When will FIIs return to the Indian equity market? Bernstein has an answer

When will foreign institutional investors (FIIs) return to the Indian equity market? Bernstein believes the more important question is not when foreign money will come back, but why it would return in the first place.

The foreign brokerage does not expect FIIs to return in large numbers even after the current artificial intelligence-driven investment cycle peaks. A durable revival in foreign inflows, it said, will depend on India’s ability to build globally competitive businesses in areas such as semiconductors, batteries and energy storage.

Over the next 12 months, FII flows are likely to remain broadly flat to modestly positive, Bernstein said. But any improvement would largely reflect an easing of recent headwinds rather than a meaningful change in the structural factors that drive long-term foreign investment decisions.

“We do not believe FIIs will return in large numbers even after the AI trade peaks. Global capital was never designed to chase annuity-like returns while accepting the valuation, liquidity, and execution risks that increasingly characterize parts of the Indian market,” Bernstein said.

The brokerage said India needs to move beyond simply adopting technologies developed elsewhere and build businesses capable of competing globally.

This means advanced semiconductor manufacturing rather than just assembly, deeper capabilities in batteries and energy storage, greater energy self-sufficiency and business models that can capture meaningful global market share.

Bernstein pointed to early signs of progress in space, defence, semiconductors and deep-tech innovation. However, it said most of these sectors remain too small to materially influence global capital allocation decisions through much of this decade.

“Above all, India must demonstrate that it can create the next generation of globally relevant companies, not merely consume technologies developed elsewhere,” the brokerage said.

What is keeping foreign investors away?

The question comes against the backdrop of a prolonged period of foreign outflows. September 2024 was the last month to record FII inflows of more than $5 billion. In the preceding 24 months, FIIs had brought in a cumulative $38.6 billion. The following 24-month period, however, saw combined outflows of $56.3 billion, Bernstein said.

The brokerage found that several traditional drivers of FII flows have lost their predictive power. GDP growth, for instance, had a strong relationship with foreign flows until around 2007, but that linkage has weakened over time and currently points towards a negative correlation.

Interest-rate differentials have followed a similar path. The gap between US Federal Reserve rates and India’s repo rate was closely linked to FII flows from early 2012 to late 2018, when higher relative Indian rates encouraged capital deployment into riskier markets. That relationship weakened around 2019 and has turned negative over the past four to five years.

Rupee emerges as key driver

Currency movements have become increasingly important to foreign investors. Bernstein found a historically strong relationship between the rupee’s movement against the US dollar and FII flows, with the correlation strengthening sharply in recent periods.

Its analysis using the US dollar index also showed that the relationship with FII flows strengthened after 2020, suggesting that currency stability has assumed greater importance in foreign investors’ allocation decisions.

A weaker rupee can directly hurt dollar-denominated returns, making Indian equities less attractive to overseas investors even when domestic growth remains resilient.

“If you can get 6% as a UK resident or a UK company in a 30-year bond, why would you take the risk of sending the capital to a distant part of the world with attendant exchange rate risks, compliance risks?” Bernstein quoted the concern around rising global yields.

“That is going to be a huge challenge for emerging economies and countries like India which are dependent on global capital flows,” it said.

Earnings revisions, valuations matter

Bernstein found little meaningful relationship between FII flows and current-quarter earnings growth, with the relationship also remaining weak when flows were compared with the previous quarter’s earnings growth.

The picture changes when investors look ahead. The brokerage found the strongest relationship among the combinations it tested between FII flows and three-month earnings revisions for the next quarter. This suggests that foreign investors may be responding more to changes in forward earnings expectations than to reported earnings.

Relative valuations have also gained importance since 2020. Bernstein compared India’s valuation multiple with that of emerging markets and found that as India’s valuation premium widened over the past eight to nine years, FII flows increasingly averaged around negative or zero levels.

For now, Bernstein expects FII flows to remain subdued rather than see a dramatic reversal. The longer-term question, however, goes beyond GDP growth, interest rates or the AI trade.

The brokerage said India faces near-term headwinds from global bond yields, unsettled US relations and the perceived absence of a strong AI play.