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The investment scenario in India has dramatically changed for the better. In 2005 foreign institutional investor (FII) flows touched a record $10.6bn (€8.34bn) compared with $8.5bn in 2004 and $2.84bn in 2001. The indications are the 2006 figures will easily exceed the 2005 total.

By any measure, India currently has one of the highest exposures to FII inflows among emerging economies. Compared with other BRIC nations, FIIs formed nearly 70% of the total foreign investment [FDI plus net portfolio equity flows] into India. In China and Brazil the figures were 26% and 30%, respectively, for 2005.

A major chunk of foreign investment entered China, Brazil and Russia as FDI. India, on the other hand, attracted nearly 20% of the net portfolio investments flowing into developing countries, while its FDI inflows were barely 2.4% of what was received by emerging economies, according to data from the Global Development Finance report 2006. During January-December 2005, India's capital account surplus amounted to $26bn. Nearly half of these inflows were portfolio investments according to the Reserve Bank of India.

The official figures suggest that foreign investors are being well rewarded. Kamal Nath, the Indian Minister for Commerce and Industry, says that of all the foreign investors in India, at least 77% make a profit and 8 % break even.

India's popularity among investors can be gauged from the fact that the number of FIIs registered with the Securities and Exchange Board of India (SEBI) has increased from none in 1993 to 528 in 2001 and 803 in 2006. In 2005 alone, 145 new FIIs registered themselves. "FIIs are finding the Indian markets attractive mainly because the fall in prices happened too quickly. In terms of P/E ratios too, the markets look fairly priced," says Andrew Holland, head of the strategic risk group of DSP-Merrill Lynch.

Local experts suggest the Indian markets have become a global force and the trend of foreign activity will only increase from here. Uday Kotak, managing director of Kotak Mahindra Bank, is particularly bullish: "I expect that in the next five years, if nothing goes wrong, India will be the second largest capital market in the world after the US. The current trading volume on Indian bourses is $10bn and I expect it to be $30-40bn in the next three to four years."

 

Foreign fund gold rush to real estate

Historically, India has never had a nationwide property boom. Rising real estate prices and relaxation of FDI rules by the government have started attracting foreign funds and thereby further fuelling the real estate boom. Property prices in India have gone up by 60-70 % over the last two years.

In March 2005, the Union Government allowed FDI in real estate development under the automatic approval route for large projects. The boom has attracted global fund investors to commit an estimated $12bn over the next couple of years. Morgan Stanley, Lehman Brothers, HSBC, Merrill Lynch and ABN Amro are among those showing interest. Recently, SEBI has issued guidelines allowing real estate mutual funds to invest directly in properties . Merrill Lynch expects the Indian real estate sector to grow almost nine times to $90bn by 2015.

"The floodgates opened in real estate and created a skew towards investments in a sector that was untapped," says Arun Natarajan, CEO and founder of Venture Intelligence Group. "Sixty per cent of new funds in the last quarter were targeted at one sector."

Morgan Stanley is already a substantial investor in Asian real estate. The group now plans to invest $1bn in next four years in India, according to Zain Fancy, executive director of Morgan Stanley Real Estate in Asia Pacific.

There are at least 12 real estate focused funds, both Indian and international, from the likes of Trikona Capital armed with $450m to Kotak Real Estate Fund with a portfolio of $100m. "Indian real estate is a long term commitment for us, we want to institutionalise developers instead of doing 100 opportunistic deals," says Aashish Kalra, managing director, Trikona Capital.

Given the unprecedented growth in real estate development, there is a huge equity component required by developers, which cannot be met by in-house funds. This is why many developers are opting to partner with major groups. Foreign investors are opting for the fund-in-fund route with other established foreign funds, or by subscribing to the dollar component of domestic Indian funds. Domestic funds have raised over $1 billion in the first year since the opening of foreign investment in real estate.

 

Banks and debt instruments still in demand

FIIs own over a third of the public shareholding in the state-owned banks in India. Moreover, FII shareholding has more than doubled in each of the listed nationalised banks in the past two years. In 12 out of the 16 listed public sector banks, foreign investors account for more than one-third of the public shareholding. In all the listed public sector banks - barring State Bank where foreign holding has been close to 20 % for years - the foreign shareholding had more than doubled since March 2004 coinciding with the sharp rise in bank stock prices.

The dominant role of foreign shareholders was highlighted by the Reserve Bank governor YV Reddy, in a recent speech: "Foreign investors have been major providers of capital for the banking industry. It would also have implications for the capital-raising ability of the banks where foreign shareholders have already reached the limit. It may be recalled that in private sector, ICICI Bank has managed to raise capital at high valuations because of the high level of interest from FII."

The debt market also continues to attract foreign funds. Moses Harding, executive vice-president, IndusInd Bank, says FII investment in the debt market could be a cash management exercise to avoid exchange rate risk and to retain the funds in the country. "Instead of repatriating the money or keeping the funds idle at zero per cent interest rate, investing in short-term papers in the debt market with some interest rate appears to make better fund management sense. However, as a percentage, the investment in debt is still very small." Foreign funds seem to have adopted a similar strategy of parking funds in the debt segment in other markets. Overall figures of FIIs in the Indian debt market from the time they were permitted to invest, show that they are net buyers for $368.5m.

