What circumstances lead to preferring foreign capital to foreign aid and debt?

Critically evaluate the policy measures adopted by the Government of India to

encourage inflow of foreign capital.

Ans. Foreign capital played an important role in the early stages of

industrialisation of most of the advanced countries of today, like the countries of Europe
(including the USSR) and North America. Though the problems development of the
developing countries of today are not very much similar to those faced by the advanced
countries in the past, there is a general view that foreign capital, if properly directed and
utilised, can assist the development of the developing countries.
Economic growth is a function of, among other things, capital formation. In the
developing countries, the per capita income and savings rate being very low, domestic
capital formation is inadequate to give a `big push' to the economy to take it to the 'take-
off' stage. Hence, the domestic resources may be supplemented with foreign capital to
achieve the critical minimum investment to break the vicious circle of 'low income-low
savings-low investment-low income.'
Another way by which foreign capital helps accelerate the pace of economic growth
is by facilitating essential imports required for carrying out development programmes,
like capital goods, know-how, raw materials and other inputs and even consumer goods.
The machinery, know-how and other inputs needed may not be indigenously available.
Further, the demand spurt created by large-scale investments may necessitate import of
consumer goods. When the export earnings are insufficient to finance such vital imports,
foreign capital should help reduce the foreign exchange gap.
Foreign investments may also help increase a country's export and reduce the import
requirements if such investments take place in export-oriented and import-competing
industries.

` Following the analysis of Donald MacDougall and Paul Streeten, Gerald Meier
observes' that, from the standpoint of national economic benefit, the essence of the case
for encouraging an inflow of capital is that the increase in real income resulting from the
act of investment is greater than the resultant increase in the income of the investor. If the
value added to output by the foreign capital is greater than the amount appropriated by
the investor, social returns exceed private returns. As long as foreign investment raises
productivity, and this increase is not wholly appropriated by the investor, the greater
product must be shared with others, and there must be some direct benefits to other
income groups as mentioned below:
(i) Domestic Labour: Domestic labour may get higher real wages because of the
increase in productivity. There might also be an expansion of the employment
opportunities.
(ii) Consumers: If foreign investment is cost-reducing in a particular industry,
consumers of the product may gain through lower product prices. If the investment is

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product-improving or product-innovating, consumers benefit from better quality products
or new products.
(iii) Government: The increase in production and foreign trade resulting from foreign
capital might increase the fiscal revenue of the government.
(iv) External Economies: Foreign capital may bring in a number of indirect gains
through the realisation of external economies. For instance, if foreign investment is used
for the development of infrastructure, this could stimulate domestic investment in
industrial and other sectors.`

Further advantages of foreign capital are mentioned under 'Private Foreign Capital.'
Private Foreign Capital
Private foreign capital mostly takes the form of direct investment. Hence, we deal
here with the direct foreign investment (private). The important advantages of direct
foreign investment are the following:
1. It helps increase the investment level and thereby the income and employment
in the host country.
2. Direct foreign investment facilities transfer of technology to the recipient
country.
3. It may kindle managerial revolution in the recipient country through
professional management and the employment of highly sophisticated
management techniques.
4. Foreign capital may enable the country to increase its exports and reduce
import requirements.
5. Foreign investments may stimulate domestic enterprise because to support
their own operations, the foreign investors may encourage and assist domestic
suppliers and consuming industries.
6. Foreign investment may also help increase competition and break domestic
monopolies.

