Foreign direct investment- An Introduction

Foreign direct investment (FDI) is defined as a long term investment by a

foreign direct investor in an enterprise resident in an economy other than that in
which the foreign direct investor is based. The FDI relationship, consists of a
parent enterprise and a foreign affiliate which together form a Transnational
Corporation (TNC). In order to qualify as FDI the investment must afford the
parent enterprise control over its foreign affiliate.

TYPES OF FDI
• Greenfield investment: direct investment in new facilities or the
expansion of existing facilities. Greenfield investments are the primary
target of a host nation’s promotional efforts because they create new
production capacity and jobs, transfer technology and know-how, and can
lead to linkages to the global marketplace. However, it often does this by
crowding out local industry; multinationals are able to produce goods
more cheaply (because of advanced technology and efficient processes)
and uses up resources (labor, intermediate goods, etc). Another downside
of greenfield investment is that profits from production do not feed back
into the local economy, but instead to the multinational's home economy.
This is in contrast to local industries whose profits flow back into the
domestic economy to promote growth.

• Mergers and Acquisitions: occur when a transfer of existing assets from

local firms to foreign firms takes place, this is the primary type of FDI.
Cross-border mergers occur when the assets and operation of firms from
different countries are combined to establish a new legal entity. Cross-
border acquisitions occur when the control of assets and operations is
transferred from a local to a foreign company, with the local company
becoming an affiliate of the foreign company. Unlike greenfield
investment, acquisitions provide no long term benefits to the local
economy-- even in most deals the owners of the local firm are paid in
stock from the acquiring firm, meaning that the money from the sale
could never reach the local economy. Nevertheless, mergers and
acquisitions are a significant form of FDI and until around 1997,
accounted for nearly 90% of the FDI flow into the United States.

• Horizontal Foreign Direct Investment: is investment in the same

industry abroad as a firm operates in at home.

• Vertical Foreign Direct Investment: Takes two forms:

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

FEATURES OF FDI
1. Stimulation of national economy
FDI is thought to bring certain benefits to national economies. It can contribute
to Gross Domestic Product (GDP), Gross Fixed Capital Formation (total
investment in a host economy) and balance of payments. There have been
empirical studies indicating a positive link between higher GDP and FDI
inflows (OECD a.), however the link does not hold for all regions, e.g. over the
last ten years FDI has increased in Central Europe whilst GDP has dropped. FDI
can also contribute toward debt servicing repayments, stimulate export markets
and produce foreign exchange revenue. Subsidiaries of Trans-National
Corporations (TNCs), which bring the vast portion of FDI, are estimated to
produce around a third of total global exports. However, levels of FDI do not
necessarily give any indication of the domestic gain (UNCTAD 1999).
Corporate strategies e.g. protective tariffs and transfer pricing can reduce the
level of corporate tax received by host governments. Also, importation of
intermediate goods, management fees, royalties, profit repatriation, capital flight
and interest repayments on loans can limit the economic gain to host economy.
Therefore the impact of FDI will largely depend on the conditions of the host
economy, e.g. the level of domestic investment/ savings, the mode of entry
(merger & acquisitions or Greenfield (new) investments) and the sector
involved,
as well as a country’s ability to regulate foreign investment (UNCTAD 1999).

2. Stability of FDI
FDI inflows can be less affected by change in national exchange rates as
compared to other private sources (portfolio investments or loans). This is partly
because currency devaluation means a drop in the relative cost of production
and assets (capital, goods and services) for foreign companies and thereby
increases the relative attraction of a “host” country. FDI can stimulate product
diversification through investments into new businesses, so reducing market
reliance on a limited number of sectors/products (UNCTAD 1999). However, if
international flows of trade and investment fall globally and for lengthy periods,
then stability is less certain. New inflows of FDI are especially affected by these
global trends, because it is harder for a foreign company to de-invest or reverse
from foreign affiliates as compared to portfolio investment. Companies are
therefore more likely to be careful to ensure they will accrue benefits before
making any new investments. Examples of regional stability are mixed, whilst
FDI growth continued in some Asian countries e.g. Korea and Thailand, during
the 1996/97 crisis, it fell in others e.g. Indonesia. During Latin America’s
financial crisis in the 80’s many Latin American countries experienced a sharp
fall in FDI (UNGA 1999), suggesting that investment sensitivity varies
according to a country’s particular circumstances.

