Indian Institute of Technology, Kanpur

ECO 202 – Macro-Economics

Term Project1

A Study of Foreign Direct Investments

Ankit Misra
Y3053
ankitm@iitk.ac.in

&

Rishabh Uppal
Y3290
rishabh@iitk.ac.in

Abstract
With FDI stocks constituting over 20% of global GDP, FDI has come in lime light in the
global economy. From a couple of years, investor confidence has soared in the emerging
market countries such as China and India and they have become the most favored
destinations for FDI. In 2005, China, India and Eastern European countries reached new
heights of attractiveness as destinations for FDI as they competed for higher value-added
investments, including R&D. All these facts make this term project topic a good fit to the
theoretical understanding we have developed in the course. In this project we develop an
understanding of the concepts related to FDI, analyze latest FDI trends in different
countries and look at FDI in India in greater detail.

1
2006-07/I
1. Objective:

The objective of this paper is to familiarize ourselves with different issues associated
with foreign direct investment (FDI) and try to correlate the trends with the theoretical
knowledge we have acquired in the course.

The term project report is arranged as follows. In section 2 we explain the concept of FDI
and its importance in an economy. We also look at the recent trends at global level and as
to why India has become a favored FDI destination in recent past [1]. In section 3 we
analyze FDI in India (its importance and problems in further increasing it) in greater
detail. We also make a succinct comparison between FDI in India and China. Also we
observe FDI trends in various different countries to get a better global picture. In section
4 we look at roles of few factors in deciding FDI (SEZ, disinvestment, tax reforms).
Finally we end in section 5 summarizing our study of FDI. References have been
reported in section 6.Appendix I-III consists of some extra but useful information.

2. Review:

In lay man terms, FDI is defined as a long term investment by a foreign direct investor in
an enterprise resident in an economy other than that in which the foreign direct investor is
based. The FDI relationship consists of a parent enterprise and a foreign affiliate. So to
qualify as FDI the investment afford the parent enterprise control over its foreign
affiliate.

2.1 Types of FDI

• Mergers and Acquisitions is the primary type of FDI. This occurs when a transfer
of existing assets from local firms to foreign firms takes place. These Cross-
border mergers occur when the assets and operation of firms from different
countries are combined to establish a new legal entity. Cross-border acquisitions
occur when the control of assets and operations is transferred from a local to a
foreign company, with the local company becoming an affiliate of the foreign
company. Acquisitions provide no long term benefits to the local economy-- even
in most deals the owners of the local firm are paid in stock from the acquiring
firm, meaning that the money from the sale could never reach the local economy.
Nevertheless, mergers and acquisitions are a significant form of FDI and until
around 1997, accounted for nearly 90% of the FDI flow into the United States.
• Greenfield investment: direct investment in new facilities or the expansion of
existing facilities. They create new production capacity and jobs, transfer
technology and know-how, and can lead to linkages to the global marketplace. So
these are the primary target of a host nation’s promotional efforts. Multinationals
are able to produce goods more cheaply because of advanced technology and
efficient processes and uses up resources labor, intermediate goods, etc so, it
sometimes crowds out local industry. One more downside of greenfield
investment is that profits from production do not feed back into the local
economy, but instead to the multinational's home economy.
 • Horizontal Foreign Direct Investment: is investment in the same industry abroad
as a firm operates in at home.

• Vertical Foreign Direct Investment: It can be of two types:

1) Backward vertical FDI: where an industry abroad provides inputs for a firm's
domestic production process
2) Forward vertical FDI: in which an industry abroad sells the outputs of a firm's
domestic production processes.

2.2 Importance

Following shows the significance of FDI:

ƒ It brings in investible resources to host countries.
ƒ Introduces modern technologies.
ƒ Provides access to export markets. The trans-national companies (TNCs/MNEs)
have large internal (inter-firm) markets, whose access is only available to
affiliates. They also control large markets in unrelated parties having established
brand names and distribution channels spread over several national locations.
They can, thus, influence granting of trade privileges in their home (or in third)
markets.
ƒ FDI flows are non-debt creating, non-volatile and their returns depend on the
performance of the projects financed by the investors.

