Weak FII inflows enough to weaken the rupee

When foreign investors have been net sellers in a month, the rupee has depreciated 89% of the time. The rupee could be under pressure if India does not get strong capital inflows as in the past

Foreign flows into the equity market have always been a determinant of the strength of the rupee in the recent few years. The movement in the rupee-dollar exchange rates has been largely dictated by foreign institutional investors (FIIs) as they pull out or flood the market. Moneylife research has shown that when foreign investors have been net sellers in a month, the rupee has depreciated 89% of the times. On taking weekly statistics, whenever FIIs have been net sellers over the week, the rupee has declined 76% of the time. In the month of July 2013, FIIs have pulled out nearly $3 billion, the rupee at Rs60 a US dollar is hovering near its all time low. If the trend continues with FIIs remaining net sellers, we could see the rupee decline further.

FII flows have been extremely volatile and are one of the main reasons for the sharp movements in rupee. In June 2013, on fear of US Federal Reserve reducing quantitative easing (QE), FIIs pulled out over $7.5 billion. This massive outflow caused the rupee-dollar rates to plunge by over 6%, taking it to an all-time low of Rs61 against the US dollar. A similar trend was seen in April and May 2012 with the fear of the Greek exit from the Eurozone. FIIs pulled out over $690 million over the two months and the rupee depreciated by 8.93% to Rs55.73 from Rs51.16. Over the past three years, net monthly outflows of FIIs were few. However, in the months where the net investments by FIIs were negative, the rupee depreciated by an average of 3.72%.

The reverse is true as well. Between the month July 2012 and September 2012, FIIs pumped in over $8 billion in the Indian market. The rupee jumped by nearly 7% to Rs52.70 from a low of Rs56.31. During the months December 2011 to February 2012, FIIs invested $13 billion, the rupee shot up by 6% to Rs49.07 from Rs52.17. Similar instances were seen in the months of September 2010 to October 2010 and March 2010 to April 2010.

There are even instances when FIIs have invested when the rupee has declined. One such instance was seen in May 2013. While FIIs have made a net investment of $6 billion, the rupee has depreciated by nearly 4% to Rs56.50 from Rs54.29 in May 2013. The reason being, Gold imports in May was around 160 tonnes. The rise in imports and decreasing exports has made the US dollar stronger. While gold imports are expected to decline the volatility in the rupee would be determined by FII flows.

FII inflows and outflows are often exogenously determined factors that the Indian government can have little control over, such as the policies of major central banks. When the rupee falls, foreign investors stand to lose from their Indian holdings, leading to a possible pullout from the market. A volatile currency also means that foreign investors need to pay more to hedge against a rising foreign exchange risk.

A reversal of FII fund flows is needed. As seen in 2007-08, the rupee appreciation happened mainly due to FII inflows into the capital market in India. The government’s effort to encourage investment and instil confidence on long-term basis with FIIs has failed in the past. The government is pledging a slew of domestic policy reforms to shore up domestic and foreign investor sentiment. Would this pull in further inflows? If not, rupee is unlikely to gain strength.

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