Will a slower US economy result in sustained FII inflows into emerging markets like India ?

The US economy (as measured by growth in real GDP) grew by 1.1 per cent in the December 2005 quarter, the slowest in the last three years. The slower growth poses a few difficult questions ?

1. Is the US economy headed towards a recession ?
2. Will the US Federal Reserve do a U-turn on its interest rate policy ?
3. If yes, then will foreign portfolio investments continue to flow into the emerging markets (like India) ?
4. And, if FII's continue to pour money into Indian equity markets then where are the markets headed (12,000 + ) ?

I am no expert on international economics and clearly have no _exact_ answer to the first three questions. But, after reading a few articles in the recent past, it does seem that the US economy is indeed headed towards a slowdown (though not as slow as the Dec'05 quarter) and that the US federal reserve is likely to halt its interest raising spree.

Now assuming that the first two assumptions (or rather faint conclusions) are right, then will they result in a sustained flow of foreign money into emerging markets (more specifically India) ? The answer is yes.

This is because, not only do Indian markets offer better economic fundamentals, but also offer great arbitrage opportunities. Here is a simple one:

1. Yield on a 10-year note in the US - 4.5%
2. Yield on a 10-year Gsec in Indian market - 7.5%

A straightforward difference of 300 basis points. Further, periods during which FII flow of money remained strong, the INR witnessed a significant appreciation. The last 3 years were no different. The INR appreciated from over Rs.48-to-a-USD to Rs.44-to-a-USD.

Result - Avg. annual appreciation of 2.4%.

Now for the investing opportunity for a typical US investor -

Option A

Invest USD 10,000 in the US in a 10-yr note for one year.
Return - USD 450
RoI - 4.5%

Option B

Invest USD 10,000 in the Indian mkt in a 10-yr note for one year.
Execution:

- Converting USD 10,000 into INR @ 44.2 = INR 442,000
- Invest the same in a 10-yr Gsec @ 7.5% for one year.
- Capital at the end of one year - 442,000 + (7.5% of 442,000) = INR 475,150
- INR-to-a-dollar at the end of the year = 43.12
(assuming a 2 per cent appreciation in the INR)
- Capital in USD at the end of one year - (475,150/43.12) = USD 11,019.25.

Return - USD 1,019.25
RoI - 10.19 %

Excess returns from Option B (ie. investing in Indian markets) over Option A - 5.69 %

Given that the return seems almost double of what a typical investor in the US market gets, India definitely seems more attractive. The downside to this strategy would be a sharp depreciation in INR (which seems highly unlikely given the current strength of FII inflows). Ofcourse, if the FII inflows themselves were to stop then maybe this opportunity will not yield much.

The example stated above is the simplest of all and involves debt markets. The same principle will also hold true in case of equity markets. Returns of over 10-12 per cent in 2006, plus a currency appreciation of around 2-3 per cent should see FII's getting a healthy 12-15 per cent return for 2006. Not bad considering that last three years have produced returns in excess of 30-40 per cent per annum.

However, the larger questions remain - will FII inflows sustain in 2006 ? If yes, then would Indian markets keep doing what they have been over the past 2-3 years - head North (12,000 +) ?