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CHAPTER 1: FOREIGN DIRECT INVESTMENT

Meaning
These three letters stand for foreign direct investment. The simplest explanation of
FDI would be a direct investment by a corporation in a commercial venture in
another country. A key to separating this action from involvement in other ventures
in a foreign country is that the business enterprise operates completely outside the
economy of the corporations home country. The investing corporation must
control 10 percent or more of the voting power of the new venture.
According to history the United States was the leader in the FDI activity dating
back as far as the end of World War II. Businesses from other nations have taken
up the flag of FDI, including many who were not in a financial position to do so
just a few years ago.
The definition of FDI originally meant that the investing corporation gained a
significant number of shares (10 percent or more) of the new venture. In recent
years, however, companies have been able to make a foreign direct investment that
is actually long-term management control as opposed to direct investment in
buildings and equipment.
It

usually

involves

participation

in management, joint-

venture, transfer of technology and expertise. There are two


types of FDI: inward foreign direct investment and outward
foreign direct investment, resulting in a net FDI inflow (positive or
negative) .Foreign direct investment reflects the objective of
obtaining a lasting interest by a resident entity in one economy
(direct investor) in an entity resident in an economy other than
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that of the investor

(direct investment enterprise).The lasting

interest implies the existence of a long-term relationship between


the direct investor and the enterprise and a significant degree of
influence on the management of the enterprise. Direct investment
involves both the initial transaction between the two entities and
all subsequent capital transactions between them and among
affiliated enterprises, both incorporated and unincorporated.
Foreign Direct Investment when a firm invests directly in production or
other facilities, over which it has effective control, in a foreign country.
Manufacturing FDI requires the establishment of production facilities.
Service FDI requires building service facilities or an investment foothold via
capital contributions or building office facilities.
Foreign subsidiaries overseas units or entities.
Host country the country in which a foreign subsidiary operates.
Flow of FDI the amount of FDI undertaken over a given time.
Stock of FDI total accumulated value of foreign-owned assets.
Outflows/Inflows of FDI the flow of FDI out of or into a country.
Foreign Portfolio Investment the investment by individuals, firms, or public
bodies in foreign financial instruments.
Stocks, bonds, other forms of debt.
Differs from FDI, which is the investment in physical assets.

Definition
Foreign direct investment is that investment, which is made to serve the business
interests of the investor in a company, which is in a different nation distinct from
the investor's country of origin. A parent business enterprise and its foreign affiliate
are the two sides of the FDI relationship. Together they comprise an MNC.
The parent enterprise through its foreign direct investment effort seeks to exercise
substantial control over the foreign affiliate company. 'Control' as defined by the
UN, is ownership of greater than or equal to 10% of ordinary shares or access to
voting rights in an incorporated firm. For an unincorporated firm one needs to
consider an equivalent criterion. Ownership share amounting to less than that
stated above is termed as portfolio investment and is not categorized as FDI.
FDI stands for Foreign Direct Investment, a component of a country's national
financial accounts. Foreign direct investment is investment of foreign assets into
domestic structures, equipment, and organizations. It does not include foreign
investment into the stock markets. Foreign direct investment is thought to be more
useful to a country than investments in the equity of its companies because equity
investments are potentially "hot money" which can leave at the first sign of trouble,
whereas FDI is durable and generally useful whether things go well or badly.
FDI or Foreign Direct Investment is any form of investment that earns interest in
enterprises which function outside of the domestic territory of the investor.
FDIs require a business relationship between a parent company and its foreign
subsidiary. Foreign direct business relationships give rise to multinational
corporations. For an investment to be regarded as an FDI, the parent firm needs to
have at least 10% of the ordinary shares of its foreign affiliates. The investing firm
may also qualify for an FDI if it owns voting power in a business enterprise
operating in a foreign country.
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Types of FDI

Types of Foreign Direct Investment


FDIs can be broadly classified into two types:
Outward FDIs
Inward FDIs
This classification is based on the types of restrictions imposed, and the various
prerequisites required for these investments.
Outward FDI: An outward-bound FDI is backed by the government against all
types of associated risks. This form of FDI is subject to tax incentives as well as
disincentives of various forms. Risk coverage provided to the domestic
industries and subsidies granted to the local firms stand in the way of outward
FDIs, which are also known as 'direct investments abroad.'
Inward FDIs: Different economic factors encourage inward FDIs. These include
interest loans, tax breaks, grants, subsidies, and the removal of restrictions and
limitations. Factors detrimental to the growth of FDIs include necessities of
differential performance and limitations related with ownership patterns.
Other categorizations of FDI
Other categorizations of FDI exist as well. Vertical Foreign Direct Investment takes
place when a multinational corporation owns some shares of a foreign enterprise,
which supplies input for it or uses the output produced by the MNC.
Horizontal foreign direct investments happen when a multinational company carries
out a similar business operation in different nations.
Horizontal FDI the MNE enters a foreign country to produce the same
products product at home.
Conglomerate FDI the MNE produces products not manufactured at home.
Vertical FDI the MNE produces intermediate goods either forward or
backward in the supply stream.
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Liability of foreignness the costs of doing business abroad resulting in a


competitive disadvantage.

