A PROJECT REPORT ON STUDY OF IMPACT AND INFLUENCE OF FOREIGN INVESTMENT IN INDIA BY : SOHAM A PARINGE ROLL NO: 9 EXECUTIVE S UMMARY Foreign Direct Investment (FDI) flows are usually preferred over other forms of external finance because they are non-debt creating, non-volatile and their returns dep end on the performanc e of the pro jec ts financed by the inves tor s. FDI al so 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. 1
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A PROJECT REPORT
ON
STUDY OF IMPACT AND INFLUENCE OF FOREIGN
INVESTMENT IN INDIA
BY:
SOHAM A PARINGE
ROLL NO: 9
EXECUTIVE SUMMARY
Foreign Direct Investment (FDI) flows are usually preferred over other forms
of external finance because they 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.
1
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Over the years, FDI inflow in the country is increasing. However, India has
tremendous potential for absorbing greater flow of FDI in the coming years. Serious
efforts are being made to attract greater inflow of FDI in the country by taking
several actions both on policy and implementation front. An essential requirement of
the foreign investing community in making their investment decision is availability of
timely and reliable information about the policies and procedures governing FDI in
India.
Foreign direct investment (FDI) in India has played an important role in the
development of the Indian economy. FDI in India has - in a lot of ways - enabled
India to achieve a certain degree of financial stability, growth and development. This
money has allowed India to focus on the areas that may have needed economic
Attention, and address the various problems that continue to challenge the country.
India has continually sought to attract FDI from the world’s major investors. In 1998
and 1999, the Indian national government announced a number of reforms designed
to encourage FDI and present a favorable scenario for investors. FDI investments are
permitted through financial collaborations, through private equity or preferential
allotments, by way of capital markets through Euro issues, and in joint ventures.
TABLE OF CONTENTS
CAHPTER 1
1.1 INTRODUCTION……………………………………………………………………
………………………. 1
1.2 RESEARCH
PROBLEM………………………………………………………………………………
………. 3
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1.3 LITERATURE
REVIEW……………………………………………………………………………………….
. 4
1.4 RESEARCH
METHODOLOGY…………………………………………………………………………….
7
1.5
LIMITATIONS…………………………………………………………………………………
……………….. 8
CHAPTER 2
2.1 FOREIGN DIRECT INVESTMENT (FDI)
…………………………………………………………………. 9
2.2 WHAT IS
FDI………………………………………………………………………………………………
……….. 14
2.3 ADVANTAGES OF
FDI…………………………………………………………………………………………. 17
2.4 DISADVANTAGES OF
FDI……………………………………………………………………………………. 19
2.5 IMPACT OF FDI ON HOSTCOUNTRY………………………………………………………………….. 20
The Government of India has recognized the key role of the foreign direct investment
(FDI) and foreign institutional investment (FII) in its process of economic
development, not only as an addition to its own domestic capital but also as an
important source of technology and other global trade practices. In order to attract the
required amount of FDI and FII, it has bought about a number of changes in its
economic policies and has put in its practice a liberal and more transparent FDI and
FII policy with a view to attract more foreign direct institutional investment inflows
into its economy. These changes have heralded the liberalization era of the foreign
investment policy regime into India and have brought about a structural breakthrough
in the volume of FDI and FII inflows in the economy.
Growth of Indian economy is playing hide and seek with the double digit growth
(Gross Domestic Product) mark. The latter is a key index, which the foreign investorscheck before committing large sums of money for investment. Of its own, the Indian
economy will find it difficult to reach this target, except for an occasional burst of
activity; like the one in 2003. To sustain it, outside help is needed and domestic house
is to be placed under strict discipline.
Democracy is a great buzzword, if it translates into order and political stability. Labor
unrest, political opportunism and corporate irregularities are a few issues, which
tarnish democracy and discourage outside investors. But the current government in
both its terms has opened up the economy to welcome foreign investment to keep up
with the strong domestic demand for quality goods and services. This has attracted
unprecedented amount of foreign investment in the last decade, but of the two forms
of foreign investment – foreign portfolio investment (FPI) and foreign direct
investment (FDI), the former has reached our shores much more than the latter.
As FPI essentially interacts with the real economy via the stock market, the effect of
stock market on the country’s economic development will also be examined.
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Research shows that the perceived benefits of foreign portfolio investment have not
been realized in India. It can be seen that the mainstream argument that the entry of
foreign portfolio investors will boost a country's stock market and consequently the
economy, does not seem be working in India.
The influx of FIIs has indeed influenced the secondary market segment of the Indian
stock market. But the supposed linkage effects with the real economy have not
worked in the way the mainstream model predicts. Instead there has been an
increased uncertainty and skepticism about the stock market in this country. On the
other hand, the surge in foreign portfolio investment in the Indian economy has
introduced some serious problems of macroeconomic management for the
policymakers like inflation, currency appreciation etc.
On the other hand FDI is what the government really needs to attract in various
sectors like infrastructure, education etc. it is much more stable than the foreign
institutional investment which comes via the stock market route, and has more
accountability and brings fundamental and tangible benefits to the economy.
The dependence on FPI is pushing many developing countries, including India,
towards a more stock market oriented financial system. This makes it imperative to
evaluate the relative merits and demerits of a stock market based financial system in a
developing country as compared to the Chinese model where conditions are
conducive to foreign investment in the real sector. The global recession in 2008
proved how volatile the money pumped in by the FIIs into the secondary segment of
the financial market is, leading to huge losses for the domestic investors who had to
bear the brunt even though the economy as such was insulated from the adverse
effects of the recession. Whereas the sectors where there was FDI didn’t experiencesuch knee-jerk reactions.
In this context, this report is going to analyze the trends and patterns of foreign direct
investment (FDI) and foreign institutional investment (FII) flows into India during the
post liberalization period.
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RESEARCH PROBLEM
The opening up of the Indian economy served as a great boon for our country as the
foreign investors saw vast opportunities in it and started investing through the various
routes allowed by the government of India. It is important to keep record of all such
inflows to form strict regulatory procedures, search for areas or sectors that needs
more investment etc, which is what this research proposes to do i.e. collect data
regarding inflow of foreign direct investment and foreign institutional investment
from credible sources for a specified timeline and tabulate such data to perform trend
analysis of these investments to understand whether these investments fluctuate
rapidly or move in a fixed pattern and also what provides impetus to these
investments or what are the parameters that trigger a massive pull-out of them. As it
is seen that FII is a volatile investment as compared to FDI the factors affecting the
inflow of both types of investment are explored and their investment annually is
compared on the basis of certain common parameters.
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RESEARCH METHODOLOGY
The research has been carried out by collection of secondary data with the use of
primarily the internet, books on banking and finance, various business magazines,
journals, newspapers. No primary data has been used here like face to face interviews
or telephonic interviews, questionnaires etc.
For FDI The study takes into account a sample of top 10 investing countries e.g.
Mauritius, Singapore, USA etc. and top 10 sectors e.g. service sector, computer
hardware and software, telecommunications etc. which had attracted larger inflow of
FDI from different countries.
For FII Correlation tool has been used to determine whether two ranges of data move
together — that is, how the Sensex, Foreign exchange reserves and exchange rates are
related to the FII which may be positive relation, negative relation or no relation.
