Is FII currency play reversing on the bourses?

MUMBAI: With US mid-term elections a done deed, foreign institutional investors seem to be persuaded to reverse their currency play of the past three months. And in that turn of position may lie a cautionary tale.

Perhaps the reversal has already begun.

On Tuesday, FII investment in single-stock futures surged to Rs 418 crore, the most since June 8, 2006, from Rs 35 crore on Monday.

This is unusual because the FII play since September has been to buy in cash, short single-stock futures, earn a cost-of-carry of around 10% and also, simultaneously, gain from the rapid appreciation in the rupee.

In that period, since FIIs knew the dollar was going to fall, they gained from shorting it. To short, they converted dollars into rupees, bought shares in the cash segment and, simultaneously, shorted — or sold — single-stock futures. By their last act, they were also shorting the dollar de facto.

Now that the George Bush administration has lost the Senate race to the Democrats, it may want to do some reality check and tighten matters in the world’s largest economy.

The Democrats, with Senate in hand, want to reduce the US budget deficit, which could lift the dollar against major currencies in the near term.

The dollar fell 26% against the euro in the three years through 2004 as the US ran up a budget deficit of as much as $413 billion, from a surplus of $236 billion in 2000, according to Bloomberg data.

“The US currency may be supported because any reduction in government spending would rein in the US budget deficit,” Michiyoshi Kato, a senior vice president of currency sales in Tokyo at Mizuho Corporate Bank Ltd, a unit of Japan’s second-largest lender by assets, told Bloomberg. “That would be favourable for the dollar.”

If that is the case, FIIs now need to go long on the greenback to continue profiting. Which is what they are doing now, perhaps. This possible turn in play could mean a couple of things:

For one, it could just be the closing out carry-positions or cash future arbitrage positions by reversing the original trade of buying in cash and selling single-stock futures.

Or, it could be profit-taking on a 4% gain in the rupee over dollar in the last two months.

What the FII selling in cash does is send out a negative “pullout” signal.

But it needs to be understood is that a large part of FII inflows in September and October was not because of love for Indian equities but purely an opportunity in the currency and cost-of-carry game.

Changes in the US, the dollar and narrowing cost-of-carry are the red flags rising.

But the positive inflows of the past 9 days do show there is new money also coming in. So much so, the reversal of FII arbitraging have been more than offset. That’s  perhaps the silver lining.