MEPP Lectures 19-20-21 Foreign Direct Investment in India - Policies and Prospects

Presented by Prof. Tarun Das
IILM, New Delhi.

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

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

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  Foreign institutional investment is also volatile and can be withdrawn in the case of economic, financial, foreign exchange crisis.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

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

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

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1.6 Advantages of FDI over other capital flows

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

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1.7 Advantages of FDI
• Consumer Benefits - Price, quality and variety - FDI players are better equipped to invest in difficult and remote markets and develop products and services better adapted to consumers - More and more countries can hope to develop comparative advantages in new sectors. As FDI currently is more market seeking than efficiency seeking , offereing opportunities to any country willing to open its market or integrate with its neighbours.
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2.1 Types of FDI
Market seeking- to take advantage of huge domestic markets in host countries Resource exploitingdriven by availability of mineral and other resources Export enhancing- to shift production base to take advantage of low wage rates but technical manpower and availability of resources Efficiency enhancing through technology transfer and infrastructure development
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2.1 Host Country Policies
FDI inflows are determined by a complex set of economic,  political and social factors. Foreign investors look beyond the array of fiscal  incentives offered by the host country. FDI is attracted by sound macro-economic policies, stable  economic systems, sustained high growth,liberalisation of trade, investment and industry, particularly by liberal FDI regimes. Full currency convertibility, free repatriation, less  performance criteria, tax holidays and other incentives, abolition of screening requirements, relaxation of sectoral limits on foreign equity.

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2.2 Other Factors Attracting FDI  Domestic market potentials
 Low wage rates  Low transactions costs  High rates of return  Labour mobility  Matured capital market  Modern financial system  Efficient infrastructure  Established legal and institutional set-up  Transparent rules and regulations  Administrative speed and efficiency  Special economic zones, EPZs etc.
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       

2.3 Other Factors Attracting FDI National treatment to foreign investors

Most favored nation treatment (MFN) Free transfer of profits and dividends International standards for laws International arbitration in the case of disputes Protection of intellectual property rights (IPR) Right to employ management of its choice The formation of regional trading blocks such as NAFTA, ASEAN, APEC, SAARC etc. had also an important impact on the FDI pattern  In future, countries outside the regional blocks might have disadvantages in attracting FDI.

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

2.4 Foreign Investors Dislike Most  Any screening of investment except for national

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

2.5 Role of Fiscal Incentives Fiscal and other incentives remain an

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

3.1 Home Country Policies

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

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

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

4.5 Incentives for FDI

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4.6 Sectoral Distribution of FDI (%) at end FDI approvals during Sectors FDI outstanding
March 1990 Aug 1991- Aug 2003

1. Plantation & agriculture
2. Mining

9.5
0.3

1.4
0.1

3. Power 4. Manufacturing • Petroleum
• • • • • • • •

0.1 84.9 0.1
6.0 3.4 10.5 13.1 5.2 10.9 28.4 7.5

16.5 50.4 10.5
3.3 1.2 5.6 2.6 5.4 9.9 8.4 3.5

Food processing Textiles Transport equipment Machinery & machine tools Metals and its products Electrical goods Chemicals & allied products Others

5. Services
(a) Financial services & real estate (b) Telecommunications (c) Transport (d) Hotels and retail trade (e) Consultancy services & others Total

5.2
na na na na na 100
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32.4
6.4 19.8 1.9 2.7 1.6 100
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4.7 Share of Home Countries in FDI inflows to India (%)
Host country 1981 -1990 1991 -2003 Approvals Approvals Mauritius 0.0 14.5 United State s 25.5 24.2 Japan 8.4 4.9 United Kingdom 7.1 9.7 Germany 18.0 3.9 Netherlands 1.5 3.8 Korea, Rep.of 1.2 4.1 France 3.5 2.7 Singapore 0.8 2.3 Italy 4.7 2.0 Australia 0.5 2.8 Malaysia 0.1 2.5 NRIs 9.7 3.8 Others 13.2 18.8 Total 100.0 100.0 FDI Policies - Tarun Das 1991 -2003 Actual Flows 37.0 17.5 6.8 5.4 5.2 4.6 3.3 2.8 2.4 2.2 1.0 0.8 10.0 1.0 100.0

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4.8 Share of Indian States in FDI in 1991States share 1. Maharashtra 2. Delhi 3. Tamil Nadu 4. Karnataka 5. Gujarat 6. Andhra Pradesh 7. Madhya Pradesh 8. West Bengal 9. Orissa 10. Uttar Pradesh 11. Rajasthan 2003 Percentage 17.3 12.0 8.6 8.3 6.5 4.6 3.2 3.2 2.9 1.7 1.0
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4.9 FDI Inflows as % of World FDI
Country 2000 India China Hong Kong Korea, Rep. Malaysia Philippines Singapore 0.4 Thailand 1990 0.1 1.7 0.9 0.4 1.1 0.3 2.7 1.2 - Tarun Das0.6 FDI Policies 1995 0.7 10.9 2.7 0.5 1.3 0.4 2.2 0.4
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0.2 3.2 5.1 0.8 0.4 0.1