CHAPTER 2: FOREIGN DIRECT INVESTMENT IN DEVELOPING


COUNTRIES

Now-a-days Foreign Direct Investment (FDI) is the most important issue in most
of the countrys foreign economic policy. FDI is defined as Any investment in
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another country which is carried out by private companies or individuals as


opposed to government aid.
The positive role of FDI in accelerating pace of development in developing
countries as is evidenced I Hong Kong, Singapore, Korea and Taiwan these
countries are known as newly industrialized Economic, attracting FDI has become
a priority agenda for the developing counties foreign economic policy. At present
there is hardly any country in around the globe, big or small, financial base or
newly emerging which is not in the race of capturing foreign investment.
Over the recent past, most developing nations in the, are adopting increasingly
more open policy toward FDI.
There are various things working as barrier in the way of FDI in developing
countries. The major impediments in the way of the sufficient inflow of FDI are
the negative image of the country. Moreover, political instability, particularly
repeated strikes, red tapism, bureaucratic hurdles and lengthy administrative
procedure, inadequate infrastructure, particularly energy and telecommunication
facilities, rigid and conservative banking system and absence of service-oriented
banks, lack of accurate information for taking correct business decision etc. are
now working as barriers in the way of sufficient inflow of FDI. Even due to nonfulfillment of commitment.
In order to face the challenges of the 21st Century, the governments of the
developing countries have to take necessary measures to remove those constraints,
e.g. shortage of power inadequate infrastructures, low level of human resources
etc. And have to promote the image of the country as a sage and profitable
destination of FDI.
FACTORS THAT AFFECT FDI IN DEVELOPING COUNTRIES:
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Macroeconomic stability: This is the first thing which firms will look at when
deciding where to invest. Stability is very important because it make investment
easier since when inflation is stable, firms will be able to take into account the
anticipated inflation into their future costs where as if inflation is out of
control, firms will hold their investment or won't even invest at all. So
government need to foster a stable environment for business investment
Lower Corporate Taxes: Level of taxation is very important. If taxes are high in
a country, firm will not invest because a large proportion of their profits will
be confiscated by the state so this is a very strong disincentive to invest. Also, to
corporations, corporate taxes are a cost so they will pass it on to
consumers through higher prices which lead to a general rise in price levels so
lower corporate taxes will make a country more attractive for investment.

Skilled Workforce: Skilled workforce is very important to a firm who is


transferring its capital to a different place/country because if a country's labour
is unskilled, firms who want to invest will have to spend a fortune on training
and education of their workforce which costs a lot and will outweigh the likely
benefit of moving their production plant/capital to a new country.Also, their
costs will also rise due to low productivity which at the end affects their
profitability.

Minimum Wage: Firms look at labour as a cost and a production unit.

When the government imposes a minimum wage, they simply interfere in


the labour market and mass unemployment will be the result. Not only
minimum wage hurts workers because firms have to lay workers off, but it
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also leads to a rise in costs which lowers firms profitability and firms have to
pay workers the minimum wage regardless of their productivity which leads
to lower productivity in general because whatever the worker produces in
one hour, he will get the minimum wage.
Regulation: Some regulations are good and need to be in place but most of the
regulations are very costly and often seen as unnecessary to firms. Small
businesses will get hit the hardest and often due to these heavy regulations,
businesses wont start in the first place. In the case of big firms, they might not
be hit as hard but this adds to their costs and these costs are passed on to
consumers since corporations wont lower their profit margins so regulations
wont in some cases help the consumer but in fact, it hurts them. Employment
regulations will actually lead to firms not employing workers in the first place
because it costs a lot for firms and the the fact that firms won't be able to get rid
of workers easily scares them away from the beginning so they just won't hire
from the beginning. Some employment regulations are good such as anti
discrimination act which stops employers from discriminating on the basis of
gender, race and disability.Another good regulation is basic health and safety,
not the one we currently have.

Free Trade: Free trade allows firms to move capital around freely and export
their products to wherever they want and also import whatever they want. For
the sake of this topic, free trade allows firms to freely trade with no restrictions.
Let me give you an example: Imagine a firm in a protectionist country, they
cant trade freely due to tariffs, quotas and embargoes. This affect their costs
when trying to trade and in some cases, not being able to trade with the world
markets means they will have a substantially smaller market to sell their
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products which minimises their profit levels and they won't be abler to achieve
economies of scale.

National Debt: If a country has high levels of national debt, this means that the
real interest rates are high and if the government doesn't deal with its debts,
the investor confidence will fall.Also high levels of taxation will soon follow
because the debts will have to be paid of eventually. Now as i mentioned earlier,
high taxes are a disincentive to investment and high interest rates will mean
lower borrowing which again puts investment off because it costs a lot to
borrow so firms will not invest.

CHAPTER 3: FDI IN INFRASTRUCTURE


In developing countries, an essential requirement for economic growth and
sustainable development is the provision of efficient, reliable and affordable
infrastructure services, such as water and sanitation, power, transport and
telecommunications. The availability of efficient infrastructure services is an
important determinant of the pace of market development and output growth, and,
in addition, access to affordable infrastructure services for consumption purposes
serves to improve household welfare, particularly among the poor. In most
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countries, however, the potential contribution of infrastructure to economic growth