For the purpose of comparison between FDI and FII the raw data has been arranged
into a table for better observation and then this numerical data has been incorporated
into bar charts and line charts. These are statistical tools used to read their pattern and
conduct trend analysis.
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LIMITATIONS
Limitations are conditions that restrict the scope of the study period or may affect the
results of the research. It cannot be controlled by the researchers and can even affect
the analysis of research adversely.
One of the limiting factors of my project was that I have taken only three variables for
a time period of about seven to ten years for analysis due to time constraints. Since
the sample size is small so the results can be different from actual facts and may not
give an appropriate judgements.
Also all the data have been collected from secondary sources. Information collectedfirst hand from professionals and scholars through interviews would have given the
report a larger perspective.
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CHAPTER – II
FOREIGN DIRECT INVESTMENT
– AN OVERVIEW
INTRODUCTION
Foreign direct investment (FDI) plays an extraordinary and growing role in global
business. It can provide a firm with new markets and marketing channels, cheaper
production facilities, access to new technology, products, skills and financing. For a host
country or the foreign firm which receives the investment, it can provide a source of new
technologies, capital, processes, products, organizational technologies and management
skills, and as such can provide a strong impetus to economic development.
Foreign direct investment, in its classic definition, is defined as a company from one
country making a physical investment into building a factory in another country. The
direct investment in buildings, machinery and equipment is in contrast with making a
portfolio investment, which is considered an indirect investment. In recent years, given
rapid growth and change in global investment patterns, the definition has been broadened
to include the acquisition of a lasting management interest in a company or enterprise
outside the investing firm’s home country. As such, it may take many forms, such as a
direct acquisition of a foreign firm, construction of a facility, or investment in a joint
venture or strategic alliance with a local firm with attendant input of technology, licensing
of intellectual property, In the past decade, FDI has come to play a major role in the
internationalization of business.
Reacting to changes in technology, growing liberalization of the national regulatory
framework governing investment in enterprises, and changes in capital markets profound
changes have occurred in the size, scope and methods of FDI. New information
technology systems, decline in global communication costs have made management of
foreign investments far easier than in the past. The sea change in trade and investment
policies and the regulatory environment globally in the past decade, including trade policy
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and tariff liberalization, easing of restrictions on foreign investment and acquisition in
many nations, and the deregulation and privatization of many industries, has probably
been the most significant catalyst for FDI’s expanded role.
One of the most striking developments during the last two decades is the spectacular
growth of FDI in the global economic landscape. This unprecedented growth of global
FDI in 1990 around the world make FDI an important and vital component of
development strategy in both developed and developing nations and policies are designed
in order to stimulate inward flows. Infact, FDI provides a win – win situation to the host
and the home countries. Both countries are directly interested in inviting FDI, because
they benefit a lot from such type of investment. The ‘home’ countries want to take the
advantage of the vast markets opened by industrial growth. On the other hand the ‘host’
countries want to acquire technological and managerial skills and supplement domestic
savings and foreign exchange. Moreover, the paucity of all types of resources viz.
financial, capital, entrepreneurship, technological know- how, skills and practices, access
to markets- abroad- in their economic development, developing nations accepted FDI as a
sole visible panacea for all their scarcities. Further, the integration of global financial
markets paves ways to this explosive growth of FDI around the globe.
A SHORT HISTORY
After getting independence in 1947, the government of India envisioned a socialist
approach to developing the countries economy – broadly based on the USSR system.
The government decided to adopt an economic agenda that would follow five year
plans. Each five year plan was focused on certain sectors of the economy that thegovernment felt needed to be developed for the countries progress. The government
followed an interventionist policy and dictated most of the norms of running a
business by favoring certain sectors and ignoring others.
Until 1991, India was primarily a closed economy. The industrial environment in
India was highly regulated and a license system – known as “ licence raj” - was in
place to ensure compliance with the government regulations and directives. Under the
Industries Development and Regulations act (1951) starting and operating any
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industry required approval - in the form of a licence - from the government. Any
change in production capacity or change in the product mix also called for obtaining
government approval. This led to the development of increasingly complex and
opaque procedures for obtaining a licence and led to a burgeoning bureaucracy. The
licence system thus shifted lot of power and perverse incentives in the hands of file
pushing bureaucrats (or “ Babus”). This directly led to increased corruption as the
procedure for obtaining a licence was vaguely defined and left open to individual
interpretations. In addition, there was no monitoring system in place to ensure speedy
disposal of licence applications. Also, the labor markets were highly regulated and the
government did not allow the companies to lay off its workers. This meant that even
in severe downturns the companies kept bleeding but could not rationalize itsworkforce. Eventually these companies - majority of them public sector companies –
would become chronically sick and the government kept subsidizing them at huge
costs to the taxpayer.
One draconian measure was the introduction of the Foreign Exchange Regulation act
(FERA) of 1973 which curtailed foreign investment to 40% in Indian companies. in
1973. Foreign companies also came under the Monopolies and Restrictive Policy
(MRTP), 1969 Act during this period. MRTP (1969) Act restricted companies on the
size of operation and the pricing of products and services. The Reserve Bank of India
geared itself to implement the above act. As a result, many companies that did not
want to increase equity participation of Indians as per section (2) of FERA, 1973
decided to cease their operations in India. As many as 54 companies applied to wind
up their operations by 1977-78 since the implementation of the above Act in 1974 and
9 companies applied to wind up their operations in 1980-81
(Annual Reports, Reserve Bank of India 1977, 1978, 1981).
This had a very adverse impact and companies such as Coca-Cola and IBM exited
the country. The government also adopted a policy of import substitution and the idea
was to help the domestic industry improve in a safe environment until the local
industries could compete internationally. This was implemented by levying extremely
high tariffs or completely banning imported goods. Due to the government’s
protection most of the industries failed to catch up with the technological innovations
taking place around the world. As they were shielded from imports due to extremely
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high import tariffs the industries had no incentive to improve their operations. This
led to a vicious circular logic where the tariffs were not reduced since domestic
companies could not compete and the high tariffs prevented industries from
innovating. Corruption and opaqueness of the system added to the difficulties and the
situation became extremely complex.
THE BOP CRISIS
Gulf war broke out in 1990 and the resulting oil shock was enough to trigger a serious balance of payment (BoP) crisis for India in 1991. The cost of oil imports went up to
10,820 crores from the estimated 6,400 crores. Traditionally, India received lot of
remittances from the expatriates working in the Gulf countries and this source also
dried up as the migrant Indian workers were forced to return home due to the war.
The problem was compounded due to an extremely high inflation of about 16% and a
fiscal deficit of about 8.5%. The situation was so severe that India had foreign
reserves of only around $1 Billion - barely enough to cover two weeks of its payment
obligations. India’s credit rating was downgraded as its debt servicing capability was
critically impaired and the government had to pledge its gold reserves to soothe
creditors. Ostensibly, the trigger for the BoP crisis was the oil shock but the deeper
issue was that the government’s heavy hand in trying to regulate businesses and to
move the country towards economic progress had failed to produce results and drastic
measures were now called for.
