MEPP Lectures 19-20-21

Foreign Direct Investment in

India - Policies and Prospects

Presented by

Prof. Tarun Das

IILM, New Delhi.
 CONTENTS

1.Advantages of FDI
2.Types of FDI
3.Host country policies
4.Home country policies
5.FDI regime in India
6.FDI in services production,
investment and trade
FDI Policies - Tarun Das 2
 1.1 Summary Results of Studies
 Report of the UNCTAD Ad-Hoc Working Group
on Non-debt Creating Financial Flows 1993-1995
(Author was a member of the WG).
 Study on Foreign Investment, Technology
Transfer and Growth Nexus in Asian Economies, by
the author as Consultant to UN-ESCAP,1999.
 Study on Globalisation and Industrial
Diversification in Asian Countries, by the author as
Consultant to UN-ESCAP, 2002.
 Studies on Foreign Investment by ICRIER and
IIFT during 1995-1999 (Author was a Member of
the Advisory Committees).
 Other studies on FDI by the author.

FDI Policies - Tarun Das 3

 1.2 Advantages of FDI
 FDI facilitates global integration, industrial
diversification, privatization, infrastructure deve-
lopment, technology upgradation, and acts as an
engine of external trade and overall growth.
 Unlike other capital flows, FDI is a package that
embodies capital along with technology and
managerial, marketing and technical skills.
 Presence of multinationals promotes greater
efficiency and dynamism in the domestic sector and
widens external trade.
 Training gained by local employees and their
exposure to modern organizational system and
international best practices are valuable assets for
the host country.

FDI Policies - Tarun Das 4

 1.3 Advantages of FDI
 FDI is a non-debt creating financial flow and is
preferred to other forms of capital flows.
 External debt has attendant problems of
repayment of principal and payment of interest
charges, which may create problems in case the
project becomes non-viable due to market risk.
 Example: East Asian crisis in 1998-1999.
 Foreign institutional investment is also volatile
and can be withdrawn in the case of economic,
financial, foreign exchange crisis.
 FDI does not face any such problems, there is
repatriation of dividends only when the project is
profitable.

FDI Policies - Tarun Das 5

 1.4 Types of capital flows
 Bonds
 External Loans from commercial banks
 Financial derivatives- commercial papers
and note issuance, interest rate and exchange
rate swaps, options and futures etc.
 Foreign direct investment- equity sharing
and participation in management
 Portfolio investment- buying of shares
 Quasi equity investment- joint ventures,
licensing agreements, franchising, management
contracts, turnkey contracts, production sharing
and international subcontracting.

FDI Policies - Tarun Das 6

 1.5 Costs and Risks in different
types of capital flows
Modes of Expected Risk- Managerial
capital flow Cost Sharing Participation
___________________________________
Bond Lending Low Low Low
Bank loans High Low Low
Derivatives Low Low Low
FDI Low Medium High
Portfolio Medium High Medium
Quasi-Equity Medium High Medium
__________________________________

FDI Policies - Tarun Das 7

 1.6 Advantages of FDI
over other capital flows
• FDI is a non-debt creating financial flow
and does not have the attendant
obligation for debt servicing (repayment
of principal and payment of interest
charges) as in the case of external debt.
• Only indirect cost in the form of
increasing dividend remittances and
import intensity, which are much less
than debt service charges.

FDI Policies - Tarun Das 8

 1.7 Advantages of FDI
• Consumer Benefits
- Price, quality and variety
- FDI players are better equipped to
invest in difficult and remote markets
and develop products and services
better adapted to consumers
- More and more countries can hope to
develop comparative advantages in new
sectors. As FDI currently is more market
seeking than efficiency seeking ,
offereing opportunities to any country
willing to open its market or integrate
with its neighbours.

FDI Policies - Tarun Das 9

 2.1 Types of FDI
Market seeking- to take advantage of
huge domestic markets in host countries
Resource exploiting- driven by
availability of mineral and other resources
Export enhancing- to shift production
base to take advantage of low wage rates
but technical manpower and availability of
resources
Efficiency enhancing through
technology transfer and infrastructure
development
FDI Policies - Tarun Das 10
 2.1 Host Country Policies
 FDI inflows are determined by a complex set of economic,
political and social factors.
 Foreign investors look beyond the array of fiscal
incentives offered by the host country.
 FDI is attracted by sound macro-economic policies, stable
economic systems, sustained high growth,liberalisation of
trade, investment and industry, particularly by liberal FDI
regimes.
 Full currency convertibility, free repatriation, less
performance criteria, tax holidays and other incentives,
abolition of screening requirements, relaxation of sectoral
limits on foreign equity.