FDI also facilitates international trade and transfer of knowledge, skills and technology.
In a world of increased competition and rapid technological change, their complimentary
and catalytic role can be very valuable

2.3 Factors affecting FDI

Quality off Infrastructure

Poor infrastructure leads to poor productivity of the economy as a whole which results in
low GDP/per capita GDP. The industries which try to have a comparative advantage by
using such infrastructure more intensely are also reduced. In the context of FDI, poor
infrastructure has more worsening effect on export production than on production for the
domestic market. FDI directed at the domestic market suffers the same handicap and
additional costs as domestic manufacturers that are competing for the domestic market.
Say, a foreign direct investor planning to set up an export base in developing/emerging
economies has the option of choosing between India and other locations with better
infrastructure, India is handicapped in attracting export oriented FDI. Poor infrastructure
is found to be the most important constraint for construction and engineering industries.

State Obstacles
Taxes like octroi and entry taxes which are levied on transportation of goods from State
to State adversely impact the economic environment for export production, this imposes
both cost and time delays on movement of inputs used in production of export products
as well as in transport of the latter to the ports. Investments that could raise the
productivity and quality and thus make them competitive in global markets remain
unprofitable because they cannot overcome the tax advantage given to small producers in
the domestic market. At the local level (sub-state) issues pertaining to land acquisition,
land use change, power connection, building plan approval are sources of project
implementation delay.

Legal Delays
India’s legal system as codified is otherwise considered to be superior to that of many
other emerging economies by many legal experts, but is often found in practice to be a
hurdle in investment. One of the reasons is the inordinate delay are the interlocutory
procedures that characterize judicial procedures. As a result the “Rule of law,” which has
often been cited as one of the attractive features of the Indian economy for foreign
investors, is found to be a significant positive factor by only 3 per cent for FDI in India.

2.4 Trends

Global foreign direct investment (FDI) almost quadrupled between 1995 and 2000. FDI
in developed countries not only grew but also its proportion became more than the
developing nations.
FDI inflows into developing countries virtually halted in 1998 as a result of the Asian
crisis. The share of developing countries in global flows reached a peak of 39.6 percent in
1996, declining rapidly thereafter to reach 18.9 per cent of total flows in 2000 (Table 1).
Though absolute FDI amounts have declined in 2001, the share of developing countries
has increased dramatically to 30 per cent.
Table 1

2.5 India – A favored FDI destination

Today, India is perceived as the second most favorable investment destination. The
global economic growth is becoming more and more dependant upon Asia’s growth, in
which India is playing an increasingly more important role.

Economic Reforms in India

Major initiatives put forth as a part of the liberalization and globalization strategy since
the early Nineties. With the announcement of the new industrial policy the strategy of
industrialization followed is an “outward looking’ one. All manufacturing activities,
except a few (due to strategic, environmental reasons, etc.) are now open to competition
and the entrepreneurs are free to make investment decisions based on their commercial
judgment.

Over the years, there has been a steady liberalization of the exchange controls with full
convertibility on current account transactions. Various reforms towards the road to
liberalization include:

• Virtual scrapping of the industrial licensing regime.

• Amendment of the Monopolies and the Restrictive Trade Practices Act
• Reduction in the number of areas reserved for the public sector
• Reduction in rates of both direct and indirect taxes and change over to market
determined exchange rates.
• Launching of the privatization program
• Opening of many new sectors to FDI.
• Raising FDI equity caps in sectors already opened and procedural simplification.

Today, the FDI policy in India is widely reckoned to be among the most liberal in the
emerging economies and FDI up to 100% is allowed under the automatic route in most
sectors and activities. FDI under the automatic route does not require approval of the
Government and merely involves intimating to the Reserve Bank of India with 30 days of
inward remittances and filing of documents with in 30 days of issue of shares top foreign
investors.

Along with the policies on inward FDI, the policies on outward investment are also
liberalized. Various steps taken for liberalization of outward FDI are:
• Controls on inward FDI and external commercial borrowing by domestic firms
have been eased.
• The emergence of world-class Indian corporate is being encouraged by the lifting
of controls on outward investment.
• Indian corporate can now invest up to 200% of their net worth overseas under the
automatic route.
There has been a trend of increased overseas investments by Indian corporate.