3. Social development
FDI, where it generates and expands businesses, can help stimulate
employment, raise wages and replace declining market sectors. However, the
benefits may only be felt by small portion of the population, e.g. where
employment and training is given to more educated, typically wealthy elites or
there is an urban emphasis, wage differentials (or dual economies) between
income groups will be exacerbated (OECD a). Cultural and social impacts may
occur with investment directed at non-traditional goods. For example, if
financial resources are diverted away from food and subsistence production
towards more sophisticated products and encouraging a culture of consumerism
can also have negative environmental impacts. Within local economies, small
scale and rural businesses of FDI host countries there is less capacity to attract
foreign investment and bank credit/loans, and as a result certain domestic
businesses may either be forced out of business or to use more informal sources
of finance (ECOSOC 2000).

4. Infrastructure development and technology transfer

Parent companies can support their foreign subsidiaries by ensuring adequate
human resources and infrastructures are in place. In particular “Greenfield”
investments into new business sectors can stimulate new infrastructure
development and technologies to host economies. These developments can also
result in social and environmental benefits, but only where they “spill over” into
host communities and businesses (ECOSOC 2000). Investment in research &
development (R&D) from parent companies can stimulate innovation in
production and processing techniques in the host country. However, this
assumes that in-house investment (in R&D, production, management, personnel
training) will result in improvements. Foreign technology/organisational
techniques may actually be inappropriate to local needs, capital intensive and
have a negative affect on local competitors, especially smaller business who are
less able to make equivalent adaptions. Similarly external changes in suppliers,
customers and other competing firms are not necessarily an improvement on the
original domestic-based approaches (UNCTAD 1999).
5. “Crowding in” or “Crowding out”?
“Crowding in” occurs where FDI companies can stimulate growth in up/down
stream domestic businesses within the national economies. Whilst “Crowding
out” is a scenario where parent companies dominate local markets, stifling local
competition and entrepreneurship. One reason for crowding out is “policy
chilling” or “regulatory arbitrage” where government regulations, such as
labour and environmental standards, are kept artificially low to attract foreign
investors, this is because lower standards can reduce the short term operative
costs for businesses in that country. Exclusive production concessions and
preferential treatment to TNCs by host governments can both restrict other
foreign investors and encourage oligopolistic (quasi-monopoly) market
structure (ECOSOC 2000, UNCTAD 1999).
Empirical data for these scenarios is variable, but crowding out is thought to be
more common in specific sectors. For example, in industries where demand or
supply for a product or service is highly price elastic (market sensitive) and
capital intensive. Hence regulation brings additional costs of compliance and is
therefore much more likely to influence a company’s decision to invest in that
country (OECD b).

6. Scale and pace of investment

It may be difficult for some governments, particularly low income countries, to
regulate and absorb rapid and large FDI inflows, with regard to regulating the
negative impacts of large-scale production growth on social and environment
factors (WWF 1999). Also a high proportion of FDI inflows in developing
economies are commonly aimed at primary sectors, such as petroleum, mining,
agriculture, paper-production, chemicals and utilities. Primary sectors are
typically capital and resource intensive, with a greater threshold in economies of
scale and therefore slower to produce positive economic “spill over” effects
(OECD a). Thus, in the short term, low income economies will have less
capacity to mitigate environmental damages or take protective measures,
imposing greater remediation costs in the long term, as well as potentially
irreversible environmental losses (WWF 1999, OECD b).
FDI IN INDIA
Foreign direct investment in India:
Liberalization of the Indian economy in the early 1990s boosted the inflow of
Foreign Direct Investments (FDI) to India. It also helped to open Indian
markets to foreign direct investment. Further the government of India
simplified the procedures for foreign direct investment in the country in order
to encourage the foreign investors to invest in the country. Foreign direct
investment in India, came from non resident Indians, international companies,
and other foreign investors. FDI inflows to India grew significantly over the
years and assumed significant proportions by 2006-2007.