Policy relating to foreign investments in India was first made in April 1949 y the late
Prime Minister Nehru. The underlying principles of the policy were as follows:
(1) Foreign capital once admitted will be treated at par with
indigenous capital;
1. Facilities for remittance of profits abroad will continue;
2. If and when foreign enterprises are acquired, compensation will be paid on
fair and equitable basis;
3. As a rule, the majority interest in ownership and effective control of an
undertaking should be in Indian hands;
4. Government would not object to foreign capital having control of a concern
for a limited period if it is found to be in the national interest, and each individual case
will be dealt with on its merits.
Conclusion. The Government promised non-discriminatory treatment of foreign
investment and remittance facilities for both profit and capital. Emphasis was laid on the
employment and training of Indians at higher positions. In keeping with those guidelines,
the general policy was to allow such foreign investments and collaborations as would be
in line with the priorities and targets of five year plans. The policy was to restrict foreign
collaboration to those cases which would bring technical know-how into the country,
such as was not available indigenously for developing new lines of production. Foreign

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investment was not to be allowed in banking, financial. commercial or trading activities
and in consumer goods industries which could be developed with indigenous know-how.
Liberal Policy, 1958-65. The foreign exchange crisis of 1957-58 led to an
increased emphasis on foreign financial collaboration. It was also easier at this time for
foreign investors to secure majority capital participation where the import content of any
project exceeded 50 p.c. of the proposed equity and production was primarily for exports,
The liberal policy which was followed during 1958-65 in regard to foreign
investments was revealed by an announcement of the Union Ministry of Commerce and
Industry in May, 1961. It emphasised among other things that allowed private capital
investment, foreign or Indian, as rule, was not to be allowed in the industries listed in
Schedule 'A' of the Industrial Policy Resolution of 1956, exceptions might be made in
special circumstances where after full consideration, it was found to be in the public
interest.
From the late fifties till the mid-sixties, conditions were very favourable for the existing
foreign enterprises to expand. The strictness of the import policy encouraged production
of imported goods within the country. Many. foreign companies which engaged in
marketing the products of their parent companies found production inside the country
easier and more profitable. These companies had sizable internal resources generated out
of depreciation and retained earnings. The Government also encouraged the conversion
of branches into subsidiaries and the bringing in of additional resources from their parent
companies aboard to finance their expansion schemes in industries. Foreign investment in
the manufacturing subsidiaries increased mainly as a result of additional input of capital
by the parent companies both n cash and in the shape of plant and machinery, and partly
due to the ploughing back of profits. Besides, this period witnessed a rapid rise in the
number of financial and technical collaborations. The Government permitted formation of
new enterprises with foreign majority participation which in some cases was allowed to
more than 80 p.c. and even 100 p.c.
Change in government policy towards foreign private investment took place in the
mid-sixties when the country again experienced a serious foreign exchange problem.
Government's attention was particularly drawn to the remittance of profits and dividends
by foreign branches and subsidiaries.
Government thought of dilution of foreign holdings and restrictions were put on
the appointment of certain persons and companies as agent or technical or management
advisers. The Controller of Capital Issues also started exerting pressure on foreign
subsidiaries to admit Indian participation. Despite this change, however, the increase in
foreign private investment continued unabated mainly due to retained earnings in
subsidiaries rather than through the inflow of additional capital from abroad.
1968-73: Policy and Procedural Changes. The policy towards private foreign
investment took a more definite shape and became more strict in the late sixties.
Specific guidelines for the approval or disapproval of foreign collaboration proposals
were laid down as follows:
1. Whether capacity in the particular field of industry is required to be developed
having regard to the plan targets;
2. Whether the technology i n volved is not indigenously available;
3. Whether the import of a capital goods involved is of such a high order that
without the collaboration proposal the scheme would involve an avoidable drain on

3
 the foreign exchange resources of the country;
4. Whether the approval of collaboration will jeopardise the industries already
existing in that particular field or in associated fields of industries;
5. Whether the proposal would involve any undue exploitation of foreign
patents, trade marks and brand names, etc.,
6. Whether the manufacturing scheme proposed fits in with our policy, both in
respect of availability of raw materials and components;
7. Whether the products to be manufactured were exportable and if so whether the
collaboration will accelerate or increase our export potential.
The criteria for allowing majority foreign participation were also explicitly
formulated. A foreign-majority interest was to be considered only when both the
following conditions were satisfied:
(a) The main contribution of the project is in a field of technology in

such areas where a great deal of initial or additional development is necessary.

