- Date : 03/08/2021
- Read: 10 mins
Many investors wonder how to invest in US and European stock markets to benefit from them. While this is possible through RBI's LRS scheme, you should be aware of the risks involved.
Asset allocation, which allows investors to diversify their investment portfolios, is at the very core of financial planning. Appropriate asset allocation allows you to diversify your investment portfolio within various asset classes such as equity, debt, gold, real estate, etc. However, if you are making all these investments in one specific country (say, India), you are still exposing yourself to country-specific risks.
In the above scenario, if India goes through a recession, there is a high probability that all assets classes in India will be affected adversely. Hence, it is important to diversify some portion of your portfolio outside India to insulate yourself from risks specific to this country. You can do this through foreign investment.
What is a foreign investment?
Foreign investment involves the movement of money from one country to another to purchase an asset in that country. It can be done by individuals, companies, or even governments. This article will focus on foreign investment by individual investors who wish to diversify their investment portfolios.
Foreign investment under LRS
Under the RBI’s Liberalised Remittance Scheme (LRS), Indians are permitted to make investments in any country. For example, you can purchase an asset in the US (say, US stocks or real estate). The scheme permits an Indian resident individual to allocate up to $2,50,000 per financial year for foreign investment.
As an investor, it is important for you to diversify your investment portfolio beyond India to mitigate country-specific risks. However, you should be mindful of the risks that the other country may expose you to when doing so. Here are some country-specific risks that you should consider while investing abroad:
1) Interest rate risk – Central bank action – US subprime crisis
Interest rate policy by the central bank of a country can have an overall bearing on the economy. The US economy had to deal with the twin blows of the dot-com bust in 2000 and the terrorist attack on the World Trade Center in 2001. To pull out the US economy from the slump, the US Federal Reserve started cutting interest rates – from above 6% in 2000 to below 1% in 2003. The loose monetary policy adopted by the Federal Reserve led to an economic boom in US real estate and stock markets.
Collapse of US real estate and stock markets
However, from 2004 the Federal Reserve started increasing interest rates. The rate tightening cycle continued till 2007. During this period, interest rates were increased from less than 1% to more than 5%. The high interest rates made it difficult for many US citizens to service EMIs on mortgages, student loans, and other loans. As a result, many people were left with no choice but to default on their loans. The subprime crisis ultimately led to the collapse of the US real estate and stock markets.
The low interest rate regime (2000–2003) fuelled the investment-led boom. The high-interest rate regime (2004–2007) led to a crash and pull-out of investment.
Key takeaway for investors: The subprime crisis started with loan defaults affecting the US real estate as an asset class. It then spread to other asset classes like US stock markets, leading to a crash. So, as an investor, you should be mindful of interest rate risk in the foreign country you are investing in.
2) Fiscal deficit – Government debt/borrowing – European sovereign debt crisis
A government’s fiscal position can impact the financial markets in that country. If the government’s finances are constrained and can’t borrow more, it can hamper economic development. The European sovereign debt crisis started in 2010 with Greece, and later spread to Portugal, Spain, Italy, and some other European economies. The financial markets of most European economies suffered because of this and it led to a flight of foreign investment from these economies.
Chart: 10-year government bond yields for various European economies
Key takeaway for investors: A lot of investors believe that government securities are risk-free. That is not the case. The European Union (EU) states bailed out the governments of Greece, Portugal, Ireland, and others. Or else, these governments would have defaulted on their debt obligations. The crisis started from the debt asset class and spread to other asset classes like European stock markets and euro currency, leading to a fall in all these asset classes. As an investor, you should consider a government's fiscal position before investing in that particular economy.
3) Currency risk – Asian financial crisis
The stability of the currency of any country is important for its financial markets to do well. If there is sharp depreciation of the currency, it can lead to a financial crisis for the economy. During the 1997 Asian financial crisis, the value of currencies of some Asian countries fell sharply, to the tune of 30%–80%. This in turn led to a steep fall in the financial markets of these countries – and a flight of foreign investment from these countries. As an investor, you should consider the stability of the local currency before deciding to invest in a particular economy.
Chart: Fall in Asian currencies during 1997–1998
Key takeaway for investors: The Asian financial crisis started with the fall in currencies as an asset class. It then spread to other asset classes like Asian equity markets and real estate, leading to a drop in all these asset classes.
4) Change in government policy – Banning of P-notes
A change in government policy can lead to a big fall in financial markets. For example, in October 2007, Indian capital market regulator SEBI announced a ban on participatory notes (P-notes). At that time, most Foreign Institutional Investors (FIIs) were investing most of their money in India through P-notes. The ban announcement led to a knee-jerk reaction in the market. The Sensex and the Nifty hit the lower circuit, leading to one of the biggest intraday falls.
