MANAGERIAL ECONOMICS

PROJECT ON

FOREIGN CAPITAL IN INDIA

TABLE OF CONTENTS What is Foreign Capital Need for Foreign Capital Forms of Foreign Capital Pre-Liberalisation Period(1947-1991) Foreign Institutional Investors Liberalisation of FIIs into India FDI -What is FDI? -Routes available for FDI Sources of FDI Merits and Demerits of FDI Loans taken from World Bank by India

What is foreign capital? Foreign capital is money entering the country in the form of concessional assistance or non concessional flows. Need for Foreign capital: Inadequacy of domestic capital Foreign capital can show the way for domestic capital For speeding up economic activity in a developing country Financing of projects needed for economic development Brings in technical know how, business experience and knowledge Forms of Foreign capital: Direct Foreign investment Foreign collaboration Inter-Government loans Loans from International institutions External Commercial Borrowing(ECB)

1. 2. 3. 4. 5. 1. 2. 3. 4. 5.

Pre Liberalisation period in India: After independence from British colonial rule in 1947, India opted a socialist economy which was influenced by the Soviet Union, with government control over private sector participation, foreign trade and foreign direct investment. This economic policy aimed to substitute products which India imports with locally produced substitutes, industrialization, and state intervention in labour and financial markets, a large public sector, business regulation and centralized planning. Policies were protectionist in nature and the government made efforts to reduce the import to the minimum level to safeguard the interests of the domestic Industries. Plus at the time of Independence, the attitude towards foreign capital was that of fear and suspicion. The common belief was that foreign capital was draining away resources from the economy. As a result the Prime Minister had to give following assurance to foreign capitalists in 1949: 1.) No discrimination between foreign and Indian Capital 2.) Full opportunities to earn profits 3.) Guarantee of compensation Jawaharlal Nehru, who formulated and oversaw this economic policy, expected a favourable outcome from this strategy because it features both capitalist market economy and socialist command economy. But the outcome was unfavourable to the country and lead to liberalization and privatization in India. Government made large investments in heavy industries and expects these industries will produce enough capital for investment in other sectors of the economy. But it didn't happen. In the other hand, government has to invest more money for the survival of these companies because of poor management and low productivity. For example, the public sector steel company losses were more than its initial investment while the private sector steel company was making profit.

India's average annual growth rate from 1950-1980 was 3.5%. At the same time other Asian countries like Hong Kong, Singapore, South Korea and Taiwan recorded an annual growth rate of 8%. Now 'Hindu rate of growth' is an expression to refer low annual growth rate. The failure of pro-socialist economic policy to produce an annual growth rate comparable to its neighbours leads to the economic reforms going on now.

Foreign institutional investors: FII means an entity established or incorporated outside India which proposes to make investment in India. Foreign Institutional Investors (FII) include the following foreign based categories: Pension Funds, Mutual Funds, Investment Trust, Insurance or reinsurance companies, Investment Trusts, Banks, Endowments, University Funds, Foundations, Charitable Trusts or Charitable Societies. Portfolio investors provide institutional character to the capital markets, flavoured by highly intensive research and diversified investments. FII investments seek to inject global liquidity into the markets, raise the priceearning ratio and thus reduce the cost of capital. Portfolio investment represents purchases and sales of foreign financial assets such as stocks and bonds that do not involve a transfer of management control. International portfolio investments have become popular in recent years due to the desire of investors to diversify risk globally. Global investors may feel that they may also benefit from higher expected returns from some foreign markets. Such investments can be in the form of bonds (convertible and non-convertible) as well as equity (say in the form of ADRs/ GDRs). Investments may be made directly or through institutional investments (say FIIs). Liberalisation of Portfolio Investment Flows into India: Prior to 1992, only NRIs and OCBs were allowed to undertake Portfolio Investment in India. In line with the recommendations of High Level Committee on Balance of Payments, FIIs were allowed to invest in Indian Debt market and Equity market. FII Investment first started flowing into India in 1993. In the case of FIIs, the total holding of each FII/SEBI approved sub account shall not exceed 10% of the total paid up capital or 10% of the paid up value of each series of convertible debentures issued by an Indian company and the total holdings of all FIIs/sub-accounts of FIIs put together shall not exceed 24% of the paid-up capital or paid-up value of each series of convertible debentures. Sub-account includes those foreign corporations, foreign individuals, and