and poverty reduction has not been fully realized, and existing infrastructure stock
and services fall far short of the requirements.
Traditionally, infrastructure was the exclusive province of the public sector, with
large, state-owned enterprises (SOEs) being responsible for investment and service
delivery. Typically, SOEs were costly and inefficient providers of infrastructure
services in most developing countries. Since the mid-1980s, however, governments
around the world have pursued policies to involve the private sector in the delivery
and financing of infrastructure services. Encouraged by international organizations
such as the World Bank, privatization has been a major component of the economic
reform programmes pursued by many developing countries over the past two
decades (Parker and Kirkpatrick, 2004). Privatization was thought to promote more
efficient operations, expand service delivery, reduce the financial burden on
government and increase the level of foreign and domestic private investment
(World Bank, 1995). Early privatization measures were, on the whole, concentrated
in the manufacturing sector but, in recent years, the private sector has become
increasingly involved in the financing and delivery of infrastructure services. A
large number of developing countries have introduced private participation into
their infrastructure industries and, by the end of 2001, developing countries had
received over $755 billion in private investment flows in nearly 2,500
infrastructure projects (World Bank, 2003a).
Utilities such as water supply, gas, electricity and telecommunications and certain
modes of transport, e.g. rail, all have natural monopoly characteristics arising from
pervasive economies of scale and scope. These characteristics mean that
competition is unlikely to develop or, if it develops, it will be uneconomic because
of the duplication of assets. Although technological advances, notably in
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telecommunications, have whittled away some of the natural monopoly


characteristics in utilities, permitting economic competition in certain areas of
service delivery, each of the utilities retains some natural monopoly features. As a
consequence, privatization of these industries, in whole or in part, risks the
introduction of private-sector monopolies that will exploit their economic power,
leading to supernormal profits (high producer surplus) and reduced consumer
welfare (a lower consumer surplus). Consumers may suffer from no or a
limited choice of goods and services and face monopoly prices.
To prevent such an outcome, governments need to develop strong regulatory
capabilities so that they can police the revenues and costs of production of the
privatized utility firms and protect consumers from monopoly exploitation. At the
same time, there needs to be commitment on the part of government to the
regulatory rules so that they are perceived as credible by investors. Where
regulatory credibility is weak or absent, private investment decisions will be
adversely affected.

CHAPTER 4: FDI IN INFRASTRUCTURE IN DEVELOPING COUNTRIES


FDI has expanded steadily over the past three decades. The growth in FDI
accelerated in the 1990s, rising to $331 billion in 1995 and $1.3 trillion in 2000. As
a result, developing countries experienced a sharp increase in the average ratio of
FDI to total investment during the 1990s. A principal feature of the growth in FDI
has been its rise in the services sector, which is now the dominant sector in global
FDI. For developing countries, FDI in services increased at an annual rate of 28%

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over the period 1988 to 1999, and by 1999, accounted for 37% of total foreign
investment inflows.
A significant part of the increase in FDI in the services sector has been the growth
in private capital flows for infrastructure in response to the general trend towards
privatization of infrastructure in developing countries. In contrast, there was a
sharp decline in donor support for infrastructure projects during the 1990s, with
aggregate flows of official development assistance for the infrastructure industries
falling by half during the course of the decade (Willoughby, 2002). Private sector
participation in infrastructure projects in developing countries has risen
dramatically since 1990 and the annual investment commitments reached a peak of
$128 billion in 1997. According to the World Banks Private Participation in
Infrastructure (PPI) database, 26 countries awarded 72 infrastructure projects with
private participation in 1984-89, attracting almost $19 billion in investment
commitments. In the 1990s, 132 low- and middle-income countries pursued private
participation in infrastructure 57 of them in three or all four of the sectors
covered in the database (transport, energy, telecommunications, and water and
sewerage). In 1990-2001, developing countries transferred to the private sector the
operational responsibility for almost 2,500 infrastructure projects, attracting
investment commitments of more than $750 billion.
Private infrastructure projects have taken a number of forms, involving varying
degrees of investment risk. Management and lease contracts involve a private
entity taking over the management of an SOE for a given period although the
facility continues to be owned by the public sector. The public sector retains the
responsibility of financing the investments in fixed assets. In the case of
management contracts, the public sector also finances working capital. Under a
concession agreement, a private entity takes over the management of an SOE for a
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given period, during which it assumes significant investment risk. The ownership
of the facility reverts back to the public sector at the end of the concession period.
With greenfield projects a private entity or a public-private joint venture builds and
operates a new facility for the period specified in the project contract. The facility
may return to the public sector at the end of the contract period or may remain
under private ownership. The fourth form of private participation in infrastructure
is divestiture where a private entity buys an equity stake in an SOE through an
asset sale, public offering or mass privatization programme. Over the period 19902001, divestitures accounted for 41% ($312 billion) of total private participation
infrastructure projects in developing countries, greenfield projects accounted for
42% and concessions for 16% (World Bank, 2003a).
Among the developing regions, Latin America and the Caribbean accounted for
48% of the cumulative investment in infrastructure. In this region, private
participation in infrastructure was often part of a broader reform programme aimed
at enhancing performance through private operation and competition, and
generating the financial resources needed to improve service coverage and quality
through tariff adjustments (World Bank, 2003a, pp. 2-3). Under this approach,
divestitures and concessions of existing assets predominated, accounting for 75%
of the cumulative investment in private infrastructure projects in Latin America
during the period. In more recent years, Latin Americas share of investment in
infrastructure has declined from 80% in 1990 to 40% in 2001, as other regions
have opened their infrastructure industries to private participation. The East Asia
and Pacific region has been the second largest recipient of private investment in
infrastructure. Over the period 1990-2001, it accounted for 28% of cumulative
private participation in infrastructure in developing countries. In contrast to Latin
America, the Asia region has focused on the creation of new assets through
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greenfield projects, which accounted for 61% of the investment in East Asia in
1990-2001. The Asian financial crisis of 1997-1998 saw the regions share in
annual investment in infrastructure decline from 40% in 1996 to 11% in 1998,
before recovering to 28% in 2001.
Private participation in infrastructure in developing countries has been
concentrated in the telecommunications industry, which accounted for 44% of the
cumulative investment in 1990-2001. Energy, which includes electricity and the
transmission and distribution of natural gas, attracted the second largest share of
investment, accounting for 28% of the cumulative investment in private
infrastructure projects in 1990-2001. In contract, private participation in the water
and sewerage industry has been limited, accounting for 5% of cumulative
investments over the period 1990-2001. The limited amount of private involvement
in water utilities is likely to be a reflection of the inherent difficulties that face
privatization in this industry, in terms of the technology of water provision and the
nature of the product, transaction costs and regulatory weaknesses.