FDI Policies - Tarun Das 11

2.2 Other Factors Attracting
FDIpotentials
 Domestic market
 Low wage rates
 Low transactions costs
 High rates of return
 Labour mobility
 Matured capital market
 Modern financial system
 Efficient infrastructure
 Established legal and institutional set-up
 Transparent rules and regulations
 Administrative speed and efficiency
 Special economic zones, EPZs etc.
FDI Policies - Tarun Das 12
 2.3 Other Factors Attracting
 FDIinvestors
National treatment to foreign
 Most favored nation treatment (MFN)
 Free transfer of profits and dividends
 International standards for laws
 International arbitration in the case of disputes
 Protection of intellectual property rights (IPR)
 Right to employ management of its choice
 The formation of regional trading blocks such as NAFTA,
ASEAN, APEC, SAARC etc. had also an important impact
on the FDI pattern
 In future, countries outside the regional blocks might
have disadvantages in attracting FDI.

FDI Policies - Tarun Das 13

 2.4 Foreign Investors Dislike
Most
 Any screening of investment except for national
security, public health, individual safety, and
environmental protection.
 Performance requirements such as export
orientation, local content, value addition, foreign
exchange, as these distort international trade and
investment flows, and result in diminished returns to
both home and host countries.
 Since 1980, countries that guaranteed full
repatriation of profits attracted 95% of foreign
investment, countries adhering to Convention of
Settlement of Investment Disputes attracted 90% of
foreign investment from USA.

FDI Policies - Tarun Das 14

 2.5 Role of Fiscal
 Incentives
Fiscal and other incentives remain an important
part of a country’s investment promotion package,
and can tilt the balance in investors’ location choices,
particularly for “footloose industries” such as
automobiles and food processing industries.
 Incentives play, however, only a minor role for
FDI and attract only those “fly-by-night” firms, which
exist on exploitation of incentives.
 As incentives represent substantial economic
costs, a rational, efficient, equitable and
internationally competitive tax system is more
conducive to FDI than fiscal incentives.

FDI Policies - Tarun Das 15

 3.1 Home Country Policies
 Few developing countries have paid
due attention to outward FDI policies by
liberalizing outward capital flows.
 There is a need to liberalize further
capital markets and foreign exchange
regulations to move towards full capital
account convertibility.
 Liberalisation of policies for
institutional investors such as insurance,
pension and provident funds could lead to a
multiple increase of foreign investment.

FDI Policies - Tarun Das 16

 4.1 FDI Regime in India
 Since 1991 India adopted an open door
policy and welcomed FDI in most areas.
 Foreign investment is not allowed in:
- Chit fund
- Nidhi company
- Agriculture and plantation
- Real estate or construction of farm houses
- Trading in Transferable Development
Rights
FDI Policies - Tarun Das 17
4.2 FDI is not permissible in
India
in the following activities:
•Retail trading
•Atomic energy
•Lottery business
•Gambling and betting
•Housing and real estate
•Agriculture (except floriculture,
develop-ment of seeds, animal
husbandry, pisiculture and
cultivation of vegetables and
mushrooms etc.) and Plantations
(except tea plantations).
FDI Policies - Tarun Das 18
 4.3 Factors affecting
FDI Inflows in India
• Fourth largest economy in terms of PPP adjusted GDP
after USA, China and Japan
• One of ten fastest economies of the world
• Largest pool of technical manpower
• Demographic dividend- youngest workforce
• Rich in mineral and natural resources
• Major country in agrl and industrial products
• Fiscal incentives and investment environment
• Low wage rates and low production costs
• High Return and Huge domestic market
• Well developed banking and capital markets
• Dynamic private sector

FDI Policies - Tarun Das 19

 4.4 Incentives for Investment
• Various incentives by Centre and
States. These are equally applicable to
both domestic and foreign companies.
• Tax holidays up to 15 years for
backward regions and infrastructure.
• Incentives for exporters, R&D, SEZs,
EPZs, Science and Technology Parks.
• States provide capital subsidy, tax
breaks or deferment, concessional
land, power and utility tariffs.