(b) The import content of the project is such that unless the foreign investor is
allowed to have a majority shareholding the country will have to find a substantial
amount of foreign exchange and to alternative method of securing long-term finance is
available.
In 1968, the Government issued an "illustrative'. list in which industries were
grouped into three categories: Cases in which foreign and technical collaboration might
be permitted, cases in which only technical collaboration would be allowed, and cases
in which no foreign collaboration at all would be permitted. In conformity with these
lists foreign i n vestment up to 40 p.c. in equity was normally allowed, and attempt was
made to keep the proportion between 30% and 35% where royalty and technical fees
were also payable.
In 1969-70 a further tightening of the foreign Investment policy was reflected in
the Fourth Five Year Plan which stated that foreign collaboration should only be resorted
to for meeting a "critical gap"; foreign collaboration in producing consumer goods
should not be allowed at all; and in fields in which indigenous enterprise was not
established but would be forthcoming within a short time, no foreign collaboration
should be permitted. In 1970, following the recommendations of the Dutt Committee, it
was decided that foreign investment would in the future be encouraged only in the 'core
sector' consisting of industries like fertilizers, non-ferrous metal and heavy machinery,
the sector in which the large business houses would also be permitted to invest. In 1973,
the fields in which foreign investment was to be encouraged were further narrowed
down to 19 industries.
Foreign Investment Board. In December, 1968, that Government set up the
Foreign I n vestment Board (F.i.B). with a view to minimising procedural delays in the
disposal of applications relating to foreign investment and collaboration. The F.I.B. was
constituted with ten members with the Secretary Department of Economic Affairs
(Ministry of Finance) as Chairman.
The F.I.B. was empowered to consider for disposal all cases of collaboration where
the total equity capital did not exceed Rs. 2 crores or where the foreign equity
participation did not exceed 40 p.c. Other cases were put up to the Cabinet Committee
with recommendation of the F.I.B. for final decision. Review of any collaboration
proposal by F.I.B. was governed by certain principles as follows:

4
 (i) The technology proposed to be purchased should not already be available in India,
and, once purchased, the Indian Company should be able to lease it to other Indian
companies.
(ii) The collaboration agreement should not put any restriction on imports of plant,
machinery, raw materials, pricing policy and selling arrangements or on the use of
consultants' services, for which top' priority should be given to Indian firms.

(iii) There should be no restriction on the Indian company to export the product.

(iv) No stipulation should be made for the use of foreign brand names for internal sale
of the product; for export purposes, use of foreign brand names may be allowed. In the
case of product covered by patent, the agreement should specify that payment of royalty
would include compensation for patent rights, and that the Indian company would be free
to produce the item after the expiry of the agreement without any additional payment.

(v) Equity investment would normally be permitted when there is transfer of a

technology which India needs and which cannot be procured except through equity
participation of the foreign collaborator.
(vi) Extension of collaboration agreements would not be ordinarily allowed, except
when Government is satisfied that the initial period was insufficient for proper
assimilation of the technology, or it is required for export purposes.
1980 Policy Statement. The Statement on Industrial Policy presented to Parliament in
July 1980 spelt out the regulatory framework and Government's policy with respect to
foreign investment and collaboration as follows:
a) Advanced Technology for Economies of Scale. In a number of cases Indian
industry has not been able to complete in markets abroad because the scale of output
related to the level of domestic demand is too small to give them the advantages of
modern technology and economies of scale. In cases where a larger production base
would increase the competitiveness of Indian industry abroad, Government will consider
favourably the induction of advanced technology, and will permit creation of capacity
large enough to make it competitive in world markets, provided substantial exports are
likely. The purpose of introducing such a policy would be not only to encourage exports
but also to enable industry to produce better quality products at lower cost which will
ultimately benefit the consumer in terms of price and quality.
b) Research and Development. The Indian industry must earmark substantial
resources for R&D to constantly update technologies with a view to optimal utilisation of
scarce resources, better service to the consumer and achieving greater exports. We also
have to lay greater emphasis on bringing the benefits of the latest R&D to the medium
and small units.
c) Transfer of Technology. Government will take active measures to facilitate
the transfer of technology from efficiently operating units to new units. Companies which
have well established R&D organisations, and have demonstrated their ability to absorb,
adapt and disseminate modern technology will increase their efficiency and cost
effectiveness. This will not only lead to saving of foreign exchange but would also ensure
self-sufficiency and higher exchange earnings.
Guidelines for Approval. The following are some of the important guidelines for