Faced with these insurmountable problems, the Indian government turned to the IMF
and thus began a series of far reaching reforms in the India economy which
envisioned transforming the country’s economy from an interventionist and overly-
regulated economy to a more market oriented one.
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THE BEGINING OF A NEW ERA
The year 1991 marks a new growth phase of FDI in India with an all time high flow
of FDI. Following the Industrial Policy (1991) , a large number of foreign companies
from different parts of the world rushed into India. In this period, in addition to
thousands of foreign collaborations in India, as many as 145 foreign companies
registered in India within a span of 10 years from 1991-2000. Companies like General
Motors, Ford Motors, and IBM that divested from India in the 1950s and 1970s
reentered India during this period. A large number of Asian companies like Daewoo
Motors, Hyundai Motors and LG Electronics from S. Korea, Matsushita Television
and Honda Motors from Japan invested in India during this period.
With the legislation of the Industrial Licensing Policy, 1991, industrial licensing was
abolished except for 18 industries. FDI up to 51% equity was allowed in 34 formerly
high priority industries and the concept of phased manufacturing requirement on
foreign companies was removed. Further, the tariffs on imports have been steadily
reduced in every budget since 1991. Subsequently, GOI replaced FERA, 1973 that
regulated all foreign exchange transactions with Foreign Exchange Management Act
(FEMA), 1999. The objectives of FEMA have been to facilitate external trade and
payments and to promote orderly development and maintenance of foreign exchange
market. The total number of foreign collaborations increased from 976 in the year
1991 to 2144 in the year 2000.
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WHAT IS FOREIGN DIRECT INVESTMENT?
Is the process whereby residents of one country (the source country) acquire
ownership of assets for the purpose of controlling the production, distribution, and
other activities of a firm in another country (the host country). The international
monetary fund’s balance of payment manual defines FDI as an investment that is
made to acquire a lasting interest in an enterprise operating in an economy other than
that of the investor. The investors purpose being to have an effective voice in the
management of the enterprise. The united nations 1999 world investment report
defines FDI as ‘an investment involving a long term relationship and reflecting a
lasting interest and control of a resident entity in one economy (foreign direct investor
or parent enterprise) in an enterprise resident in an economy other than that of the
foreign direct investor ( FDI enterprise, affiliate enterprise or foreign affiliate).
TYPES OF FDI
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A)BY DIRECTION
Inward FDIs:
Inward FDI for an economy can be defined as the capital provided from a foreign
direct investor (i.e. the coca cola company) residing in a country, to that economy,
which is residing in another country. (I.e. India's economy).
EXAMPLE: General Motors decides to open a factory in India. They are going to
need some capital. That capital is inward FDI for India.
Different economic factors encourage inward FDIs. These include interest
loans, tax breaks, grants, subsidies, and the removal of restrictions and limitations.
Outward FDIs:
A business strategy where a domestic firm expands its operations to a foreign country
either via a Green field investment, merger/acquisition and/or expansion of an
existing foreign facility. Employing outward direct investment is a natural
progression for firms as better business opportunities will be available in foreign
countries when domestic markets become too saturated.
In recent years, emerging market economies (EMEs) are increasingly becoming a
source of foreign investment for rest of the world. It is not only a sign of their
increasing participation in the global economy but also of their increasing
competence. More importantly, a growing impetus for change today is coming from
developing countries and economies in transition, where a number of private as well
as state-owned enterprises are increasingly undertaking outward expansion through
foreign direct investments (FDI). Companies are expanding their business operations
by investing overseas with a view to acquiring a regional and global reach.
B) BY TARGET
Greenfield investment:
A form of foreign direct investment where a parent company starts a new venture in a
foreign country by constructing new operational facilities from the ground up. In
addition to building new facilities, most parent companies also create new long-term
jobs in the foreign country by hiring new employees.
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Green field investments occur when multinational corporations enter into developing
countries to build new factories and/or stores. Developing countries often offer
prospective companies tax-breaks, subsidies and other types of incentives to set up
green field investments. Governments often see that losing corporate tax revenue is a
small price to pay if jobs are created and knowledge and technology is gained to boost
the country's human capital.
Horizontal FDI:
Horizontal FDI arises when a firm duplicates its home country-based activities at the
same value chain stage in a host country through FDI. For example, Ford assembles
cars in the United States. Through horizontal FDI, it does the same thing in differenthost countries such as the United Kingdom (UK), France, Taiwan, Saudi Arabia, and
India. Horizontal FDI therefore refers to producing the same products or offering the
same services in a host country as firms do at home.
Vertical FDI:
Vertical Foreign Direct Investment takes two forms:
1. Backward vertical FDI: where an industry abroad provides inputs for afirm's domestic production process like exploiting the available raw materialsin the host country.
2. Forward vertical FDI: in which an industry abroad sells the outputs of afirm's domestic production i.e to be nearer to the consumers through theaquisition of distribution outlets.
C) BY MOTIVE
Resource seeking:
Investments which seek to acquire factors of production that is more efficient than
those obtainable in the home economy of the firm. In some cases, these resources
may not be available in the home economy at all (e.g. natural resources,naturally
occurring materials such as coal, fertile land, etc., that can be used by man, and cheap
labor). This characterizes Foreign Direct Investment into developing countries, for
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example seeking cheap labor in India and China, or natural resources in the Middle
East and Africa.
Market seeking:
Market seeking FDI is driven by access to local or regional markets. Investing locally
can be driven by regulations or to save on operational costs such as transportation.
General Motors’ investment in China is market seeking because the cars built in
China are sold in China, the size and growth of host country markets are among the
most important FDI determinants.
Efficiency seeking:
Investments which firms hope will increase their efficiency by exploiting the benefits
of economies of scale and scope, and also those of common ownership. It is
suggested that this kind of Foreign Direct Investment comes after either resource or
market seeking investments have been realized, with the expectation that it further
increases the profitability of the firm.
Efficiency seeking FDI is commonly described as off shoring, or investing in foreignmarkets to take advantage of a lower cost structure. A credit card company opening a
call center in India to serve U.S. customers is a form of efficiency seeking FDI.
ADVANTAGES OF FDI
1. Raising the Level of Investment: Foreign investment can fill the gap
between desired investment and locally mobilized savings. Local capital markets
are often not well developed. Thus, they cannot meet the capital requirements for
large investment projects. Besides, access to the hard currency needed to purchase
investment goods not available locally can be difficult. FDI solves both these
problems at once as it is a direct source of external capital. It can fill the gap
between desired foreign exchange requirements and those derived from net export
earnings.
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2. Up gradation of Technology: Foreign investment brings with it technological
knowledge while transferring machinery and equipment to developing countries.
Production units in developing countries use out-dated equipment and techniques
that can reduce the productivity of workers and lead to the production of goods of
a lower standard.
3. Improvement in Export Competitiveness: FDI can help the host country
improve its export performance. By raising the level of efficiency and the
standards of product quality, FDI makes a positive impact on the host country’s
export competitiveness. Further, because of the international linkages of MNCs,
FDI provides to the host country better access to foreign markets. Enhancedexport possibility contributes to the growth of the host economies by relaxing
demand side constraints on growth. This is important for those countries which
have a small domestic market and must increase exports vigorously to maintain
their tempo of economic growth.
