Foreign Direct Investment: Spurring the Economic Growth

          An investment or an acquisition is termed Foreign Direct Investment (FDI) when an individual or business owns 10% or more of the shares in the target foreign company's capital. All later financial transactions are extra direct investments. If an investor owns less than 10%, it's considered an addition to his or her stock portfolio. A 10% ownership, however, doesn't give the investor a controlling interest but does give a significant influence on the company's management, operations, and policies. FDI is actually a particular type of foreign capital, as opposed to domestic investment. What makes investment “direct” as opposed to other forms of foreign capital is the concept of managerial control over an enterprise in which foreign capital participates.

          FDI is commonly classified as vertical or horizontal. Vertical FDI involves a geographical decentralization of the firm’s production chain, where foreign affiliates in low-wage countries typically produce labour-intensive intermediates that are shipped back to high-wage countries, often to the parent company itself. Vertical FDI is sometimes referred to as “efficiency seeking” FDI, since the main motive for the investment is to improve the cost effectiveness of the firm’s production.

          For example, in the textile and clothing industry, global supply chains are common. The capital-intensive stages (textiles) are located in relatively capital rich countries, human capital-intensive stages (design and up-market apparel) are located in human capital rich countries and labour-intensive stages (apparel manufacturing) are located in labour abundant countries.

          Horizontal FDI involves multinational companies producing the same product in multiple plants, and service local markets through affiliate production rather than through exports from the home country of the MNE (multinational enterprises). Most of the global FDIs is horizontal. Horizontal FDI is sometimes referred to as “market seeking” FDI. The advantage of being close to the customers may be due to factors such as reduced transportation costs, smaller cultural barriers or avoidance of tariffs.

          In addition to the horizontal and vertical dimensions of FDI, investments may also be classified as either green-field or acquisitions. A green-field investment involves the establishment of a new production unit, whereas an acquisition is the purchase of (shares in) an already existing foreign company. Most of the growth in FDI taking place in recent years has been in the form of acquisitions. Indeed, in 1999, acquisitions accounted for more than 80 percent of global FDI. Between 60 and 80 percent of FDI flows to developing countries, however, have been in the form of green-field investments during the period 1995–99.

          For a firm to choose to invest in a foreign country, there must exist some comparative locational advantages or attractions in that foreign country before the final investment decision is made. The advantages may come in different forms; firms aiming at reducing costs may be attracted by low wages, firms wishing to expand their international market share may be attracted by a large home market, and so on.

          These advantages may also include a greater control over technology or reduced transaction costs for the said company. Inefficient public policies may, however, discourage investments. As an example, 16 leading MNEs operating in India named regulatory control, bureaucratic intervention, and the lack of adequate infrastructure, particularly telecommunications and transportation, as major difficulties in operating in this country.

          A widely used instrument to attract foreign firms is tax policy. We have seen that several Asian and African countries have given special tax privileges to foreign investors, particularly in the manufacturing sector. Offering various incentives to attract FDI may certainly be a rational policy if foreign investment generates positive spillovers, since market forces alone would then attract too little foreign entry.

          An investment involves a long-term exposure to the economic and political conditions in the host country, and firms, therefore, look for some commitment from the government. They need to be assured that their investment is safe from expropriation, that profits can be transferred out of the country, and that potential disputes between the host government and the multinational firm will be solved in a fair and efficient way. Countries with a record of economic, political and social stability are likely to be more attractive to foreign investment.

          Economists tend to favour the free flow of capital across national borders because it allows capital to seek out the highest rate of return. Capital goes to whatever businesses have the best growth prospects anywhere in the world. That's because investors seek the best return for their money with the least risk. This profit motive is color-blind and doesn't care about religion or form of government.

          Capital inflows from other countries in the nature of FDI have been considered very important contributor to augmenting availability of capital for funding of infrastructure, industries and other economic ventures. Equity inflows are more stable and bring in new management practices and technology together with the investment. For encouraging FDI inflows, the FDI policy is reviewed on an ongoing basis, with a view to make it more investor-friendly.

