- Factors and Impact on Markets

We have heard many times that the market crashed or the nifty went down. There can be many reasons behind it. No matter what the reason (or the cause) is, it leads to a change in the stock trader's sentiments and the end result is the market either going up or down. 

For a long time, it has been observed that foreign investors are the ones whose actions decide the final fate of the day. Now one of the reasons can be that DIIs (domestic institutional investors) are not as strong as the FIIs (foreign institutional investors) are.

As foreign investors are an influential factor of the financial markets, in this article, we will first analyze whether there is any relationship between FII activity (amount invested or liquidated by foreign investors in stock market) and Nifty Index. I will then explain three big moves of recent time, which are the factors affecting foreign investments and in turn the financial markets.

In the whole article foreign investors are the ones who are buying or selling shares of companies which are a part of the NIFTY index.

1. Regression Analysis ~ A Game of Numbers

There are two images above, first one has data regarding two factors: Net change in nifty and net FII activity (inflows of cash - outflows of cash) on a monthly basis. The second image consists of a full-fledged regression analysis, which will help us to understand whether our hypothesis is valid or not.

Note that our hypothesis is that “changes in net FPI activities have a direct impact on net change in the nifty index”.

Now just have a hold on the second image. Let us start from the beginning, a positive covariance (5942542) means that our variables are positively related to each other, which means if net FII is positive (cash inflows > cash outflows) there will be a positive change in Nifty Index. But we can’t say how closely these factors are related as of now.

The correlation(R) of 0.6340 shows how strongly both these factors are positively related to each other. (The extent of relatedness increases as correlation approaches closer to 1). 

Now in the ANOVA section, we can see that the SS i.e. error explained by regression is less than residual, the F value is also a lower number but the P-value is near to zero. Both these tell us that our independent variable (net FPI change), however is not adding high predictive value but it is significant to the dependent variable (net change in nifty).

All this combined can be seen on the scatter chart. The points, most of the time, are going in the same direction (but are away from the best fit line).

So, by our regression analysis we can say that our hypothesis is valid, FIIs activity will directly impact the index returns. We will now see the cases which affect these FII activities.

2. Bans & Restrictions - A Hurdle

The bans and restrictions have a direct impact on the compliance cost and monitoring activities. This on the one hand increases the transactional cost and on the other hand makes it a bit dissuading for the foreign investors to invest in another country. 

UAE coming under the grey list of FATF (financial action task force) is the first move which we will analyze in this article. As the UAE is now under the gray list of FATF, it will face increased monitoring from other countries in terms of financial transactions and activities. This will lead to an increase in compliance as well as transactional costs.

The other impact will be the rating adjustments by the rating agencies (most probably we can expect a fall in their ratings). This will lead to an increase in the financial costs for investors in UAE, as the credit from international banks will become expensive as compared to before.

All this will lead to a fall in FPI (foreign portfolio investments) activities from Dubai. Perhaps the way we are increasing our tie ups with the UAE the impact may not be this severe but we will experience a slight fall in the FPI activities from Dubai.

The main impact will be on FDI activity, as it aims at buying a considerable stake in an entity. Particularly the NBFC sector which has to comply with the RBI regulations on funding from a nation in the grey or black list of FATF.

Note that the major difference between a FDI and FPI is that FDI aims at buying a stake in the entity but FPI may or may not.

3. Inflation and Interest rates - Queen & The King

The other main factor which is driving the market these days is the fear of inflation. The food prices have already skyrocketed due to the Russia-Ukraine war. Central banks all over the world are trying to cope with rising inflation. Interest rate is one of the main tools which they have to control inflation. As rising interest on one hand will make borrowing expensive for firms, it will, on the other hand, reduce the leveraging benefit for the investors from developed nations. 

[In layman terms, leveraging means borrowing at a low interest rate and investing at a higher rate of return at the same level of risk].