4. Employment Generation/Development: Foreign investment can create
employment in the modern sectors of developing countries. Recipients of FDI
gain training of employees in the course of operating new enterprises, which
contributes to human capital formation in the host country.
5. Benefits to Consumers: Consumers in developing countries stand to gain
from FDI through new products, and improved quality of goods at competitive
prices.
6. Revenue to Government: Profits generated by FDI contribute to corporate
tax revenues in the host country.
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DISADVANTAGES OF FDI
FDI is not an unmixed blessing. Governments in developing countries have to be very
careful while deciding the magnitude, pattern and conditions of private foreign
investment. Possible adverse implications of foreign investment are the following:
1. When foreign investment is competitive with home investment, profits in
domestic industries fall, leading to fall in domestic savings.
2. Contribution of foreign firms to public revenue through corporate taxes iscomparatively less because of liberal tax concessions, investment allowances,
disguised public subsidies and tariff protection provided by the host government.
3. Foreign firms reinforce dualistic socio-economic structure and increase
income inequalities. They create a small number of highly paid modern sector
executives. They divert resources away from priority sectors to the manufacture
of sophisticated products for the consumption of the local elite. As they are
located in urban areas, they create imbalances between rural and urban
opportunities, accelerating flow of rural population to urban areas.
4. Foreign firms stimulate inappropriate consumption patterns through excessive
advertising and monopolistic market power. The products made by multinationals
for the domestic market are not necessarily low in price and high in quality. Their
technology is generally capital-intensive which does not suit the needs of a
labour-surplus economy.
5. Foreign firms able to extract sizeable economic and political concessions from
competing governments of developing countries. Consequently, private profits of
these companies may exceed social benefits.
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6. Profit distribution, investment ratios are not fixed: Continual outflow of
profits is too large in many cases, putting pressure on foreign exchange reserves.
Foreign investors are very particular about profit repatriation facilities.
7. Political Lobbying: Foreign firms may influence political decisions in
developing countries. In view of their large size and power, national sovereignty
and control over economic policies may be jeopardized. In extreme cases, foreign
firms may bribe public officials at the highest levels to secure undue favours.
Similarly, they may contribute to friendly political parties and subvert the political
process of the host country.
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1. Size of the Market: Large developing countries provide substantial markets
where the consumers demand for certain goods far exceed the available supplies.
This demand potential is a big draw for many foreign-owned enterprises. In
many cases, the establishment of a low cost marketing operation represents the
first step by a multinational into the market of the country. This establishes a
presence in the market and provides important insights into the ways of doing
business and possible opportunities in the country.
2. Political stability: In many countries, the institutions of government are still
evolving and there are unsettled political questions. Companies are unwilling to
contribute large amounts of capital into an environment where some of the basics political questions have not yet been resolved.
3. Macro-economic Environment: Instability in the level of prices and exchange
rate enhance the level of uncertainty, making business planning difficult. This
increases the perceived risk of making investments and therefore adversely
affects the inflow of FDI.
4. Legal and Regulatory Framework : The transition to a market economy entails
the establishment of a legal and regulatory framework that is compatible with
private sector activities and the operation of foreign owned companies. The
relevant areas in this field include protection of property rights, ability to
repatriate profits, and a free market for currency exchange. It is important that
these rules and their administrative procedures are transparent and easily
comprehensive.
5. Access to Basic Inputs: Many developing countries have large reserves of
skilled and semi-skilled workers that available for employment at wages
significantly lower than in developed countries. This provides an opportunity for
foreign firms to make investments in these countries to cater to the export
market. Availability of natural resources such as oil and gas, minerals and
forestry products also determine the extent of FDI.
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The determinants of FDI differ among countries and across economic sectors. These
factors include the policy framework, economic determinants and the extent of
business facilitation such as macro-economic fundamentals and availability of
infrastructure.
Recent global and regional FDI trends
The rise of FDI flows in 2011 was widespread in all three major groups – developed,
developing and transition economies. Developing economies continued to absorb
nearly half of global FDI and transition economies another 6 per cent.
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This graph gives a pretty good indicator of how relative FDI inflows have changed
since 2002 we can see that right from the year 2002 there has been an increase in FDI
investments in the developing economies. The increase in the GDP growth or the bull
phase which most of the developing economies experienced from 2003-2008 could be
attributed to the increased FDI.
FDI flows, by region, 2009–2011
Amount in billions of dollarsSource: UNCTAD
In 2011, FDI inflows increased in all major economic groups − developed,
developing and transition economies. Developing countries accounted for 45 per cent
of global FDI inflows in 2011. The increase was driven by East and South-East Asia
and Latin America. East and South-East Asia still accounted for almost half of FDI in
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developing economies. Inflows to the transition economies of South-East Europe, the
Commonwealth of Independent States (CIS) and Georgia accounted for another 6 per
cent of the global total.
FII ACCORDING TO TYPE OF INVESTMENT
Source:UNCTADCross-border mergers and acquisitions are rising, but Greenfield investment still
dominates, as the following graph shows.
Greenfield investment and M&A differ in their impacts on host economies, especially
in the initial stages of investment. In the short run, M&A’s clearly do not bring the
same development benefits as Greenfield investment projects, in terms of the creation
of new productive capacity, additional value added, employment and so forth. The
effect of M&As on, for example, host-country employment can even be negative, in
cases of restructuring to achieve synergies.
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TNCs’ top prospective host economies for 2012–2014
The importance of developing regions to TNCs as locations for international
production is also evident in the economies they selected as the most likely
destinations for their FDI in the medium term. Among the top five, four are
developing economies .Indonesia rose into the top five in this year’s survey,
displacing Brazil in fourth place. South Africa entered the list of top prospective
economies, ranking 14th with the Netherlands and Poland. Among developed
countries, Australia and the United Kingdom moved up from their positions in last
year’s survey, while Germany maintained its position.
Source: UNCTAD survey 2011
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If we analyze the above survey it can be said that the global capital which is not
providing good returns in the developed economies is moving rapidly towards
developing economies.
Major developing economies like India,China,Brazil etc have emerged as the top
destinations for FDI worldwide because the potential impact of the economic crisis
enforce the shifting of geographical focus to developing and transition economies
because of their much better economic performance than the developed countries
.Factors such as weaker economic growth in developed countries and abnormal
functioning of the world credit are putting pressures on the pace of recovery of FDI
flows towards developed economies.
FDI Approval Route
Foreign direct investments in India are approved through two
routes–
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1. Automatic approval by RBI –
The Reserve Bank of India accords automatic approval within a period of two weeks
(subject to compliance of norms) to all proposals and permits foreign equity up to
24%; 50%; 51%; 74% and 100% is allowed depending on the category of industries
and the sectoral caps applicable. The lists are comprehensive and cover most
industries of interest to foreign companies. Investments in high priority industries or
for trading companies primarily engaged in exporting are given almost automatic
approval by the RBI.
2. The FIPB Route – Processing of non-automatic approval cases –
FDI in activities not covered under the automatic route requires prior approval of theGovernment which are considered by the Foreign Investment Promotion Board
(FIPB), Department of Economic Affairs, Ministry of Finance. Indian companies
having foreign investment approval thr ough FIPB route do not require any further
clearance from the Reserve Bank of India for r eceiving inward remittance and for
the issue of shares to the non-resident investors.