Sectors attracting FDI inflows in India during 2006- 2007 are:

• Real estate
• Construction activities
• Services sector
• Telecommunications
• Electrical equipments that includes electronics and computer software

Countries contributing to FDI inflows in India during 2006- 2007 are:

• USA
• Singapore
• UK
• Netherlands
• Mauritius

In 2006-07, FDI comprised 2.31% of the GDP of India. This was merely 0.77%
in 2003-04. FDI comprised 6.42% of total investments in India in 2006-07
which was a significant growth 2.55% in 2003-04. The remarkable growth of
FDI in India during 2006-07 had major impacts on the economic growth of the
country boosting output and employment significantly.
The rapid growth of the economy, favourable investment regime, liberal policy
changes and procedural relaxations, has resulted in a horde of global
corporations investing in India. The generous inflow of FDI is playing a
significant role in the economic growth of the country.
In 2007-08, India's FDI touched US$ 25 billion, up 56 per cent against US$
15.7 billion in 2006-07, and the country's foreign exchange reserves had
crossed US$ 341 billion as on May 21, 2008. In 2005-06, the growth was even
sharper at 184 per cent, up from US$ 5.5 billion in 2004-05.
Projections say that the country will attract US$ 35 billion in FDI in 2008-09 (as
per data released by the Ministry of Commerce and Industry).
INDIA: A MUCH FAVOURED DESTINATION
India has been rated as the fourth most attractive investment destination in the
world, according to a global survey conducted by Ernst and Young in June
2008. India was after China, Central Europe and Western Europe in terms of
prospects of alternative business locations. With 30 per cent votes, India
emerged ahead of the US and Russia, which received 21 per cent votes each.
According to a report by the National Council of Applied Economic Research
(NCAER), "In the first nine months of 2007-08, the net capital flows rose to
US$ 83 billion from US$ 30 billion the country received during the
corresponding period of the previous year." The funds coming in as foreign
direct investment (FDI) or external commercial borrowing, had also upped
portfolio funds, as between FY 2004 and FY 2008, the reserves increased by
more than US$ 150 billion. The influx of foreign funds during the period was
sufficient to finance the current account deficit, the report further said.
As per the global survey of corporate investment plans carried out by KPMG
International, released in June 2008, (a global network of professional firms
providing audit, tax, and advisory services), India will see the largest overall
growth in its share of foreign investment, and it is likely to become the world
leader for investment in manufacturing. Its share of international corporate
investment is likely to increase by 8 per cent to 18 per cent over the next five
years, helping it rise to the fourth, from the seventh position, in the investment
league table, pushing Germany, France and the UK behind.
According to the AT Kearney FDI Confidence Index 2007, India continues to
be the second most preferred destination for attracting global FDI inflows, a
position it has held since 2005. India topped the AT Kearney's 2007 Global
Services Location Index, emerging as the most preferred destination in terms of
financial attractiveness, people and skills availability and business environment.
Similarly, UNCTAD's World Investment Report, 2005 considers India the 2nd
most attractive investment destination among the Transnational Corporations
(TNCs).
A recent survey conducted by the Japan Bank for International Cooperation
(JBIC) shows that India has become the most-favoured destination for long-
term Japanese investment.

