Correction of overvalued stocks, selloff by foreign portfolio investors (FPIs), economic concerns, and shifting market sentiments, there are multiple possible reasons for present stock markets decline. FPIs, a major contributor to the decline, have been net sellers in recent months as they are exiting markets in mammoth proportions. The total outflows attributed to them in the month of January, 2025 have been to the tune of ₹ 77,211 crores. In less than last five months the Sensex plummeted by more than 15% from its peak of 85,978.25 in September 2024. The sharp decline is leaving retail investors grappling with heightened volatility and uncertainty. New retail investors who invested within the last one year have invariably lost money as markets continue to be in negative territory.
The stock market frenzy of the decade tempted many new retail investors to participate in the equity markets. The trend is reflected from the splendid increase in the number of demat accounts. An analysis by SEBI brought out that the number of unique individual demat account holders has more than tripled to 8.96 crores at the end of March 2024 from 2.82 crores in March 2019. At the same time the unique individual mutual fund accounts grew to 4.43 crores from 1.92 crores.
The number of demat accounts, even when markets are falling continue to rise, perhaps on account of momentum. At the end of January, 2025, the total number of demat accounts in India, inclusive of multiple accounts by individual persons, stands at 18.8 crore. However, the recent losses are set to make a major dent in their sentiments. Small investors anyway have low interest in the security markets as studies have shown that many of them prefer fixed deposits over capital markets. This is not healthy for overall economic wellbeing of individuals as well as country.
Amongst different reasons of the freefall a significant factor contributing is large scale exodus of funds by the FPIs. The mammoth outflows by FPIs are only hastening the speed and amount of fall. Some of the probable reasons that could have led to this flight of money by FPIs are given below:
- Shift from overvalued markets to other lucrative markets: It is a normal practice that FPIs, in their pursuit for higher risk adjusted returns, reallocate from overvalued markets to other attractive opportunities. A large-scale shift may get triggered when a market becomes overvalued—characterized by high price-to-earnings ratios, inflated stock prices, and diminishing corporate growth. They shift investments to markets offering better growth potential, lower valuations, favourable economic conditions. With very high PEs, and constricted recent growth, the Indian markets are definitely overvalued. The perception of limited potential may have led to the outflows from Indian markets, triggering quicker price corrections and increased volatility. Unfortunate part is while many FPIs must have made money, the falling markets is being left with other investors that include many retail investors. In the process, the ultimate loser is the retail investors, particularly the ones with recent participation.
- Changes in regulatory structures: While FPIs prioritize stability and predictability in the regulatory frameworks, regulators work on overall good of all investors and regularly plug the gaps routinely identified for honest functioning. A recent disclosure requirement aimed at curbing potential misuse of the FPI route by Indian entities attempting to bypass Sebi’s minimum public shareholding norms is considered by some as potential reason for exit by at least a few FPI. Presently, a minimum public float of 25% is to be ensured by a listed entity. Frequent changes in regulatory framework, stringent compliances can create uncertainty, that may not augur well with the FPIs. Overregulation or frequent changes may prompt FPIs to divert capital to markets with clearer and uniform structures.
However, regulators in their pursuit for having honest ecosystems have to bite the bullet and take tough decisions. At the same time a delicate regulatory balance needs to be maintained to encourage FPIs to Indian markets and simultaneously safeguard the interests of other investors particularly the retail investors. Striking this equilibrium can ensure interest of FPIs without compromising market stability, transparency, and fair access to capital markets by investors of all types, albeit, easier said than done. - Increase in capital gains tax: A major trigger point for the present selloff by FPIs is stated to be the increase in the capital gains tax which is reducing their returns and damaging their sentiments. Historically, the tax was removed in 2004, only to be reintroduced later in 2018. In the year 2004, the then Finance Minister abolished the long-term capital gains tax on security transactions to introduce a small tax on transactions in securities on stock exchanges based on the value of security transactions. Considering, capital gains tax a vexed issue, tax of security transactions (STT) was seen as a major step towards simplification of processes and curb the tax evasion on capital gains. With the technological advancements in the capital markets, it was easier for the government to implement such a regime. The responsibility of collecting STT and depositing it with the government was given to recognised stock exchange and Mutual Funds. However, the capital gains tax at the rate of 10% was reintroduced from the financial year 2018-19, on any transfer carried out after 1st April, 2018 that has resulted in long term capital gains above limits. There was no indexation benefit given. The rate was enhanced to 12.5% from 23rd July, 2024. While government needs resources for the inclusive growth in the emerging Indian economy, the cost of generating revenue from incrementally harnessing existing sources can be high.
- Rupee depreciation: With the fall in value of rupee, the returns of FPIs shrink when converted into dollars or other foreign currencies terms. In some cases, rupee gains that are taxed for capital gains may actually are losses in their respective currencies. A depreciating rupee may set off a vicious cycle of FPI outflows, amplifying pressure on rupee, and prompt them to further withdraw from capital markets. Left unchecked, this spiral can deplete forex reserves, drive up import costs, and fuel inflationary pressures.
Efforts to foster domestic institutional participation and improve retail investor resilience through financial literacy can reduce dependence on foreign capital. However, the same is possible only in long run. India is an emerging economy with a dream to become a $ 5 trillion. The three important pillars of growth so far have been – liberalisation, privatisation and globalisation. In this regard FPIs have played a key role that must be continued as they have been fuelling liquidity, enhancing market efficiency, and reinforcing global confidence in the Indian economy. The recent exodus driven by multiple concerns is deepening market volatility and shaking investor sentiments. Many new investors are facing losses leading to their dampened interest in equity markets.
To maintain the growth momentum, it is important for the policy makers to strike a balance to ensure investor friendly environment that retains FPIs while safeguarding domestic interests. Competitive taxation, regulatory stability and stable currency are crucial to maintain their interest in Indian capital market. Regulatory continuity fosters confidence and assure them of stable environments for long term commitments.
(Note: Data used in this article are based from SEBI bulletins and other publicly available sources.)