Turning the Tide: What will drive Foreign Institutional Investors (FII) flows back into India?

Key Macro-Economic Factors Influencing FII Flows:

1. Global Economic Conditions
   • Strong global GDP growth encourages FIIs to allocate capital to emerging markets.
   • Economic slowdowns lead to risk aversion, reducing FII inflows.
   • Ample global liquidity fosters increased capital flows into emerging markets.


2. Interest Rates, Monetary Policy & Bond Market Dynamics
   • 10-Year US Treasury Yield – Rising yields reduce the attractiveness of emerging market assets.
   • Interest Rate Differential – Higher domestic rates attract FIIs, while lower rates discourage them.


3. Inflation & Commodity Prices
   • Inflation Rate (India & Globally) – High inflation erodes real returns, leading to outflows.
   • Oil Prices – Rising prices increase India’s trade deficit and weaken the rupee, reducing FII confidence.


4. Currency Exchange Rates & Stability
   • Rupee Depreciation – A weakening rupee can lead to outflows due to FX losses for FIIs.
   • Dollar Index (DXY) – A stronger USD makes emerging market assets less attractive.
   • Foreign Exchange Reserves – Higher reserves provide economic stability, boosting FII confidence.

The below table shows correlations between annual FII flows and the equivalent rate of change in macro-economic factors. A positive correlation indicates that factors tend to move in the same direction and a negative correlation indicates that factors move in different directions.

Correlation	Net FII Equity Flows
DXY Index	-0.5
US 10Y	-0.5
Oil Price	-0.2
Bond Yield Spread	0.3

Source: Bloomberg, NSE, NSDL and Investing.com. Data Period: 1 Jan, 2010 to 31 Dec, 2024.

Key findings from the correlation table, as below:

• FII flows have the strongest relationship with the DXY Index and US 10Y Treasury Yields, among all the key macro-variables.
• Oil Prices and Bond Yield Spreads are also important indicators of FII flows direction, but the relationship may vary across different time periods.

Valuations / Earnings Momentum: Equity valuations have also proven to be an important indicator of flows in the past but have lacked consistency at times. To test the relevance of equity valuations on FII volatility, we looked at the MSCI India 12M forward (NTM) P/E vs. the next 3-month and 6-month average FII equity flows.

Key takeaways from our analysis, as below:

• The highest inflows come in when the valuations are cheap (<15x 12M Fwd. P/E), while flows tend to dry up when valuations become expensive (>21x 12M Fwd. P/E).
• The current MSCI 12M Fwd. P/E is at ~21x, which indicates muted net equity FII flows into the Indian capital markets over the next couple of months, based on past historical trends.

MSCI India 12M Fwd. P/E	Number of Observations	Next 3M Avg. FII flows (INR cr)	Next 6M Avg. FII flows (INR cr)
8-12x	9	5,589	7,158
12-15x	62	5,712	5,822
15-18x	71	4,884	4,994
18-21x	50	4,229	5,111
21-24x	35	1,216	909
>24x	2	-16,133	-25,056

FII equity flows retreat, when stocks get too pricey.

Source: Bloomberg. Data Period: 1 Jan, 2006 to 31 Dec, 2024.

Overview of the recent FII Equity Outflows from India:

Indian markets experienced significant FII outflows in the past few months, with Oct-24 marking the highest monthly equity outflows to date (Rs 94,017 cr). This trend continued into Jan-25, with more than Rs 175,000 cr being pulled out in the last four months from Indian equity markets. Collectively, these outflows have led to c.10-15% correction in India’s major benchmark indices.

The major factors driving the FII outflows this time:

• Elevated valuations. The MSCI India Index is significantly overvalued as compared to some of the other emerging markets (~100% premium as of Sep-24 vs. long-term median of ~60%).
• Subdued corporate earnings growth trajectory. The Nifty50 2QFY25 diluted earnings grew only 4% y/y and declined ~11% sequentially; whereas the Nifty Midcap100 declined on a sequential basis for the fourth straight quarter.
• Higher global bond yields driven by US policy uncertainty. Rising US 10Y bond yields and narrowing India-US bond yield spread gap to ~200bps, significantly increases the appeal of safer assets.
• USD Strengthening; the DXY Index is currently at 108.5 as of 31 Jan-25 (+7% vs. beginning of CY24).