FDI Policies - Tarun Das 20

 4.5 Incentives for FDI
• Nationality treatment
• MFN Treatment
• No expropriation of capital
• Free expatriation of foreign equity
• Rupee fully convertible on current account
• Fully convertible on capital account for
foreign investors.
• FERA replaced by FEMA.
• Foreign companies can own real estate, and
use their trade marks and brand names for
domestic sales.
• India is a member of the Multilateral
Investment Guarantee Agency (MIGA) and has
signed comprehensive treaties for avoidance
of double taxation with 66 countries, and FTA
with many countries.

FDI Policies - Tarun Das 21

 4.6 Sectoral Distribution of FDI
Sectors
(%)
FDI outstanding at end FDI approvals during
March 1990 Aug 1991- Aug 2003
1. Plantation & agriculture 9.5 1.4
2. Mining 0.3 0.1
3. Power 0.1 16.5
4. Manufacturing 84.9 50.4
• Petroleum 0.1 10.5
• Food processing 6.0 3.3
• Textiles 3.4 1.2
• Transport equipment 10.5 5.6
• Machinery & machine tools 13.1 2.6
• Metals and its products 5.2 5.4
• Electrical goods 10.9 9.9
• Chemicals & allied products 28.4 8.4
• Others 7.5 3.5
5. Services 5.2 32.4
(a) Financial services & real estate na 6.4
(b) Telecommunications na 19.8
(c) Transport na 1.9
(d) Hotels and retail trade na 2.7
(e) Consultancy services & others na 1.6
Total 100 100

FDI Policies - Tarun Das 22

 4.7 Share of Home Countries
in FDI inflows to India (%)
Host country 1981 -1990 1991 -2003 1991 -2003
Approvals Approvals Actual Flows
Mauritius 0.0 14.5 37.0
United State s 25.5 24.2 17.5
Japan 8.4 4.9 6.8
United Kingdom 7.1 9.7 5.4
Germany 18.0 3.9 5.2
Netherlands 1.5 3.8 4.6
Korea, Rep.of 1.2 4.1 3.3
France 3.5 2.7 2.8
Singapore 0.8 2.3 2.4
Italy 4.7 2.0 2.2
Australia 0.5 2.8 1.0
Malaysia 0.1 2.5 0.8
NRIs 9.7 3.8 10.0
Others 13.2 18.8 1.0
Total 100.0 100.0
FDI Policies - Tarun Das 100.0 23
4.8 Share of Indian States in FDI in 1991-
2003
States Percentage
share
1. Maharashtra 17.3
2. Delhi 12.0
3. Tamil Nadu 8.6
4. Karnataka 8.3
5. Gujarat 6.5
6. Andhra Pradesh 4.6
7. Madhya Pradesh 3.2
8. West Bengal 3.2
9. Orissa 2.9
10. Uttar Pradesh 1.7
11. Rajasthan 1.0
FDI Policies - Tarun Das 24
4.9 FDI Inflows as % of World FDI
Country 1990 1995
2000
India 0.1 0.7 0.2
China 1.7 10.9 3.2
Hong Kong 0.9 2.7 5.1
Korea, Rep. 0.4 0.5 0.8
Malaysia 1.1 1.3 0.4
Philippines 0.3 0.4 0.1
Singapore 2.7 2.2
0.4
Thailand 1.2 0.6
FDI Policies - Tarun Das
0.4 25
 4.10-A FDI Inflows as % of GDI
Country 1984-1989 1990 2004
India 0.1 0.1 3.4
China 1.8 2.6 8.2
Hong Kong 12.2 8.5 92.1
Indonesia 1.6 2.8 1.9
Korea, Rep. 1.4 0.8 3.8
Malaysia 8.8 23.8 23.4
Philippines 5.1 5.2 3.3
Singapore 28.3 47.1 62.7
Taiwan 3.3 3.8 3.1
Thailand 4.4 7.1 2.5
FDI Policies - Tarun Das 26
4.10-B FDI Outflows as % of GDI
Country 2002 2003 2004
India 1.0 0.7 1.4
China 0.5 - 0.2
Hong Kong 47.6 15.9 107.6
Indonesia 0.5 - 0.2
Korea, Rep. 1.6 1.9 2.4
Malaysia 8.6 6.0 8.5
Philippines 0.4 1.5 2.9
Singapore 18.0 16.5 41.6
Taiwan 9.8 11.4 11.6
Thailand 0.4 1.4 0.9
FDI Policies - Tarun Das 27
4.11-A FDI Inward Stock as % of GDP
Country 1980 1990 2004
India 0.7 0.6 5.9
China 3 7 14.9
Hong Kong 487 218 277.6
Indonesia 14 34 4.4
Korea, Rep. 2 2 8.1
Malaysia 21 24 39.3
Philippines 4 7 14.9
Singapore 53 77 150.2
Taiwan 6 6 12.8
Thailand 3 10 29.7
FDI Policies - Tarun Das 28
 4.11-B FDI Outward Stock as % of
GDP
Country 1990 2000 2004
India 0.0 0.4 1.0
China 1.3 2.6 2.4
Hong Kong 15.9 234.9 246.5
Indonesia 0.1 4.6 0
Korea, Rep. 0.9 5.8 5.8
Malaysia 6.1 23.6 11.7
Philippines 0.3 2.1 1.9
Singapore 21.3 62.1 94.5
Taiwan 19.0 21.5 29.9
Thailand 0.5 1.8 2.1
FDI Policies - Tarun Das 29
 5.1 Impact of FDI on Indian
Economy
- FDI inflows are more of tariff
jumping and market seeking rather
than efficiency seeking or export
driven
- 40 percent of FDI inflows went into
acquisition of gross fixed assets
such as plant and machienery.
Increase in Exports
- Export as a proportion of sales
among a sample of 450-odd (FDI)
controlled firms in India was just
11.6 percent.
FDI Policies - Tarun Das 30
 5.2 Advantages of FDI
• Infrastructure and technology transfer
- More through merger and acquisition (M&A) route
to increase its share in the Indian market rather
than greenfield investment to establsh new
industrial and service units.
- A study by Nagesh Kumar of RIS states that 40
percent of FDI in India came through M&A route
to take over Indian companies, increase control in
existing subsidiaries by issuing shares at low cost
or buy back shares and de-list from stock
exchanges.
• Less or limited ripple effect of the technology
transfer that the FDI is supposed to bring across a
large economy.

