The Hindu Business Line : Why Indian stocks dance to FII tunes

BL Research Bureau It is no secret that foreign institutional investors (FII) are a big influence on the Indian stock market; but did you know that they completely call the shots?

A correlation analysis between leading market indices and the market value of assets held by FIIs shows the two share an extremely close linear relationship from 2003. Though FIIs hold only 15 per cent of the overall market capitalisation, they have had an overarching influence on stock prices in recent years.

Correlated

A correlation analysis of FII assets (market value of holdings) to the movement of some of our frontline indices reveals an almost perfect positive correlation between the monthly movement of the broad-based CNX 500 and the assets under FII management (AUFM).

The ratio stood at above 0.95 since 2004 (1 is said to be a perfect correlation when every move in one variable is mimicked by the other).

The correlation is even stronger with the Nifty – at above 0.98 in the same period. This trend is repeated in Nifty Junior too, implying that mid-tier stocks are also influenced by the buying and selling of overseas investors over a longer time frame.

Though the correlation is slightly lower if we consider the daily transactions of the FIIs and the movement of CNX 500, it is still positively correlated at above 0.75 since the beginning of this year. June is an exception where a negative correlation is observed. But we can pin this down to the fact that Indian market was trending sideways and overseas inflow too varied from day to day, keeping everyone guessing.

Steady FII share

The market capitalisation of Indian exchanges has burgeoned in the bull run witnessed since 2003. Assets under FII management have also kept pace, going up from Rs 98,000 crore in September 2003 to over Rs 10 lakh crore towards the end of 2007. The share of FII assets in the overall market capitalisation spiked from 10 to 15 per cent in this period.

Interestingly, the crash in stock prices that ensued has not caused a serious decline in the FII stake in Indian exchanges. Their share has remained between 13 and 15 per cent since early-2008.

Free float

If FIIs control less than 15 per cent of the market share then how are they able to make our bourses dance to their tunes? The answer could lie in the proportion of FII stake to the free-float market capitalisation of Indian companies.

Free-float portion of a listed company’s market capitalisation comprises shares not held by promoters, group companies and other with strategic or controlling interest. The portion of AUFM in the free-float market capitalisation of Indian exchanges is roughly one third.

That the other stakeholders in the free-float market cap – such as the mutual funds, banks, retail investors – do not always act in concert, the way FIIs do, could account for the big moves in Indian stocks everytime the overseas investors go on a buying or selling spree.

Stock price movement and FII flows form a virtuous or vicious cycle (depending on the direction of the move) in which each exert influence on the other. This could explain the high correlation between the two.

Another interesting sidelight is that the net sales put through by FIIs between January 2008 and March 2009 (the worst phase of the stock market meltdown) were at only Rs 59,139 crore; just 10 per cent of the average AUFM in that period.

The high-impact cost on our bourses with no other investor class capable of absorbing these sales could account for the heightened impact of even limited FII sales.

The gross value of FII trades between January and June ranged between 10 and 20 per cent of their assets.