ICAI Notes- Unit 5: International Capital Movements | Business Economics for CA Foundation PDF Download

 Page 1


  
 
BUSINESS ECONOMICS 
a
 
 
9.70 
LEARNING OUTCOMES 
UNIT - 5: INTERNATIONAL  
CAPITAL MOVEMENTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in India
 
 
 
 
 
  
International Trade
International Capital Movements 
FDI FPI
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 2


  
 
BUSINESS ECONOMICS 
a
 
 
9.70 
LEARNING OUTCOMES 
UNIT - 5: INTERNATIONAL  
CAPITAL MOVEMENTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in India
 
 
 
 
 
  
International Trade
International Capital Movements 
FDI FPI
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.71 
INTERNATIONAL TRADE 
5.1 INTRODUCTION 
In unit one, our focus was on international trade in goods and services. Lately, we have 
observed enormous increase in international movement of capital. This phenomenon has 
received a great deal of attention not only from economists and policy-makers, but also from 
people in different walks of life- including workers’ organisations and members of the civil 
society. In this unit, we shall look into international capital movements; more precisely, why 
do capital move across national boundaries and what are the consequences of such capital 
movements.  We shall also briefly touch upon the FDI situation in India.  
5.2 TYPES OF FOREIGN CAPITAL  
The term 'foreign capital' is a comprehensive one and includes any inflow of capital into the 
home country from abroad and therefore, we need to be clear about the distinction between 
movement of capital and foreign investment. Foreign capital may flow into an economy in 
different ways.  Some of the important components of foreign capital flows are: 
1. Foreign aid or assistance which may be:  
(a) Bilateral or direct inter government grants. 
(b) Multilateral aid from many governments who pool funds with international 
organizations like the World Bank. 
(c) Tied aid with strict mandates regarding the use of money or untied aid where there 
are no such stipulations 
(d) Foreign grants which are voluntary transfer of resources by governments, 
institutions, agencies or organizations. 
2. Borrowings which may take different forms such as: 
(a) Direct inter government loans  
(b) Loans from international institutions (e.g. world bank, IMF, ADB) 
(c) Soft loans for e.g. from affiliates of World Bank such as IDA 
(d) External commercial borrowing, and  
(e) Trade credit facilities 
3. Deposits from non-resident Indians (NRI)  
4. Investments in the form of : 
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and  
© The Institute of Chartered Accountants of India
Page 3


  
 
BUSINESS ECONOMICS 
a
 
 
9.70 
LEARNING OUTCOMES 
UNIT - 5: INTERNATIONAL  
CAPITAL MOVEMENTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in India
 
 
 
 
 