Industrial Licensing has already been liberalized in India since 1991. Reforms taken in
Industrial licensing are:
• Now entrepreneurs are free to set up industries.
• Opening of Companies has been made simple.
• With the introduction of IT in operations of registrars of Companies, it has been
made possible to open a company even in a day. Registrations with tax
authorities, local authorities and other are also were made IT friendly, thus
resulting in lesser time taken.
The Indian customs tariff rates have been brought down.
Bullish Indian Economy
Table 2

Real Growth Rates in GDP (at Factor Cost)

Percentage change over the previous year
Item 1980-81 1992-93 1999-
1993- 1994- 1995- 1996- 1997- 1998- 2000-
to to 2000
94 95 96 97 98 99 (P) 01 (A)
1991-92 2000-01 (Q)
Total GDP 5.4 6.4 5.9 7.3 7.3 7.8 4.8 6.6 6.4 6.0

(Source: www.indiastat.com )

The last decade has seen an annual average growth rate of around 6% per annum in
India’s GDP. From the figures of H1 of 2005-06, GDP (at factor cost at constant
prices) grew by 8.1% as against 7.1% in the corresponding period last year.
Manufacturing GDP grew by 10.2% in H1 of 2005-06 as compared to 8.8% during the
corresponding period last year. More importantly, India has been maintaining GDP
growth of 6-8% year after year.

FDI Components Revision

FDI reporting in India was capturing only the capital component provided by the
investor. However, FDI, as per international practices of reporting, includes equity
capital, reinvested earning (refer to Appendix - 1) and intra company loans. Government
had undertaken an exercise for adoption of the international practice in compilation of
FDI statistics. Based on the information so far collected, the RBI has revised the FDI
inflow figures since 2001-02.

Industrial Performance
Table 3

Year IIP
1992-93 2.3
1993-94 6.0
1994-95 8.9
1995-96 13.1
1996-97 6.1
1997-98 6.6
1998-99 3.8
1999-00 8.1
2001-02 5.7
2002-03 7.0
2003-04 8.4
2004-05 8.8
Source: www.indiastat.com

The year 2004-05 witnessed further industrial recovery. The industrial growth, measured
in terms of Index of Industrial Production (IIP), increased from 2.7% in 2001-02 to
5.7% in 2002-03, 7.0% in 2003-04 and further to 8.4% in 2004-05. The robust industrial
growth continues and the IIP has grown by 8.8% during the period April-November2005
over the corresponding period last year.

Prospects
The A.T. Kearney in ‘The FDI Confidence Index 2005’ [1] has ranked India as the 2nd
most attractive investment destination. ‘World Investment Report, 2005’ [5] has ranked
India as 2nd most attractive investment destination among Transnational Corporations.

The World Investment Community particularly Foreign Institutional Investors have

responded strongly to share the Indian growth story. The Government of India has started
very large national program for infrastructure modernization and creation. This has also
resulted in unprecedented business prospects. Higher disposal income of ever increasing
young population is also offering strong demand for consumer goods, which in turn fuels
the manufacturing and services sectors. India has become a place to be.

3. Data and Analysis:

3.1 FDI in India

Table 4

India’s share in FDI inflows among developing countries reached a peak of 1.9 per cent
in 1997. It declined sharply to 1 per cent in 1999 and 2000 but has recovered sharply to
1.7 per cent in 2001(Table 4). India’s performance on the FDI front has shown a
significant improvement during 2001-02. FDI inflows grew by 65 per cent to US$ 3.91
billion during 2001-02 thus exceeding the previous peak of US $ 3.56 billion in 1997-98
(as per BOP 2 accounts of RBI). This growth of 65 per cent is particularly encouraging at
a time when global FDI inflows have declined by over 40 per cent. The upward trend in
FDI inflows has been sustained during the current financial year with FDI inflows during

2
See Abbreviations in the Appendix-III.
April-June 2002 about doubles that during the corresponding period of 2001 (as per
DIPP 3 data).
Engineering, Services, Electronics and Electrical equipment and Computers were the
main sectors receiving FDI in 2000-01 (Table 5). Domestic appliances, finance, food &
diary products which were important sectors attracting FDI in the early nineties, have
now seen a downtrend in the latter half of the nineties.

