Last week the Swiss based investment banking firm UBS downgraded Indian shares to neutral, saying it preferred China to India. Earlier, CLSA, Asia’s leading and longest-running independent brokerage and investment group cut the Sensex target citing several reasons in doing so. Foreign net inflows which were robust in the first three months of the year are now beginning to slowdown dramatically.

What's bothering foreign investors?
There are plenty of reasons why foreign investors have turned bearish. CLSA cited reasons such as the widening current account and fiscal deficits, as well as the uncertainty over foreign taxation, as amongst the issues to cut its Sensex target.

And, the renowned firm may well be spot on, in its concerns. Firstly, let's take the case of the current account deficit which the firm has said was one of its concerns. The nation is likely to see a current account deficit of 4% in 2011-2012, which is the worst in eight years.

Rising prices of crude oil and a depreciating rupee are having a cascading effect on the current account deficit, which if not controlled could have a damaging effect on the country's ability to honour obligations.

Now, let's take the case of fiscal deficit. Pranab Mukherjee in his Union Budget for 2011-2012 had said that fiscal deficit would be 4.6% of GDP for 2011-2012. However, the figure is slated to be closer to 5.9% of GDP.

This is an extremely high deficit and is not sustainable over the long run. Rising crude prices and subsidies continue to put pressure on the deficit and it is unlikely that the government will take measures to control the same, due to mounting political pressure from its allies. Diesel decontrol is almost ruled out, which means the government would continue to subsidize and the result would be that the fiscal deficit would continue to mount.

Reforms at the centre are completely stalled and policy paralysis has reached a new zenith. India's Chief economic Advisor Kaushik Basu in fact recently admitted that there was a slowdown in decision making and blamed it on a spate of recent corruption related scams saying the bureaucracy doesn't want to take risks now. Basu also blamed coalition compulsions for policy paralysis and suggested that reforms might be on hold till 2014.

The newly introduced General Anti Avoidance Rule (GAAR) has been a major concern for foreign investors, who believe that they would now be subject to greater scrutiny for tax evasion. The ambiguity over the policy has compounded problems further, with no clear cut clarity on the policy. CLSA has in fact cited this as as one of the reasons for it to cut its Sensex target. Should foreign investors be subject to tax, rest assured that we could see a flight of capital from India to other markets. In any case valuations in countries like China and Russia are much lower than in India and far more attractive.

Clearly, foreign investors are a worried lot, over a spate of issues. Unless these are are resolved, one cannot expect foreigners to pour money into Indian equities, as they did in the last three months.

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