SECTOR-WISE FDI
A large portion of the FDI has been flowing into the skill-intensive and high
value-added services industries, particularly financial services and information
technology. India, in fact, dominates the global service industry in terms of
attracting FDI with its unassailable mix of low costs, excellent technical and
language skills, mature vendors and liberal supportive government policies.
Now, global investors are also evincing interest in other sectors like
telecommunication, energy, construction, automobiles, electrical equipment
apart from others.
• Leading Japanese, Korean, European, French, and American automobile
companies have set up their manufacturing base in India.
• Currently, FDI inflows into the Indian real estate sector are estimated to be
between US$ 5 billion and US$ 5.50 billion. Investment in the Indian realty
market is set to increase to US$ 20 billion by 2010. Prominent foreign players
include Emaar Properties (Dubai), IJM Corp (Malaysia), Lee Kim Tah Holding
(Singapore) and Salim Group (Indonesia).
• Many big names in international retail are also entering Indian cities. Global
players, such as Wal Mart, Marks & Spencers, Roseby, etc, have lined up
investments to the tune of US$ 10 billion for the retail industry.
• According to Mines Minister, Sis Ram Ola, "FDI of about US$ 2.5 billion per
annum is expected in the mining sector from the fifth year of implementation of
the new National Mineral Policy (NMP)."
• The surge in mobile services market is likely to see cumulative FDI inflows
worth about US$ 24 billion into the Indian telecommunications sector by 2010,
from US$ 3.84 billion till March 2008.
Aggressive Investment Plans
The surging economy has resulted in India emerging as the fastest growing
market for many global majors. This has resulted in many companies lining up
aggressive investment plans for the Indian market.
• Panasonic is planning to line up US$ 200 million investment in India over the
next 3 years for setting up new units, brand positioning and upgrading its
facilities.
• Japanese engineering major, Toshiba plans to put up a power boiler plant at
Ennore, north of Chennai with an initial investment of around US$ 232.91
million.
• Dell would be investing more in India to commensurate with the growth of its
products.
• Intel Corp will invest US$ 40 billion in partnership with Indian IT companies
to create an end-to-end IT solution for the health sector in the country.
• Cairn India, the Indian arm of British oil and gas company Cairn Energy, will
invest about US$ 2 billion over the next 18 months for the development of oil
fields and building a pipeline.
• HPCL and Mittal Energy will together put in US$ 81.94 billion worth
investment in developing a petrol hub.
• Havells India will bring in US$ 64.92 million as issue of shares and
convertible warrants.
• Essar Power will infuse up to US$ 2 billion as foreign equity for undertaking
various downstream projects, including power and coal mining.
• Coca Cola India plans to invest US$ 250 million over the next three years in
equipment purchases, brand promotion and marketing.
• Goldman Sachs (Mauritius) NBFC LLC will invest US$ 46.51 million in
NBFC activities.
• A Merrill Lynch & Co entity had bought 49 per cent equity in seven
residential projects in Chennai, Bangalore, Kochi and Indore for US$ 345.78
million.
• Zoom Entertainment Network will bring in US$ 28.02 million through
induction of foreign equity.
• Toyoda Gosei Company Ltd of Japan will set up a wholly owned subsidiary
worth US$ 10.51 million to manufacture automobile safety systems, body
sealing and steering parts.
• Another Japanese company, T S Tech Company, will invest US$ 3.50 million
to set up a joint venture firm to manufacture seats and interior of doors for cars.
• UAE mobile retailer, Cellucom, will invest US$ 116.79 million for rolling out
500 stores across India by the end of 2009.
Government Initiatives
The Indian Government's approach towards foreign investment has changed
considerably during the past decade. Foreign investment, which was permitted
only in restricted industries under exceptional conditions, has been liberalised
across the board, excluding certain restricted or prohibited industries. The
sweeping economic reforms undertaken by the government aimed at opening up
the economy and embracing globalisation have been instrumental in the surge in
FDI inflows.
The government has taken various steps to further facilitate and augment the
inflow of foreign investment into India.
• The government would soon remove the compulsory disinvestment clause on
overseas companies in major sectors like food processing and chemicals, a
move aimed at simplifying foreign direct investment (FDI) rules further. The
finance ministry is weighing the proposal after the Department of Industrial
Policy and Promotion (DIPP, which formulates FDI policy) suggested waiving
the clause for all companies that have decided on divestment.
• The government may allow 49 per cent FDI in segments such as gems &
jewellery and apparel after National Council of Applied Economic Research
(NCAER), which studies the effects of multi-brand retail in India, submits its
report.
• Restructuring the Foreign Investment Promotion Board (FIPB).
• Shri Kamal Nath, Union Minister of Commerce & Industry, has stated that
Foreign Direct Investment (FDI) up to 100 per cent is permitted under the
automatic route in most of the sectors.
• Establishment of the Indian Investment Commission to act as a one-stop shop
between the investor and the bureaucracy.
• Progressively raising the FDI cap in other sectors like telecom, aviation,
banking, petroleum and media sectors among others.
• Removal of the investment cap in the small scale industries (SSI) sector.
• Companies will now require only an FIPB approval for investments up to US$
231.90 million (Rs 1,000 crore). Clearance from Cabinet Committee of
Economic Affairs (CCEA) will be imperative only for investments above US$
231.90 million (Rs 1,000 crore).
These measures will greatly enhance the global community's confidence in the
fundamentals of the Indian economy, and reflect the efforts of the Indian
Government to integrate with the global economy. With government planning
more liberalisation measures across a broad range of sectors and continued
investor interest, the inflow of FDI into India is likely to further accelerate.
Already, upbeat due to the buoyant FDI growth in the country, the government
has put a target of US$ 35 billion in FDI, in 2008-09.
Investment in India - Investing in India - Venturing
into the Indian Market
Investment in Indian market
India, among the European investors, is believed to be a good investment
despite political uncertainty, bureaucratic hassles, shortages of power and
infrastructural deficiencies. India presents a vast potential for overseas
investment and is actively encouraging the entrance of foreign players into the
market. No company, of any size, aspiring to be a global player can, for long
ignore this country which is expected to become one of the top three emerging
economies.