4.10-A FDI Inflows as % of GDI
Country 1984-1989 India 0.1 China 1.8 Hong Kong 12.2 Indonesia 1.6 Korea, Rep. 1.4 Malaysia 8.8 Philippines 5.1 Singapore 28.3 Taiwan 3.3 Thailand 4.4 1990 0.1 2.6 8.5 2.8 0.8 23.8 5.2 47.1 3.8 7.1 2004 3.4 8.2 92.1 1.9 3.8 23.4 3.3 62.7 3.1 2.5
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4.10-B FDI Outflows as % of GDI
Country India China Hong Kong Indonesia Korea, Rep. Malaysia Philippines Singapore Taiwan Thailand 2002 1.0 0.5 47.6 0.5 1.6 8.6 0.4 18.0 9.8 0.4 2003 0.7 15.9 1.9 6.0 1.5 16.5 11.4 1.4 2004 1.4 0.2 107.6 0.2 2.4 8.5 2.9 41.6 11.6 0.9
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FDI Policies - Tarun Das

4.11-A FDI Inward Stock as % of GDP Country 1980 India 0.7 China 3 Hong Kong 487 Indonesia 14 Korea, Rep. 2 Malaysia 21 Philippines 4 Singapore 53 Taiwan 6 Thailand 3 1990 0.6 7 218 34 2 24 7 77 6 10
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2004 5.9 14.9 277.6 4.4 8.1 39.3 14.9 150.2 12.8 29.7
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4.11-B FDI Outward Stock as % of GDP Country 1990 2000 India 0.0 0.4 China 1.3 2.6 Hong Kong 15.9 234.9 Indonesia 0.1 4.6 Korea, Rep. 0.9 5.8 Malaysia 6.1 23.6 Philippines 0.3 2.1 Singapore 21.3 62.1 Taiwan 19.0 21.5 Thailand 0.5 1.8
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2004 1.0 2.4 246.5 0 5.8 11.7 1.9 94.5 29.9 2.1
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5.1 Impact of FDI on Indian Economy - FDI inflows are more of tariff jumping and market seeking rather than efficiency seeking or export driven - 40 percent of FDI inflows went into acquisition of gross fixed assets such as plant and machienery. Increase in Exports - Export as a proportion of sales among a sample of 450-odd (FDI) controlled firms in India was just 11.6 percent.
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5.2 Advantages of FDI
• Infrastructure and technology transfer - More through merger and acquisition (M&A) route to increase its share in the Indian market rather than greenfield investment to establsh new industrial and service units. - A study by Nagesh Kumar of RIS states that 40 percent of FDI in India came through M&A route to take over Indian companies, increase control in existing subsidiaries by issuing shares at low cost or buy back shares and de-list from stock exchanges. • Less or limited ripple effect of the technology transfer that the FDI is supposed to bring across a large economy.

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

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

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

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

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6.6 Water supply and sanitation
• Water is a merit good with many positive health and environmental spillovers. • Under UN-Millennium Development Goals, Government is committed to provide universal access to the minimum daily requirement of safe water, but this may require subsidies. • Water distribution pipes are a monopoly network of the local government and many water and sanitation systems are buried. • These factors complicate the transfer of water distribution to private sector.
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6.7 Water supply and sanitation
• Scope of unbundling the water sector is not clear with limited potential for competition amongst bulk water service providers because the main water sources in municipalities are location specific and limited in number. • Operational costs of providing the raw resource are relatively low compared with sunk capital costs in pipes, dams and treatment stations. • Efficiency gains in water supply come from increased trade amongst water users and reduced distribution losses rather than competition amongst suppliers. • In the case of water supply, organizational restructuring, corporatization and unbundling of risks should precede full private participation.

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6.8 Water supply and sanitation
• Resource management functions such as catchment planning should be separated from commercial functions of service delivery. Government should be responsible for the former while private operators can compete for the latter. • Govt. should own water pipe and sewerage network while private operators lease longterm rights to use pipelines and collect revenues from service delivery. • Private operators have incentives to reduce water losses and costs, expand consumer connections and to improve services to the consumers.
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6.9 Water supply and sanitation
• It is necessary to develop private property rights and commercial law, to establish clear accounting and environmental standards, transparent legal and regulatory system, and introduce specific BOT legislation for private investment in utilities. • Tariff reform is equally fundamental to improve utility efficiency and delivery. • While private operators should bear construction, commercial and operation costs and risks, government should bear the sovereign risks.- Tarun Das FDI Policies 41

• As the first generation reforms take root and second generation reforms unfold, India is emerging as a favourite destination for foreign investment, and a land of immense opportunity for all. • India should maintain its open door policy in goods and services production, investment and trade. • Carried to their logical ends, reforms would make India as one of the most dynamic and fastest growing economies of the by 2010. • India is an economic miracle waiting to happen. FDI Policies - Tarun Das 42

7. Concluding Remarks

1. What are the special advantages of Foreign Direct Investment (FDI) over other forms of external capital flows? 2. (a) Discuss broad types of FDI. (b) Which one is the dominant type of FDI flows to India and what are main reasons for that? (c) Indicate the major sources of FDI inflows to India. (d) Which are the major sectors attracting FDI to India? 3. (a) Discuss the general host country and home country policies attracting foreign investment. (b) discuss relative merits and demerits of fiscal incentives for FDI 43 attracting FDI. Policies - Tarun Das

8.1 Review Questions

8.1 Review Questions
4. (a) Discuss policies, strategy and regulatory regime for foreign investment of India. (b) What has been their impact on he Indian economy? 5. (a) Discuss the strengths and weaknesses of the Indian economy for attracting FDI. (b) Discuss special problems for attracting FDI in agriculture and plantation, minerals including oil and gas, power generation, water supply and sanitation.
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Thank you Have a Good Day

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