          FDI is perhaps the clearest sign of globalization in the past decade. The average annual growth rate of FDI has been 23 percent since 1986, which is twice as much as that of trade. However, during the 1990s, and until the Asian financial crisis in 1997, the share of FDI hosted by countries in the developing world increased.

          The Asian financial crisis in 1997–98 fully exposed the weakness of the corporate structures. Like crises before, this one also forced reforms, including the opening up of the economy to foreign investment. FDI, however, has proved to be resilient during financial crises. For instance, in East Asian countries, such investment was remarkably stable during the global financial crises of 1997-98.

          In sharp contrast, other forms of private capital flows namely portfolio equity, debt and short-term flows were subject to large reversals during the same period. The resilience of FDI during financial crises was also evident during the Mexican crisis of 1994-95, the Latin American debt crisis of the 1980s or the financial crisis during 2007-08.

          Even though a major reason for soliciting FDI includes a sustained flow of capital and technology, FDI, however is not the only source of capital and technology. Countries may rely on their own savings or borrow money in international markets to add to the capital stock. Or the countries may rely on domestic research and development (R&D) in order to upgrade technological sophistication. The experience of South Korea with regard to attracting FDI is notable in this regard. The main lesson from the South Korea is perhaps that FDI is not necessary for economic growth. There are alternative ways of accessing capital and technology; purchasing machines on the international market and hiring foreign experts to communicate the technology to local workers has been the growth strategy of South Korea. Whether this strategy is the most cost effective way to access foreign technology is of course debatable.

          FDI, however, has been deemed critical for developing and emerging market countries. Their companies need the sophisticated investors' funding and expertise to expand their international sales. In 2014, they received more than half (55 per cent) of total global FDI. Developing Asia attracted more foreign investment than either the EU or the United States. The developed world also needs cross-border investment, but for different reasons. Most of their investment is via mergers and acquisitions between mature companies.

Advantages of Foreign Direct Investment:

·        FDI benefits the global economy, investors and recipients as a whole if pursued with a right mix of policies. FDI not only creates profits for the investors, but also corporate tax revenue for the host country, not to speak of creation of the huge employment and other opportunities. In principle, therefore, FDI contributes to investment and growth in host countries through these various channels.

·        Recipient businesses receive "best practices" in management, accounting or legal guidance from their investors. They also benefit from the latest technology, innovations in operational practices and new financing tools. The FDI, thus, allows the transfer of technology, particularly in the form of new forms of capital inputs that cannot be achieved through financial investments or trade in goods and services. FDI also promotes competition in this domestic input market. Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country.

·        Another advantage of FDI is that it offsets the volatility created by ‘hot money’ or portfolio investment in the national stock market. That creates a kind of boom-bust cycle that often ruins economies a la the East Asian crisis of the late 1990s. FDI, on the other hand, takes longer to set up and has a more permanent footprint in a country.

·        Unrestricted, international capital flows reduce the risk faced by owners of capital by allowing them to diversify their lending and investment.

·        The global integration of capital markets can contribute to the spread of best practices in corporate governance, accounting rules, and legal traditions.

·        The global mobility of capital limits the ability and penchant of governments across the world to pursue bad policies. Capital unfriendly policies may lead to the flight of capital to the more attractive shores.

·        An additional benefit is that FDI is thought to be "bolted down and cannot leave so easily at the first sign of trouble." Unlike short-term debt or portfolio investment, direct investments in a country are immediately re-priced in the event of a crisis.

·        Mostly, FDI is a boon for environmental protection given the new resources it brings for improving efficiency, transferring knowledge, and addressing existing pollution.

·        While FDI is not necessary to achieve economic development, the entry of foreign firms may play an important role in adding technology and competition to the host economies thereby making it more efficient.