FDI Policies - Tarun Das 31

 5.3 Advantages of FDI
- Increased productive and managerial
efficiency due to competition from
multilateral subsidiaries.
- Studies of Clive Harris(2003) and McKinsey
Global Institute(2003) indicated that FDI
has a significant positive impact on
productivity and coverage of services,
particularly financial and
telecommunications.
- In sectors like automotive, telecom and
financial services, increased competition
and investments have resulted in an
increase in output and employment, fall of
prices, wide range of products and rise of
quality.
FDI Policies - Tarun Das 32
 6.1 Policy Issues for Foreign
Investment
• Liberalisation of labour laws and labour
markets to enhance labour mobility
• Simplification of land laws and regulations
• Unbundling and sharing of risks
• Rationalisation of user charges
• Strengthening of capital markets
• Development of municipal bonds
• Strengthening Regulatory, legal and
institutional set up
• Strengthening of Public-Private Partnership
• Improvement of model BOT legislation
• Separation of policy makers, regulators and
operators

FDI Policies - Tarun Das 33

6.2 Sectoral Policies and Regulation
• Locational, safety and environmental
regulations are necessary for the efficient
functioning of industry.
• Simplification of excessively detailed,
outdated and complicated regulations for
utilities, petroleum sector, banking and
insurance, transport and
telecommunications.
• Reduction, simplification, and greater
transparency of the rules and procedures
and further reduction of the bureaucratic
intervention are needed to attract more
foreign investment.
FDI Policies - Tarun Das 34
 6.3 Minerals including oil and gas
• Mineral industries, including petroleum and gas,
create particular problems for private
investment because resource rents have to be
divided between local landowners, the States
and the central governments.
• Private firms also seek a share of such rents to
compensate for the risk of mineral exploration &
subsequent mine development.
• The efficient and equitable apportioning of
mineral rents is thus an important aspect of the
economic policy framework for attracting private
investment including FDI.

