Markets
Indian Equities Face Pressure Due To FII Selloffs, Likely To Continue Into 2025. Decoding The Market Dynamics That May Fuel The Momentum.
The Indian stock market is currently facing significant headwinds, primarily driven by aggressive Foreign Institutional Investor, FII selloffs.
Despite the strong evolution of India’s equity markets since the days of retrospective taxation and the General Anti-Avoidance Rule (GAAR), the market’s resilience is being tested. While a record surge in domestic participation through mutual funds and systematic investment plans (SIPs) has provided a counterbalance, FIIs continue to wield substantial influence over market trajectories.
Domestic Strength Amid FII Weakness
Over the past few years, domestic investors have emerged as a formidable force in the Indian equity markets. SIP inflows have skyrocketed, growing from INR 8,000 crore in January 2021 to an impressive INR 25,300 crore as of October 2024—an increase of around 200%. This influx shows the growing confidence of Indian investors in the long-term potential of domestic markets.
However, the market’s dependence on foreign capital remains evident. The aggressive selling by FIIs in October and November 2024 led to a significant downturn in equities and pushed the Indian rupee to record lows.
The FII-DII Dynamics
An analysis of market correlations illustrates the crucial role FIIs play in influencing market movements. Historically, there is a negative relationship of -0.27x between FII activity and the Nifty on a monthly closing basis.
In contrast, domestic institutional investors (DIIs) exhibit a positive correlation of 0.44x with the Nifty. This implies that FII selloffs exert a downward pressure on the markets, while DII inflows provide a stabilizing force. Despite the growing clout of DIIs, their efforts have not been sufficient to fully offset the impact of FII withdrawals.
Why FII Selloffs May Persist In 2025
The persistence of FII selloffs can be attributed to a confluence of macroeconomic factors, with the narrowing rate differential between India and the US standing out as a key driver –
1) Shrinking Yield Spread: The spread between the risk-free returns in the US and India has reached a historic low of around 225 basis points (bps). This marks a sharp contrast to 2012, when Indian 10-year government securities (G-Secs) offered yields of 8.5%-9.0%, compared to US 10-year Treasury yields of 1.5%-2.0%, creating a spread of approximately 700 bps.
Even as recently as March 2022, this spread stood at 450 bps. Today, with Indian G-Secs yielding 6.79% and US Treasuries at 4.52%, the arbitrage opportunity has diminished significantly, especially when factoring in currency hedging costs.
2) Flight to Safety: The elevated yields on US Treasuries—currently above the 10-year average of 2.4%—are attracting global investors seeking safer, higher returns. This has given rise to the “T-bill and chill” mantra among US investors, reflecting a risk-off sentiment towards emerging markets like India.
3) Currency Risks: For foreign investors, the additional need to hedge against rupee depreciation further erodes the attractiveness of Indian bonds and equities. The recent weakness in the rupee has exacerbated these concerns, amplifying the outflows.
Currency Depreciation and Its Impact on Foreign Investments
A depreciating currency poses a significant challenge for foreign investors, as hedging currency risks can be both complex and costly. For instance, consider an investor who allocated USD 1 billion to the Indian market when the exchange rate was INR 70 to a dollar, as seen in 2021. This investment would translate to INR 7,000 crore.
However, if the exchange rate at the time of exit rises to INR 85 to a dollar, as it stands today, the investor would need INR 8,500 crore to retrieve their initial USD 1 billion. This scenario demands an additional 21% return solely to offset the currency-depreciation impact, assuming the position remains unhedged.
The Dollar’s Strength and Emerging Market Pressures
The strengthening of the US dollar has diverted capital flows into the US market, exerting downward pressure on emerging market currencies, including the Indian rupee. Although the rupee’s depreciation has been less severe compared to the dollar’s appreciation, this stability has come at the expense of a sharp decline in India’s foreign exchange reserves.
According to a December 17 report from CRISIL Market Intelligence and Analytics, “The rupee depreciated 0.4% in November, averaging at 84.4, a record low. A stronger dollar and FPI outflows pressured the currency. It is notable that the rupee depreciated at a lesser rate than the dollar’s appreciation.” The Reserve Bank of India’s (RBI) interventions, such as selling dollars in the forex market, have played a critical role in limiting the rupee’s depreciation.
Challenges for the Reserve Bank of India
This situation complicates the RBI’s monetary policy decisions. A weakening currency aggravates imported inflation, while a narrowing rate differential limits the central bank’s ability to cut interest rates even in a slowing growth environment. This creates a feedback loop where a depreciating rupee triggers FII exits, which further weakens the currency. Historically, such loops have been broken only when the dollar weakens and capital inflows return to emerging markets.