Disadvantages of Foreign Direct Investment:

          Even though economic theory and praxis through recent empirical evidence suggest that FDI has a beneficial impact on developing host countries, many studies also points to some potential risks with an over-exposure to FDI. The same are mentioned as below:

·        FDI can be excessive owing to adverse selection and fire sales. Often domestic companies are not able to complete with the foreign corporations. Taking advantage of the same, foreign corporations may, while pursuing a predatory marketing policy, buy a local company to shut it down in a bid to capture the local market completely.

·        Sophisticated foreign investors might strip the business of its value without adding any. They can sell off unprofitable portions of the company to local, less sophisticated investors.

·        A high share of FDI in a country's total capital inflows may reflect its institutional weakness rather its strength. A country’s relative economic backwardness and underdevelopment goads it to look for its growth and development by seeking FDI.

·        More exposure to FDI may also sometimes lead to increased imports. This is because the foreign companies, in a bid to maximize their profits, often try to source cheapest materials from different sources, which often result in increased imports thereby affecting the balance of payment situation.

·        Repatriation of profits by the foreign companies often stresses the domestic balance of payments situation. Thus, FDI can be reversed through financial transactions;

·        The tendency of governments to extend tax holidays to foreign corporations to attract FDIs often leads to loss of revenue for the government.

·        Higher wages in foreign corporations often lead to talent drain to foreign companies thereby reducing domestic corporations’ competitiveness.

·        Countries should not allow too much foreign ownership of companies in strategically important industries. That not only lowers the comparative advantage of the country, but also often becomes problematic from the point of national security.

Foreign Direct Investment in India:

          Significant changes have been made in the FDI policy regime in the recent times to ensure that India remains an increasingly attractive investment destination. The Government regularly disseminates information on the investment climate and opportunities in India as well as advises prospective investors about investment policies, procedures and opportunities. International cooperation for industrial partnerships is solicited both through bilateral and multilateral arrangements including through interaction with the industry associations.

          In order to make the FDI policy more liberal and investor-friendly, further rationalization and simplification has been done. Government has allowed FDI up to 100 per cent on the automatic route for most activities and a small negative list was notified where either the automatic route was not available or there were defined limits on FDI. The Government also reviewed the FDI policy in pharmaceuticals sector and decided that the existing policy would continue with the condition that ‘non-compete’ clause would not be allowed except in special circumstances with the approval of the Foreign Investment Promotion Board.

          The FDI policy on defence was reviewed to allow FDI up to 49 per cent through Government route though management control is to be in Indian hands. FDI up to 100 per cent has been allowed through automatic route in construction, operation and maintenance of suburban corridor projects through PPP; high speed train project; dedicated freight lines; rolling stock including train sets, and locomotives/coaches manufacturing and maintenance facilities; railway electrification; signalling systems; freight terminals; passenger terminals; infrastructure in industrial park pertaining to railway line/sidings including electrified railway lines and connectivities to main railway line; and mass rapid transport systems.

          The amended policy regarding construction development sector includes easing of area restriction norms, reduction of minimum capitalization and easy exit from project. Further, in order to give boost to low cost affordable housing, it has been provided that conditions of area restriction and minimum capitalization will not apply to cases committing 30 per cent of the project cost towards affordable housing.  

          The Government has also allowed 100 per cent FDI on automatic route for manufacture of medical devices. The Government increased FDI limits for insurance sector from 26 per cent to 49 per cent, effective from March, 2015. FDI up to 49 per cent has been permitted in the Pension Sector from April, 2015. The Government revised the investment limit from 1,200 crores to 3,000 crores, for cases requiring prior approval of the Foreign Investment Promotion Board (FIPB)/Cabinet.

          The Government reviewed the FDI Policy on investments by Non Resident Indians (NRIs), Persons of Indian Origin (PIOs) and Overseas Citizens of India (OCIs). The Government amended the definition of Non Resident Indian as contained in the FDI Policy and also to provide that for the purposes of FDI Policy, investment by NRIs under schedule 4 of FEMA (Transfer of issue of Security by Persons Resident outside India) Regulations will be deemed to be domestic investment at par with the investment made by residents.