CHAPTER 5: GOVERNANCE AND FDI


There is long established and extensive literature on the determinants of FDI flows
to developing countries. The focus of many of the early contributions to this
literature was on the economic determinants of FDI inflows and they showed that
TNCs were attracted to invest in locations that allow the enterprise to exploit its
ownership specific advantages.
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More recent contributions have examined the influence of institutional factors in


explaining cross-country differences in foreign investment flows. Building on the
insights of the new institutional economics, it is increasingly recognized that
differences across countries in economic conditions provide only a partial
explanation of the location choices of TNCs and that the quality of a countrys
institutional framework can have a significant impact on the perceived investment
environment.
Institutions have been defined in a variety of ways. According to Douglas Norths
widely cited definition, the term institution framework refers to the set of
informal and formal rules of the game that constrain political, economic and
social interactions. From this perspective, a good institutional environment is
one that establishes an incentive structure that reduces uncertainty and promotes
efficiency, thereby contributing to stronger economic performance. Included in this
institutional structure are the laws and political and social norms and conventions
that are the basis for successful market production and exchange. This broad
concept of institutions has been incorporated into empirical studies of FDI using a
range of indicators. It is now common, for example, to include a variable to control
for inter-country differences in the broad political environment although, as noted
by Dawson (1, the results have been mixed. A measure of inter-country differences
in corruption has also been shown, in several studies, to have a significant impact
on private investment. The extent of legal protection of private property and how
well such laws are enforced is an additional factor that has also been shown to
have a significant effect on foreign investors location decision.
A parallel stream of research has focused on perceptions and assessments of the
quality of public institutions especially on how well they function and what
impact they have on private sector behaviour (IMF, 2003). The term governance
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has been adopted in the literature to cover different dimensions of the quality of
public institutions, including government effectiveness and efficiency. Recent
empirical evidence has confirmed that cross-country differences in growth and
productivity are related to differences in the quality of governance. This approach
has been extended recently to consider the impact of governance on cross-country
differences in FDI flows. Steven Globerman and Daniel Shapiro (2002) use the six
governance indicators estimated by Daniel Kaufmann et al. (1999) to assess the
impact of governance quality on both FDI inflows and outflows for a broad sample
of developed and developing countries over the period1995-1997. The Kaufmann
indices describe various aspects of the governance structures, including measures
of political instability, rule of law, graft, regulatory burden, voice and political
freedom and government effectiveness, and therefore encompass many of the
individual institutional variables used in earlier studies. The Kaufmann governance
variables are combined with measures of physical, human and environmental
capital to explain FDI flows. The results indicate that the quality of governance
infrastructure is an important determinant of both FDI inflows and outflows
(Globerman and Shapiro, 2002, pp. 1908-1914). The study by Ernesto Stein and
Christian Daude (2001) uses the gravity model approach to test for the role played
by institutional quality on FDI location in Latin American countries during the
period 1997-1999. A group of four alternative measures of institutional quality is
combined with two other sets of variables and tested as potential determinants of
FDI flows. The first consists of variables that are typically used in gravity models
of trade, such as GDP, per capita income and distance between the source and host
countries (Greenaway and Milner, 2002). The second group consists of variables,
other than the institutional ones, which can affect the attractiveness of a country as
a location for FDI, such as the level of taxes on foreign investment activities,
human capital and infrastructure quality. The results show that the governance
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variables are almost always statistically significant, confirming that the quality of
institutions has a positive impact on FDI. The results are shown to be robust to the
use of a wide range of institutional variables, to different model specifications and
to different estimation techniques.

CHAPTER6:REGULATION AND
DEVELOPING COUNTRIES

FDI

IN

INFRASTRUCTURE

IN

The role of economic regulation in the development process has generated


considerable interest among researchers and practitioners in recent years.
Economic regulation by government is associated with righting market failures,
including ameliorating the adverse effects of private enterprise activities. From the
1960s to the 1980s, the market failure argument was used to legitimize direct
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government involvement in productive activities in developing countries, such as


promoting industrialization through import substitution, investing directly in
industry and agriculture, and by extending public ownership of enterprises. Since
the early 1980s, policy in developing countries has shifted from that of the
interventionist state to the current focus on the regulatory state. The regulatory
state model envisages leaving production to the private sector where competitive
markets work well while using government regulation where significant market
failure exists.
The widespread privatization of SOEs in developing countries has focused
attention on the need for an effective regulatory framework. The available evidence
on the effects of privatization in less developed countries suggests that, in general,
privatization has improved the economic performance of former SOEs. But the
evidence also suggests that privatization, per se, may not be the critical factor in
raising productivity and reducing production costs. More important is the
introduction of effective competition and organizational or political changes. In the
case of infrastructure industries, simply moving a monopoly from the public to the
private sphere will not result in competitive behaviour. A key requirement for
privatization success then becomes the effectiveness of the regulatory regime in
promoting competition or in controlling the anti-competitive behaviour of
dominant firms. As a result, a growing number of developing countries have
introduced new, dedicated regulatory offices to supervise the activities of their
privatized utilities. Most of these regulatory offices are expected to have some
degree of independence from day-to-day political control, although, in practice,
political intervention seems to occur in a number of countries. Evidence on the
impact of utilities regulation in developing countries is still limited, but studies for

