Is FDI really a gift horse?

BISWAJIT DHARK. S. CHALAPATI RAO

Illustration: Deepak Harichandan

Data for India do not allow us to make the distinction between long-term and portfolio investments.

In less than a year, the Government of India has announced yet another set of “radical changes” in foreign direct investment (FDI) policies. The earlier announcement in November 2015 introduced changes in 15 major sectors, and the latest announcement covers nine sectors.

However, the thrust of the two sets of policy changes remains the same, namely to ease entry of foreign investors in India. Last year’s announcement stated that the policy changes were intended to “ease, rationalise and simplify the process of foreign investments in the country and to put more and more FDI proposals on automatic route instead of Government route where time and energy of the investors is wasted”, while the recent amendments “seek to further simplify the regulations governing FDI in the country and make India an attractive destination for foreign investors”.

A more cogent explanation is, however, provided in the Consolidated FDI Policy that was unveiled just a fortnight earlier and which states: “It is the intent and objective of the Government of India to attract and promote foreign direct investment in order to supplement domestic capital, technology and skills, for accelerated economic growth. Foreign Direct Investment, as distinguished from portfolio investment, has the connotation of establishing a ‘lasting interest’ in an enterprise that is resident in an economy other than that of the investor.”

FDI in theory and practice

Now that India has become “the most open economy in the world for FDI”, can the country expect to benefit from this form of investment?

We would begin by trying to understand whether FDI has retained its character of being long-term inflows of investible capital in an age when global capital markets are being ruled by investors having short-term targets. Economists have always treated FDI as that component of foreign investment in an enterprise that confers “control” to the foreign investor over the enterprise. All other foreign investment was defined as portfolio investment, and this component was considered “footloose”. As regards the threshold for identifying whether an enterprise was foreign-controlled or otherwise, most countries adopted their own definitions. For instance, in the past, the Reserve Bank of India (RBI) followed the practice of identifying “foreign-controlled rupee companies”, which were companies having foreign shareholding of 25 per cent or more of total equity or where 40 per cent share is held by investors from a single country.

In recent decades, the Organisation for Economic Cooperation and Development (OECD) and International Monetary Fund (IMF) have pushed for a globally acceptable definition of FDI, according to which 10 per cent or more of foreign equity constitutes the “controlling share” in an enterprise. But not all countries have adopted the OECD-IMF definition.

For instance, in India all investments other than those through the stock market are reported as FDI. India, therefore, does not make any distinction between the “controlling share” and the others as far as FDI is concerned. This implies that data on FDI for India do not allow us to make the distinction between long-term investments and portfolio investments.

Foreign investors consider “controlling share” to be vital for bringing in state-of-the-art technologies. However, given the fact that developing countries have been struggling to get access to proprietary technologies despite steep increases in FDI inflows over time, there seems to be the proverbial slip between access to technology and FDI inflows.

The OECD-IMF duo introduced some other components in the definition of FDI, the most significant of these being the inclusion of reinvested earnings. While it may be justified for balance of payments purposes, the fact is that retained earnings increase the host country’s liabilities without actually transferring resources from abroad. Retained earnings are a part of the profits earned by foreign companies in their host countries, which are in domestic currencies. Once capitalised and absorbed in the equity stock, retained earnings become conduits for larger dividend remittances in future. Further, if such earnings are used to take over domestic companies or to buy back shares from the public, then they would not add to the existing capacities. Data provided by the UN Conference on Trade and Development (UNCTAD) show that the share of reinvested earnings has increased progressively during the recent past and by 2013 they constituted two-thirds of the FDI outflows from the developed countries. In fact, more money was flowing into the developed countries as dividend income than that was flowing out as direct investment. Thus actual cross-border equity flows that meet the conventional definition of FDI are only a fraction of the reported global FDI flows.

Inflows and outflows

According to official statistics, India has seen a steep increase in FDI inflows totalling over $55 billion in 2015-16. However, in the world of high finance, FDI is not a gift horse —there are at least two sets of costs that host countries have to bear. The first is the direct cost stemming from outflows on account of operation of foreign companies. The RBI has reported that between 2009-10 and 2014-15, outflows due to repatriations, dividends and payments for technology have together constituted a major foreign exchange drain — nearly one-half of the equity inflows during this period! The RBI also tells us that during the same period, subsidiaries of foreign companies operating in India ran negative trade balances in almost all manufacturing sub-sectors. Together with remittances and other payments, foreign subsidiaries in most sectors regularly drew out surpluses which look quite large when compared with the capital that the foreign companies were bringing in.

Apart from the direct costs, foreign investors are able to extract indirect benefits from their host economies by using bilateral investment promotion and protection agreements (BIPA). In recent years, India has faced a number of disputes with foreign investors, which arose because the latter was able to invoke the investor-state dispute settlement (ISDS) mechanism included in the BIPAs that allows disputes to be taken to private international arbitration panels. Most of the cases have arisen as the foreign investors have challenged the tax liabilities imposed by the government. The government has amended the model BIPA ostensibly to blunt the ISDS mechanism. The new model BIPA includes a strong stricture to foreign investors to make timely payment of their tax liabilities in accordance with India’s laws. It will be well worth watching as to how this instrument gels with the investor-friendly regime that has now been put in place.

Biswajit Dhar is professor, Jawaharlal Nehru University, and K.S. Chalapati Rao is professor, Institute for Studies in Industrial Development, New Delhi.