Prof. Jayanth R. Varma’s Financial Markets Blog

In my previous blog post, I described how and why the Indian financial system has quietly pivoted from relying on foreign risk capital to mobilizing domestic risk capital, reversing a dependence that goes back to the mid 1990s. This blog post moves on from there to discuss how much further this process of supplanting foreign capital can proceed, and if so, what would be the consequences of such a “decoupling”.

As I stated in my last post, the pivot to domestic risk capital involved the creation of transparent capital markets, development of mutual funds and other institutional investors, channelling of retirement savings into equities, and the emergence of a new generation comfortable with equity investment. The factor that I did not mention earlier is the demographic dividend that India is enjoying currently. Demography is providing a significant net addition to the work force that boosts economic growth. Young entrants to the workforce also increase the savings pool. It appears to me that all these forces are there to stay, and there is little reason to believe that the pool of domestic risk capital would dry up in the years to come.

As regards foreign capital, it is prudent to prepare for a scenario of diminished inflow in coming years. The first reason for this scenario is that financial globalization probably peaked before the Global Financial Crisis of 2007-2008, and that it may at some point begin to retreat. In the last few years, we have seen a process of deglobalization in terms of cross border movement of goods and people. So far, there has not been much evidence of this process extending to services and to capital. But once countries begin to embrace autarky, restrictions on capital flows cannot be ruled out.

The second scenario is based on the proposition that even if capital flows are unimpeded, abundance of capital in India would cause the capital that was previously flowing into India to seek higher returns in other countries where risk capital is relatively more scarce. A historical parallel would illustrate this possibility: as English capital markets developed in the early nineteenth century, Dutch capital that used to flow into England in the eighteenth century was diverted to France where capital was more scarce. In other words, the very abundance of domestic capital tends to inflate valuations, reduce the returns to capital in India, and ultimately make the country less attractive to foreign investors.

While we cannot predict how the future will unfold, it is therefore quite possible that domestic capital might not just augment foreign capital but might (at least partly) supplant it. What would such a shift imply for India? The obvious macroeconomic consequence would be on the balance of payments; India might have to run a smaller current account deficit if there is a lower foreign capital inflow to finance it. This might be beneficial for the economy in the long run if it weakens the currency and makes the country more competitive in global markets (though the short term consequences might be somewhat less pleasant). But I am focused more on the financial implications than the macroeconomic ones.

What would a shift from foreign to domestic risk capital do to valuation and cost of capital? Theory suggests that foreign investors holding globally diversified portfolios would demand a lower rate of return on Indian stocks than a domestic investor investing only in the Indian market. This is because risks that are idiosyncratic to India get diversified away in a global portfolio. To take a topical example, the profitability of the Indian corporate sector would depend on how tariffs on India compare with that of its competitors. An Indian investor would worry about this risk, and would demand a risk premium for bearing this risk. For a global investor, this risk would matter very little as one country’s loss would be another country’s gain, and a portfolio spread across both countries would be largely unaffected. (A general rise in tariffs for all countries that reduces world trade and global economic growth would of course hurt the global investor also. But a redistribution of the same average global average tariff rate across different countries would not matter much.)

There is a lot of evidence that this diversification effect was significant till a few years back. First, companies found that attracting foreign institutions into their investor base reduced their cost of capital, and, therefore, many of them obtained shareholder approval for increasing the limit on foreign institutional shareholding from the default level of 24% to the regulatory sectoral cap of 74% or 100%. Several companies also listed in foreign stock markets to attract foreign investment. Second, the steady increase in foreign shareholding of Indian companies during the first two decades of this century could also be interpreted as foreign investors being willing to pay a higher price than domestic investors.

In the last few years however, the situation appears to have reversed with many foreign investors finding the Indian market overvalued. In the last couple of years, significant selling by foreign investors has been absorbed by domestic buyers without a major impact on stock prices. Either Indian investors are more optimistic than foreigners about the prospects of Indian companies, or they are demanding a lower rate of return on their investment. The latter would be contrary to the theoretical expectation that it is the globally diversified foreign investors who should demand a lower rate of return.

One possibility is that foreign investors are more nervous about certain risks than domestic investors. This does happen in the context of domestic political risks, but is unusual in a situation like the present where global geopolitical risks are dominant. It is of course possible that investors from historically highly globalized countries find the risks of deglobalization more terrifying than those from more insular countries. But I do not find this argument very compelling because of the robust foreign investment flows to emerging markets as a whole.

The intriguing possibility is that demographic factors are creating an inflow of funds into equities that is large enough to induce elevated valuations (and consequently depressed expected future returns). The obvious solution to this would be to encourage Indian investors to invest outside India. The historical experience that I alluded to in my previous post suggest that countries that build large pools of domestic risk capital tend to move to the next stage of exporting this capital. This would enable investors to earn a better risk adjusted return on their savings, and would also avoid a misallocation of capital arising from a depressed cost of capital.

I think the time has come for Indian financial markets and policy makers to prepare for a potential scenario in which India is simultaneously importing and exporting capital. The imported capital would provide Indian companies with a globally diversified shareholder base, while the capital export would provide Indian investors with the superior risk-return opportunities arising from globally diversified portfolios. This is a scenario in which Indian financial markets begin to finance investments in other countries with less developed capital markets (either in the neighbouring region or across the world).

During the last decade or so, the Indian financial system has quietly pivoted from relying on foreign risk capital to mobilizing domestic risk capital, reversing a dependence that goes back to the mid 1990s. In this blog post, I will discuss how and why this change happened. In the next post, I will analyse how much further this process of supplanting foreign capital can proceed, and if so, what would be the consequences of such a “decoupling”.

