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Thursday, October 24, 2013

The investment technology of foreign and domestic institutional investors

Ila Patnaik and I have a recent paper in the Journal of International Money and Finance on the investment technology of foreign and domestic institutional investors.

The question

Do the firms chosen by FIIs do well? What is the stock market performance, and the operating performance, in the period after a firm has been selected for investment by FIIs?

This is an important question for many reasons. Investors (both foreign and domestic) would like to know the information content of seeing an FII or DII present in the shareholding of a firm. If, hypothetically, domestic financial regulation hampers DIIs, there may be a special role for FIIs in rationally allocating capital and alleviating financing constraints. If FIIs fare poorly in security selection, as has often been the case in the international finance literature, these mistakes have consequences for the allocation of capital and the incentives of entrepreneurs. Perhaps what India requires is policies that foster deep engagement with international capital, through which FIIs would achieve better information and thus fare better in security selection.

The opportunity for measurement

There is strong evidence of home bias: foreigners own too little of most Indian firms with an ownership of 0 for most firms. Less than a thousand companies have over 1% investment by FIIs. This is true for DIIs also. This opens up the opportunity to see how the chosen companies fare against those that were not chosen. To construct a quasi-experiment, we identify three groups of firms: 
  1. Those chosen by FIIs but not DIIs
  2. Those chosen by DIIs but not FIIs
  3. Those chosen by neither.
On the 31st of each year, it is possible to make these three lists of firms. An examination of future performance would give us insights into the investment technology of FIIs and DIIs. Specifically, if the firms chosen by FIIs but not DIIs (i.e. Group 1) do much better than those in Group 3, then we would think that FIIs have a valuable investment technology.

Pitfalls in measurement

Institutional investors are different. Institutional investors are different from individual investors. Hence, a fair comparison is between FIIs and DIIs.

Treatment effects or selection effects or both. Why might a firm fare well after FII investment? There can be two channels. There can be a `selection effect' where FIIs identify better firms. There can be a `treatment effect' where FIIs exert governance, and push firms to behave better. Investment technology is about the overall effect, i.e. the reduced form outcome. The economists' perennial quest for separating out selection effects from treatment effects is inappropriate here.

Asset allocation versus security selection. It is well known that the firms chosen by foreign investors are different in many dimensions such as beta, size, liquidity, etc. This hampers comparison. As an example, when Nifty fares well, high beta firms tend to do well. In such times, the portfolio held by foreign investors will look good as they have loaded up on high beta firms.

In order to address this, we utilise the three Fama-French empirical asset pricing factors: size, B/P and beta. For each firm chosen by the FII (but not DII), we find the partner firm (that was chosen by neither FII nor DII) where the Mahalanobis distance in size, B/P and beta is the lowest. If a good match cannot be found, the firm is dropped. This gives us a series of pairs of firms, which are alike in size B/P and beta, where one got FII (but not DII) investment and the partner got neither.

Holding a money manager accountable for security selection after controlling for asset allocation is an old idea in finance. However, the application of this idea into the question of investment technology of FIIs and DIIs is new, as is the matching-based quasi-experimental strategy through which we control for the asset allocation.


We find that the firms chosen by FIIs have exuberant growth in fixed assets in the following 3 years. But their output growth is not commensurately strong; there is some evidence of a decline in productivity. In terms of stock market performance, these firms under-perform over the three years after observation date.

Firms chosen by DIIs are strikingly different. They seem to be firms that are retrenching: both capital and labour drop slightly. But output grows. There is productivity growth. In terms of stock market performance, these firms outperform by 18 percentage points over three years.

These results suggest that foreign investors have a weak investment technology. Their access to information, and their ability to process information, adds up to poor security selection. In contrast, DIIs -- who are present in India and are likely to have ample information about portfolio companies -- fare better.


Implications for persons analysing Indian securities. A firm which has FII investment but not DII investment is probably going to grow assets but not give strong results. Conversely, a firm which has DII but not FII investment is likely to have slow growth but improve productivity and deliver stock market returns.

Implications for foreign investors. The results of this paper are about the average foreign investor, and there are surely many foreign investors who fare very well on security selection. However, on average, foreign investors need to be more cautious about their activities in India. They need to either amplify their efforts in security selection, so as to achieve strong information and information processing on Indian firms, or not attempt security selection.