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telecommunications and electricity industries confirm that privatization brings


greater benefits when it is accompanied by an effective regulatory regime.
The aim of utility regulation is to establish a policy environment that sustains
market incentives and investor confidence. For this to be achieved, the regulator
needs to be shielded from political interference, and the government needs to
support a regulatory environment that is transparent, consistent and accountable.
This implies that the capacity of the state to provide strong regulatory institutions
will be an important determinant of how well markets perform. In particular, this
form of arms length, independent regulation is expected to encourage private
capital to invest in infrastructure utilities in the face of a potential hold up
problem. Privatization requires investors to sink funds into fixed assets that are
specific to the venture, so that once a network is created the balance of bargaining
advantage shifts from the private-sector investor to the regulator (on behalf of the
government) with implications for prices and investment. Where the investor fears
this outcome, referred to as hold up, investors may be deterred from committing
to investment, or may require front-end loading of returns or sovereign guarantees
from the state or international agencies. In turn, such guarantees reduce the net
economic benefits of attracting private capital by reducing managerial incentives to
control costs. Some form of independent regulation can provide reassurance to
investors that prices, output and profits will not be politically manipulated
The challenge of providing infrastructure regulation that establishes credibility
with the private sector and, at the same time, ensures efficient economic
performance on the part of the regulated enterprises is not easily achieved. There is
an extensive literature on the distorting effects of state regulation even when
conducted by dedicated regulatory bodies (Armstrong et al. 1994; Guasch and
Hahn, 1999). Regulation is associated with information asymmetries. The regulator
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and the regulated can be expected to have different levels of information about
such matters as costs, revenues and demand. The regulated company holds the
information that the regulator needs to regulate optimally. Thus, the regulators
need to establish rules and incentive mechanisms to obtain this information from
the company. Given that it is highly unlikely that the regulator will receive all of
the information required to regulate optimally, the results of regulation, in terms of
outputs and prices, remain second best to those of a competitive market. This
leads on to credibility and commitment considerations: credibility that the
regulatory rules will bring about the intended outcome; and commitment of
government to the current regulatory rules, so that post-privatization or postconcession award, the regulator does not act opportunistically to reduce the prices
and profits of the private regulated businesses.
Regulatory regimes are also prone to regulatory capture, by which the regulatory
process becomes biased in favour of particular interest groups, notably the
regulated companies. The regulatory capture literature concludes that in the
extreme case regulation always leads to socially sub-optimal outcomes because of
inefficient bargaining between interest groups over potential utility rents . In the
Chicago tradition of regulatory capture, regulators are presumed to favour producer
interests because of the concentration of regulatory benefits and diffusion of
regulatory costs, which enhances the power of lobbying groups as rent-seekers.
What is clear is that the capability of firms to influence public policy is an
important source of competitive advantage. Balanced against the risks of
regulatory capture, however, is the possibility that regulators might develop a
culture of arrogant independence, bordering on vexatious regulation. This creates
some uncertainty about the desirable degree of regulatory independence. In
principle, three broad forms of regulation can be identified:
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(a) the regulatory authority is integrated into the normal government machinery,
notably where it is a section of the ministry and controlled by the minister;
(b) the semi-independent agency, which has some independence from the ministry
but where decisions can still be over-ruled by a superior government authority; and
(c) the independent agency, where there is no right of appeal to a superior
government (political) authority, though there usually will be a right of appeal to
the courts to ensure fairness and rationality in the decision-making process. The
independent agency is normally favoured by western advisors, who draw from the
experience of regulation in the United Kingdom and the United States. However,
regulatory independence and an impartial judicial review of the due process may
not be credible in some institutional settings. An additional constraint on
establishing credible and effective infrastructure regulation in developing countries
can be related to the resource constraints that exist in lower income countries.
Many developing countries lack the necessary trained personnel to sustain
regulatory commitment and credibility. Regulatory offices in developing countries
tend to be small, under-manned for the job they face, and possibly more expensive
to run in relation to GDP than in developed countries. Familiarity with the
regulatory models and methods of regulatory policy analysis is often limited. The
other main difficulties found in many developing countries relate to broader
governance problems or the legal powers and responsibilities of regulators,
including their effective independence from regulatory (including political)
capture.

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CHAPTER 7: FDI AND INFRASTRUCTURE A GLOBAL PRESPECTIVE.