  
International Trade
International Capital Movements 
FDI FPI
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.71 
INTERNATIONAL TRADE 
5.1 INTRODUCTION 
In unit one, our focus was on international trade in goods and services. Lately, we have 
observed enormous increase in international movement of capital. This phenomenon has 
received a great deal of attention not only from economists and policy-makers, but also from 
people in different walks of life- including workers’ organisations and members of the civil 
society. In this unit, we shall look into international capital movements; more precisely, why 
do capital move across national boundaries and what are the consequences of such capital 
movements.  We shall also briefly touch upon the FDI situation in India.  
5.2 TYPES OF FOREIGN CAPITAL  
The term 'foreign capital' is a comprehensive one and includes any inflow of capital into the 
home country from abroad and therefore, we need to be clear about the distinction between 
movement of capital and foreign investment. Foreign capital may flow into an economy in 
different ways.  Some of the important components of foreign capital flows are: 
1. Foreign aid or assistance which may be:  
(a) Bilateral or direct inter government grants. 
(b) Multilateral aid from many governments who pool funds with international 
organizations like the World Bank. 
(c) Tied aid with strict mandates regarding the use of money or untied aid where there 
are no such stipulations 
(d) Foreign grants which are voluntary transfer of resources by governments, 
institutions, agencies or organizations. 
2. Borrowings which may take different forms such as: 
(a) Direct inter government loans  
(b) Loans from international institutions (e.g. world bank, IMF, ADB) 
(c) Soft loans for e.g. from affiliates of World Bank such as IDA 
(d) External commercial borrowing, and  
(e) Trade credit facilities 
3. Deposits from non-resident Indians (NRI)  
4. Investments in the form of : 
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and  
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.72 
(ii) Foreign direct investment (FDI) in industrial, commercial and similar other 
enterprises 
A detailed discussion about all types of capital movements is beyond the scope of this unit 
and therefore, we shall concentrate only on foreign investments.  
5.3 FOREIGN DIRECT INVESTMENT (FDI) 
Foreign direct investment (FDI), according to IMF manual on 'Balance of payments' is "all 
investments involving a long-term relationship and reflecting a lasting interest and control of a 
resident entity in one economy in an enterprise resident in an economy other than that of the 
direct investor”. This typically occurs through acquisition of more than 10 percent of the shares 
of the target asset. Direct investment comprises not only the initial transaction establishing 
the relationship between the investor and the enterprise, but also all subsequent transactions 
between them and among affiliated enterprises, both incorporated and unincorporated. 
According to the IMF and OECD definitions, the acquisition of at least ten percent of the 
ordinary shares or voting power in a public or private enterprise by non-resident investors 
makes it eligible to be categorized as foreign direct investment (FDI). India also follows the 
same pattern of classification. FDI has three components, viz., equity capital, reinvested 
earnings and other direct capital in the form of intra-company loans between direct investors 
(parent enterprises) and affiliate enterprises. 
Foreign direct investors may be individuals, incorporated or unincorporated private or public 
enterprises, associated groups of individuals or enterprises, governments or government 
agencies, estates, trusts, or other organizations or any combination of the above-mentioned 
entities. The main forms of direct investments are: the opening of overseas companies, 
including the establishment of subsidiaries or branches, creation of joint ventures on a 
contract basis, joint development of natural resources and purchase or annexation of 
companies in the country receiving foreign capital.  
Direct investments are real investments in factories, assets, land, inventories etc. and involve 
foreign ownership of production facilities. The investor retains control over the use of the 
invested capital and also seeks the power to exercise control over decision making to the 
extent of its equity participation. The lasting interest implies the existence of a long-term 
relationship between the direct investor and the enterprise and a significant degree of 
influence by the investor on the management of the enterprise.    
Based on the nature of foreign investments, FDI may be categorized as horizontal, vertical or 
conglomerate.  
© The Institute of Chartered Accountants of India
Page 4


  
 
BUSINESS ECONOMICS 
a
 
 
9.70 
LEARNING OUTCOMES 
UNIT - 5: INTERNATIONAL  
CAPITAL MOVEMENTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in India
 
 
 
 
 
