Chennai: In 2013, Morgan Stanley included India in the list of the “Fragile Five” countries due to its high dependence on foreign funds for growth. It advocated a strong government as a prerequisite for inflow of foreign money and arresting the depreciation of the rupee. More than a decade later, in FY25, net foreign direct investment was down to its lowest level in 25 years. FY25 also saw one of the largest net foreign institutional investment outflows in recent history and the rupee too has significantly depreciated. .
Dhananjay Sinha, CEO and co-head, Institutional Equities, Systematix Group, finds that India needs structural policy measures at both the central and state levels that can stimulate manufacturing, employment and household income growth and eventually attract foreign funds.
Since 2014, India has had strong governments as prescribed by Morgan Stanley. As per this, we should have seen foreign capital flows growing year after year. How have FII and FPI inflows behaved during these years? How valid were Morgan Stanley’s findings?
Back in 2013-14, India was labeled as a Fragile Five country, implying that among various countries across the world, India was one of the most vulnerable economies. We had high inflation, issues relating to fiscal deficit and current account deficit, and concerns about policy paralysis in the previous regime.
There was considerable worry regarding market correction, rupee depreciation and foreign capital flows into India. The expectation was that with the onset of a new government, which was considered more business-oriented and with a stronger mandate, there would be a better outlook for India’s growth, private capex and foreign inflows, both FDI and FPI.
The reality, however, has been different. If you look at FY15, there was some positivity based on anticipation. But from FY15 onwards, FPI flows into India have been fairly modest. In the 11 years ending FY26, positive flows were seen only during a couple of phases, including the rebound after the Ukraine war-related retrenchment.
Most of the time, it was either outflows or very modest inflows. So, the expectation that a stronger government and stronger growth outlook would automatically translate into sustained foreign investor optimism has not really materialised. The expectations regarding both FPI and FDI inflows have not been as sanguine as people thought.
Recently, Morgan Stanley also said that lack of direct exposure to AI, along with higher valuations of Indian stocks, is limiting FII flows into India. What is your view on this?
AI is a much more recent phenomenon. US companies innovated aggressively in AI, and technology sector contribution to the US market has been extremely strong.
Technology and telecom together now contribute about 45 per cent of total earnings for the US stock market. That 45 per cent segment is growing at nearly 35 per cent, whereas the remaining sectors are growing only around 1.5 to 2 per cent.
But if you look at India, FPI flows have not been robust since FY15. It has been 11 long years during which FPI participation has steadily declined. In fact, FPI participation in Indian markets has fallen to an all-time low of around 15-16 per cent.
So it would be simplistic and naïve to attribute weak FPI flows only to the lack of AI exposure. Many countries around India have attracted better FPI participation despite not being AI leaders. There are several broader issues driving this trend.
Let’s look at FDI flows. How has India’s net FDI-to-GDP ratio evolved over the past 15 years? Has there been any structural improvement?
Gross FDI has remained somewhat resilient and moved slightly higher, roughly around $80-85 billion annually. But over time, repatriation and retrenchment of FDI have increased sharply.
Today, nearly 65 per cent of the FDI coming into India is being repatriated. As a result, net FDI has dwindled sharply. Indian companies are also increasingly investing abroad.
If you look at net FDI on a run-rate basis, it is now below $1 billion. As a percentage of GDP, the peak was around 3.5 per cent in 2008. Today, it is close to zero.
This has especially been the trend after 2014. The same weakness visible in FPI flows is reflected in FDI as well. Repatriation of profits by multinational companies has also been substantial.
Assume gross FDI is around $85 billion. Nearly $60 billion goes back as repatriation. If you combine capital repatriation and profit repatriation, the total outflow is nearly $105 billion — significantly larger than gross FDI inflows.
That raises important questions about how much FDI is actually contributing to India’s investment cycle. Private capex has also remained fairly lacklustre since 2013-14.
Even the Chief Economic Adviser, V. Anantha Nageswaran, recently highlighted concerns that despite strong corporate profit growth, private capex has not picked up as expected.
There is clear commonality between weak FPI flows, weak net FDI flows and sluggish private capex.
Even during the Covid years, we saw profits rise sharply without corresponding investment in capex. Morgan Stanley had argued that India’s problem was its inability to attract foreign money. But increasingly, foreign flows seem driven more by global liquidity than domestic fundamentals. Is this India’s problem or simply a liquidity issue?