The economic model followed by India after independence relied on import
substitution and selective foreign capital inflow, both through portfolio investment
and the Foreign Direct Investment (FDI) route. This changed radically with the
liberalization measures post-1990. Both portfolio and Foreign Direct Investment
were not only allowed but also actively encouraged. The Foreign Investment
Promotion Board (FIPB) was created to approve FDI proposals speedily and in
most sectors, particularly infrastructure. The Reserve Bank of India gives
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automatic approvals for investments. During the decade of the nineties, the
ceilings on FDI in different sectors were progressively raised. From 2001, 100
per cent foreign investments were allowed in several industrial sectors. Currently,
100 per cent Foreign Direct Investment is allowed in almost all the infrastructure
sectors.
Cross border investments and technology transfers that broadly constitute Foreign
Direct Investment have multiplied greatly over the past two decades especially
since the mid-1980s. Several global economic changes have fuelled this growth.
These include:
Liberalization and economic reforms across a large swathe of national
economies.
The emergence of regional trading blocs particularly in Europe and North
America.
Rapid technology absorption and industrialization in East Asia.
As a consequence, the annual magnitude of FDI flows across the globe has risen
from US$ 55 billion in the early eighties to US$ 1393 billion in 2000 and then
declined to US$ 560 billion by 2003.
The Role of Foreign Direct Investment.
The role of Foreign Direct Investment in an economy goes beyond simply easing
financial constraints. FDI inflows are associated with multiple benefits such as
technology transfer, market access and organizational skills. Consequently, there is
an increasing and intense competition between countries to maximize the quantity
of FDI inflows. Any successful policy for attracting FDI has to keep this
competitive scenario in mind.
The Benefits of FDI Inflows can be broadly identified as:
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Bridging the financial gap between the quantum of funds needed to sustain a
level of growth and the domestic availability of funds.
Technology transfer coupled with knowledge diffusion that leads to
improvement in productivity. It can, thus, fasten the rate of technological
progress through a contagion effect that permeates domestic firms.
The transfer of better organisational and management practices through the
linkages between the investing foreign company and local suppliers and
customers.
In the context of a developing country like India, the role of FDI in easing financial
constraints becomes critical. According to the Planning Commission, at current
levels of efficiency in the economy, the increase in investment needed to achieve a
percentage point rise in the overall growth would be 6 percentage points. Since this
addition to investment cannot come entirely from domestic sources, a substantial
portion will have to be funded by FDI.

FDI in Infrastructure: Alternative Modes of Investment


Of the total quantum of FDI flows across the globe, a large fraction has gone into
infrastructure projects. Growing pressures on Government budgets and a general
concern about the quality of service provision by incumbent entities saw an
explosion of private sector FDI into infrastructure, particularly in the developing
countries. Between 1990 and 1998, infrastructure projects in the developing
countries attracted about US$ 63 billion through the following routes:
Privatization sales
Concessions
Leases and other contractual agreements
New capacity creation through Build-Operate-Transfer (BOT) Agreements1
25

The bulk of infrastructure FDI in terms of quantum of investment has flowed into
the telecom and power sectors. This is not surprising since projects in these sectors
tend to be large. In terms of the number of projects, the distribution is more or less
even across sectors.
Infrastructure FDI in Asia and Latin America: A Contrast
Internationally, countries have followed two routes to infrastructure development.
Latin American economies generated the vast majority of their infrastructure FDI
inflows through privatization. This constituted about 88 per cent of total inflows
during 1999-2000 with the rest coming from green-field investments and
concessions. In Asia, on the other hand, Governments relied exclusively on greenfield investments through the BOT route. India has followed the Asian route where
the bulk of FDI in infrastructure has come in through the green-field route rather
than through privatization. The Government, for instance, has allowed strategic
investment in major airports with a 74 per cent equity ceiling.
Modes of Foreign Direct Investment in India
FDI can enter India through two possible channels:
The automatic route under which companies receiving Foreign Direct
Investment need to inform the Reserve Bank of India within 30 days of
receipt of funds and issuance of shares to the foreign investor.
For sectors that are not covered under the automatic route, prior approval is
needed from the Foreign Investment Promotion Board (FIPB)
The Infrastructure Focus of Indias FDI Policy
The effort of attracting FDI should not be an end in itself but a means of
industrialization and development. Thus, FDI is not an undifferentiated black box
26

the specific nature of the FDI determines its impact on development and growth. In
the Indian case, expanding infrastructure investments are viewed as critical
adjuncts to the policy of stepping up the growth rate of the economy. This is
coupled with the view that domestic sources alone may not be adequate to provide
commensurate resources.

The FDI Needs of the Telecom Sector in India


The telecom services sector in India has seen explosive growth over the last two
years. Revenue growth in the sector touched 16 per cent in 2003-04 and it is likely
that a similar growth rate will be sustained in 2004-05. From 13 million in March
2003, the mobile phone subscriber base grew to 33.7 million by March 2004. This
rapid growth necessitates a sharp rise in capital investment over the next few years.
Total FDI inflows into the telecom sector were US$ 2.6 billion between August
1991 and July 2004. Industry estimates put the quantum of investments required in
the sector over the next four years at about US$ 20 billion. A substantial portion of
this investment is to come from FDI. Thus throughout the phase of liberalisation,
the Indian Government has adopted a liberal approach towards allowing FDI in the
infrastructure sectors. This is reflected in the sectoral mix of investment inflows
where energy and telecommunications account for 43 per cent of total FDI
approvals and 23 per cent of inflows.
FDI Norms in Infrastructure Sectors
Automatic clearance for foreign investment (not requiring the approval of the
FIPB) was first introduced for infrastructure sectors like power and roads.
Other determinants of FDI in Infrastructure
27