SECTOR SPECIFIC CONDITIONS ON FDI
PROHIBITED SECTORS.
• Retail Trading (except single brand product retailing)
• Lottery Business including Government /private lottery, online lotteries, etc.
• Gambling and Betting including casinos etc.
• Chit funds
• Nidhi company
• Trading in Transferable Development Rights (TDRs)
• Real Estate Business or Construction of Farm Houses
•
Manufacturing of Cigars, cheroots, cigarillos and cigarettes substitutes
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• Activities / sectors not open to private sector investment e.g. Atomic Energy
• Railway Transport (other than Mass Rapid Transport System
PERMITTED SECTORS
In the following sectors/activities, FDI up to the limit indicated against each
sector/activity is allowed, subject to applicable laws/ regulations; security and other
conditionality. In sectors/activities not listed below, FDI is permitted upto 100% onthe automatic route, subject to applicable laws/ regulations; security and other
conditions.
Sr.
No.
Sector/Activity FDI cap/Equity Entry/Route
1. Hotel & Tourism 100% Automatic
2. NBFC 49% Automatic
3. Insurance 26% Automatic
4. Telecommunication:
cellular, value added services
ISPs with gateways, radio-paging
Electronic Mail & Voice Mail
49%
74%
100%
Automatic
Above 49% need
Govt. licence
5. Trading companies:
primarily export activities
bulk imports, cash and carry
wholesale trading
51%
100%
Automatic
Automatic
6. Power(other than atomic reactor
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power plants) 100% Automatic
7. Drugs & Pharmaceuticals 100% Automatic
8. Roads, Highways, Ports and Harbors 100% Automatic
9. Pollution Control and Management 100% Automatic
10 Call Centers 100% Automatic
11. BPO 100% Automatic
13. Airports:
Greenfield projects
Existing projects
100%
100%
Automatic
Beyond 74% FIPB
14 Assets reconstruction company 49% FIPB
15. Cigars and cigarettes 100% FIPB
16. Courier services 100% FIPB
17. Investing companies in infrastructure
(other than telecom sector)
49% FIPB
Foreign Direct Investment in India in the last 10 Years
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It can be seen that the flow of FDI has consistent and gradually increasing over the
years. There has been an increase of 129% i.e. Rs. 13851 Crores from the year 2000-
01 to 2005-06 while the increase from 2005-06 to 2011-12 has been a phenomenal
607% i.e. from Rs. 24584 Cr to Rs. 173947 Cr which can be attributed to relaxation
of foreign investment rules. Despite the global financial credit squeeze brought by the
recession India continues to be an attractive destination for investment as there is
tremendous potential for growth in the vast and diverse markets of our country.
The bars from 2000-01 to 2004-05 have been almost hovering the same levels but
importantly haven’t gone down which is because the foreign investors saw immense
potential but were not getting enough incentives to enter with huge business
propositions. The breakout came from the year 2005-06 when the investment nearly
doubled as compared to 2000-01, after which there was no looking back as consistent
economic growth, de-regulation, liberal investment rules, and operational flexibilityhelped increase the inflow of Foreign Direct Investment or FDI. So much so that even
during the year 2008-09 when the recession had taken its toll on the western countries
there was no indication of falling investment via the FDI route as can be seen from
the chart. In fact during 2008-09 the chart shows that FDI breached the Rs. 1 lakh
crore marks. In percentage terms FDI inflow increased by 28% from 2007-08 to
2008-09.
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DIFFERENT SECT O RS ATTRACTING HIG H EST FDI EQUITY INFLOW S
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DIFFERENT COUNTRIES ATTRACTING HIG H EST FDI EQUITY
INFLOW S :
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CHAPTER – III
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FOREIGN INSTITUTIONAL INVESTMENT
FOREIGN INSTITUTIONAL INVESTMENT (FII)
Background
Indian Markets have been one of the most attractive investment places for the FII's.
India being a developing nation attracts the foreign flows looking at the growth
potential in the Indian Economy. The FII's contribute a major chunk of volumes on
the Indian bourses and this in turn impacts the market moves. In case of recession in
the world economies, the foreign investors look for saver bets and India with a risingGDP where other nations GDP / Growth is shrinking has always offered greater
investment avenues. Indian Markets have been the clear outperformers vis-a-vis the
global markets in the past years.
HISTORY OF FOREIGN INSTITUTIONAL INVESTORS
Since 1990-91, the Government of India embarked on liberalization and economic
reforms with a view of bringing about rapid and substantial economic growth and
move towards globalization of the economy. As a part of the reforms process, the
Government under its New Industrial Policy revamped its foreign investment policy
recognizing the growing importance of foreign direct investment as an instrument of
technology transfer, augmentation of foreign exchange reserves and globalization of
the Indian economy. Simultaneously, the Government, for the first time, permitted
portfolio investments from abroad by foreign institutional investors in the Indian
capital market. The entry of FIIs seems to be a follow up of the recommendation of
the Narsimhan Committee Report on Financial System. While recommending their
entry, the Committee, however did not elaborate on the objectives of the suggested
policy. The committee only suggested that the capital market should be gradually
opened up to foreign portfolio investments. From September 14, 1992 with suitable
restrictions, Foreign Institutional Investors were permitted to invest in all the
securities traded on the primary and secondary markets, including shares, debentures
and warrants issued by companies which were listed or were to be listed on the Stock
Exchanges in India. While presenting the Budget for 1992-93, the then Finance
STUDY ON IMPACT AND INFLUENCE OF FOREIGN INVESTMENT IN INDIA32
management company, nominee company, bank, institutional portfolio
manager, university funds, endowments, foundations, charitable trusts,charitable societies, a trustee or power of attorney holder incorporated or
established outside India proposing to make proprietary investments or with
no single investor holding more than 10 per cent of the shares or units of the
fund.
• As Sub-accounts: The Sub account is generally the underlying fund on
whose behalf the FII invests. The following entities are eligible to be registered as
sub-accounts, viz. partnership firms, private company, public company, pension fund,
investment trust, and individuals. A domestic portfolio manager or a domestic asset
management company shall also be eligible to be registered as FII to manage the
funds of sub-accounts.
FIIs registered with SEBI fall under the following categories:
• Regular FIIs- those who are required to invest not less than 70 % of their
investment in equity-related instruments and 30 % in non-equity instruments.
• 100 % debt-fund FIIs- those who are permitted to invest only in debt
instruments.
The Government guidelines for FII of 1992 allowed, inter-alia, entities such as asset
management companies, nominee companies and incorporated/institutional portfolio
managers or their power of attorney holders (providing discretionary and non-
discretionary portfolio management services) to be registered as FIIs. While the
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guidelines did not have a specific provision regarding clients, in the application form
the details of clients on whose behalf investments were being made were sought.
While granting registration to the FII, permission was also granted for making
investments in the names of such clients. Asset management companies/portfolio
managers are basically in the business of managing funds and investing them on
behalf of their funds/clients. Hence, the intention of the guidelines was to allow these
categories of investors to invest funds in India on behalf of their 'clients'. These
'clients' later came to be known as sub-accounts. The broad strategy consisted of
having a wide variety of clients, including individuals, intermediated through
institutional investors, who would be registered as FIIs in India. FIIs are eligible to
purchase shares and convertible debentures issued by Indian companies under the
Portfolio Investment Scheme.