Table 5

Services and computer have seen an increasing trend in the latter half of the nineties. The
inflow of FDI into computers increased from 6 per cent in 1999-00 to 16 per cent in
2000-01. On the whole there have been significant changes in the pattern and
composition of FDI inflows with few clear trends over the decade as whole.

Table 6
In 2001, the sectors that account for maximum FDI are fuel (power, oil refineries, gas);
telecom; electronic goods, IT and software; automobiles; and services. The major
investing countries are Mauritius (mainly routed from developed countries), USA, Japan,
UK, Germany, the Netherlands and South Korea. The States that account for maximum
FDI are Maharashtra, Delhi, Tamil Nadu, Karnataka and Gujarat. During the first half of
2002 the FDI inflows went mainly into transportation industry, services, telecom and
electronics/IT/software.

Some of the factors that explain the recent spurt in FDI inflows into India are:
• Progressive liberalization of FDI policy has strengthened investor confidence –
opening up of new sectors (integrated townships, defense industry, tea
plantations, etc.); removal of FDI caps in most sectors, including advertising,
airports, private sector oil refining, drugs and pharmaceuticals, etc.; and greater
degree of automaticity for investment.
• Liberalization of foreign exchange regulations by way of simplification of
procedures for making inward and outward remittances.
• Sectoral reforms, especially in sectors such as telecom, information technology
and automobiles have made them attractive destination for FDI.
• Policy to allow foreign companies to set up wholly owned subsidiaries in India
has enabled foreign companies to convert their joint ventures into wholly owned
subsidiaries.
• Public sector disinvestment has finally emerged as an important means to promote
FDI.
• Government has set up an inter-ministerial Committee to examine the extant
procedures for investment approvals and implementation of projects, and suggest
measures to simplify and expedite the process for both public and private
investment.
• The Foreign Investment Implementation Authority (FIIA) has been activated and
now meets at regular intervals to review and resolve investment-related problems.

3.2 Problems of FDI in India

In this section we highlight some of the weakness and constraints on achieving higher
FDI inflows into India. Not all are relevant to every originating country or every
destination sector. Some factors are more relevant for first time investors with no
previous experience of investment in India.

Though economic reforms welcoming foreign capital were introduced in the nineties it
does not seem so far to be really evident in our overall attitude. There is a perception
abroad that foreign investors are still looked at with some suspicion. There is also a view
that some unhappy episodes in the past have a multiplier effect by adversely affecting
the business environment in India. Besides the “Made in India” label is not conceived by
the world as synonymous with quality.

When a foreign investor considers making any new investment decision, it goes through
four stages in the decision making process and action cycle, namely,
 a) Screening,
b) Planning,
c) Implementing and
d) Operating and expanding.

The biggest barrier for India is at the first, screening stage itself in the action cycle. This
is primarily because we do not get across effectively to the decision-making “board
room” levels of corporate entities where a final decision is taken. Our promotional effort
is quite often of a general nature and not corporate specific. India is, moreover, a multi-
cultural society and a large number of multinational companies (MNC) do not understand
the diversity and the multi-plural nature of the society and the different stakeholders in
this country. Though in several cases, the foreign investor is discouraged even before he
seriously considers a project, 220 of the Fortune 500 companies have some presence in
India and several surveys (A T Kearney) [1] show India as the most promising and
profitable destination.

On the other hand China is viewed as ‘more business oriented,’ its decision-making is
faster and has more FDI friendly policies. Despite a very similar historical mistrust of
foreigners and foreign investment arising from colonial experience, modern (post 1980
China) differs fundamentally from India. Its official attitude to FDI, reflected from the
highest level of government (PM, President) to the lowest level of government
bureaucracy (provinces) is one of consciously enticing FDI with a warm welcome.

3.3 Comparison of India’s FDI with China

Figure 1

China remains in a class of its own among the largest other non-member economies, as a
destination for FDI. China is among the world’s foremost recipients of direct investment.
According to Chinese official pronouncements the sectoral balance of inward FDI, which
was previously tilted toward manufacturing investment, is beginning to swing toward the
service sectors.
China’s increasingly active role as an outward investor – in the 1980s and 1990s mainly
in natural resources, but now increasingly also in high-tech sectors – is not yet fully
reflected in internationally comparable FDI statistics. There is evidence of widespread
evasion of the burdensome approval and registration procedures by Chinese enterprises,
particularly in the non-state-owned sector, using funds parked abroad in subsidiaries and
special purpose entities in low-tax jurisdictions as well as retained foreign earnings. Very
large projected outflows of capital to the developing world, particularly Africa, are
raising concern in some countries over competition for scarce energy resources and over
possible undermining of internationally-recognized standards of corporate conduct,
including in weak governance zones.