5
 approval of proposals foreign collaboration (financial and/ or technical):
(A) Equity Participation. Government's policy towards permitting foreign
equity participation will continue to be selective. Such participation has to be justified
having regard to factors such as the priority of the industry, the nature of the
technology involved, whether it will enable or promote exports which may not
otherwise take place, and the alternative terms available for securing the same or
similar technological transfer. The ceiling for foreign equity participation is 40 percent
although exceptions can be considered on merit.
The foreign share capital should be by way of cash without being linked to tied
imports of machinery and equipment or to payment for know-how trade marks, brand
names, etc.
Keeping in view the need to provide additional facilities to promote investment
in the country from Oil Exporting Developing Countries, which have large financial
resources but not the type of technology that the country needs, it has been decided that
foreign proposals from these countries need not be associated with transfer of
technology from the equity holders and that such investments may be of a portfolio
nature. Within the framework of the investment policy of the Government, it has been
decided to provide the following facilities.
Investment from oil-exporting developing countries may be permitted in new
companies even if it is in the nature of portfolio investment.
Such investments should not exceed 40 percent in the equity.
The new companies should be export-oriented or should undertake
manufacturing activities covered under Appendix—1 of the Press Note of 2nd
February, 1973.
Investment on the aforesaid pattern may be allowed in hotels.
Investment may also be allowed in new hospital projects and such hospitals
should have adequate provision for outdoor and emergency medical services to the
general public and also for a minimum percentage of occupancy by Indian public.
Loans should also be allowed to be raised abroad for such joint ventures
provided the terms are reasonable.
(B) Technical Collaboration. Technical collaborations are considered on the
basis of annual royalty payments, which are linked with the value of actual production.
The percentage of royalty will depend on the nature of technology but should not
ordinarily exceed 5 percent. Royalty is calculated on the basis of ex-factory selling
price of the product net of excise duties minus the cost of standard bought out
components and landed cost of imported components. Royalty payments are subject to
Indian taxes. Wherever appropriate, payment of a fixed amount of royalty per unit of
production will be preferred.
Lumpsum payments may also be considered in appropriate cases for the import of
drawings, documentation and other forms of know-how. In deciding on the
reasonableness of such payments, account will be taken of the value of production so that
the lumpsum and the recurring royalty, if any, is an acceptable proportion of the value of
production. Such payments will be subject to applicable Indian taxes. The lumpsum
payments should be phased out as follows:
1/3rd after the agreement has been taken on record.
1/3rd to be paid on the transfer of documentation, etc. and