          FDI Inflows in the industrial sector manufacturing sectors were the first ones to be opened up for FDI inflows as with the product market reforms, it was considered necessary to invite FDI inflows in these sectors. The infrastructure and services sector were gradually opened up in subsequent phases partly because these were for a long time considered to be the public sector responsibility. The overall equity flow, however, indicate that industrial sector covering mining, manufacturing and power as of today accounted for nearly 50 per cent of the total equity inflows.

          FDI has particularly been active in sectors like machinery, chemicals, auto sector, miscellaneous manufacturing, telecommunication and power. In case of telecommunication, the FDI is both for setting up of production base and also for providing telecommunication services. In traditional sectors of Indian industry, inflow of FDI has been limited. This may be partly because of a low technological intensity of these sectors. It may also be due to the strength of domestic industry and the perception of foreign investors with regard to these sectors.

Some Recent Government Measures to Attract FDI in India:

          The measures taken by the Government are directed to open new sectors for foreign direct investment, increase the sectoral limit of existing sectors and simplifying other conditions of the FDI policy. FDI policy reforms are meant to provide ease of doing business and accelerate the pace of foreign investment in the country. The important steps taken recently in this regard include:

·         49% FDI under automatic route permitted in Insurance and Pension sectors;

·         Foreign investment up to 49% in defence sector permitted under automatic route. The foreign investment in access of 49% has been allowed on case to case basis with Government approval in cases resulting in access to modern technology in the country or for other reasons to be recorded;

·         FDI limit for defence sector made applicable to Manufacturing of Small Arms and Ammunitions covered under Arms Act 1959;

·         FDI up to 100% under automatic route permitted in Teleports, Direct to Home, Cable Networks, Mobile TV, Headend-in- the Sky Broadcasting Service;

·         FDI up to 100% under automatic route permitted in Up-linking of Non-‘News & Current Affairs’ TV Channels, Down-linking of TV Channels;

·         In case of single brand retail trading of ‘state-of- art’ and ‘cutting-edge technology’ products, sourcing norms can be relaxed up to three years subject to Government approval;

·         Foreign equity cap of activities of Non-Scheduled Air Transport Service, Ground Handling Services increased from 74% to 100% under the automatic route;

·         100% FDI under automatic route permitted in Brownfield Airport projects;

·         FDI limit for Scheduled Air Transport Service/Domestic Scheduled Passenger Airline and regional Air Transport Service raised to 100%, with FDI upto 49% permitted under automatic route and FDI beyond 49% through Government approval;

·         Foreign airlines would continue to be allowed to invest in capital of Indian companies operating scheduled and non-scheduled air-transport services up to the limit of 49% of their paid up capital;

·         In order to provide clarity to the e-commerce sector, the Government has issued guidelines for foreign investment in the sector. 100% FDI under automatic route permitted in the marketplace model of e-commerce;

·         100% FDI under Government route for retail trading, including through e-commerce, has been permitted in respect of food products manufactured and/or produced in India;

·         100% FDI allowed in Asset Reconstruction Companies under the automatic route;

·         74% FDI under automatic route permitted in brown-field pharmaceuticals. FDI beyond 74% will be allowed through government approval route;

·         FDI limit for Private Security Agencies raised to 74%;

·         For establishment of branch office, liaison office or project office or any other place of business in India if the principal business of the applicant is Defence, Telecom, Private Security or Information and Broadcasting, approval of Reserve Bank of India would not be required in cases where FIPB approval or license/permission by the concerned Ministry/Regulator has already been granted;

·         Requirement of ‘controlled conditions’ for FDI in Animal Husbandry (including breeding of dogs), Pisciculture, Aquaculture and Apiculture has been done away with.