Foreign Investment | Management Optional Notes for UPSC PDF Download

Foreign direct investment and foreign portfolio investment

Foreign direct investment:

• Foreign direct investment (FDI) is like a big player in the global economy, helping countries develop by bringing in money from other places.
• FDI has grown a lot over the years, especially from 1980 to 1990, when it tripled worldwide.
• Not all countries benefit the same from FDI. How much they benefit depends on their strategies and the rules set up for international investments.
• There are old theories that help us understand why companies invest in other countries. For example, after World War II, American companies were really good at technology and known in other countries. They went abroad to keep their edge and didn't face much competition.
• To sum up, FDI is a big deal in helping countries grow, but how much they benefit depends on their plans and the global investment rules.

Factors Influencing FDI in a Host Country: 

1. The policies in place for Foreign Direct Investment (FDI).
2. Stability in economic, political, and social aspects of the country.
3. Regulations related to entry into the market and operational procedures.
4. Standards for how foreign affiliates are treated.
5. Policies governing the functioning and structure of markets, especially competition, and Merger and Acquisition (M&A) policies.
6. International agreements concerning FDI.
7. Privatization policies.
8. Trade policies, including tariff and non-tariff barriers, and how well FDI and trade policies align with each other.

Foreign Direct Investment (FDI) and Growth:

• FDI positively affects a country's growth by improving productivity and making better use of resources.
• Studies show that FDI contributes to increased productivity and income growth in host countries, going beyond what domestic investment alone achieves.
• It's not easy to measure the exact impact due to various factors influencing growth alongside FDI.

Crowding Out and Net Effect:

• Experts debate whether FDI might reduce domestic investment ("crowding out"), but even if it happens, the overall impact tends to be beneficial.
• In less developed economies, FDI may have a smaller growth effect due to "threshold externalities."

Conditions for FDI Benefits:

• Developing countries need a certain level of development in education, technology, infrastructure, and health to fully benefit from FDI.
• Weak financial markets can hinder a country's ability to gain maximum benefits from FDI.
• Foreign investors participating in physical infrastructure and financial sectors can help address these challenges.

Globalization and FDI:

• Over the past two decades, FDI has played a role in the globalization process.
• Changes in technology, trade and investment liberalization, and market deregulation contribute to the rapid growth of FDI by multinational enterprises.

Capital Formation and Economic Development:

• FDI complements domestic investments by filling the gap between domestic savings and investment.
• At the macro level, FDI provides non-debt-creating external finances.
• At the micro level, FDI enhances productivity, technology, skills, employment, and connections with other sectors.

Transfer of Technology and Knowledge:

• FDI is a good way to transfer technology and knowledge to developing countries, contributing to their development.

Sector-specific Effects:

• FDI flows into different sectors have varied effects on economic development.
• Manufacturing sector FDI tends to have a positive impact, while evidence for the service sector is less clear.

Studies and Findings:

• Various studies highlight the positive effects of FDI in India, including technology transfer, competitive advantages, and positive impacts on GDP per capita.

FDI in India

1. Foreign Direct Investment (FDI) in India:

   • FDI is seen as a tool for development in India, helping various sectors and boosting the overall economy.
   • After India opened up its economy in 1991, there was a big increase in foreign investment.

2. FDI Inflows in India:

   • FDI started entering India in 1991-92 to bridge the gap between planned investments and actual savings.
   • India needed a growth rate of about 7 percent in GDP, but its savings were only at 24 percent. FDI helped fill this gap.

3. Forms of Financial Support:

   • Apart from FDI, India also received support from portfolio investments by Foreign Institutional Investors and loans from foreign banks.
   • Among these, FDI was the preferred choice for India.

4. Government Policies and FDI:

   • Government policies and trade barriers can impact FDI inflows and their effectiveness in boosting the economy and GDP.
   • The Indian government has taken steps to attract more FDI, including allowing foreign enterprises to have more equity participation and offering incentives like tax concessions and simplified licensing procedures.