Similarly, a change in government policy can often lead to a big rise in financial markets. For example, in February 2021, many people were expecting the Indian Finance Minister to announce a higher fiscal deficit in the Union Budget. But, while presenting the budget, the FM announced a fiscal deficit and borrowing lower than expected. The government also announced capital expenditure towards a lot of infrastructure projects to boost the economy. This change in government policy led to a big rally in Indian stock markets over the next few days.
Key takeaway for investors: As an investor, you should be aware of such changes in government policy. While you cannot time the announcement of such policy changes, you need to do asset allocation and diversify your risks.
5) Sovereign rating downgrade by rating agencies
During the European debt crisis, which we discussed earlier, credit rating agencies downgraded the sovereign rating of Greece and some other European nations. It further aggravated the problem and led to a fall in asset classes such as European stock markets and euro currency.
Key takeaway for investors: Some financial institutions invest in certain countries and government debt only when they have a credit rating of a certain level (for example, BBB or above). If the credit rating falls below this level, they sell all their investments and exit the country altogether. So, as an investor, you need to be aware of the credit rating of the country where you plan to invest. Analyse whether the country’s credit rating is under watch for a downgrade anytime soon by the credit rating agencies.
6) Change in taxation policy – US corporate tax rate cut
A change in taxation policy by the government can lead to a big rise/fall in the financial markets. In 2017, the Trump administration reduced the US corporate tax rate from 35% to 21%. This move led to a big rally in the US stock markets.
Key takeaway for investors: As an investor, you should consider those countries for investment that have a favourable tax policy. Also, the tax regime should be stable and predictable to make proper investment decisions.
7) Election results – Change in government
Election results have a big impact on financial markets. A change in government can lead to a big rise or fall in the stock markets, depending on whether the market players believe the new government is market-friendly or not.
Indian market crashes due to 2004 election results
In 2004, the markets were betting that the Vajpayee-led NDA government will return to power. But when the Congress won, the markets fell sharply by about 16% over the next 2-3 days.
Chart: Sensex fall in 2004
Indian market hits upper circuit due to 2009 election results
Similarly, in 2009, the markets believed that the Congress-led UPA government would not return to power, and there would be instability. But when Congress retained power, the market hit the upper circuit after the election results were announced.
On 18 May 2009, the market opened sharply higher at 13,479, which was up by more than 1300 points over the previous session’s close of 12,173. The market rallied further to hit the upper circuit at 14,284 and closed there itself. The Sensex gained a whopping 2111 points (17%) in a single day.
Key takeaway for investors: As an investor, you should know that election results can change the outlook of foreign investors towards a country. In 2004, the election loss of the market-friendly NDA government could have led to the withdrawal of some foreign investment from India. At the same time, in 2009, the Congress victory and a stable government at the Centre could have brought in some foreign investment.
The takeaway? Election results, depending on how the market views the new government (whether it’s market-friendly or not), can lead to either inflow or outflow of foreign investment from the country.
The key to mitigating country-specific risk
As an investor, you should make some allocation of your investment portfolio to foreign investment. While doing so, you should be aware of various country-specific risks. Some of these include interest rate risk, government debt default risk, currency risk, change in government policy risk, sovereign credit rating downgrade risk, change in taxation policy risk, adverse election results, etc.
Just like your domestic investments, while making foreign investments, you can diversify your investments among different countries and different asset classes in the following manner:
a) Invest in global equity mutual funds: These funds are truly global in nature as they don't limit their investments in equity securities of a specific country. For example, DSP Global Allocation Fund FoF, PGIM India Global Equity Opportunities Fund FoF, etc. invest in equity securities from different countries. So, by investing in these global funds, you can mitigate country specific risk.
b) Diversify into various asset classes at the international level: You should diversify your investment portfolio among different asset classes just as you do at the domestic level. You should invest in international funds that can give you exposure to different asset classes such as equity, debt, commodities, real estate, etc. Best International Mutual Funds
For example, in the above section, we saw two equity funds (DSP Global Allocation Fund FoF, PGIM India Global Equity Opportunities Fund FoF) that can give you exposure to equities from different countries. Similarly, you can invest in international real estate funds such as Aditya Birla Sun Life Global Real Estate Fund FoF. To invest in commodities, you can consider international commodity funds like DSP World Agriculture Fund FoF, DSP World Energy Fund, etc. If you wish to take exposure to a specific theme such as consumer trends at an international level, you can consider Invesco India – Invesco Global Consumer Trends FoF. In this manner, you can do asset allocation at an international level.