Success in India
Success in India will depend on the correct estimation of the country's potential,
underestimation of its complexity or overestimation of its possibilities can lead
to failure. While calculating, due consideration should be given to the factor of
the inherent difficulties and uncertainties of functioning in the Indian
system.Entering India's marketplace requires a well-designed plan backed by
serious thought and careful research. For those who take the time and look to
India as an opportunity for long-term growth, not short-term profit- the trip will
be well worth the effort.

Market potential
India is the fifth largest economy in the world (ranking above France, Italy, the
United Kingdom, and Russia) and has the third largest GDP in the entire
continent of Asia. It is also the second largest among emerging nations. (These
indicators are based on purchasing power parity.) India is also one of the few
markets in the world which offers high prospects for growth and earning
potential in practically all areas of business.Yet, despite the practically
unlimited possibilities in India for overseas businesses, the world's most
populous democracy has, until fairly recently, failed to get the kind of
enthusiastic attention generated by other emerging economies such as China.

Lack of enthusiasm among investors

The reason being, after independence from Britain 50 years ago, India
developed a highly protected, semi-socialist autarkic economy. Structural and
bureaucratic impediments were vigorously fostered, along with a distrust of
foreign business. Even as today the climate in India has seen a seachange,
smashing barriers and actively seeking foreign investment, many companies
still see it as a difficult market. India is rightfully quoted to be an incomparable
country and is both frustrating and challenging at the same time. Foreign
investors should be prepared to take India as it is with all of its difficulties,
contradictions and challenges.

Infrastructural hassles
The rapid economic growth of the last few years has put heavy stress on India's
infrastructural facilities. The projections of further expansion in key areas could
snap the already strained lines of transportation unless massive programs of
expansion and modernization are put in place. Problems include power demand
shortfall, port traffic capacity mismatch, poor road conditions (only half of the
country's roads are surfaced), low telephone penetration (1.4% of population).

Indian Bureaucracy
Although the Indian government is well aware of the need for reform and is
pushing ahead in this area, business still has to deal with an inefficient and
sometimes still slow-moving bureaucracy.

Diverse Market .
The Indian market is widely diverse. The country has 17 official languages, 6
major religions, and ethnic diversity as wide as all of Europe. Thus, tastes and
preferences differ greatly among sections of consumers.

Therefore, it is advisable to develop a good understanding of the Indian market

and overall economy before taking the plunge. Research firms in India can
provide the information to determine how, when and where to enter the market.
There are also companies which can guide the foreign firm through the entry
process from beginning to end --performing the requisite research, assisting
with configuration of the project, helping develop Indian partners and financing,
finding the land or ready premises, and pushing through the paperwork
required.
INVESTMENT IN INDIA - FOREIGN DIRECT
INVESTMENT - \

Foreign Direct Investment (FDI) is permited as under the following forms

of investments.

• Through financial collaborations.

• Through joint ventures and technical collaborations.
• Through capital markets via Euro issues.
• Through private placements or preferential allotments.

Forbidden Territories:
FDI is not permitted in the following industrial sectors:

• Arms and ammunition.

• Atomic Energy.
• Railway Transport.
• Coal and lignite.
• Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds,
copper, zinc.