Who can be registered as an FII?
The applicant should be any of the following categories:
1. Pension funds
2. Mutual funds
3. Investment trust
4. Insurance or reinsurance companies
5. Endowment funds
6. University funds
7. Foundations or charitable trusts or charitable societies who propose to invest on
their own behalf and
a) Asset management companies
b) Nominee companies
c) Institutional portfolio managers
d) Trustees
e) Power of attorney holders
f) Bank
Who propose to invest their proprietary funds or on behalf of “broad based” funds or
on of foreign corporate and individuals.
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Prohibitions on Investments:
Foreign Institutional Investors are not permitted to invest in equity issued by an Asset
Reconstruction Company. They are also not allowed to invest in any company which
is engaged or proposes to engage in the following activities:
• Business of chit fund
• Nidhi Company
• Agricultural or plantation activities
• Real estate business or construction of farm houses (real estate business does
not include development of townships, construction of residential/commercial
premises, roads or bridges)
Reasons for strong flow of FIIs in India
FIIs attracted by the fast growing economy of India and strong performance of Indian
companies have been attracted towards India to an extent that India has gone on to
become the preferred investment destination.
The primary reasons for India being a preferred destination for FIIs are:
• Global liquidity into the equity markets.
• Improved performance and competitiveness of Indian firms.
• Opening up of Indian economy.
• Cheap labor and other factors of production.
• Highly developed stock market and high degree of vigilance over it.
• Tax Incentives.
• Regulation and Trading Efficiencies
• F and O Segment
Role of FIIs:
• The Indian stock market has come of age and has substantially aligned itself
with the international order.
• Market has also witnessed a growing trend of 'institutionalization' that may be
considered as a consequence of globalization.
•
It is influence of the FIIs which changed the face of the Indian stock markets.Screen based trading and depository are realities today largely because of FIIs.
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• FII which based the pressure on the rupee from the balance of payments
position and lowered the cost of capital to Indian business.
• FIIs are the trendsetters in any market. They were the first ones to identify the
potential of Indian technology stocks. When the rest of the investors invested
in these scrips, they exited the scrips and booked profits.
• Rolling settlement was introduced at the insistence of FIIs as they were
uncomfortable with the badla system.
• The FIIs are playing an important role in bringing in funds needed by the
equity market.
• The increase in the volume of activity on stock exchanges with the advent of
on screen trading coupled with operational inefficiencies of the former
settlement and clearing system led to the emergence of a new system called
the depository System.
• Flow of money into Indian economy via FIIs has been increasing at a rapid
rate. This has forced economist and policy makers to consider impacts of this
inflow on the macro economic factors as well. This has resulted in deeper
analysis of factors like Interest Rate, Inflation Rate, GDP and Exchange Rate
etc. both in short term as well as long term
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Divergent views on FII
FIIs inducing instability to Stock Markets
Many experts consider FIIs to be "Fair Weather Friends", who come in bulk when
there is money to be made and leave abruptly at the first sign of impending trouble in
the host country, thereby inducing undesirable risk and uncertainty into markets. A
good recent example is evident from FII behavior in last eighteen months itself.
Better fundamentals of Indian economy as compared to the western economies,
attracted and prompted FIIs to invest aggressively here, raising the total to a
astronomical figure of $ 20 billion. This almost single handily took the Sensex to
touch the 20,000 mark again. However, come November 2010, few local factors like
inflation, lower IIP and internal political drama, resulted in major square off of FII
positions in no time, thereby pushing the market into a sluggish and corrective mode.
There are other disturbing instances when the FIIs became the agents triggering a
blood bath at Dalal Street. On 16th Oct, 2007 Finance Minister Mr. P. Chidambaram
made a statement expressing his apprehensions over the usage offshore derivativeinstrument: P-notes, through which the FIIs made about 60% of their investment in
India. Little did the market analysts or the Finance Minister knew that this seemingly
ordinary statement would have the potential to inflict a deadly free fall of the market
indices. The markets crashed by a staggering 9% within few hours, registering one of
the biggest absolute fall in Indian stock market history. The consequences were so
severe that the markets had to be closed down for an hour and Mr. Chidambaram had
to call a press conference to rephrase his statements. It was yet another alarming callto the domestic investors that woke them up to the rising dominance and influence of
the FIIs on Indian Stock Markets.
The Alternate View
There is another set of experts who believe that FIIs are life blood for an emerging
economy like India. They augment domestic saving without increasing foreign debt,
provide vital liquidity to Indian companies to sustain road to growth, reduce cost of
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equity capital and help reduce deficit of Balance of payments (BOP). Also these
experts believe that FIIs, like any other investors buy or sell according to prevailing
sentiments in the market, rather than creating any sentiments that drive the markets.
Hence there lies a conflict between the pros and cons of FIIs and the all important
question regarding the role of FIIs in deciding the fate of our stock markets
Relationship between FII inflow and Sensex
Source:BSE & SEBI
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YEAR NET FII
INVESTMENTS
BSE SENSEX
CLOSING2005 47181.9 9397.93
2006 36540.2 13786.91
2007 71486.3 20286.99
2008 -52987.4 9647.31
2009 83424.2 17464.81
2010 133266.8 20509.1
2011 2714.2 15454.9
2012 42263.3 16950
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From the above charts it is clear that net FII investments at BSE show a similar
pattern to the Yearly average closings. The blue bars denoting the net FII can be
called a volatile from the chart as there are sudden sharp drops and sharp rises. It has
no fixed pattern. The net FII started declining from 2007-08 till the middle of 2008-
09 which caused a sharp fall in Sensex also which went below the 10000 level in
2007-08 falling by almost 52% as compared to the previous year. But the FIIs started
pouring in again from the end of 2009 after the governments abroad started providing
bail-out packages, sops and various other incentives to the ailing companies. The
Sensex also rises sharply from 2008-09 after the FIIs turned into net buyers and hence
a similar pattern can be found between these two.
Conclusion & Recommendations
The study conducted for the time frame from 2005 to 2012, supports the “FII
inducing volatility and driving the market indices” theory to a substantial level.
Compared to security markets in developed economies, Indian markets being
narrower and shallower, allows foreign investors with access to significant funds, to
become the dominant player in determining the course of markets. Because of their
over sensitive investment behavior and herding nature, FIIs are capable of causing
severe capital out flight abruptly, tumbling share prices in no time and making stock
markets unstable and unpredictable. In the process, more often than not, the domestic
individual investors are on the receiving end, losing their precious savings in such
outrageous speculative trading.
India as an emerging economic power cannot afford to be intimidated down by the
FIIs every now and then. We need formidable Domestic Investors which can pump in
liquidity even during cash crunch circumstances thereby fuelling the development.
With savings to the tune of roughly 35% of GDP, India can use this to its strength by
formulating policies which ensure that domestic funds like Pension Funds, Provident
Funds & other Large Corpus Funds have a greater exposure to the equity market. The
foreign investment in India should be encouraged, but only from a strategic long term
perspective. Derivative instruments which facilitate long term foreign investment
with specified lock in periods should be introduced. Sustained long term foreign
investments would not only contribute to India's growth but also help in curbing
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volatility, maintaining currency stability and creating environment for inclusive
economic development.