Growth Divergence. India vs. the US
The US economy has exhibited a growth rate of 3.1% in the July-September quarter contrasts sharply with India’s seven-quarter low growth rate of 5.4% during the same period. India’s economic slowdown is driven by a slump in manufacturing and deceleration in private consumption and investment. The RBI recently revised its GDP growth projection for 2024-25 downward to 6.6% from an earlier estimate of 7.2%.
Inflation adds another layer of complexity. After appearing restrained in September, inflation surged to 6.2% in October, marking a 14-month high. “We find ourselves in a slow growth, high inflation scenario,” said Nagesh Kumar, a member of the RBI’s Monetary Policy Committee (MPC), during its December meeting, where he advocated for interest rate cuts.
Key Tax Changes and Their Impact on Foreign Investments
The Union Budget announced in July introduced significant changes to tax laws, which have adversely impacted post-tax returns for investors. The tax burden for both long- and short-term investors has increased substantially—by 25% and 33%, respectively.
Short-term capital gains tax (STCG) has been raised from 15% to 20%, while long-term capital gains tax (LTCG) has increased from 10% to 12.5%. Additionally, the introduction of taxes on buybacks has dampened investor sentiment, particularly among Foreign Institutional Investors (FIIs), who have the flexibility to invest across global markets.
Foreign investment remains a crucial component in managing India’s current account deficit. While domestic flows have provided support to equity markets, FII participation is indispensable for sustaining market momentum and driving economic stability.
The Trump Effect on Global Capital Flows
The anticipation of Donald Trump’s victory in the US elections, followed by his subsequent win, has triggered institutional investors to withdraw funds from global markets and redirect them to the US. Since the November 5 election results, US equity funds have recorded inflows of USD 150 billion, while funds focused on emerging markets have faced net withdrawals of USD 8 billion. Similarly, Europe- and Japan-focused funds have also witnessed substantial outflows.
Compounding this trend, the US Federal Reserve’s recent hawkish stance has intensified challenges for India. Slowing domestic growth, moderating corporate earnings, and high market valuations create a precarious environment for Indian markets, heightening the risk of sustained capital outflows.
Rising Dollar and Bond Yields
In the current climate of a strengthening US dollar and rising US bond yields, emerging markets, including India, are bearing the brunt of FII outflows. The strong expansion of the US economy stands in contrast to India’s slowing growth trajectory. This disparity amplifies the attractiveness of US investments over emerging markets, further fueling outflows.
In A Nut Shell
Impact on Currency Stability: Sustained FII outflows puts further pressure on the rupee, increasing import costs, especially for essential commodities like crude oil leading to inflationary pressures, further complicating monetary policy decisions. The ripple effect of a weaker currency impacts businesses reliant on imports and raises the cost of foreign debt servicing.
Foreign Exchange Reserves: The Reserve Bank of India’s (RBI) efforts to stabilize the rupee by selling foreign exchange reserves have limited depreciation but at a significant cost. Depleting reserves leave the economy vulnerable to external shocks and reduce the RBI’s ability to intervene effectively in future crises.
Sector-Specific Challenges: The banking, IT, and real estate sectors are particularly susceptible to FII selloffs, given their higher dependence on foreign investments. Reduced FII inflows can slow down credit growth, delay project financing, and dampen corporate earnings.
Alternative Growth Areas: Despite challenges, some sectors, such as renewable energy, technology, and manufacturing, remain attractive to FIIs. Government initiatives like “Make in India” and “Digital India” could offer long-term investment opportunities, which could offset short-term volatility.
The Last Bit
As the Indian markets enter 2025, the dual pressures of FII selloffs and a depreciating rupee are likely to persist.
The evolving macroeconomic environment, characterized by high US yields and a narrow rate differential, suggests that India will remain vulnerable to capital outflows. While domestic investors have demonstrated remarkable resilience, their capacity to offset the full impact of FII activity remains constrained.
Thus for market participants, understanding the underlying factors driving FII behavior is crucial.
Efforts to stabilize the rupee, enhance market liquidity, and delivering a favorable investment climate will be key to mitigating the impact of external headwinds. At the same time, continued encouragement of domestic participation can serve as a vital buffer against global volatility.
The Indian equity story remains compelling, but facing the challenges posed by global capital flows will require a nuanced and proactive approach.
Despite the challenges posed by FII withdrawals, the Indian government has so far relied on domestic investors to bridge the gap. However, with domestic growth slowing and investor sentiment waning, this strategy may not suffice in the long term.