While a liberal entry policy can go a long way in encouraging foreign


investments in infrastructure, the willingness to invest in infrastructure projects has
been restrained by a number of constraints across a number of economies. Thus,
any successful strategy of attracting Foreign Direct Investment into these sectors
will have to deal with these issues directly. These are:
Subsidised prices: In most developing countries, infrastructure services are
priced below the cost of supply. Subsidies may be hidden as increasing
arrears to the banking system or outstanding payments to State agencies
(like State Electricity Boards). This undermines the financial viability of
projects.
Mixed signals from different constituencies: Many diverse groups with
varying levels of influence on Government policy have a stake in the policy
that affects private infrastructure operations. Consumers benefitting from
subsidised prices may resent price increases associated with privatisation.
Managers and employees of public utilities are understandably concerned
about their jobs. This often influences policy related to private infrastructure
and affects the investment environment.
Loss of authority: Governments are often reluctant to abdicate control over
key sectors of the economy particularly where foreign ownership is
involved. Most Governments do not have a strong record of regulating
private industries because the public sector has been so dominant. This often
results in rules prohibiting private entry into certain sectors, imposing limits
on foreign ownership.
Misunderstanding regarding what private involvement can offer and what investors
require: Although private sector involvement does offer extra financing and the

28

willingness to manage some risks (construction and operation risks), they are
unwilling to bear risks that they cannot control (policy or regulatory risk).

CHAPTER 9: FOREIGN DIRECT INVESTMENT (FDI) AND THE


REGULATORY ENVIRONMENT

Major infrastructure development requires a substantial influx of investment


capital. The policies of the Indian Government seek to encourage investments in
domestic infrastructure from both local and foreign private capital. The country is
already a hot destination for foreign investors. As per the World Investment Report
of the UNCTAD, India was rated the second most attractive location (after China)
for global FDI in 2007.
FDI inflows, particularly with a view to catalyzing investment and enhancing
infrastructure, the Indian Government had introduced significant policy reforms.
For example, it had permitted 100% FDI under the automatic route for a broad
range of the approval route process, including setting up several agencies to
expedite FDI approval. Further liberalisation is expected as the Government
continues to emphasise infrastructure investment.
29

From an exchange control perspective, India is moving towards full current


account convertibility. Most revenue transactions are freely permitted, except
certain transactions like royalty, consultancy fees, etc., which are subject to certain
limits. Capital account transactions need prior approval, except where specifically
permitted. In order to promote the construction sector, the Indian Government has
relaxed some of the exchange control restrictions and is now allowing foreign
nationals/ citizens to acquire immovable property in India, subject to certain
conditions and procedures. Hurdles to investment remain. Although India has a
well-developed legal system, the current legal and regulatory environment
sometimes acts as an obstacle to the necessary injections of foreign private capital
into Indias infrastructure. Major infrastructure projects are governed by the
concession agreements signed between public authorities and private entities.
Tariff determination and the setting of performance standards vary somewhat by
sector. In the roads and highways sector, the ministry generally sets tolls while in
major ports projects, and many of those in electricity generation, an independent
regulator will decide relevant tariffs. In the airport sector, a new independent
regulator was planned for 2009 and is likely to play a major role in determining
tariffs in concession agreements for the segment. In some instances, ministry or
regulator control over potential proceeds can act as a disincentive to the private
infrastructure developer. As is the case in many countries, there is no single
regulator which formulates the policy for all infrastructure projects. There is also
no standardization in the concession agreements across the different infrastructure
sectors. As a result, the development of certain sectors in India may be hampered
due to lack of adequate and co-ordinated planning. Projects which were approved
may face difficulties if related projects are substantially delayed. One example is
Bangalores new international airport, one of the largest PPP projects to date. The
project is facing growing pains related to insufficient road and rail connections to
30

the new facility, in part due to delays of expected high-speed rail and highway
projects under the auspices of other government bodies.

Opportunities for FDI in infrastructures in India


The Planning Commission of India has planned extensive expansion in the roads
and highways, ports, civil aviation and airports, and power infrastructure segments
all of which provide substantial opportunities for FDI.

Roads and highways:


Indias roads are already congested, and getting more so. Annual growth was
projected at over 12% for passenger traffic and over 15% for cargo traffic. The
Indian Government estimated around US$90 billion plus investment was required
over FY07-FY12 to improve the countrys road infrastructure. Plans were
announced by the Government to increase investments in road infrastructure would
increase funds from around US$15 billion per year to over US$23 billion in 201112. Such programmes would be funded via a mix of public and private initiatives.
The Indian Government, via the National Highway Development Program
(NHDP), planned more than 200 projects in NHDP Phase III and V to be bid out,
31

representing around 13,000km of roads. The average project size was expected to
US$150 million-US$200 million. Larger projects reached upto the US$700
million-US$800 million range. About 53 projects with aggregate length of 3000km
and an estimated cost of around US$8 billion were already at the pre-qualification
stage. The procurement process favors players with good experience and sound
financial strength.
More than 10 states were also actively planning the development of their
highways. While the average size of these projects was smaller than the NHDP
projects, most will still be substantial, in the US$100 million-US$125 million
range. More than 4,500km of state highways were awarded by the end of 2010.
State Roads (Highways, Major District

Rural

Roads, Other Roads)

Roads

North
East

National Highways
NHDP1

NHD
P
Privat
e

Total

Non-NHDP

Year

Public

(Public)

Total

Public

Private

Total

2007-08

3,173

3,702

463

7,338

4,347

1,333

5,680

1,875

212

15,104

2008-09

3,305

3,966

486

7,757

4,528

1,428

5,956

2,025

238

15,976

2009-10

3,464

4,495

510

8,469

4,745

1,618

6,364

2,150

291

17,273

2010-11

3,834

5,685

536

10,055

5,253

2,047

7,299

2,300

317

19,971

2011-12

4,707

6,478

563

11,747

6,488

2,345

8,834

2,463

344

23,387

Total

18,483

24,326

2,557

45,365

25,361

8,771

34,132

10,813

1,401

91,711

Rail
The Indian Government had also recognised existing infrastructure gaps and
capacity constraints in the rail system, and as a consequence planed large scale
investment over the five years from FY07-FY12. Projected investments total
32