5. Regulation of FDI:

   • To manage FDI outflows and regulate the flow of investment, the Indian government established the Foreign Investment Board in 1973.
   • The Foreign Exchange Regulation Act was also enacted for this purpose.
   • Additionally, the Foreign Investment Promotion Board (FIPB) was set up to process FDI proposals in India.

Benefit of Foreign Direct Investment

1. Benefits of Foreign Direct Investment (FDI) for Developing Countries:

   • FDI brings in foreign expertise, improving technology and technical processes in the host country.
   • It enhances human capital formation, contributing to the development of local skills and knowledge.
   • FDI promotes international trade integration, making the host country more connected globally.
   • It creates a competitive business environment, fostering the growth of enterprises in the host nation.

2. Economic Growth and Poverty Alleviation:

   • FDI contributes to higher economic growth, which is crucial for reducing poverty in developing countries.
   • The investment helps improve environmental and social conditions in the host country.

3. Technological Advancements and Competitiveness:

   • Foreign direct investment introduces advanced technology, making countries more competitive in their domestic economies.
   • It enhances the quality of products and processes in specific sectors, boosting overall industry standards.

4. Job Creation and Employment:

   • FDI typically leads to job creation, increasing employment opportunities in the target country.
   • It facilitates resource transfer and knowledge exchange, giving access to new skills and technologies.

5. Productivity Boost:

   • The equipment and facilities brought in by foreign investors can significantly increase the productivity of the local workforce.
   • FDI supports economic development by creating benefits for local industries and providing a favorable environment for investors.

Disadvantages of Foreign Direct Investment (FDI)

1. Impact on Domestic Investment:

   • FDI can sometimes divert resources away from domestic investment, affecting the development of local industries.

2. Exchange Rate Fluctuations:

   • FDI may lead to changes in exchange rates, benefiting one country while putting the other at a disadvantage.

3. Capital-Intensive and High-Risk Nature:

   • From the investor's perspective, FDI can be capital-intensive, posing risks and economic challenges.

4. Negative Effects on Investing Country:

   • The rules governing FDI and exchange rates may have negative consequences for the country making the investment.

5. Restrictions in Foreign Markets:

   • Some foreign markets have restrictions on specific types of investments, limiting opportunities for investors.

Classifications of Foreign Direct Investment

Foreign Direct Investment (FDI) can be divided into two types: Inward FDI and Outward FDI, based on the direction of money flow. Inward FDI happens when foreign capital is invested in local resources. Factors driving Inward FDI include tax breaks, low interest rates, and grants. Outward FDI, also known as "direct investment abroad," occurs when a government funds investments in foreign resources, assuming associated risks.

Regulatory Framework

Key Regulations for Foreign Direct Investment (FDI) in India:

1. Foreign Exchange Management Act, 1999 (FEMA) and Related Regulations
2. Securities and Exchange Board of India Act, 1992 and Its Regulations
3. Foreign Trade (Development and Regulation) Act, 1992
4. Companies Act, 1956
5. Indian Contract Act, 1872
6. Arbitration and Conciliation Act, 1996
7. Civil Procedure Code, 1908
8. Income Tax Act, 1961
9. Foreign Direct Investment Policy (FDI Policy)
10. Competition Act, 2002

Major Governmental Authorities Involved:

1. Department of Industrial Policy and Promotion (DIPP), Government of India
2. Foreign Investment Promotion Board of India (FIPB), Government of India
3. Reserve Bank of India (RBI)
4. Securities and Exchange Board of India (SEBI)
5. Directorate General of Foreign Trade (DGFT), Government of India
6. Ministry of Corporate Affairs, Government of India
7. Income Tax Department
8. Industry-Specific Ministries such as Ministry of Power, Ministry of Communications & Information Technology

Concerns Regarding FDI in India:

• FDI is allowed through various channels, including financial collaborations, joint ventures, and technical collaborations.
• Capital market involvement through Euro issues (Foreign Currency Convertible Bonds (FCCBs)/Equity Shares under the Global Depository Mechanism).
• Private placements or preferential allotments are also avenues for FDI.
• FDI is generally permitted in all sectors, including the service sector, with certain limitations in specific sectors where existing policies do not allow FDI beyond a set ceiling.
• Most FDI cases can follow the Automatic Route, delegated to the RBI, while exceptional cases may require government approval as detailed below.