Earnings Growth (%)	1QFY24	2QFY24	3QFY24	4QFY24	1QFY25	2QFY25
NIFTY 50	243	246	242	254	288	257
Growth (YoY)	12%	32%	24%	17%	18%	4%
Growth (QoQ)	12%	1%	-2%	5%	13%	-11%
NIFTY Midcap 100	467	513	496	406	366	358
Growth (YoY)	25%	114%	75%	12%	-22%	-30%
Growth (QoQ)	29%	10%	-3%	-18%	-10%	-2%

Source: Bloomberg, NSDL, Investing.com. Note: Priced as on 31 Jan 2025.

When Will FII Flows Rebound?

Historically, FII flows have rebounded once key macroeconomic concerns subside, equity valuations normalize, and sustained corporate earnings growth becomes more visible. Since 2002, prolonged net FII outflows for three or more consecutive quarters have occurred only thrice, with most periods witnessing just 1-2 quarters of consecutive outflows.

Key Triggers for FII Inflows:

• US Trade Policy clarity: Policy uncertainties under Trump 2.0, particularly concerning trade tariffs, have impacted investor sentiment. A clearer policy direction could drive FII inflows.








Source: IMF. Note: The uncertainty measures are news-based indices that quantify media attention to an issue, in which a value of 100 corresponds to 1% of news articles that reference the issue.



• INR Stability: A more flexible INR strategy under the new RBI governor may impact FX volatility. Stable INR levels are crucial for attracting FIIs.
  • Impact on Equity Returns: Rs 100 invested on 1 Jan 2024, would have turned into Rs 108 in INR terms as of 31 Jan, 2025 vs. Rs 104 in USD terms, reflecting ~4% lower returns.
  
  
  • DXY Index: In the above section, we had highlighted a strong negative correlation between the DXY Index and FII flows. So, whenever the DXY index has weakened, FII flows bounce back.
  
  
  
  
  
  
  

  Source: Investing.com, NSE and NSDL.

  
  
• Equity valuations have started to normalize: Post the significant correction, we notice some signs of improvement in equity valuations, which could slowly drive back FII flows, as follows:
  • Large-caps valuations attractive: While the mid and small-cap valuations still remain frothy, the large-cap valuations have normalized post the recent correction.
  
  
  • MSCI India vs. MSCI World: The MSCI India 12M Fwd. P/E premium against the MSCI World Index has declined from >30% in Sep-24 to 13% currently (10Y Median: 20%).
  
  
  • Earnings vs. Bond Yield: The earnings vs. bond yield spread reduced from 2.0% in Sep-24 to 1.4% currently, indicating equities are relatively cheap post-correction.
  
  

Source: Bloomberg. Note: Priced as on 31 Jan 2025.

Our Take:

FII outflows have weighed on Indian equities in recent months, but historical trends suggest that prolonged outflows are rare, and muted years are typically followed by strong inflows. With 2024 being a subdued year in terms of flows, a strong rebound is expected in 2025. Additionally, macro-economic variables are likely to stabilize in the coming months as markets gain clarity on US policy direction, especially since the DXY Index's current level (>109) has historically been unsustainable. Equity valuations have also become more attractive, with the MSCI India 12M Forward P/E correcting from 24x in September 2024 to ~21x. Given this backdrop, large caps are expected to benefit the most from a potential FII flow reversal, as FIIs typically hold a higher allocation in large caps compared to mid and small caps. The BFSI sector, particularly private banks, stands out as a key beneficiary, given FPIs' significant exposure to financials (~30% as of September 2024). Overall, a large-cap and private banks-focused strategy appears well-positioned to capitalize on the anticipated recovery in FII flows in 2025.