institutions, funds or portfolios established or incorporated outside India on whose behalf investments are proposed to be made in India by a FII. This limit of 24% can be increased to the sectorial cap/statutory limit as applicable to the Indian company concerned by passing a resolution by its Board of Directors followed by passing of a special resolution to that effect by its General Body. Guidelines were originally issued in Sept.1992. It consists of pension funds, mutual funds, investment trusts, AMCs, endowments, etc. There is a good track record, competence, financial soundness, registration from regulatory authority in the home country. Registration of 5 years by the nodal agency SEBI, also RBI. Is required. They are allowed to invest in all the securities traded on the primary and secondary markets. Foreign Institutional Investors can buy dated Government securities/ treasury bills, non-convertible debentures /bonds issued by Indian companies and units of domestic mutual funds either directly from the issuer of such securities or through a registered stock broker on a recognised stock exchange in India. FII net inflows are as follows: $10.7 billion in 2005, $9.2 billion in 2004 and $ 6.6 billion in 2003. Total net inflow since 1993: $42 billion in a total market capitalisation of $ 550 billion. Investments can be performed through three routes: registered FII, registered as a sub-account of a sponsoring FII, and indirectly through access products or Participatory Notes (PNs). Estimated 90% investment through sub-accounts, as this avoids procedural problems: establishing broker and custodian relationships, filing of tax certificates, etc. PNs account for about 25% of total FII investment, including sub-accounts. Participatory Notes (PNs): In view of the concerns of some unregulated entities taking positions in the stock market through the mechanism of PNs issued by FIIs, the issue was examined by the Ministry of Finance in consultation with the Reserve Bank of India (RBI) and Securities and Exchange Boards of India (SEBI). Following these consultations, in January 2004, SEBI stipulated that PNs are not to be issued to any non-regulated entity, and the principle of know your clients may be strictly adhered.

FDI What is FDI? Foreign direct Investment or FDI is a measure of foreign ownership of domestic productive assets such as factories, land and organizations. Foreign direct investments have become the major economic driver of globalization, accounting for over half of all cross border investments. The most profound effect is seen in developing countries that use FDI to boost their economic growth Now two routes available for FDI:1. Automatic approval by RBI 2. Govt. Approval via Foreign Investment Promotion Board (FIPB) FDI in India Substantial liberalization was announced in the New Industrial Policy declared by the government in July 1991 and doors of several industries have opened up for investment. Prior to this policy, foreign capital was generally permitted only in those industries where Indian capital was scarce and was not normally permitted in trading activities, plantations, banking and financial institutions. It was not permitted in those industries which had received government protection or which are of basic and/ or strategic importance to the country. The declared policy of the government was to discourage foreign capital in certain inessential consumer goods and services industries. In a bid to attract foreign capital and investments from NRIs, the government has in recent years announced a number of tax concessions, lower rates of taxation for certain designated priority industries; tax holidays on profits for a certain period to new industrial undertakings, etc. NRIs investing in India were allowed higher investment limits, priority allotment of items in short supply, permission to buy shares in Indian companies, etc. however the real opening up came with the announcement of the new industrial policy in July 1991. In subsequent period, several other measures for promoting foreign investment in India were announced. After the announcement of the new industrial policy, larger foreign investments were allowed in industries such as NBFCs (Non Banking Financial

Companies) such as merchant banking, stock broking, foreign exchange banking, financial consultancy, housing finance, venture capital, financial consultancy, etc., business to business e commerce, oil refining, mining, plantations, aviation, real estate, commodity exchanges, credit formation companies, tourism sector, infrastructure, advertising, films, telecom and IT, etc.

Sources of FDI Largest inflows of FDI over the period January 2000 to April 2008 have been received from Mauritius, its share in inflows being as high as 40.5% ($27,118 million out of $66,938 million). Singapore was second with a share of 7.1%, UK third with a share of 6.6%, USA fourth with a share of 2.8% and Cyprus fifth with a share of 1.6%. However it should be noted here that Mauritius based investments are nothing but US investments and investments from other developed countries. They are routed through Mauritius because of the tax advantages. The tax advantage emanates from the double taxation avoidance agreement (DTAA) that India has with that country. This agreement implies that any foreign investor has the option of paying tax either in India or in Mauritius. Since the tax rates prevailing in Mauritius are amongst the lowest in the world, many multinational companies prefer to route their investments to India through Mauritius. According to the OECD (organization for Economic Co operation and Development, Mauritius is an important tax haven. Other tax havens are Cyprus, British Virgin Islands, Cayman Islands, Bahamas, Hong Kong, Malta, etc. Tax havens are characterized by low or zero taxation, a lack of transparency and a refusal to provide information to foreign tax authorities. Thus they become a preferred route of investment by MNCs in other countries. Tax havens lead to tax avoidance. The most obvious method is for an individual method is for an individual to move to the tax haven country and become a resident for the purpose of paying taxes. Another was is to incorporate a business in the tax haven country and then move all the companys assets to it. Any new income made by the incorporated company would then be subject to taxation only in the tax haven country

Merits and Demerits of FDI: Merits:

1.