 

Japan, South Korea and Taiwan are expected to be the biggest Asian investors in India. A survey by the Japan Bank for International Co-operation shows that in the next three years, India will be the third most favoured investment destination for Japanese investors, after the US and Russia. A Smith Barney study shows the estimated market value of FII investment in the top 200 companies (including ADRs and GDRs) at current market prices is $43bn. This is 18 % of the market capitalisation of the Bombay Stock Exchange 200. Worldwide, India has displaced the US as the second-most favoured destination for FDI after China, according to an AT Kearney's FDI Confidence Index.

Supporting this bullish view, GE has revised upwards its 2010 sales target for India from $8bn to $10bn (compared with $1bn in 2005). Foreign investment in the IT and telecom sector is expected to double in 2006, on the back of recent policy measures and the buoyant industry. In the financial sector, AIG and JP Morgan, British fund house Dawnay Day and Singapore-based Temasek are developing broadly-based financial services businesses. AP Kurian, chairman of the Association of Mutual Funds in India says he expects these groups to be fully operational by the first quarter of 2007.

There has been a tremendous amount of activity in private equity during the last two years. Last year alone, more than 40 private equity players realised investments worth $1.5bn. This year, Baring Private Equity sold its stake in Cybernet Software Systems to Softbank Asia Infrastructure Fund (SAIF), Carlyle sold its stake in Sharekhan to General Atlantic Partners and ICICI Ventures sold its stake in Intas Pharma to Chrys Capital. "It is the sign of a mature market where one fund is acquiring the portfolio of another, and secondary transactions are coming into being," says Arun Natarajan, founder of Venture Intelligence.

Small and mid-size enterprises, including a host of closely held family-owned firms, are emerging as a big draw for private equity funds. Unlike in the developed markets where private equity firms look to pick up majority stake in mature businesses through the buyout route, in India, private equity companies seem to be chasing growth capital through minority stake holding in mid-cap firms having bankable business models.

The first half of 2006 saw investments worth $3.5bn through private equity funds, compared with $2.3bn during the whole of 2005. A substantial chunk of this went into mid-caps, most of which are unlisted, regional players. For example, Helion Venture Partners, an India-focused technology fund, invested $2.2m in Bangalore-based JiGrahak Mobility Solutions. Kleiner, Perkins, Caufield & Byers picked up a 10 % stake in the distillery equipment maker Praj Industries while IntelCapital picked up stake in Chennai-based digital media firm Real Image. Mauj Telecom, which operates in the mobile value-added services space, received $10m in funding led by WestBridge Capital Partners. Meanwhile unregistered offshore investors are readying to tap India's potential. Indications are that regulatory authorities may set the ground rules to make it easier for sub-accounts to buy and sell local stocks.‘Sub-account' includes foreign corporates, funds or portfolios established outside India, on whose behalf investments are made in India by a FII registered with SEBI.

 

The future perfect

India is quickly becoming one of the world's hottest private equity destinations. Over the last several months a dozen private equitty firms have revealed plans to raise India-related funds or to invest in the region. Many of them are small, emerging managers, but there are household names in there, too, like The Carlyle Group. India "is drawing foreign investors like moths to a light bulb," states Anil Ahuja, CEO of JP Morgan Partners in Singapore. "There is a growing understanding that by 2010 India will be the world's third largest economy and boast a population of more than a billion people."

India still has a long way to go before we can be sure it has fully emerged into the global market. Not the least of its problems is the chronic lack of infrastructural development. The government's greatest challenge in the next five years is to implement the current infrastructure programme, says Sanjay Verma of Cushman & Wakefield in Delhi. The investment is planned, as much as $190 billion of it in the next five years. But Verma remains cautiously optimistic: "This is the one problem that could spoil the party before it begins. India has a more stable long term growth outlook than the other BRICs countries. But it is just not comparable with other emerging countries when it comes to infrastructure. I just hope they (the Government) at least stick to what they have said they will do."

Sidharth Mahapatra, an India fund manager with Credit Agricole, says of the infrastructure issue: "Although it will be phenomenal if the government achieves its stated investment plans of the next five-10 years, it will also be quite impressive if they manage to do just half of that. We expect 2007 to be a crucial year for infrastructure-related measures, since it is the last year of the current five-year plan. 2007 is also the last full year for this government before the focus moves on to the next round of elections, expected some time in second half of 2008 and first half of 2009."

India's share of investor inflows to emerging markets has also increased dramatically over those three years. In 2003, out of a total of $35,000m received by key emerging markets (see chart), India received just 19%. This year India's share had increased to 60% at the end of September.

Compared to other emerging markets, India is less exposed to global turbulence in commodities and trade imbalances. The Indian capital market is more diverse, has a high RoE and compares well with other markets which are largely commodity or property driven.

Uday Pai is a freelance journalist based in Mumbai.

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