Why FIIs are betting on India

Now that the flow of funds is showing signs of slowing down once again, all eyes are glued to the foreign institutional investor data.

Several foreign broking houses have openly said that the Indian market is overvalued, adding to the uncertainty. With the market dependent entirely on FII flows, much of the energy of market experts is spent in anxiously trying to second guess their intentions.

One way of doing that is to take a step back a little and consider FII flows as part and parcel of recent flows to emerging markets. This story tells us about the surge of liquidity in the United States which has lifted all asset classes, of which emerging market equities are an inseparable part. This is the cyclical story.

A slightly different, more 'fundamental' narrative emphasises the improvement in emerging markets in recent years, their high rates of growth, and the liberalisation of the Chinese and Indian economies, which have led to fund flows to them.

But there are other, more deep-seated non-cyclical long-term trends, all of which have driven capital flows to emerging markets, and, in the process, are changing the structure of the global economy.

The first of them, of course, is technology. As Citibank's ex-CEO Walter Wriston put it, "We are witnessing a galloping new system of international finance...one that differs radically from its precursors" in that, it "was not built by politicians, economists, central bankers or finance ministers . . . it was built by technology . . . by men and women who interconnected the planet with telecommunications and computers." Technology was undoubtedly the facilitator for capital mobility.

But it is far from being the only factor. One major reason for the rise of global capital flows has simply been the rise of prosperity. As people become wealthier, their appetite for financial products increases. They save and invest more, or, as in the US, borrow and invest more.

The result is an upsurge in the financial sector, with mutual funds, insurance companies, banks and pension funds all competing with one another for a slice of an increasingly bigger pie. Pension fund assets as a share of GDP nearly tripled in the US between 1980 and 2001.

At the same time, there has been a big rise in speculative activities. John Eatwell, one of the leading specialists in finance at Cambridge University, estimated that, in 1970, about 90 per cent of international capital was used for trade and long-term investment, and 10 per cent for speculation. By 1990, those figures had reversed: 90 per cent was used for speculation and 10 per cent for trade and long-term investment.

Whatever the reason for the accumulation of this short-term financial capital, there's no doubt that it has had a profound impact on global markets, the huge growth of hedge funds in recent years being a prime example.

Yet another major change has been in the asset allocation of pension funds. While only 40 per cent of their assets were allotted to equities in the eighties, by 2001 this proportion had moved up to 57 per cent. Allocations to equity had reached as high as 80 per cent in UK pension funds, before coming down in recent years.

US pension plans maintained a share of equities of about 65 per cent in both 2003 and 2004. What's more, this was accompanied by a higher proportion invested in international assets -- investments by US pension funds in international stocks and fixed income instruments went up from $2.5 billion in 1981 to $68.2 billion 10 years later, and to $272 billion in 2001. By last year, the average US pension fund had between 10 per cent and 15 per cent of its total assets invested in non-US equities, while for UK pension funds the figure was between 16 and 25 per cent in the past five years.

In fact, as early as 1994, in a paper titled, "Pension Fund Investment from Ageing to Emerging Markets", B Fisher and H Reisen of the OECD Development Centre had predicted that "the rapid ageing of populations in the rich economies can be expected to stimulate strong growth in private funded pensions, providing a massive potential of foreign finance for developing countries".

The need to earn higher returns to pay pensions for an ageing population has sent capital scurrying across the globe in a relentless search for yield.

Moreover, this rise in portfolio investment to emerging markets has been accompanied by a relocation of manufacturing, and, to an increasing extent, the provision of services, to countries like China and India, adding to their attraction as growth centres.

The good news is that all of these trends -- ageing populations in the developed world, the growth of finance capital and speculation and the rise of globalisation -- are going to continue for the foreseeable future. In short, while funds to emerging markets may ebb and flow in cycles, the long-term trend in fund flows is crystal clear.