Let me begin with a bit of prehistory. In the era of the planned economy from the 1950s to the early 1990s, the government was the main engine of economic growth, and the principal task of the financial system was to mobilize household savings and channel it to the coffers of the government. An extensive bank branch network, a vast army of insurance agents, and the wide reach of post office savings products enabled the financial system to mobilize financial savings from every nook and corner of the country. The government preempted a huge fraction of these savings though regulatory mechanisms. For example, the cash reserve ratio (CRR) and statutory liquidity ratio (SLR) required banks to lend more than 40% of their deposits to the government. A consequence of this entire system was that household savings were almost entirely in the form of “risk free” fixed income products. The government was the principal risk taker in this environment assuming almost all of the risks of almost any large investment project whether it was the Bhakra Nangal Dam, the Bhilai Steel Plant or the Ashok luxury hotel.

A core element of the Indian economic reforms in the early 1990s was that the government stopped doing this and decided to shift this investment burden to the private sector. An immediate problem was the availability of risk capital since Indian household savings was almost entirely in safe bank deposits and other fixed income products which could provide only debt capital. The solution that emerged almost by accident was to tap foreign risk capital by allowing foreign portfolio investors to buy non controlling minority stakes in Indian companies. When China was attracting huge flows of foreign direct investment (foreigners holding controlling majority stakes), India enjoyed a massive inflow of portfolio capital. (Much later China too “copied” India’s regulatory framework for foreign portfolio capital).

It is important to note that the pressing need was not for foreign capital as such, but for foreign risk capital. To take an illustrative example, suppose India’s savings rate was around 30%, and its investment rate was 31% with the gap bridged by a current account deficit of 1% of GDP. This meant that if all foreign inflow stopped, India could theoretically finance nearly 97% of the investment (30/31 =0.97) using only domestic savings. The real problem was that most of the domestic savings could only provide debt capital, and private sector investment requires equity or risk capital. It was foreign risk capital that bridged this gap. Foreign investment flows (direct and portfolio) often amounted to more than twice the amount required to meet the current account deficit. India responded to this problem of plenty by accumulating foreign exchange reserves which mainly took the form of lending to the US government (directly or indirectly). So effectively, we took a lot of risk capital from the rest of the world and sent a substantial part of it back as debt capital.

Thus an arrangement designed to alleviate short term balance of payments pressures ended up alleviating the shortage of domestic risk capital. It worked very well for many years, and there is little doubt that it enabled rapid economic growth and the creation of world beating companies. But it was not a permanent solution. Historically, countries have relied on foreign capital in early stages of their development, but successful countries have always shifted to domestic capital over a period of time. For example, the Dutch financed England when it was building its empire in India and elsewhere (often in conflict with the Dutch). But soon England shook off this dependence and began financing other countries especially the United States which in turn developed capital markets that could finance the rest of the world.

India also has succeeded in creating adequate pools of domestic risk capital, but this required many reforms each of which took many years to bear fruit. First, was the complete overhaul of the stock market with modern technology and strong regulation. Second, was the creation of investment institutions including private sector mutual funds, insurance companies and retirement savings vehicles. Third and perhaps least appreciated was the fading away of the old generation, and the coming of age of a new generation willing to look beyond bank deposits and adopt newer products if they offered better returns. The great physicist Max Planck once remarked that science progresses one funeral at a time, and in a sense the financial system also develops one funeral at a time. Generational transition was not a reform in itself, but it was what enabled other reforms to start yielding results. (For example, when private sector mutual funds were first launched they were primarily vehicles for parking corporate cash surpluses in debt securities. Individuals too invested mainly in debt oriented mutual funds. It took tax reforms and generational change to transform mutual funds into equity oriented periodic savings plans). The fourth major reform was the set of regulatory changes that allowed retirement savings vehicles (the Employees Provident Fund, the New Pension Scheme and other pension funds) to invest in equities. This move was bitterly opposed by organized labour, and the only reason that this could be pushed through was the fact that by then the equity market was perceived to be reasonably clean and transparent.

As a result of this multi-decadal process, India has reached the point where it has a large pool of domestic risk capital. Reflecting this, the ownership share of foreign portfolio investors in Indian companies listed at the National Stock Exchange (NSE) peaked just before the Covid pandemic, and has declined steadily since then. (All the data in this paragraph is from the NSE India Ownership Tracker). During the early and mid 2000s, the ownership of foreign portfolio investors had doubled from less than 10% to over 20%. After a modest transient drop during the Global Financial Crisis, this number reached an all time high of a little over 22% at the end of December 2019. From that peak, foreign ownership has fallen to less than 17% taking it back to the levels that prevailed two decades ago. Domestic institutions (including mutual funds, banks, insurance companies) now hold a larger ownership (nearly 19%) than foreign portfolio investors. Individuals own nearly 10% of NSE listed companies and if we add their holding via mutual funds, then their total ownership rises to nearly 19% which is well above that of foreign portfolio investors. All this means that foreign capital flows no longer move Indian stock prices to the extent that they did in the past.

A number of questions arise at this stage. Could the trends of the last few years reverse at least partially in coming years? Conversely, could this process go much further? If so, would this lead to a decoupling of Indian capital markets from the rest of the world? What impact would that have on the cost of capital for Indian companies? Alternatively, could India start exporting risk capital to the rest of the world? I do not have answers to any of these questions, but I will try to analyse them in my next blog post.