How can a foreign investor improve security selection? Two paths are visible: To establish operations in India, and hold the team accountable for security selection using the methods of this paper, or contract-out to money managers who have deep roots in India.

How can a foreign investor harness asset allocation to India without attempting security selection? It is possible to setup index funds for the three Fama-French factors and thus replicate the bulk of the desired portfolio characteristics.

Implications for policy makers. Many of the pathologies of international finance are rooted in asymmetric information and the lack of deep engagement of foreign investors. These results are a reminder that even a large emerging market like India suffers from these problems. It is in India's interest to have a deep engagement with foreign capital, so as to obtain higher allocative efficiency. This suggests a re-examination at the constraints placed against deep engagement by foreign capital:
  1. It is difficult for foreign investors to contract-out money management to locals.
  2. `Permanent establishment' rules by the tax authorities have encouraged foreign investors to not open offices in India. This hampers deep engagement. Offices in Singapore or London will not be able to match the information and information processing that can be done in India.
  3. Source-based taxation, capital controls, and taxation of transactions, give incentives for foreign investors to avoid transacting in India. It is cheaper for a foreign investor to invest through the PN and NDF markets. However, not being in India hampers deep engagement.

How might this change over time?

In my opinion, in the 2000s, a certain kind of Indian entrepreneur started producing companies that look good to foreign investors. But you can't fool all the investors all the time. I think many investors are now more circumspect. Wall Street is changing course, and this is changing incentives for entrepreneurs. When finance rewards honest businessmen, more honest businessmen will show up asking for capital from the financial system. Many years from now, we might say that the results of this paper described a moment in time in the evolution of Indian capitalism.

Thursday, October 10, 2013

The cleansing of downturns

There is universal gloom in India today about economic conditions. This perspective is flawed in two ways.

First, every market economy experiences business cycle fluctuations. Trend growth is roughly 7%. When we get 10% growth in an expansion, we should not conclude that trend growth has gone up to 10%, and when we get 4% growth in a downturn, we should not conclude that trend growth has gone down to 4%.

Second, downturns are an essential part of capitalism. I have an article in the Economic Times today titled The cleansing of downturns. I feel these effects are more important in India when compared with mature market economies, where ethical standards are superior and where the policy process is less vulnerable. If the economy was permanently kept in good times through artificial means, we would damage the foundations and reduce trend growth. 

Wednesday, October 02, 2013

Who's afraid of a big current account deficit?

A big CAD is a bad thing -- much like a big fiscal deficit.

A country is always better off with a small or zero CAD or ideally a surplus.

The CAD is a drag on growth.

The large CAD is a profound drag on India's outlook.

If we managed to reduce the CAD, things would get better.

Statements like this are rife. They are wrong.

What is the CAD?

The CAD is three things, all of which are identical. It is the gap between revenues from selling goods and services versus the payments made for buying goods and services. This has to be exactly matched by the capital inflow into the country. This is exactly equal to the gap between investment and savings. These three relationships are accounting identities.

What if there was no capital account?

If there was no capital account, then the proceeds from selling goods and services would have to exactly match the payments for goods and services, in every minute. Every small mismatch between the two would generate extreme currency fluctuations (large enough to incite a current account response).

The capital account is what smooths these things out. Let us imagine the currency market for one minute in which someone is buying \$1 billion in order to import something. In that very same minute, it is very unlikely that there will be a double coincidence of wants, in the form of an exporter who wishes to sell \$1 billion. What fills the breach is the capital account. Some speculator comes in and supplies that \$1 billion in the hope of scoring a short-term speculative profit. The real economy demands liquidity in the currency market and finance supplies this, through the capital account.
The CAD is exactly equal to the gap between savings and investment. A CAD of zero is tantamount to only investing what we have saved. In general, this is a bad idea. If the country is all set to invest 35% of GDP, and savings are only 30% of GDP, it is a good thing if capital flows of 5% of GDP show up, through which investment exceeds savings.

Should we bemoan the large Indian CAD?

Should you be unhappy that investment is bigger than domestic savings by 5 per cent of GDP? If we insisted that the CAD should be 0 (i.e. we had no capital account) then investment would have to be lower and savings would be higher (which in turn implies reduced consumption). This would give reduced GDP growth.

Financial autarky implies that we live within our means. With savings of 30% of GDP, investment is forced to 30% of GDP under autarky. Opening up to the world makes it possible for a country to import or export capital.