Risk taking: Undertaking the initial risk of developing new lines of production in an underdeveloped country is of great significance because of the in adequacy of native innovators, risk takers or industrial entrepreneurs. Foreign capital brings with it expertise, experience and resources to explore new lines. Technical know-how: Foreign capital brings with it technical know-how which enables the recipient nation to organize its resources in the most efficient manner i.e. least cost production methods are adopted. High Standards: Private foreign capital brings with it traditions of keeping high standards in respect of quality of goods, salary and wages to employees, business practices, etc. Such things not only serve the interest of these ventures but act as an important factor in raising the quality of products of native concerns, improving payments to employees, etc.

2.

3.

Demerits:
Increase in dependence: India is now facing these problems. We have taken so much from the foreign technical know-how that we have not yet developed what may be described as an appropriate technology suited to our resources and needs. Remittance of large amounts: Remittance of profits is a normal facility but often the profits in the early stages are high and in many collaborations contracts, it is this very amount that must be paid back wholly to the foreign investor. Hence large remittances are made. Limited Sphere: Private foreign investors usually choose those industries where it can make large and quick profits irrespective of the fact whether development of those industries is in the national interest. Further that does not take much interest in collaborating with the public sector. Hence in this hence, the function in a very limited sphere

Loans taken by India from the World Bank: 1. The World Bank approved four loans worth $4.345 billion dollars on 23/8/2009, which is the second largest volume of lending to a single country in a year. The goal of the four projects is to contribute to improving India's infrastructure and help bolster the country's response to the global economic and financial crisis and lay the foundations for stronger growth in the future. The financial package consists of: -Banking Sector Support: $2 billion -Support for India Infrastructure Finance Company Limited: $1.195 billion -The Fifth Power Sector Support Project: $1 billion -The Andhra Pradesh Rural Water Supply and Sanitation Project: $150 million.
2. On June 1, 2010, the World Bank approved a Statistical Strengthening Loan

for India of US$107 million. This loan supports institutional and policy based reform by the Government of India to strengthen state statistical systems within a national policy framework. This project was developed to enable States and Union Territories of India to progress towards common national standards for key statistical activities and improve the credibility, timeliness and accuracy of statistics at both central and state levels. One of the World Banks main priorities is to help countries develop National Strategies for the Development of Statistics as well as helping countries invest in statistical capacity improvement and helping mobilize the expertise of the international statistical system. The Bank has been working with India for over a decade on statistical reforms and the India Statistical Strengthening Loan is the result of detailed analytical work and a rigorous consultative process that the Bank supported in identifying a core area of intervention. This loan is the first Bank-wide Development Policy Loan in statistics and is innovative in several aspects:

it supports an institutional and policy based framework for a centrally sponsored scheme, i.e. voluntary participation of states and provision of financial resources from center to states on a grant basis; it allows states to design, prioritize and implement their own statistical reform strategies within the national policy in statistics; it provides adequate space and flexibility for states to adapt to the institutional framework; and

it establishes performance linked criteria for central government transfer of resources to states.

India has been a leader in the use and collection of statistics including the designing and implementation of large scale surveys. Through this operation, India adds a new dimension globally on sub-national statistical reforms. The World Banks work to improve statistical capacity focuses on helping countries and the international community to better monitor Poverty Reduction Strategies and Millennium Development Goals, and enhance the Results Measurement System agreed for the 14th replenishment of the International Development Association. The overarching strategy is guided by a global action plan (commonly referred to as the Marrakech Action Plan for Statistics (MAPS) to improve national and international statistics. We provide financial and advisory services, in addition to tools to help our clients develop better statistical systems.

The country has become the largest recipient of the World Bank loans with over $9 billion worth assistance this fiscal ending June 2010, up fourfold over the previous fiscal. The Washington-based multilateral lender had extended only $2.2 billion loan to the country for the year ended June 2009. India's share among the various recipients of the Bank is 15 percent in terms of loans, followed by Mexico with 11 percent and South Africa with 7 per cent as of June 20, 2010. As of June 20, the Bank has lent $9.26 billion to India and is expected to provide another $0.04 billion in the remaining period of June. The Bank follows a fiscal year from July to June.