FDI into India apparently continues to grow. National sources estimate inward direct
investment in 2005 at an all-time high USD 6.5 billion. This is likely to be an
underestimate, as recent sectoral liberalization measures have ensured that an increasing
proportion of inward FDI now arrives unscreened via the “automatic route”, requiring
only notification to the central bank – an obligation that is not enforced and therefore
widely ignored. Although manufacturing is generally open to foreign investment and
there has recently been substantial liberalization of the FDI regime in some sectors, such
as telecommunications, others, notably the retail industry, remain closed to foreign
investors.

Direct investment in India is in public debate often linked with offshore outsourcing,
especially in the information technology sector (though it should be noted that this is also
an area of major domestic as well as foreign investment), but the real picture is more
mixed. If borne out by the facts this could push up inward FDI further in the coming
years and lead to an even stronger concentration in the service sectors.

Also, while international direct investment in India is only recorded at about one-tenth of
that in China, it should be noted that India receives far more equity investment than
China in its more developed capital markets. India’s outward FDI is starting to become
significant, though this may not yet be apparent from official statistics, possibly because
of some under-recording. Much Indian outward FDI in 2005 was in the form of cross-
border mergers and acquisitions, mainly in telecommunications, energy and
pharmaceuticals, though these remained small by international standards. Larger M&A
transactions on the part of Indian multinationals are likely to follow in future years. Some
large Indian services companies specializing in offshore outsourcing have in recent years
also been active in investing in a large number of developed countries.

3.4 Inter-Country FDI Comparisons

In 2000, China with 17 per cent had the highest share of developing country FDI
followed by Brazil with 13.9 per cent of developing country FDI. The gap between the
shares of these two countries narrowed during the nineties with Brazil gradually catching
up with China, but has again widened in 2001. Though the share of Argentina, South
Korea, Singapore, Malaysia and Taiwan is much lower than that of China and Brazil, it
was, till 2000 two to five times that of India’s measured inflow. The most remarkable
transformation has occurred in South Korea, whose share in developing country FDI
inflows was identical to that of India in 1993, and which fell below that of India in 1994
and 1995, but was four times that of India’s in 2000 (Table 7). Because of the Asian
crisis in 1997-98 and the effect of sanctions on investor’s sentiment, India’s share of
developing country FDI fell at the end of the nineties. There has however been a
significant improvement during 2001.

Table 7

Table 8

India’s measured FDI as a percentage of total Gross Domestic Product (GDP) is quite
low in comparison to other competing countries (Table 8). India the 12 largest country in
th

the world in terms of GDP at current exchange rates is able to attract FDI equal only to
0.9 per cent of its GDP in 2001. In contrast FDI inflows into Vietnam were 6.8 per cent
of its GDP in 2000. Even Malaysia, which has recently developed an image of being
somewhat against the globalization paradigm, receives FDI equal to 3.9 per cent of its
GDP. Similarly China attracts FDI equal to 3.8 per cent of its GDP. Thailand, which has
a relatively low FDI-GDP ratio among the major developing country recipients of FDI,
had a ratio four times that of India in 2000. This gap probably narrowed in 2001 and
could narrow further in 2002 if the recent acceleration in growth of FDI into India can be
sustained.

Figure 2. FDI flows to and from OECD

As shown above, direct investment into OECD (Organization of Economic Cooperation &
Development) countries picked up in 2005 and reached an estimated 622 billion US
dollars (USD). This represents a 27 per cent increase over 2004 and is the highest level of
inflows since the previous investment boom petered out in 2001.

