Soaring inflation and rate rises are starting to hit corporate margins in India, tempting more foreign fund managers to slash holdings in favour of markets that can better capitalise on the global economic recovery.

With oil and food prices not seen easing in the near future, money managers reckon the exodus has some more months to run.

This January alone, foreign funds have pulled $900 million from Indian equities, Thomson Reuters data shows. This contrasts with the record $29.3 billion they pumped in last year.

So a market that last year returned over 20 percent in dollar terms is down 8 percent this year -- the worst performer of the four BRICs -- Brazil, Russia, India and China - and one of the biggest emerging markets losers so far in 2011.

The view is India faces a difficult year, says Michael Penn, chief global equity strategist at BoA/ML. It is the only underweight of the BRICs ... and the size of that underweight is increasing, showing people are becoming more pessimistic.

Underweight positions on Indian stocks have reached 35 percent on a net basis, the most since last April, BoA/Merrill Lynch's investor survey showed in January. Compare that to November when 8 percent of foreigners were overweight India.

There are several reasons why the bulls are forsaking India.

The big one is inflation, with food price rises well in the double digits and a real risk this will spill into the economy. To counter this the Reserve Bank (RBI) raised interest rates this week, for the seventh time since March, to 6.5 percent.

The inflation is rooted in supply-side factors such as bad weather damaging crops and global prices that cannot be fixed by interest rates. But another 75-100 bps of tightening is expected with implications for consumer spending and corporate margins.

As rates rise, margin pressures start to increase...we are starting to see earnings downgrades come through, Penn said.

While most fourth quarter corporate results have beaten forecasts, seven of ten sectors have suffered margin contraction, a Morgan Stanley survey found this week.

The market is also pricy, trading 20 times 2011 earnings versus 12 times for emerging markets. With gains of 110 percent between end-2008 and 2010, it looked ripe for a reversal.

Michael Konstantinov, who runs $3 billion in BRIC stocks at Allianz RCM, recently pared India holdings in favour of Russia.

You have the valuations argument, pressure from inflation, and on the monetary side there's rising oil prices. So there are plenty of reasons to reduce your position, Konstantinov said.


If there are push factors from India, there are the pull factors of other emerging -- and even developed -- markets.

Few doubt the long-term potential of India, an economy that is growing at close to 10 percent a year. Plans for $1.5 billion in infrastructure spending and fast-rising middle class incomes underpin the longer-term potential for the market.

But in the short-term, much of Mumbai's current weakness is linked to a turn in the world economic cycle.

With the U.S. recovery finally looking more sustainable, investors are rebalancing portfolios by rotating more cash into Western markets, or to commodity-heavy markets like Russia or South Africa which gain as oil and metals prices rise.

And India is not the only victim. Indonesia, the other big Asian domestic consumption play, did well last year but so far in 2011 is faring even worse than India.

When markets were worried about world economic growth (investors) were willing to pay a premium for a strongly growing economy but now...they are reluctant to continue that trade, said Arvid Bohm, equities strategist at SEB in Stockholm.

The question investors are facing is where do you remove cash from? You remove it from a market where valuations are pricy. Even if earnings are great, that's already in the price.


All this is bad news for India which is increasingly relying on these short-term portfolio flows to plug a current account gap of around 3.5 percent of GDP and likely to widen more under the impact of $100 a barrel oil prices.

But financing the deficit is not expected to be a problem -- the big fear is for growth.

The fear is the RBI is very hawkish. It could derail the pace of economic growth. So when economic growth is your USP (unique selling proposition) and that comes off, how does one sell? said Rakesh Rawal head of private wealth management at Mumbai brokerage Anand Rathi.

But bulls are still out there, and any sign that food price pressures are subsiding, should bring them back in, especially as valuations ease. India is also ahead of most markets in the rate rise cycle. Some like Indonesia are yet to start on that path.

Structurally India is such as exciting story that any correction will see people come back and buy, said David Cornell, fund manager at India Investment Group in Mumbai.

But what the market wants to see is evidence that inflation is coming back down into the RBI's target range.. we have a little way to go yet.

The RBI'S perceived comfort zone for inflation is 5-6 percent in the short term and 3-4 percent in the medium term.