One factor that has largely determined the movement of Indian indices in the past has been the rapidly growing foreign institutional investor inflows.

The fiscal FY04, especially, has been a witness to one of the largest net inflows ($8.6 billion to be precise) of FII money into Indian equities. Out of this chunk, more than 40 per cent came in the third quarter ending December 2003. However, since then, inflows seem to have slowed down marginally.

And this has had an effect on the movement of the key Indian indices that have traded with increased volatility. Take a look at the graphs below.

While there are several factors that have aided these inflows into the Indian stock markets, the key among them have been:

• Relative difference in US and Indian interest rates (US because it has been one of the largest supplier of funds into the Indian markets),
• The 'emerging market' growth theory, and
• Improving prospects of the Indian economy.

Now, the third factor continues to hold true, as the Indian economy is expected to grow by over 8 per cent in FY04 and the prospects over the long-term hold promise. Corporates are carrying on with initiatives that would make them more efficient. And as a result of these initiatives, in the last three years, bottomline growth has outpaced revenues growth for index companies.

Going forward, revenue growth prospects remain promising not only from the domestic market from also from international expansions.

India is also in the limelight for its potential as an outsourcing destination for services. Besides software, auto components, pharma research, engineering services are also benefiting from the cost arbitrage factor. Some examples in this regard are Dr Reddy's (pharma research), Bharat Forge (auto components), ABB (engineering services), Siemens (engineering and software), Tata Motors (cars) and Infosys (software services).

These factors, combined with efforts taken by the government (like infrastructure development and housing), have reinforced optimism in the minds of foreign investors. They have, consequently, responded through investing in Indian companies.

However, apart from this, the relative difference in interest rates in the United States and India has also resulted in increased inflow. Interest rates in the US have been kept at their 45-year lows (of 1 per cent) by the Federal Reserve that is still waiting for some sustenance in economic recovery before changing stance on the interest rate policy. This has led to US investors (who contribute the largest chunk of foreign funds) eyeing equities in India and other emerging nations like South Korea, Thailand and the Philippines.

Besides, the global economy was flush with funds (read liquidity) considering the fact that all major economies were struggling for growth and therefore most central banks took a softer interest rate stance. The emerging markets have thus been duly rewarded for the risks (emerging markets are relatively more risky then their developed counterparts) they have taken. Take a look at the table below.

Now when the Fed has somewhat changed its stance by substituting 'for a considerable period' with 'it can be patient' in its stance on the interest rate policy, there are certain indications for Indian investors.

If the US economic recovery really shows signs of sustainability and that job growth picks up, the Fed might raise interest rates. And this is likely to affect the flow of FII money into the Indian equities. If that happens, we might witness further correction in the markets as FII inflows, which have held up the Indian indices in the past, might slow down. Investors, in this regard, need to exercise caution.

The bottomline – Do not bank on FII inflows for any upward movement in the stock markets.

Going forward, any sustainable increase in FII flows into the Indian markets would rest on the expectations of sustained improvement in the Indian economy and, more importantly, its ability to outperform other emerging markets. This is to say that it would not only be India's growth, but the relative differential of its growth to other emerging markets, which would determine the flow of foreign funds into the Indian economy.

Now, the challenges are many. Key amongst them are building up effective institutions, sustaining investments in infrastructure and keeping a close check on red-tapism. Though these factors sound very macro, these are fundamental issues that have shaped the way we are being looked at in the global arena.

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