If a country has good prospects but low savings, running a CAD is a way to front-load the investment, and service the foreign capital through a stream of dividends, interest payments and debt repayments into the future. If a country has poor prospects, it is better off sending capital to good uses overseas, instead of investing it domestically. For these gains, we have to have an open capital account and run large and variable CADs.

(There are also gains from risk sharing from large gross capital flows, even if the CAD is 0, but that's a separate topic of discussion).

A big CAD got us into trouble in 1991. Won't that happen again?

In 1991, FERA (1973) was in force. Capital account transactions by private parties had been criminalised. The only mechanism that generated flows on the capital account was the government. The entire CAD had to be financed by government borrowing. When the government lost creditworthiness in the eyes of the world, we had a funding crisis on the capital account.

On a day to day basis, imports required dollars which came from the government. The Ministry of Finance monitored daily inflows and outflows of dollars, and controlled who could access foreign exchange.

When GOI lost credit-worthiness in the eyes of overseas lenders, this was a collapse in the flow of dollars. If you wanted to import penicillin, you needed to get dollars, and RBI had none. That's where it came to crunch: when an importer is told that he cannot import as there are no dollars.

Nothing remotely like this can happen in the present environment. With capital account liberalisation, many channels have opened. There is FII investment in equity and debt, there is FDI, there is ECB, and so on. The money moving in these channels dwarfs the borrowing by the government. India is now well connected into financial globalisation. All these channels won't choke.

Suppose there is some big mess abroad and all fixed income funds stop buying Indian bonds. Under these circumstances, capital inflow will come through the other channels. The more we open up to a diverse array of investors into a diverse array of asset classes, the safer the environment becomes, the lower the exchange rate volatility becomes.

Why won't all channels choke all at once?

We require a capital inflow, on average, of Rs.20 billion per day. That's the gap, on the currency market, which has to be filled. If foreign capital does not come in, there is a supply-demand mismatch on the currency market. This gives a currency depreciation.

Ex-post, supply always equals demand. On the market, this demand will be met. Every day, the CAD of the day will equal the capital inflow of the day. The only question is: At what price?

When bad news comes out in India, foreign capital becomes more circumspect. They require a more attractive exchange rate at which to get in. Or, to say it differently, suppose INR/USD is at Rs.65 to the dollar. Suppose bad news come out. The inflow of Rs.20 billion is not forthcoming. The market has a gap. The rupee starts falling. At Rs.70 to the dollar, some foreign investors think `Hmm, maybe at this price, it's a good deal, and I should get in'.

How far does the depreciation go? Minute by minute, the rupee moves to elicit the net capital inflow (or outflow) required to clear the currency market. In response to bad news, the INR drops till a speculator feels that it might be a good idea to come into India, buy a 91 day treasury bill, and hope that the rupee will do well in a few minutes or few days. That's how the current account deficit always gets financed under a floating exchange rate.

Rupee depreciation makes Indian assets more attractive. It would be nice if foreign capital found Indian assets attractive for other reasons. But when all else fails, rupee depreciation is what gets the job done.

What kinds of foreign investors respond the most to rupee depreciation?

Sharp spikes of the rupee are fertile ground for currency speculators. The more currency speculators that we have, who are operating on the rupee market, the smaller is the INR movement associated with an event.

Imagine an INR depreciation of 5% in one day. A currency speculator believes this is over done and wishes to come in. What does he do? He sells dollars, buys INR, and invests in short-dated government bonds. This would add up to a pure play on INR. Currency speculators are not comfortable holding Nifty in India. They want a pure exposure to INR.

Hence, the best way to obtain a deep and liquid currency market, where shocks will lead to small exchange rate fluctuations, is to remove capital controls on the rupee denominated debt market.

A big CAD increases the damage caused by a sudden stop in capital inflows. What should the country do to forestall this?

Sudden stops are ultimately about asymmetric information in the hands of foreign investors. If India has a deep engagement with financial globalisation, then the informational asymmetry will be removed.

Our policy goal should be to have thousands of global financial firms who are running business activities connected with India, who have large scale organisational and human capital that is devoted to understanding India. This deep engagement will deter problems such as home bias, sudden stops, etc.

The Indian capital controls are damaging this deep engagement. As an example, repeated stop-go policies frustrate the development of teams inside global financial firms that have deep knowledge about India. When these teams know less about India, there is a greater likelihood of encountering the pathologies of international finance.