Developments in selected countries

In the United Sates the net FDI inflows were USD 110 billion in 2005. This represents an
18 per cent decrease from 2004 (USD 133 billion) and is way below the levels of
investment that were recorded around 2000, but is still relatively high in a longer
perspective (Table 9 and Figure 3). US inflows increasingly reflect inter-company loans
and reinvested earnings, whereas equity capital inflows actually decreased in 2005.
Total FDI outflows from Japan in 2005 were USD 46 billion, up from USD 31 billion in
2004. This is a spectacular increase. Even as the Japanese economy is traditionally one of
the world’s most important outward investors, the 2005 figure is the highest on record
since 1990. However, most of the rise does not derive from “new projects” (equity capital
investment, in statistical parlance), but from reinvested earnings in existing projects. FDI
in 2005, at USD 3 billion, was low by past standards and in comparison with other large
economies.

Figure 3, Inward FDI in selected countries

German FDI inflows and outflows recovered briskly in 2005 from levels in previous
years that were unusually low. Outflows totaled USD 46 billion, mostly in the form of
equity capital. Inward direct investment in 2005, at USD 33 billion, was high compared
with the recent past, but less impressive in a longer historical perspective. The figures
were influenced by a few very large transactions, especially in the financial and
pharmaceutical sectors.

With inflows of USD 165 billion, the United Kingdom was the world’s largest recipient
of inward FDI in 2005. This is the largest inward direct investment flow ever recorded in
the United Kingdom, and it represents a tripling of the already internationally high
inflows in 2004. Outward FDI likewise grew, from USD 95 billion in 2004 to USD 101
billion in 2005. In consequence, the United Kingdom, traditionally a net exporter of
direct investment, in 2005 recorded large net inflows for the first time since 1990.
France continued to attract large direct investment inflows. FDI into France more than
doubled from USD 31 billion in 2004 to USD 64 billion in 2005. As in previous years,
one of the factors underpinning foreign direct investment in France was the acquisition
by foreign companies of corporate and residential real estate. Moreover, France was the
world’s largest outward direct investor in 2005. Total outflows for the year as a whole
were estimated at close to USD 116 billion. This is mostly attributed to a few very large
foreign corporate takeovers by companies domiciled in France.

FDI inflows to Canada bounced back in 2005 from historically low levels in the previous
years. Total inward FDI, at USD 34 billion, reached its second highest level ever, which
has so far only been exceeded in the boom year 2000. One of the main factors at play
seems to have been that the investment by large US-based enterprises in Canada has
regained momentum. Several large corporate takeovers took place across the US-
Canadian border in the course of 2005.

Among the relatively new OECD member countries, the Czech Republic was very
successful in attracting FDI in 2005. Total inflows reached USD 11 billion, which is the
highest level ever recorded in this country and well above what small and medium-sized
economies normally attract.

FDI inflows into Mexico remained strong in 2005, remaining close to the level of around
USD 18 billion around which they have fluctuated in recent years (at just above USD 18
billion in 2005). At the same time, Mexico’s role as an outward investor has also
gathered pace, with outward FDI reaching an all-time-high of USD 6 billion in 2005.

Among the non-member adherents to OECD’s investment instruments, Brazil confirmed

its position as the world’s foremost destination for direct investment to developing and
emerging economies outside Asia (Table 9). Inflows of USD 15 billion to this country in
2005 were not vast by historical standards, but easily the largest in South America.
Investment was down a bit from the year before, but this reflects the one-off effect of a
large investment in the brewery sector in 2004.

Inward FDI in Argentina was close to USD 5 billion. This figure is low compared with
the inflows of around USD 10 billion per year that were recorded prior to the Argentine
financial crisis (and USD 23 billion in the peak year), but it is nevertheless a rebound
from the depressed levels of 2001 to 2003.

Direct investment into Chile, at USD 7 billion, was almost unchanged in 2005. With an
already large foreign corporate presence in the country, much of the inflows represent
reinvested earnings. In addition to mining, some of the main foreign-invested sectors in
Chile are related to infrastructure, especially transport, communication and electricity.

Direct investment in Israel jumped in 2005 to reach USD 6 billion, or more than three
times the levels recorded in 2004. In the main this reflects foreign participation in a
number of large-scale privatizations, including some in the financial sector. Israel is also
one of the most active outward investors among the smaller non-member economies,
including in technology-intensive sectors. For the last three years, total annual outflows
have exceeded USD 2 billion and the indications are that levels in 2006 will be even
higher.
Inward investment in Romania in 2005 remained high at around USD 6.5 billion for the
second year in a row. Inflows continue to be influenced by an ongoing process of
privatization. However, the high 2005 figure also includes considerable greenfield
investment and extensions of previous investment projects, particularly in the automotive
industry and the service sectors.