US$65 billion, of which 40% was expected to be contributed by the private sector.
One major PPP programme was already in its initial phases. The Dedicated Freight
Corridor project was designed to alleviate congestion on the rail routes between
Delhi and Mumbai and Delhi and Kolkota by building long-distance, cargo-only
rail lines, at an estimated cost of US$6 billion-7 billion.
Other proposed initiatives included the development of manufacturing plants for
rolling stock with long-term committed procurement for several years, and the
setting up of logistics parks. City metro systems were also in the pipeline. The first
corridor of the Mumbai Metro Project was awarded to Reliance Infrastructure and
the Government had asked the final shortlisted companies to submit detailed
financial bids for the second phase of the Mumbai Metro.

Ports and airports


Increasing connectivity with inland transport networks is just one of many
challenges currently facing Indias ports, which have seen massive swells in the
amount of goods transported. Traffic was estimated to reach 877 million tonnes by
2011-12, and containerized cargo was expected to grow at 15.5% (CAGR) over the
next 7 years. Indias existing ports infrastructure was not sufficient to handle the
increased loads cargo unloading at many ports was currently inadequate, even
where ports have already been modernised. An estimated investment of around
US$22 billion was targeted for port projects in the five year period from FY07FY12. The National Maritime Development Programme included 276 projects,
with a required investment of about US$15 billion over the next ten years, with
private investment targeted at around US$8 billion. In addition to improving road
and rail connections, projects related to port development (construction of jetties,
33

berths, container terminals, deepening of channels to improve draft, etc.), will


provide major opportunities for FDI. Recent deregulation of the sector now permits
100% FDI, and an independent tariff regulatory authority has been set up to
facilitate projects at major ports.
Air traffic had increased rapidly in recent years, although this slowed in 2007.
While a number of Indian airlines had faced challenging market conditions in
2008, and the rate of growth is likely to be significantly less than initially
projected, Indians are still flying in much greater numbers. Estimates made in 2007
by the Indian Governments Committee on Infrastructure suggest that passenger
traffic will grow at a CAGR of over 15% in the next 5 years. Indian manufacturers
are also looking to the skies the same source anticipates that cargo traffic will
grow at over 20% p.a. over the next five years.
The Indian Government has projected that an investment of around US$8 billion in
the five year period from FY07-12 will be needed to help cope with additional
demand, and private sector participation is expected to play a key role. The private
sector had already stepped up to the challenge of airport infrastructure
development in several cases, with private participation in recent years at Delhi,
Mumbai, Hyderabad, Cochin and Bangalore supplementing the efforts of the
Airports Authority of India.

Power
Increased manufacturing activities and a growing population are also causing a
surge in power usage. India has the fifth largest electricity grid in the world with
135 GW capacity, and the worlds third largest transmission and distribution
34

(T&D) network. Large investments were needed to meet growing demand and
provide universal access. An investment of US$167 billion was projected for
electricity projects in the five year period from FY07-FY12. The massive number
and scope of potential projects had attracted a number of new investors, lenders
and operators.

CHAPTER 9: CONCLUSIONS
The 1990s saw an unprecedented increase in private foreign investment in
infrastructure projects in developing countries. Much of this investment was in the
telecommunications and electricity industries. For the private sector, infrastructure
investment is associated with a sizeable investor risk linked to the long-term sunk
cost characteristics of infrastructure projects. For the government, the involvement
of the private sector in natural monopolies raises new challenges in designing
regulatory structures that can control anti-competitive or monopolistic behaviour,
while at the same time maintaining the attractiveness of the domestic economy to
potential foreign investors in the infrastructure industries.
The purpose of this article was to assess the impact of regulatory governance on
FDI in infrastructure projects in middle and low income economies. Using a
dataset on private participation in infrastructure projects in developing countries
for the period 1990 to 2002 recently made available by the World Bank, we
constructed an econometric model that was used to estimate the determinants of
FDI in infrastructure. The determinants were grouped into control variables for
35

economic policy and structural characteristics and infrastructure regulation


variables. The selection of control variables was motivated by existing research on
FDI, and our results are consistent with the empirical evidence on the key
determinants of FDI reported in the literature. Three alternative measures of
regulation quality were used in our empirical analysis. All are positively signed and
statistically significant.
We interpret these results as confirmation of the basic hypothesis that FDI in
infrastructure responds positively to the existence of an effective regulatory
framework that provides regulatory creditability to the private sector. By
implication, where regulatory institutions are weak and vulnerable to capture by
the government (or the private sector), foreign investors may be more reluctant to
make a major commitment to large scale infrastructure projects in developing
countries. The main policy implication of our findings is the need for supporting
capacity building and institutional strengthening for robust and independent
regulation in developing countries.

36

CHAPTER 10: BIBLIOGRAPHY

BOOK:

INTERNATIONAL BUSINESS P.K. BANDGAR

WEBSITES:
https://www.imf.org/external/pubs/ft/fandd/2001/06/loungani.htm

https://www.imf.org/external/pubs/ft/fandd/2001/06/loungani.htm

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http://unlimitedeconomicszone.over-blog.org/article-how-can-foreign-directinvestment-help-developing-countries-108953176.html

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