  
International Trade
International Capital Movements 
FDI FPI
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.71 
INTERNATIONAL TRADE 
5.1 INTRODUCTION 
In unit one, our focus was on international trade in goods and services. Lately, we have 
observed enormous increase in international movement of capital. This phenomenon has 
received a great deal of attention not only from economists and policy-makers, but also from 
people in different walks of life- including workers’ organisations and members of the civil 
society. In this unit, we shall look into international capital movements; more precisely, why 
do capital move across national boundaries and what are the consequences of such capital 
movements.  We shall also briefly touch upon the FDI situation in India.  
5.2 TYPES OF FOREIGN CAPITAL  
The term 'foreign capital' is a comprehensive one and includes any inflow of capital into the 
home country from abroad and therefore, we need to be clear about the distinction between 
movement of capital and foreign investment. Foreign capital may flow into an economy in 
different ways.  Some of the important components of foreign capital flows are: 
1. Foreign aid or assistance which may be:  
(a) Bilateral or direct inter government grants. 
(b) Multilateral aid from many governments who pool funds with international 
organizations like the World Bank. 
(c) Tied aid with strict mandates regarding the use of money or untied aid where there 
are no such stipulations 
(d) Foreign grants which are voluntary transfer of resources by governments, 
institutions, agencies or organizations. 
2. Borrowings which may take different forms such as: 
(a) Direct inter government loans  
(b) Loans from international institutions (e.g. world bank, IMF, ADB) 
(c) Soft loans for e.g. from affiliates of World Bank such as IDA 
(d) External commercial borrowing, and  
(e) Trade credit facilities 
3. Deposits from non-resident Indians (NRI)  
4. Investments in the form of : 
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and  
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.72 
(ii) Foreign direct investment (FDI) in industrial, commercial and similar other 
enterprises 
A detailed discussion about all types of capital movements is beyond the scope of this unit 
and therefore, we shall concentrate only on foreign investments.  
5.3 FOREIGN DIRECT INVESTMENT (FDI) 
Foreign direct investment (FDI), according to IMF manual on 'Balance of payments' is "all 
investments involving a long-term relationship and reflecting a lasting interest and control of a 
resident entity in one economy in an enterprise resident in an economy other than that of the 
direct investor”. This typically occurs through acquisition of more than 10 percent of the shares 
of the target asset. Direct investment comprises not only the initial transaction establishing 
the relationship between the investor and the enterprise, but also all subsequent transactions 
between them and among affiliated enterprises, both incorporated and unincorporated. 
According to the IMF and OECD definitions, the acquisition of at least ten percent of the 
ordinary shares or voting power in a public or private enterprise by non-resident investors 
makes it eligible to be categorized as foreign direct investment (FDI). India also follows the 
same pattern of classification. FDI has three components, viz., equity capital, reinvested 
earnings and other direct capital in the form of intra-company loans between direct investors 
(parent enterprises) and affiliate enterprises. 
Foreign direct investors may be individuals, incorporated or unincorporated private or public 
enterprises, associated groups of individuals or enterprises, governments or government 
agencies, estates, trusts, or other organizations or any combination of the above-mentioned 
entities. The main forms of direct investments are: the opening of overseas companies, 
including the establishment of subsidiaries or branches, creation of joint ventures on a 
contract basis, joint development of natural resources and purchase or annexation of 
companies in the country receiving foreign capital.  
Direct investments are real investments in factories, assets, land, inventories etc. and involve 
foreign ownership of production facilities. The investor retains control over the use of the 
invested capital and also seeks the power to exercise control over decision making to the 
extent of its equity participation. The lasting interest implies the existence of a long-term 
relationship between the direct investor and the enterprise and a significant degree of 
influence by the investor on the management of the enterprise.    
Based on the nature of foreign investments, FDI may be categorized as horizontal, vertical or 
conglomerate.  
© The Institute of Chartered Accountants of India
 
 
a
 
 9.73 
INTERNATIONAL TRADE 
i) A horizontal direct investment is said to take place when the investor establishes the 
same type of business operation in a foreign country as it operates in its home country, 
for example, a cell phone service provider based in the United States moving to India 
to provide the same service. 
ii) A vertical investment is one under which the investor establishes or acquires a  business 
activity in a foreign country which is different from the investor’s main business activity 
yet in some way supplements its major activity.  For example; an automobile 
manufacturing company may acquire an interest in a foreign company that supplies 
parts or raw materials required for the company. 
iii) A conglomerate type of foreign direct investment is one where an investor makes a 
foreign investment in a business that is unrelated to its existing business in its home 
country. This is often in the form of a joint venture with a foreign firm already operating 
in the industry, as the investor has no previous experience.  
 Yet another category of investment is ‘two - way direct foreign investments’ which are 
reciprocal investments between countries. These investments occur when some 
industries are more advanced in one nation (for example, the computer industry in the 
United States), while other industries are more efficient in other nations (such as the 
automobile industry in Japan). 
5.4 FOREIGN PORTFOLIO INVESTMENT (FPI) 
Foreign portfolio investment is the flow of what economists call ‘financial capital’ rather than 
‘real capital’ and does not involve ownership or control on the part of t he investor. Examples 
of foreign portfolio investment are the deposit of funds in an Indian or a British bank by an 
Italian company, the purchase of a bond (a certificate of indebtedness) of a Swiss company or 
the Swiss government by a citizen or company based in France. Unlike FDI, portfolio capital, 
in general, moves to investment in financial stocks, bonds and other financial instruments and 
is effected largely by individuals and institutions through the mechanism of capital market. 
These flows of financial capital have their immediate effects on balance of payments or 
exchange rates rather than on production or income generation.  
Foreign portfolio investment (FPI) is not concerned with either manufacture of goods or with 
provision of services. Such investors also do not have any intention of exercising voting power 
or controlling or managing the affairs of the company in whose securities they invest. The sole 
intention of a foreign portfolio investor is to earn a remunerative return through investment 
in foreign securities and is primarily concerned about the safety of their capital, the likelihood 
of appreciation in its value, and the return generated.  Logically, portfolio capital moves to a 
recipient country which has revealed its potential for higher returns and profitability. 
© The Institute of Chartered Accountants of India
Page 5