Table 9. FDI flows in selected non-member economies: 2001-05

Russian inward investment, estimated at USD 14.5 billion in 2005, remains at a high
level following a sharp pick-up in 2004. However, the high figures appear to include non-
trivial amounts of concurrent in- and outflows in the context of corporate restructuring.
The main sectors of investment were manufacturing and the energy sector, which
accounted for 45% and 32% respectively of total inflows.8
A final observation from Table 9 regards South Africa, which is active in direct
investment by African standards but usually not comparable with the larger OECD
economies. South Africa experienced massive FDI inflows in 2005 of close to USD 6.5
billion.
4. Role Government can play in FDI

4.1 Role of SEZs

China’s success in attracting export related FDI and its success in labor intensive exports
contrasts sharply with that of India. Many of the policy reforms that are politically
difficult in India were equally difficult in China. China however was able to introduce
these reforms on an experimental basis in their Special Export Zones and then use the
demonstrated success of these reforms to make them deeper and wider.
4.1.1 State SEZ Law(s)

States consider enactment of a Special Economic Zone (SEZ) law that would apply to all
SEZs in the State. The Maharashtra SEZ law can be used as a basis or a possible model
for this purpose. The law should cover State level industrial, labor, environmental,
infrastructure and administrative issues, with a view to simplifying and promoting
investment and production in the SEZs.

4.1.2 SEZ Infrastructure Policy

Though it will take a decade or more to improve infrastructure services across the
country, infrastructure availability and quality can be brought to global standards in the
Special Economic Zones (SEZs) within a couple of years. The effect of a weak highway
and railway system can be minimized by locating SEZs in the coastal regions as was
done by China and many other countries in South East Asia. Among the measures needed
for accelerated development of infrastructure in and exports from SEZs are:
a) Power generation and distribution for the SEZ needs to be isolated from the
problem ridden SEBs to the extent possible. As size limitations make electricity
generation for the SEZ alone, non-optimal, the private electricity generator for the
SEZ should be allowed to sell excess power to parties outside the SEZ.
b) There should be free entry and exit of telecom service providers into the SEZ
without any service, subject only to the condition that the spectrum would be
auctioned if and only if it ceases to be a “free good” within the SEZ.
Interconnectivity with other countries (international long distance) should be free
and unrestricted (subject only to the condition that this cannot be used as a
conduit for provision of unregulated telecom services into the Domestic Tariff
Area (DTA).
c) Private parties would also be free to set up a private airport or port to service the
SEZs (FDI is already automatic 100 per cent). If an unused harbour is not
available nearby, the requisite number of berths in the closest port should be made
available to private parties for the purpose of servicing the SEZ. These parties or
another developer should be given the authority to set up toll highway connecting
the port to the SEZ.
d) A law should be passed by the State governments under which 100 per cent
privately owned townships could be set up and run by private developers as
private municipalities. Private SEZs should be designated as private
 municipalities under this law and road, electricity transmission and other linkages
provided by State/Central government

4.1.3 Marketing of SEZ

A special marketing effort is needed for export oriented FDI. For instance, Taiwanese
and other exporters in East and South East Asia can be targeted for this purpose. Our
missions in OECD and other FDI source countries should be fully briefed on the
comparative advantages of SEZs in India and distribute the required literature.

4.2 Role of Dis-investment

Across the world, dis-investment has acted as a magnet for FDI. Though foreign
companies are allowed to bid for government strategic share sale, there is some
apprehension about doing so. If a clear signal is given that foreign companies are not only
allowed but also encouraged to bid in dis-investment auctions, this could attract a
significant amount of FDI. This in turn means that additional outside capital and
investment will flow into industry from outside the system rather than existing private
investment moving from one industry or sector to another. FDI flow into privatization is
more likely to be complimentary, strategic purchase by domestic investors may have
some element of substitution. As the strategic sale route has now crystallized into a
transparent, time-bound, non-discretionary process, FDI investors should have
confidence in the mechanism.

