In the first part of a series on how foreign portfolio investment is driving the Sensex, Janaki Krishnan and Rakesh P Sharma examine what it is that is drawing these funds to the Indian equity market

How long will foreign institutional investors, which have pumped Rs 23,747 crore, or $5 billion, into the Indian equity and debt markets this year, continue fuelling the boom? The answer is in three parts: valuations, arbitrage, and inflows into emerging market funds.

The Sensex attraction

VALUATION: Indian stocks are trading at a price-earning multiple of 17. In Western markets, the P/E multiple is 22-25 ARBITRAGE: The rupee has appreciated nearly 6% against the dollar

The first part of the answer is obvious: FII money will keep coming so long as share valuations appear attractive. U R Bhatt, head of J P Morgan in India, said FIIs were still bullish on Indian stocks.

With a price-earnings (P/E) multiple of around 17, Indian stocks are undervalued, compared with leading western markets, which trade at P/Es of between 22 and 25. "They will keep investing here so long as they can make money," he says.

The second part of the answer depends on how hedge funds and FIIs view the currency arbitrage option. Many FIIs are currently taking advantage of the rupee's strength against the dollar. Many hedge funds are doing the same in other emerging markets, too.

"The local currency in many emerging markets has been appreciating against the dollar, and, therefore, these funds are parking their money in emerging markets," said V V L Sastry, country head, Firstcall India Equity Advisors, which represents some funds in India.

Hedge funds, which typically invest through participatory notes, borrow money cheaply in the West and invest it in emerging market equity. This gives them a double advantage -- appreciating stocks in an appreciating local currency.

Agreeing that a number of hedge funds were putting money into the market, Bhatt said most mutual funds also indulged in hedging. "So where is the difference," he asked.

Sastry said none of the emerging market-dedicated funds had raised fresh funds through public issues, but continued to benefit from fresh inflows into existing funds.

"Hedge funds and certain investors are investing in a big way through participatory notes," said Sastry. Not surprisingly, the Emerging Market Hedge Fund Index has gone up 24 per cent since May.

The third factor, of course, is the huge fresh flows into Asia-focused funds. According to Emergingportfolio.com, which tracks inflows into equities in emerging markets, "Flows into Asian, ex-Japan, equity funds were at a record pace in the first half of October. This fund group attracted $359.8 million of net investor contributions in the week ended October 15, the strongest week of inflows to these funds since 1996."

Said Emergingportfolio.com, which is run by research firm Emerging Portfolio Fund Research, in a recent newsletter, "Combined with the previous week's $342.8 million of inflows, October is on track to break records for monthly inflows into Asian, ex-Japan, equity funds."

The rush of liquidity into the region and the funds dedicated to investing here have nearly doubled the assets in the 285 Asian, ex-Japan, equity funds tracked by EPFR every week, to $21.2 billion from $11.8 billion at the beginning of 2003.

By October 15, these funds received $2.7 billion inflows, which is more than three times the $782 million worth of net investor contributions in all of 2002.

So is the Indian rally sustainable? The broad thinking is that the rally will continue till the end of the year, owing to sheer lack of investment opportunities elsewhere.

Foreign funds are looking at stocks where they can safely park their funds across sectors. Also, there is a lot of churning in portfolios. Many are also arbitraging between the derivatives and cash segments on domestic bourses.

This year has been a record for FII investments. In 2002, FII investments were to the tune of $555.2 million, while in 2001 they were higher at $1,492.2 million. The rally will continue at least as long as the money keeps coming.

Part II: Crowding in or crowding out?