Global liquidity does matter. After the Global Financial Crisis, we saw quantitative easing phases — QE1, QE2 and QE3. Even after the 2013 taper tantrum, global liquidity remained largely accommodative till around 2019.
But FPI flows into India had already started moderating long before liquidity tightening began. So there is clearly a strong domestic variable determining these flows.
That variable relates to the depth and quality of growth that India has been able to demonstrate.
If you look at the rupee, it has depreciated sharply since 2012, despite accommodative global liquidity conditions. Since 2019, the rupee has depreciated nearly 100 per cent against the dollar, which is significantly worse than the broader emerging market currency index.
As a result, whatever returns foreign investors generated from India were normalised due to rupee depreciation. Dollar returns became far less attractive.
At the same time, other countries delivered stronger earnings growth at lower valuations. On a valuation-adjusted-for-growth basis, Indian benchmarks are relatively expensive.
These are the dynamics driving FPI flows, and they stand in contrast to the narrative that India is among the fastest-growing economies in the world.
Even the market-cap-to-GDP ratio has risen to around 135 per cent, making valuations appear stretched.
Then what is driving these elevated valuations, especially when foreign inflows are weak and stock market performance has not been particularly strong?
Market underperformance is largely because FPI participation has steadily declined over the past decade and more sharply over the last three years.
What is holding the market up is strong domestic participation. Mutual fund inflows into equity schemes have remained robust, ranging between ₹25,000 crore and ₹40,000 crore per month.
Family offices and affluent investors are also providing support to the market. So valuations are significantly higher than what current earnings growth would justify.
SIP flows and retail participation have increased significantly in recent years. But can domestic institutional investors fully offset large-scale FII exits?
FPI investors are selling and domestic investors are buying. In a way, domestic investors are providing the exit route for FPIs.
At the same time, there have been significant primary issuances by domestic companies. Domestic investors are enabling companies to raise money from markets.
But much of this capital is not being utilised for productive investment in plant and machinery, something repeatedly highlighted by the Chief Economic Adviser as well.
Post-pandemic, corporate profits grew strongly till FY25, and markets absorbed large primary issuances. Retail investors effectively provided both the demand for corporate fund-raising and the liquidity for FPI exits.
Given the weak market performance, do you think retail investors could gradually lose interest in equities?
That concern is valid. SIP growth has already shown signs of stagnation and some decline.
Over the past one-and-a-half years, markets have not delivered meaningful positive returns. In the broader market, wealth erosion has been substantial, with several small-cap and mid-cap stocks correcting by 40-50 per cent.
As a result, SIP numbers have started softening. However, there is still considerable liquidity with high-net-worth individuals and family offices, and some of that money continues to get deployed into equities.
But the larger issue is whether earnings growth over the next two to three years can justify current valuations.
Consensus estimates are expecting earnings growth of around 13-15 per cent. But if oil prices remain elevated and manufacturing costs rise, margins could contract.
So we remain sceptical about these earnings expectations. And without strong earnings support, both FPI participation and domestic investor enthusiasm could weaken.
With global capital becoming more selective, where does India stand among emerging markets in attracting foreign investments?
India needs a more coherent growth narrative.
AI alone is not the decisive factor. During the technology boom after the dot-com bust, Indian IT companies delivered sustained earnings growth of 25-30 per cent, which supported both economic growth and foreign investor interest.
What attracted foreign flows then was not just technology, but a broad-based domestic investment cycle led by private capex across sectors.
Post-FY12, we have not seen that kind of broad-based robustness. Between FY14 and FY19, earnings growth for Nifty companies was only around 3.5 per cent, far below GDP growth figures.
So India needs to create a stronger private capex cycle and broad-based domestic demand growth. If consumption, banking and manufacturing strengthen meaningfully, both FPI and FDI inflows can revive.
The government appears increasingly aware of this dichotomy between headline GDP growth and underlying economic weakness.
That is why we saw liquidity support from the Reserve Bank of India, rate cuts, GST-related relief measures and income-tax relaxations.
But these are counter-cyclical measures, not structural reforms.
What India really needs are structural policy measures at both the central and state levels that can stimulate manufacturing, employment and household income growth.
We need more employment-intensive manufacturing that can strengthen domestic demand in real terms. That is where the real solution lies.
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