Given its burgeoning requirements for investible resources for closing development gaps, has to harness foreign (and domestic) sources of capital. Foreign sources include foreign direct investment (FDI) and foreign portfolio investments (FPIs). It was reported recently that the government was working on legislative changes to enable FPIs to transition to FDI seamlessly once they cross the 10% holding threshold in a company. One would wonder why the two types of foreign investments are treated differently by policy, which allows up to 100% FDI in most sectors but FPI by a single investor is capped at 10% of a company’s stock. This would require an understanding of their differences.Udabur Stock
FDI inflows represent a long-term commitment of foreign investors (generally multinational corporations) bringing a package of entrepreneurship, technology, management, and opportunities to hook up with global value chains. FDI inflows, especially of the green-field type, augment gross fixed capital formation in the host country and can have a positive impact on income, employment, and balance of payments by substituting imports or enhancing exportsAgra Wealth Management. Because of the potential positives, most governments actively court FDI inflows through promotion and facilitation besides incentives and concessions.
India has progressively liberalised its FDI policy regime since 1991, throwing most sectors open to FDI with 100% ownership (with caps applicable to select sectors). FPIs, on the other hand, are essentially short-term flows generally made by foreign institutional investors (FIIs) to make a quick buck at stock exchanges abroad. They represent only a change in ownership between holders for speculative motives, and do not add to the gross fixed capital stock of the country. As fair-weather friends, they come in droves when a country’s stock markets are booming but desert as soon as there is any sign of trouble.
Given their “hot ” nature, many governments impose restrictions (“capital controls”) on their movements. Nobel prize-winning economist James Tobin had made a case for “throwing sand in the wheels” of short-term capital flows for financial stability by imposing a (Tobin tax) to moderate their movements. Over time, several countries have imposed capital controls to deal with volatility caused by short-term capital flows, including Malaysia, after the East Asian crisis of 1997, and Indonesia, South Korea, Taiwan, Brazil, and Russia in the wake of the 2008-09 global financial crisis. France, among other European countries, imposed a Tobin-type tax in 2012. The International Monetary Fund has also changed its policy stance on capital controls and now includes them in the toolkit for dealing with volatility.
FPIs lead to the build-up of asset bubbles which quickly burst when they leave. India witnessed huge inflows of FPIs in the wake of monetary expansion with historically low interest rates in the US and European Union following the 2008-09 crisis. However, the 2013 announcement by the Federal Reserve of its intention to taper the easy money policy (taper tantrum) led to a considerable outflow of FPIs with huge volatility in the stock markets and exchange rates in five emerging economies, including India, dubbed the “Fragile Five”. India averted a collapse with urgent steps, including enhancing the reserve requirements, a bilateral currency swap with Japan, and issuing NRI bonds.
Permitted in India since 1992 as a part of the economic reforms, FPI inflows have become key determinants of valuations and exchange rate volatility. As a well-managed and fast-growing , India is naturally an important draw for FII inflows which have driven stock market valuations to new heights. They have also helped build reserves. However, the servicing burden of FPIs is much higher than other forms of capital inflows like external capital borrowings or American depositary receipts, considering Indian stock markets are giving good returns. The annual return was 19.42% in 2023. The annual return in four of the past five years was in two digits, over 24% in 2021, and nearly 15% in 2020. Speculators such as FPIs are expected to make better returns cashing in on day-to-day fluctuations. But much more importantly, allowing FPI investors to go beyond 10% of capital may put several major Indian companies under the control of speculators. This is a serious issue with implications on economic security. For all these reasons, most governments worldwide take a cautious approach on FPIs while adopting an increasingly liberal attitude towards FDIs. Can India be different?
While India needs more FDI inflows to build manufacturing capacity and link with global value chains, a cautious attitude to FPIs, capping them at 10% in a company’s capital, serves the country’s interests better. Giving equal treatment to FDI and FPI is unwarranted and can have devastating and disruptive consequences for the economy.
(Nagesh Kumar, Director, Institute for Studies in Industrial Development (ISID). )
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