4.3 Role of Tax Rules and Rates

Many countries, such as Malaysia, Thailand and China have had at various times, tax
rates that favor foreign direct investment over domestic direct investment. Our tax laws
treat all companies incorporated in India equally, irrespective of the proportion of foreign
equity holding (national treatment). Tax rates have however often been higher in the case
of Indian branches of foreign incorporated companies (eg. foreign airlines and banks
operating in India through such branches). There is also a clear case for making tax laws
and rules as simple and internationally comparable for FDI. In contrast the benefit-cost
ratio from providing favorable tax treatment to foreign direct investors vis-à-vis domestic
investors is less clear. Lower rates for FDI can however be considered in selected high
technology sectors (that will benefit the country), as they can act as a signaling device to
attract attention to opportunities that may have been missed otherwise.
Both domestic and foreign investment would also be encouraged by a reduction in the
corporate tax rate (35 per cent) to the highest marginal rate on personal income (30 per
cent).

5. Conclusion:

In this term project we understood the dynamics of FDI. Importance and Implications of
FDI goes a long way in determining the growth of an economy. The role of FDI has been
of great importance for the country, moreover in the recent past. Through the study done
in this term project we developed understanding to interpret FDI trends.

We would like to thank our supervisor for letting us choose this topic and for his
constructive guidance. Also we are thankful to the authors of the cited references which
made our study easier and making our term-project a successful study.

6. References

1. FDI confidence index, A T Kearney, Global Business Policy Council,

2005 Vol. 8.
2. Report of the steering group on foreign direct investment, Planning
Commission, Govt. of India, August 2002.
3. Trends and Recent Developments in Foreign Direct Investment Part I,
Chapter 1, INTERNATIONAL INVESTMENT PERSPECTIVES: 2006
EDITION.
4. Report of the committee on compilation of FDI in India, October 2002.
5. World Investment Reports, 2001-06.
 Appendix – I

Foreign Direct Investment statistics: Main Concepts

Direct investment is a category of cross-border investment made by a resident entity in

one economy (the “direct investor”) with the objective of establishing a “lasting interest”
in an enterprise resident in an economy.

The lasting interest is evidenced when the direct investor owns 10 per cent of the voting
power of the direct investment enterprise.

A foreign direct investor is an entity that has a direct investment enterprise operating in a
country other than the economy of residence of the foreign direct investor. A direct
investor could be: an individual (or a group of related individuals; an incorporated or
unincorporated enterprise; public or private enterprise (or a group of related enterprises);
a government; estates, or trusts or other organizations that own enterprises.

A direct investment enterprise is as an incorporated or unincorporated enterprise

(including a branch) in which a non-resident investor owns 10 per cent or more of the
voting power of an incorporated enterprise or the equivalent of an unincorporated
enterprise.

Direct investment is composed of: equity capital, reinvested earning and other capital.

Equity capital comprises:

i) equity in branches;
ii) all shares in subsidiaries and associates (except non-participating, preferred
shares that are treated as debt securities and included under direct investment,
other capital); and
iii) iii) other capital contributions.

Reinvested earnings of a direct investment enterprise reflect earnings on equity accruing

to direct investors less distributed earnings; they are income to the direct investor.
However, reinvested earnings are not actually distributed to the direct investor but rather
increase direct investor’s investment in its affiliate.

Other capital (or inter-company debt transactions) borrowing and lending of funds
between direct investors and subsidiaries, associates and branches.
 Appendix – II

International Direct Investment Statistics

 Appendix – III

Acronyms Used in Text

ATK AT Kearney
BOP Balance of Payments
Crore 10 million
DC Developing Countries
DIPP Department of Industrial Policy & Promotion
DTA Domestic Tariff Area
FDI Foreign Direct Investment
FIIA Foreign Investment Implementation Authority
FII Foreign Institutional Investors
GDP Gross Domestic Product
GOI Government of India
IMF International Monetary Fund
IT Information Technology
M&A Mergers & Acquisitions
MNC Multinational Corporations
MNEs Multinational Enterprises
OECD Organization of Economic Cooperation & Development
PM Prime Minister
RBI Reserve Bank of India
SEBI Securities & Exchange Board of India
SEZ Special Economic Zone
ST Sales Tax
TNCs Transnational Corporations
TRAI Telecom Regulatory Authority of India
UN United Nations
VCCs Venture Capital Companies