  
 
BUSINESS ECONOMICS 
a
 
 
9.70 
LEARNING OUTCOMES 
UNIT - 5: INTERNATIONAL  
CAPITAL MOVEMENTS 
 
 
 
 
After studying this Unit, you will be able to – 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in India
 
 
 
 
 
  
International Trade
International Capital Movements 
FDI FPI
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.71 
INTERNATIONAL TRADE 
5.1 INTRODUCTION 
In unit one, our focus was on international trade in goods and services. Lately, we have 
observed enormous increase in international movement of capital. This phenomenon has 
received a great deal of attention not only from economists and policy-makers, but also from 
people in different walks of life- including workers’ organisations and members of the civil 
society. In this unit, we shall look into international capital movements; more precisely, why 
do capital move across national boundaries and what are the consequences of such capital 
movements.  We shall also briefly touch upon the FDI situation in India.  
5.2 TYPES OF FOREIGN CAPITAL  
The term 'foreign capital' is a comprehensive one and includes any inflow of capital into the 
home country from abroad and therefore, we need to be clear about the distinction between 
movement of capital and foreign investment. Foreign capital may flow into an economy in 
different ways.  Some of the important components of foreign capital flows are: 
1. Foreign aid or assistance which may be:  
(a) Bilateral or direct inter government grants. 
(b) Multilateral aid from many governments who pool funds with international 
organizations like the World Bank. 
(c) Tied aid with strict mandates regarding the use of money or untied aid where there 
are no such stipulations 
(d) Foreign grants which are voluntary transfer of resources by governments, 
institutions, agencies or organizations. 
2. Borrowings which may take different forms such as: 
(a) Direct inter government loans  
(b) Loans from international institutions (e.g. world bank, IMF, ADB) 
(c) Soft loans for e.g. from affiliates of World Bank such as IDA 
(d) External commercial borrowing, and  
(e) Trade credit facilities 
3. Deposits from non-resident Indians (NRI)  
4. Investments in the form of : 
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and  
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.72 
(ii) Foreign direct investment (FDI) in industrial, commercial and similar other 
enterprises 
A detailed discussion about all types of capital movements is beyond the scope of this unit 
and therefore, we shall concentrate only on foreign investments.  
5.3 FOREIGN DIRECT INVESTMENT (FDI) 
Foreign direct investment (FDI), according to IMF manual on 'Balance of payments' is "all 
investments involving a long-term relationship and reflecting a lasting interest and control of a 
resident entity in one economy in an enterprise resident in an economy other than that of the 
direct investor”. This typically occurs through acquisition of more than 10 percent of the shares 
of the target asset. Direct investment comprises not only the initial transaction establishing 
the relationship between the investor and the enterprise, but also all subsequent transactions 
between them and among affiliated enterprises, both incorporated and unincorporated. 
According to the IMF and OECD definitions, the acquisition of at least ten percent of the 
ordinary shares or voting power in a public or private enterprise by non-resident investors 
makes it eligible to be categorized as foreign direct investment (FDI). India also follows the 
same pattern of classification. FDI has three components, viz., equity capital, reinvested 
earnings and other direct capital in the form of intra-company loans between direct investors 
(parent enterprises) and affiliate enterprises. 
Foreign direct investors may be individuals, incorporated or unincorporated private or public 
enterprises, associated groups of individuals or enterprises, governments or government 
agencies, estates, trusts, or other organizations or any combination of the above-mentioned 
entities. The main forms of direct investments are: the opening of overseas companies, 
including the establishment of subsidiaries or branches, creation of joint ventures on a 
contract basis, joint development of natural resources and purchase or annexation of 
companies in the country receiving foreign capital.  
Direct investments are real investments in factories, assets, land, inventories etc. and involve 
foreign ownership of production facilities. The investor retains control over the use of the 
invested capital and also seeks the power to exercise control over decision making to the 
extent of its equity participation. The lasting interest implies the existence of a long-term 
relationship between the direct investor and the enterprise and a significant degree of 
influence by the investor on the management of the enterprise.    
Based on the nature of foreign investments, FDI may be categorized as horizontal, vertical or 
conglomerate.  
© The Institute of Chartered Accountants of India
 