Let us understand this by an example. For the time being, to make things simple, just ignore the exchange rate effect (which we will see later in the article) and assume that Mr. Bill, an investor in the USA, has to make an investment decision.

The information known is:

• Interest rate on borrowing is 1.5%

• US T-bill yield is 2%

• Indian 10Y bond yield is 6%

            Profit %, if invested in US T Bill will be (2-1.5) % = 0.5%.

            But if invested in an Indian 10 Y bond, profit % will be = (6-1.5) % = 4.5%.

So Mr. Bill can earn a higher profit by investing in an Indian 10Y bond than investing in the US T-bill. Now the reason behind high rates in India is that India is a developing economy with a higher inflation growth rate and vast development scope as compared to the USA which is already a developed nation.

This is also a main reason why financial markets are witnessing continuous sell-offs by foreign investors. Inflation and interest rates are quite important factors which must be taken into consideration while investing or dealing in stocks. However, in this article I have just explained about its impact on the foreign investors' activities. I will write a separate article on how inflation runs the show of stock markets.

4. Exchange Rate - The International Trade-off

The third factor or recent big move is the fall in the Indian rupee.

Profits for foreign investors can be of three forms: first, the net change in the price of stock, second the dividends and third, the change in exchange rate.

In very simple words we can understand that, when the Indian rupee depreciates (against USD), the exchange rate goes up. That means we need more rupees to buy 1 USD as compared to before. 

In a similar fashion, when the Indian rupee appreciates, a lesser amount of Indian currency will be required to purchase 1 USD. This becomes an important factor for the foreign investors.

Let us understand this by an example:

Consider Henry Clinton, an investor (from USA) who invested $1000 in ITC ltd. He bought ITC shares at price of ₹200 per share and the exchange rate at that time was ₹75 (which means you need to have ₹75 to purchase $1).

Now the price of ITC shares has risen to ₹300. What will be the value of investment at redemption if it is known that:

1. The exchange rate is ₹80 (means that Indian rupee has depreciated) 

2. The exchange rate is ₹70 (means that Indian rupee is appreciated)

          The invested amount will be $1000* ₹75 = ₹75000 and the quantity of shares purchased will be 375. 

Therefore, the value of investment (in $) can be derived as:

• = (current price of shares* quantity of shares)/ exchange rate

• = (300*375)/80 = $1406.25 

• = (300*375)/70 = $1607.14

As we can see that the investment value is greater in the second case. This is primarily because the capital appreciation or the net change in price of ITC stock happened in Indian currency but when Mr. Henry will sell his shares; he will have to convert them into US dollars so that he can use them in the USA.  As the Indian rupee depreciated, the size of denominator in our formula also increased which led to lesser investment value in case (a).

This is however the main reaction of foreign investors to the depreciation of Indian rupee.  There are several other implications like relative wage channel, relative wealth channel etc. Again, this is also a very vast factor to study. I may post a brief article soon solely focused on exchange rates and their implications on foreign investments. But for the time being, this much information is sufficient to draw conclusions about foreign portfolio investments with regard to exchange rates:

1. A depreciation in Indian ₹ may lead to sell offs by foreign investors as they want to save their investment value by further deterioration caused by falling Indian ₹.

2. Sell offs by foreign investors, itself accelerates the fall in Indian ₹ as the demand for USD will increase against Indian rupee. (As the amount has to be converted into USD when a foreign investor sells his investment).

Conclusion

So, in this article we analyzed how the three recent moves can affect the foreign investors and financial markets and that FIIs activity will directly impact the index returns.

These are also very important factors when you want to deal in stocks. Inflation, Interest rates, Exchange rates etc. are the main macroeconomic indicators which runs the show of financial markets. No investor can afford to exclude these factors while dealing in stocks, else it will be a pure gamble. The more you understand the effects of these factors on financial markets, the better will be your chances of earning decent profits.

Shaurya Gupta

BCom Hons, University of Delhi

Financial Market Hons, Yale University

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