When India does silly things like trying to `crush the speculators' through various means fair and foul, this hinders a mature engagement with financial globalisation. When global capital feels that India operates on stable rules of the game and has mature policy makers, the resources committed for building organisational capital connected with India will be greater.

In order to avoid international finance pathologies such as sudden stops, our engagement with financial globalisation should be a deep engagement. While this issue becomes particularly salient when the CAD is large, but there is no short term solution. Over the years, we have to chip away at building a deep engagement with financial globalisation at all times, so as to reduce the risk when there is a large CAD.

This is like a rules versus discretion problem. When discretion is used at a time of a large CAD, it contaminates credibility at all times. A mature approach to public policy involves establishing capable institutions that implement stable rules of the game and not tactical dogfights.

What is the role of MOF or RBI in ensuring adequate capital comes into the country to match the CAD?

On a day to day basis -- nothing. It's a purely market process. The market does it. There are no gray men who look at the CAD and figure out how to finance it and then undertake actions through which it gets financed. The financing of the CAD is purely a market process.

The role for MOF and RBI is to get out of the way by removing capital controls, so as to reduce the magnitude of INR depreciation required when a certain negative event takes place.

Does this work differently for other countries?

A large CAD is dangerous when there is a managed exchange rate. Under a managed exchange rate, there is a propensity to borrow in foreign currency and leave it unhedged. These borrowers (whether corporations or governments) get into big trouble when there is a large exchange rate depreciation.
The central bank is much more likely to fail on exchange rate management when there is a large CAD.

The witches' brew that adds up to trouble is a central bank that believes there should be exchange rate policy + borrowers who believe the central bank will pursue exchange rate policy + a large CAD.
While India has a de facto floating exchange rate, RBI has not yet stopped talking about dreams of exchange rate management. We are relatively safe because borrowers don't believe RBI can do much about the exchange rate. Hence, there is no moral hazard and a large CAD poses no threat.

Why is a large CAD seen as a big problem?

With a large CAD, India is beholden to foreign capital inflows. If foreign investors are displeased, we get a big rupee depreciation. This generates accountability.

When India enacts capital controls, or the Food Security Bill, we get a rupee depreciation. This irritates policy makers, who feel that mirrors should reflect a little before throwing back images.
Nobody likes accountability. Hence, people in positions of power do not like a large CAD.

In a mature market economy, a key channel of accountability for the government is the bond market. When the government does bad things, their cost of financing goes up, and this directly hits the ability of politicians to spend on their pet projects. In India, the bond market has been muzzled by setting up a system of financial repression. The job of intimidating the authorities is then left to Nifty and the rupee. The voice of the latter is amplified when there is a large CAD.

If you look at the world from the viewpoint of the people who run the place, there is a desire to muzzle Nifty and the rupee (particularly when the latter is speaking loudly thanks to a large CAD). From that viewpoint, a large CAD is a bad thing. Because the establishment has a disproportionate impact upon the climate of ideas, we have started accepting their claim, that a large CAD is a bad thing.

If you care about India's future, a large CAD is a good thing, as it enhances accountability. By this logic, other things being equal, the Indian policy process generates superior outcomes when there is a large CAD. If we had a small CAD, Mr. Mukherjee might have been finance minister today.


Financial globalisation is work in progress. Capital controls and source-based taxation hinder international capital mobility. Even if there are no restrictions, it is hard for investors in country i to properly utilise the investment opportunities in country j, for reasons of `information distance'. All too often, there is home bias (people in a country holding vastly greater domestic assets than is optimal from the viewpoint of diversification). There are international finance pathologies such as capital surges, sudden stops, investments by foreigners in wrong assets, and so on. These are the hurdles along the road.

In the destination state, there is no good reason why the investment opportunities in country i at time t should match the savings of country i at time t. We should judge the success of the project of financial integration by the extent to which we are able to achieve large and variable current accounts.

In addition, in a place like India, a big CAD generates greater accountability on the part of the government. One would predict better economic policy when there is a large CAD.

The widespread mistrust of a large CAD may reflect two things. Some don't see the extent to which we're not in 1991 anymore: there is much more of a deep engagement with financial globalisation, and the exchange rate floats enough that the borrowers are not unhedged. And, establishment figures resent accountability.

I am grateful to Josh Felman for illuminating discussions on these issues.