Foreign Investment through GDRs (Euro Issues)

Foreign Investment through GDRs is treated as Foreign Direct Investment
Indian companies are allowed to raise equity capital in the international market
through the issue of Global Depository Receipt (GDRs). GDRs are designated
in dollars and are not subject to any ceilings on investment. An applicant
company seeking Government's approval in this regard should have consistent
track record for good performance (financial or otherwise) for a minimum
period of 3 years. This condition would be relaxed for infrastructure projects
such as power generation, telecommunication, petroleum exploration and
refining, ports, airports and roads.

Clearance from FIPB

There is no restriction on the number of Euro-issue to be floated by a company
or a group of companies in the financial year . A company engaged in the
manufacture of items covered under Annex-III of the New Industrial Policy
whose direct foreign investment after a proposed Euro issue is likely to exceed
51% or which is implementing a project not contained in Annex-III, would need
to obtain prior FIPB clearance before seeking final approval from Ministry of
Finance.

Use of GDRs
The proceeds of the GDRs can be used for financing capital goods imports,
capital expenditure including domestic purchase/installation of plant, equipment
and building and investment in software development, prepayment or scheduled
repayment of earlier external borrowings, and equity investment in JV/WOSs in
India.

Restrictions
However, investment in stock markets and real estate will not be permitted.
Companies may retain the proceeds abroad or may remit funds into India in
anticiption of the use of funds for approved end uses. Any investment from a
foreign firm into India requires the prior approval of the Government of India.

Foreign Direct Investment – Approval

Foreign direct investments in India are approved through two routes:

Automatic approval by RBI:
The Reserve Bank of India accords automatic approval within a period of two
weeks (provided certain parameters are met) to all proposals involving:

• foreign equity up to 50% in 3 categories relating to mining activities (List

2).
• foreign equity up to 51% in 48 specified industries (List 3).
• foreign equity up to 74% in 9 categories (List 4).
• where List 4 includes items also listed in List 3, 74% participation shall
apply.

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.

Opening an office in India

Opening an office in India for the aforesaid incorporates assessing the
commercial opportunity for self, planning business, obtaining legal, financial,
official, environmental, and tax advice as needed, choosing legal and capital
structure, selecting a location, obtaining personnel, developing a product
marketing strategy and more.

The FIPB Route:

Processing of non-automatic approval cases
FIPB stands for Foreign Investment Promotion Board which approves all other
cases where the parameters of automatic approval are not met. Normal
processing time is 4 to 6 weeks. Its approach is liberal for all sectors and all
types of proposals, and rejections are few. It is not necessary for foreign
investors to have a local partner, even when the foreign investor wishes to hold
less than the entire equity of the company. The portion of the equity not
proposed to be held by the foreign investor can be offered to the public.

TOTAL FOREIGN INVESTMENT AND FDI

Total foreign investment in IFY 1997-98 was estimated at dols 4.8 billion in
1997-98, compared to dols 6 billion in 1996-97. Foreign Direct Investment
(FDI) in 1997-98 was an estimated dols 3.1 billion, up from dols 2.7 billion
in1996-97. The government is likely to double FDI inflows within two years.
Foreign portfolio investment by foreign institutional investors was significantly
lower at dols 752 million for fiscal 1997-98, down compared to dols 1.9 billion
in1996-97, partly reflecting the effect of the recent crisis in Asia.

Foreign institutional investors

Foreign institutional investors (FIIs) were net sellers from November 1997
through January 1998. The outflow, prompted by the economic and currency
crisis in Asia and some volatility in the Indian rupee, was modest compared to
the roughly dols 9 billion which has been invested in India by FIIs since 1992.

FII investments
FII net investment declined to dols 1.5 billion for IFY 1997-98, compared to
dols 2.2 billion in 1996-97. The trend reversed itself in February and March
1998, reflecting the renewed stability of the rupee and relatively attractive
valuations on Indian stock markets.

Large outflows of capital

Large outflows began again in May 1998, following India's nuclear tests and
volatility in the rupee/dollar exchange rate. In an effort to avoid further heavy
outflows, the RBI announced in June that FIIs would be allowed to hedge their
incremental investments in Indian markets after June11, 1998.