FII’s IMPACT ON EXCHANGE RATES
To understand the implications of FII on the exchange rates we have to understand
how the value of one currency goes up (appreciates) or goes down against the other
currency. The simple way of understanding is through Demand and Supply. If say US
imports from India it is creating a demand for Rupee thus the Indian rupee appreciates
w.r.t the dollar. If India imports then the dollar appreciates w.r.t the Indian rupee.
Now considering FII’s for every dollar that they bring into the country, there is a
demand for rupee created and the RBI has to print and release the money in the
country. Since the FII’s are creating a demand for rupee, it appreciates w.r.t the
dollar. Thus if for e.g. if prior to the demand the exchange rate was 1 USD = Rs 40, it
could become 1 USD = Rs 39 after they invets. Similarly when FII withdraw the
capital from the markets, they need to earn back the U.S Dollar so that leads to a
demand for dollars the rupee depreciates. 1 USD goes back to Rs. 40. Thus FII
inflows make the currency of the country invested in appreciate and their selling and
disinvestment may lead to depreciation.
Depreciating currency not favorable to the FII’s: considering a simple hypothetical
example. I invested 1 USD in India at an exchange rate of 1 USD = Rs. 40. If rupee
appreciates the exchange rates become 1 USD = Rs. 20. Now if I disinvest I get 2
dollars, whereas I invested only 1 USD thereby a gain of 1 USD. (Though in real
terms the purchasing power of my dollar might decrease as my import cost would
increase, and cost of living back home may increase, but when I do consider practical
examples there is always a gain for FII whenever the currency of the country invested
in appreciates w.r.t the home currency)
Similarly when rupee depreciates w.r.t US Dollar and exchange rate becomes 1 USD
= Rs. 80 I get only 0.5 Dollar and I lose 0.5 of the 1 USD invested. Thus we observe
that for the FII’s to gain investing in India the rupee should appreciate w.r.t the dollar.
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Source:SEBI & Moneycontrol
The above diagram brings to light a very important occurrence regarding Net FII and
the Foreign Exchange Rate. It can be seen that whenever the red line (foreign
exchange rate) goes up the blue line (Net FII) goes down. If we look at the graph for
the last 5 years we find that during the recession of 2008 when the FIIs pulled out
money from nearly every emerging economy including India, we see that there is an
appreciation in the value of rupee from 39 to around 48, Similar relation can be
concluded from the year 2010 and 2011.
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Source:SEBI & Moneycontrol
Here also we can clearly see that when the FIIs were net purchasers in the month of
January and February the $ rates came down from 49.68 to 48.94 and similarly the
rupee started appreciating from the month of April when the FIIs turned net sellers.
The fall in April started after the passing of the union budget which leads us to
conclude that the fall in the value was majorly the implications of GAAR provisions
which speaks about retrospective taxation and also due to the worsening condition in
the Euro zone.
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Source:SEBI & Moneycontrol
This data is presented for a very short run period from May 28 to June 28.the value of
the rupee appreciated from 55.1846 on 28 may to 57.0147 on 25 June, this can be
considered to be a very big rise in less than a month and on may 28 the US dollar
settled at INR 56.8554.The reason for this is that FIIs have been net sellers for the
major part of june from the dates for which the data has been collected they have sold
worth Rs 2212 Cr and purchased worth Rs 1077.Now the appreciation in the rupee in
the last few days that is on 29 th June can be attributed to the government giving a
clarification on GAAR which is related to the FIIs coming to India via Mauritius and
also to the European Union leaders’ sensible decision to create a single supervisory
body for Euro zone banks with active involvement of the European Central bank bythe end 2012.
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Issues concerning FII’s in India
GAAR
GAAR originally proposed in the Direct Taxes Code, is targeted at arrangements or
transactions made specifically to avoid taxes. The government had decided to
advance the introduction of GAAR and implement it from the current financial year
itself. More than 30 countries have introduced GAAR provisions in their respective
tax codes to check evasion.
GAAR allows tax authorities to call a business arrangement or a transaction
'impermissible avoidance arrangement' if they feel it has been primarily entered into
to avoid taxes. Once an arrangement is ruled 'impermissible' then the tax authorities
can deny tax benefits. Most aggressive tax avoidance arrangements would be under
the risk of being termed impermissible. The rule can apply on domestic as well as
overseas transactions. It is a very broad based provision and can easily be applied to
most tax-saving arrangements. Many experts feel that the provision would give
unbridled powers to tax officers, allowing them to question any tax saving deal.
Foreign institutional investors are worried that their investments routed through
Mauritius could be denied tax benefits enjoyed by them under the Indo-Mauritius tax
treaty. The proposal has hit the stock market as FII inflows dropped on concerns, and
the rupee hit an all time low to the dollar.
The Indian law taxes gains derived from the sale of shares irrespective of whether the
shareholder is a resident or nonresident. Under India's tax treaty with Mauritius, gains
derived by a resident of Mauritius from the sale of shares in an Indian company are
taxable only in Mauritius and as it does not tax capital gains, the transaction escapes
tax in both countries. Foreign investors have been using the Mauritius holding
company structure to make investments in India right from the early 1990s.
Following the liberalization of the Indian economy, the Indo-Mauritius DTAA, was
"discovered" as an effective mechanism to avoid capital gains tax on sale of shares in
Indian companies. A Foreign enterprise can set up a subsidiary in Mauritius, and use
it to derive capital gains from acquisition and sale of shares. Although India follows
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the source rule for taxation of non-residents, which makes this transaction taxable
under the Income Tax Act, 1961, Article 13(4) of the DTAA gives Mauritius the right
to tax this transaction. Since such gains are exempt from tax in Mauritius, the
transaction becomes completely tax exempt, resulting in double non-taxation. As a
result, much of the Mauritian investment into India is actually round tripping by
Indian companies setting up a Mauritian entity to avoid capital gains tax in India.
Source:SEBI
The above figure illustrates daily movement of FII flows in India from 16 th March,
2012 when the Finance Minister announced the implementation of GAAR. It can be
observed there has been an outflow of dollars to the effect of $ 1 bn during this
period. This has also had an impact on the exchange rate which has depreciated from
Rs 50.31 on March 16th, 2012 to Rs 51.16 on March-end and further to Rs 52.51 and
Rs 53.72 on April end and May 4th, 2012 respectively. This was notwithstanding the
fact that forex reserves had remained largely stable, increasing from $294.8 bn on
March 16th to $ 295.4 bn on April 27 th.Clearly the sentiment was affected which
drove the rupee down further.
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Response of the Government
GAAR will now be applicable from April 1st, 2013. Further this rule would only be
invoked when there are specific complaints and it will not be easy for assessing tax
officers to invoke GAAR. The onus to prove that an arrangement is 'impermissible'
will lie with the tax department. Also to provide greater clarity and certainty in the
matters relating to GAAR, a Committee has been constituted under the chairmanship
of Director General of Income Tax to give recommendations for formulating the rules
and guideline for implementation of GAAR provision and to suggest safeguards so
that the provisions are not applied indiscriminately.