 
a
 
 9.73 
INTERNATIONAL TRADE 
i) A horizontal direct investment is said to take place when the investor establishes the 
same type of business operation in a foreign country as it operates in its home country, 
for example, a cell phone service provider based in the United States moving to India 
to provide the same service. 
ii) A vertical investment is one under which the investor establishes or acquires a  business 
activity in a foreign country which is different from the investor’s main business activity 
yet in some way supplements its major activity.  For example; an automobile 
manufacturing company may acquire an interest in a foreign company that supplies 
parts or raw materials required for the company. 
iii) A conglomerate type of foreign direct investment is one where an investor makes a 
foreign investment in a business that is unrelated to its existing business in its home 
country. This is often in the form of a joint venture with a foreign firm already operating 
in the industry, as the investor has no previous experience.  
 Yet another category of investment is ‘two - way direct foreign investments’ which are 
reciprocal investments between countries. These investments occur when some 
industries are more advanced in one nation (for example, the computer industry in the 
United States), while other industries are more efficient in other nations (such as the 
automobile industry in Japan). 
5.4 FOREIGN PORTFOLIO INVESTMENT (FPI) 
Foreign portfolio investment is the flow of what economists call ‘financial capital’ rather than 
‘real capital’ and does not involve ownership or control on the part of t he investor. Examples 
of foreign portfolio investment are the deposit of funds in an Indian or a British bank by an 
Italian company, the purchase of a bond (a certificate of indebtedness) of a Swiss company or 
the Swiss government by a citizen or company based in France. Unlike FDI, portfolio capital, 
in general, moves to investment in financial stocks, bonds and other financial instruments and 
is effected largely by individuals and institutions through the mechanism of capital market. 
These flows of financial capital have their immediate effects on balance of payments or 
exchange rates rather than on production or income generation.  
Foreign portfolio investment (FPI) is not concerned with either manufacture of goods or with 
provision of services. Such investors also do not have any intention of exercising voting power 
or controlling or managing the affairs of the company in whose securities they invest. The sole 
intention of a foreign portfolio investor is to earn a remunerative return through investment 
in foreign securities and is primarily concerned about the safety of their capital, the likelihood 
of appreciation in its value, and the return generated.  Logically, portfolio capital moves to a 
recipient country which has revealed its potential for higher returns and profitability. 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.74 
Following international standards, portfolio investments are characterised by lower stake in 
companies with their total stake in a firm at below 10 percent. It is also noteworthy that unlike 
the FDIs, these investments are typically of short term nature, and therefore, are not intended 
to enhance the productive capacity of an economy by the creation of capital assets. 
Portfolio investors will evaluate, on a separate basis, the prospects of each independent unit 
in which they might invest and may often shift their capital with changes in these prospects. 
Therefore, portfolio investments are, to a large extent, expected to be speculative.  Once 
investor confidence is shaken, such capital has a tendency to speedily shift from one country 
to another, occasionally creating financial crisis for the host country. 
Table 4.5.1 
Foreign direct investment (FDI) VS Foreign portfolio investment (FPI) 
Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI) 
Investment involves creation of physical 
assets 
Investment is only in financial assets 
Has a long term interest and therefore 
remain invested for long 
Only short term interest and generally 
remain invested for short periods   
Relatively difficult to withdraw  Relatively easy to withdraw 
Not inclined to be speculative            Speculative in nature  
Often accompanied by technology transfer Not accompanied by technology transfer 
Direct impact on employment of labour 
and wages 
No direct impact on employment of labour 
and wages 
Enduring interest in management and 
control  
No abiding interest in management and 
control 
Securities are held with significant degree 
of influence by the investor on the 
management of the enterprise 
Securities are held purely as a financial 
investment and no significant degree of 
influence on the management of the 
enterprise 
5.5 REASONS FOR FOREIGN DIRECT INVESTMENT 
As we know, economic prosperity and the relative abundance of capital are necessary 
prerequisites for export of capital to other countries. Many economies and organisations have 
accumulation of huge mass of reserve capital seeking profitable use. The primary aim of 
economic agents being maximisation of their economic interests, the opportunity to generate 
profits available in other countries often entices such entities to make investments in other 
countries.  
© The Institute of Chartered Accountants of India