The Hindu Business Line : FIIs and the rising rupee

Chennai, Nov. 15 Exporters have been shouting long and loud about the rise of the rupee. But foreign institutional investors (FIIs), who have been just sitting there counting their blessings, are the ones that count. The response of capital flows to exchange rates is quicker and larger than the response of exports. And these responses have loop-back effects on the exchange rate; and therefore on export profits.

A recent study by the US Treasury Department pointed out that since the current account deficit was just $800 billion, 55 per cent of the $1.8 trillion that gushed into the US through official and private channels (in 2006 alone) was in effect used to finance outbound capital flows.

About FIIs the study said that they preferred to invest abroad because the long-term rise of foreign currencies vis-a-vis the dollar got added on to higher returns available on investments in equity.

Valuation gains

The question is why FIIs would care to book valuation gains of 10 or 15 per cent when they can earn 150 or 200 per cent by just staying invested.

Part of the answer is that valuation gains are reaped on total holdings, not initial outlay. Take for instance an FII which brought in $1 billion this March, at Rs 45 to a dollar. If the stocks it holds are now worth Rs 135,000 crore, this leaves a neat 200 per cent profit. But the FII can jack this up, overnight, to 237.5 per cent by simply cashing in its chips at 40 to a dollar.

In no hurry

Since valuation gains are ‘not going anywhere’, why would FIIs be in a hurry to encash them? The answer is that they won’t; until a decisive minority decides that Indian stocks are now at or near their peak, or that the market is transiting from a phase of exponential acceleration to a state of steady growth.

The critical point is that though the original investment of the FII was $1 billion, it will now measure profits with reference to a $3.375 billion baseline. One and one makes a very tidy two, but one and 3.375 makes only 4.375.

Finally a word about exporters. The 10 per cent fall in the dollar from Rs 45 to Rs 40 between March and July 2007 would have sent net profits plummeting by 67 per cent for a company which got its entire $100 million income from exports and incurred total costs of Rs 375 crore in rupees. But then, fortunately, this is only one dire extreme of a vast spectrum of possible scenarios and outcomes.

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