HOT MONEY
Hot money is a term that is most commonly used in financial markets to refer to the
flow of funds (or capital) from one country to another in order to earn a short-term
profit on interest rate differences and/or anticipated exchange rate shifts. These
speculative capital flows are called "hot money" because they can move very quickly
in and out of markets, potentially leading to market instability
large and sudden inflows of capital with short term investment horizon have negative
macroeconomic effects, including rapid monetary expansion, inflationary pressures,
real exchange rate appreciation and widening current account deficits. Especially,
when capital flows in volume into small and shallow local financial markets, the
exchange rate tends to appreciate, asset prices to rally and local commodity prices to
boom. These favorable asset price movements improve national fiscal indicators and
encourage domestic credit expansion. These, in turn, exacerbate structural weakness
in the domestic bank sector. When global investors' sentiment on emerging markets
shift, the flows reverse and asset prices give back their gains, often forcing a painful
adjustment on the economy
The following are the details of the dangers that hot money presents to the receivingcountry's economy:STUDY ON IMPACT AND INFLUENCE OF FOREIGN INVESTMENT IN INDIA47
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• Inflow of massive capital with short investment horizon (hot money) could
cause asset price to rally and inflation to rise. The sudden inflow of large
amounts of foreign money would increase the monetary base of the receiving
country (if the central bank is pegging the currency), which would help create
credit boom. This, in turn, would result in such a situation in which "too much
money chase too few goods". Consequences of this would be inflation.
Furthermore, hot money could lead to exchange rate appreciation or even
cause exchange rate overshooting. And if this exchange rate appreciation
persists, it would hurt the competitiveness of respective country's export
sector by making the country's exports more expensive compared to similar
foreign goods and services.
• Sudden outflow of hot money, which would always certainly happen, would
deflate asset prices and could cause the collapse value of the currency of
respective country. This is especially so in countries with relatively scarce
internationally liquid assets. There is growing agreement that this was the case
in the 1997 East Asian Financial Crisis. In the run-up to the crises, firms and
private firms in South Korea, Thailand and Indonesia accumulated large
amounts of short term foreign debt (a type of hot money). The three countries
shared a common characteristic of having large ratio of short term foreign
debt to international reserves. When the capital starts to flow out, it caused a
collapse in asset prices and exchange rates. The financial panic fed on itself
causing foreign creditors to call in loans and depositors withdraw funds from
banks, all of these magnified the illiquidity of the domestic financial systemand forced yet another round of costly asset liquidations and price deflation.
In all of the three countries, the domestic financial institutions came to the
brink of default on their external short term obligations.
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CHAPTER – IV
FINDINGS
It is an accepted fact now that FIIs have significant influence on the
movements of the stock market indexes in India. If one looks at the
total FII trade in equity in India and its relationship with the stock
market major indexes like Sensex and Nifty, it shows a steadily
growing influence of FIIs in the domestic stock market.
FIIs and the movements of Sensex are quite closely correlated inIndia and FIIs wield significant influence on the movement of
Sensex. NSE also observes that in the Indian stock markets FIIs
have a disproportionately high level of influence on the market
sentiments and price trends. This is so because other market
participants perceive the FIIs to be infallible in their assessment of
the market and tend to follow the decisions taken by FIIs. This ‘herd
instinct’ displayed by other market participants amplifies theimportance of FIIs in the domestic stock market in India.
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RECOMMENDATIONS:
Some of the steps that can be taken to help influence the choices made by foreign
institutional investors include:
The Government should cut its fiscal deficits, which would result in
strengthening the economy as a whole.
Creating infrastructure and other facilities to attract foreign
investment. As described earlier, an array of services can help promote
foreign institutional investment in India, ranging from basic services such
as the provision of electricity and clean water, to fair and effective dispute
resolution systems.
The ability of governments to prevent or reduce financial crises also
has a great impact on the growth of capital flows. Steps to address these
crises include strengthening banking supervision, requiring more
transparency in international financial transactions and ensuring adequate
supervision and regulation of financial markets.
An attempt should be made to bring down the inflation level to attract
more foreign institutional investments into India.
The Banking system needs to be strengthened which could be
achieved by reducing the number of Non Performing Assets.
The FIIs investments, though shown an increasing trend over time, are
still far below the permissible limits. One such measure in this line could
be the newly announced INDONEXT, the platform for trading the small and
mid-cap companies, which might bring some focus on these companies
and hopefully add some liquidity and volume to their trading, which may
attract some further investments in them by FIIs.
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The fact is that developing country like India has its own compulsions
arising out of the very state of their social, political and economic
development. To attract portfolio investments and retain their confidence,
the host countries have to follow stable macro-economic policies,
The provision for clear procedures must be followed in the event of disputes
between investors and host governments, to ensure that rules are adhered to and that
arbitration may be established by mutual consent.
Countries may impose these kinds of measures like expropriation, domestic
content requirements, restrictions on capital outflows of short term investments, etc
with the intention of protecting domestic industries from international competition
and promoting their economic development, but this usually leads to misallocation of
resources away from the natural economic capabilities of nations.
There has been a significant shift in the character of global capital flows to the
developing countries in recent years in that the predominance of private account
capital transfer and especially portfolio investments (FPI) increased considerably. In
order to attract portfolio investments which prefer liquidity, it has been advocated to
develop stock markets.
The general perception about the foreign portfolio investments is that,
not only do they expand the demand base of the stock market, but they
can also stabilise the market through investor diversification.
Obstacles to investment prevent countries from making optimal use of their own and
other countries' resources. Countless billions of dollars of potential wealth - for
investors in the form of profits, for workers in the form of wages, and for consumers
in the form of lower prices - are lost every year due to barriers to trade and
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investment. Certain policy decisions of potential target countries of investment
receive close scrutiny from international investors. Consequently, a number of
international agreements have been written to specifically address those concerns.
CONCLUSION
What does India Need - FDI or FII
FDI usually is associated with export growth. It comes only when all the criteria to
set up an export industry are met. That includes, reduced taxes, favorable labor law,
freedom to move money in and out of country, government assistance to acquire land,
full grown infrastructure, reduced bureaucratic involvement etc. IT, BPO, Auto Parts,
Pharmaceuticals, unexplored service sectors including accounting; drug testing,
medical care etc are key sectors for foreign investment. Manufacturing is a brick and
mortar investment. It is permanent and stays in the country for a very long time. Huge
investments are needed to set this industry. It provides employment potential to semi
skilled and skilled labor. On the other hand the service sector requires fewer but
highly skilled workers. Both are needed in India. If India plays its cards right India
may be the hub for the service sector. Still high end manufacturing in auto parts and pharmaceuticals should be India’s target.
The FII (Foreign Institutional Investor) is monies, which chases the stocks in the
market place. It is not exactly brick and mortar money, but in the long run it may
translate into brick and mortar. Sudden influx of this drives the stock market up as too
much money chases too little stock. Where FDI is a bit of a permanent nature, the FII
flies away at the shortest political or economical disturbance. The Global Recession
of 2008 is a key example of the latter. Once this money leaves, it leaves ruined
economy and ruined lives behind. Hence FII is to be welcomed with strict political
and economical discipline.
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