Foreign Portfolio Investment

1. Nature of Portfolio Investments:

   • Involves buying and selling highly liquid securities like stocks, bonds, commodities, or money market instruments.
   • Investors aim to make quick profits through frequent trading.

2. Investor's Role:

   • Investors in portfolio investments are not actively involved in managing the organization issuing the investment.
   • FPI specifically refers to such investments in a different country.

3. Securities and Quick Trading:

   • FPI includes buying securities traded in another country, often stocks and bonds.
   • Securities are highly liquid, allowing investors to take advantage of favorable exchange rates.

4. Time Horizon of Investments:

   • Investments can be short-term for quick gains or long-term with plans to hold onto assets.

5. Legislation and Definition:

   • The Foreign Exchange Management Act 2000 defines FPI as buying and selling shares, debentures, and units of mutual funds in Indian stock exchanges.
   • It involves holding foreign financial assets without active management or control by the investor.

6. Historical Perspective - India's Opening Up:

   • In 1992, India opened its economy to foreign portfolio investment.
   • India relies more on FPI than Foreign Direct Investment (FDI), with over 50% of foreign investment between 1992-2005 coming from FPI.

FPI flow can help economy:

1. Impact on Balance of Payments:

   • FPI flows are volatile and play a crucial role in determining a country's overall balance of payments.
   • Reversals in FPI flows during crises can lead to balance of payments deterioration.

2. Investor Characteristics and Tax Implications:

   • FPI investors typically prefer a hands-off approach and don't seek controlling interests.
   • Tax requirements may apply in both the country where assets are based and the investor's home country.

3. Effective Returns and Forex Market Attention:

   • Under suitable conditions, FPI can provide good returns in a short time.
   • Success involves paying attention to current conditions in the foreign exchange market, taking advantage of favorable exchange rates.

Factors influencing a Portfolio:

• Tax rates applicable to interest or dividends
• Fluctuations in interest rates
• Changes in exchange rates

Benefits of Foreign Portfolio Investment

1. Enhanced Liquidity:

   • Foreign portfolio investment increases liquidity in domestic capital markets.
   • This liquidity allows for easier financing of a variety of investments, including start-ups.

2. Market Efficiency:

   • With increased liquidity, markets become more efficient and diverse investments become accessible.
   • Savers have more confidence in managing their portfolios and accessing savings when needed.

3. Discipline and Knowledge:

   • Foreign investors bring discipline and knowledge to domestic markets.
   • They demand better information disclosure and accounting standards, improving transparency.

4. Equity Market Development:

   • Foreign portfolio investment fosters equity market development and strengthens corporate governance.
   • Companies are rewarded for better performance and governance practices.

5. Efficient Allocation of Capital:

   • Well-functioning equity markets lead to better allocation of capital and resources.
   • Takeovers can transform poorly performing firms into efficient and profitable ones, benefiting the economy.

6. Introduction of Advanced Instruments:

   • Foreign investors introduce sophisticated instruments and technology for portfolio management.
   • This includes futures, options, and swaps, improving risk management opportunities.

7. Support for Domestic Capital Markets:

   • Increased demand for advanced instruments encourages development in domestic markets.
   • This improves risk management for both foreign and domestic investors.

8. Contribution to Economic Health:

   • Open capital markets support domestic economic health and resource allocation.
   • They also contribute to international economic development by improving savings and resource allocation globally.

Policies for Foreign Portfolio Investment