FDI Policies - Tarun Das 35

 6.4 Minerals including oil and gas

• Indian states impose cess and royalties on

minerals to raise resources.
•Minerals and power have also environmental
aspects that should be taken into account
while allowing private investment.
•Indonesia and Malaysia have been among
world leaders in dealing with foreign
investment in petroleum, gas and other
minerals.

FDI Policies - Tarun Das 36

 6.5 Agriculture and plantation
• Agriculture and real estate present difficulties
for foreign investment because of complexities
of landownership, rules and taxes regarding
tenancy, sale, purchase, transfer, lease or
mortgage.
• Because of these problems, India like many
countries, does not allow foreign investment in
agriculture and real estate.
• However, in the case of plantation, foreign
investment in nucleus estates and processing
facilities can provide a market for farmers and
at the same time enable them to improve their
productivity.

FDI Policies - Tarun Das 37

 6.6 Water supply and sanitation
• Water is a merit good with many positive
health and environmental spillovers.
• Under UN-Millennium Development Goals,
Government is committed to provide
universal access to the minimum daily
requirement of safe water, but this may
require subsidies.
• Water distribution pipes are a monopoly
network of the local government and
many water and sanitation systems are
buried.
• These factors complicate the transfer of
water distribution to private sector.

FDI Policies - Tarun Das 38

 6.7 Water supply and sanitation
• Scope of unbundling the water sector is not clear with
limited potential for competition amongst bulk water
service providers because the main water sources in
municipalities are location specific and limited in
number.
• Operational costs of providing the raw resource are
relatively low compared with sunk capital costs in pipes,
dams and treatment stations.
• Efficiency gains in water supply come from increased
trade amongst water users and reduced distribution
losses rather than competition amongst suppliers.
• In the case of water supply, organizational
restructuring, corporatization and unbundling of risks
should precede full private participation.

FDI Policies - Tarun Das 39

 6.8 Water supply and sanitation
• Resource management functions such as
catchment planning should be separated
from commercial functions of service
delivery. Government should be responsible
for the former while private operators can
compete for the latter.
• Govt. should own water pipe and sewerage
network while private operators lease long-
term rights to use pipelines and collect
revenues from service delivery.
• Private operators have incentives to reduce
water losses and costs, expand consumer
connections and to improve services to the
consumers.
FDI Policies - Tarun Das 40
 6.9 Water supply and sanitation
• It is necessary to develop private
property rights and commercial law, to
establish clear accounting and
environmental standards, transparent
legal and regulatory system, and
introduce specific BOT legislation for
private investment in utilities.
• Tariff reform is equally fundamental to
improve utility efficiency and delivery.
• While private operators should bear
construction, commercial and operation
costs and risks, government should bear
the sovereign risks.
FDI Policies - Tarun Das 41
 7. Concluding Remarks
• As the first generation reforms take
root and second generation reforms
unfold, India is emerging as a
favourite destination for foreign
investment, and a land of immense
opportunity for all.
• India should maintain its open door
policy in goods and services
production, investment and trade.
• Carried to their logical ends, reforms
would make India as one of the most
dynamic and fastest growing
economies of the by 2010.
• India is an economic miracle waiting
to happen. FDI Policies - Tarun Das 42
 8.1 Review Questions
1. What are the special advantages of
Foreign Direct Investment (FDI) over
other forms of external capital flows?
2. (a) Discuss broad types of FDI.
(b) Which one is the dominant type of
FDI flows to India and what are main
reasons for that?
(c) Indicate the major sources of FDI
inflows to India.
(d) Which are the major sectors
attracting FDI to India?
3. (a) Discuss the general host country
and home country policies attracting
foreign investment.
(b) discuss relative merits and
demerits of fiscal incentives for
attracting FDI.FDI Policies - Tarun Das 43
 8.1 Review Questions
4. (a) Discuss policies, strategy and
regulatory regime for foreign
investment of India.
(b) What has been their impact on he
Indian economy?
5. (a) Discuss the strengths and
weaknesses of the Indian economy for
attracting FDI.
(b) Discuss special problems for
attracting FDI in agriculture and
plantation, minerals including oil and
gas, power generation, water supply
and sanitation.

FDI Policies - Tarun Das 44

 Thank you
Have a Good Day

FDI Policies - Tarun Das 45