6
 1/3rd to be paid at the commencement of production or after completion of 48
months of the signing of the foreign collaboration agreement whichever is earlier.
(C) Renewal of Collaboration Agreement. Applications for extension of
collaboration agreements are scrutinised carefully and extensions are agreed to only in
those cases where Government is satisfied that there is need for them. Application for
extension may be considered in the following circumstances:
a) If the item of manufacture is sophisticated and it is necessary that the period of
collaboration should be extended for a short period to enable the Indian party to fully
absorb the know-how;
b) If the collaboration agreement involves the manufacture of a large number of
items and the Indian party could start manufacturing some of the items only at a later
stage. In such cases, extension is granted only in respect of those few items the
manufacture of which started later;
c) If it is felt that such extension would be in the interest of exports of the
manufactured products.
Even where extensions are considered and granted, every effort is made to reduce the
rate of royalty payable, with regard to the nature of the product and the period of
extension.
Policy Decisions 1990. While delicensing medium-sized investments up to Rs. 25
crores in non-backward areas and Rs. 75 crores in backward areas, the Central
Government, in May 1990, announced certain decisions also with respect to foreign
investment and collaborations. The objective was stated to be that of attracting effective
inflow of technology. Foreign investment up to 40 p.c. equity was decided to be
allowed on an automatic basis. The landed value of imported capital goods in such
cases was to be allowed up to 30 p.c. of the value of plant and machinery. As regards
transfer of technology, if import of technology was considered essential, the
entrepreneur would be free to conclude an agreement with the foreign collaborator
without obtaining any clearance from the Government. Two conditions were laid down
in this respect: (i) Royalty payment should not exceed 5 p.c. on domestic sales and 8 p.
c. on exports; (ii) If lumpsum payment was involved in technology import, the proposal
must seek clearance from the Government, but decisions would be communicated to the
entrepreneur within 30 days.
New Economic Policy and 1991-94 Policy Changes. The New Industrial Policy,
1991, can be described as a minor revolution as far as decisions concerning foreign
investment and foreign technology agreements are concerned. Among the major policy
decisions are the following:
Approval will be given for direct foreign investment upto 51 percent foreign
equity in high priority industries (34 such industry groups have been identified). Such
clearance will be available if foreign equity covers the foreign exchange requirement for
capital goods.
To provide access to international markets, majority foreign equity holding upto
51 percent will be allowed for trading companies primarily engaged in export activities.
While the thrust would be on export activities, such trading houses should be at par with
domestic trading and Government export houses in accordance with the Import- Export
policy.
A Special Empowered Board would be constituted to negotiate with a number of

7
large international firms and approve direct foreign investment in select areas. This
would be a special programme to attract substantial investment that would provide access
to high technology and world markets. The investment programmes of such firms would
be considered in totality, free from predetermined parameters or procedures.
Automatic permission will be given for foreign technology agreements in high
priority industries upto a lump sum payment of Rs. 1 crore, 5 percent royalty for
domestic sales and 8 percent for exports, subject to total payments of 8 percent of sales
over a 10-year period from the date of agreement or 7 years from commencement of
production.
In respect of industries other than high priority ones, automatic permission will
be given subject to the same guidelines as above if no free foreign exchange is required
for any payments.
No permission will be necessary for hiring of foreign technicians or foreign
testing of indigenously developed technologies. Payment may be made from blanket
permits or free foreign exchange according to RBI guidelines.
In addition to the above, the new industrial policy for small industries, as
announced on August 7, 1991, provides that any proposal which envisages investment
upto 24 percent by a foreign company in the equity of an SSI, will be automatically
cleared so long as there is no net foreign exchange outgo on import of raw materials,
capital goods and royalty.
The facility of automatic clearance is also available in respect of proposals for
100% export-oriented units.
Foreign institutional investors (FIIs) have been permitted to enter the Indian
capital market. They will be allowed to trade both in the primary and secondary markets.
In another significant move towards liberalisation, as announced on October 28,
1991, the Overseas Corporate Bodies (OCBs), along with NRIs, have been allowed to
invest upto 100 percent equity in high priority industries included in Schedule III of the
New Industrial Policy, 1991, with full benefits of repatriation of capital and income
accrued thereon. Automatic clearance will be given for such proposals subject to the
condition that:
(i) foreign equity covers the foreign exchange needs for imports of capital goods,
(ii) the plant and machinery to be imported must be new,
(iii) the project must be located within 25 km. from the periphery of the standard
urban area limits of a city with a population of a million.
An amendment to Section 29 of FERA, effected on January 29, 1992, frees the
FERA companies from any limits imposed on their non-priority sector operations. This
amendment also enables the FERA companies to take up any trading, commercial and
industrial activities, as also acquire any company in India or acquire shares of any
company, without obtaining RBI permission.
As announced on January 29, 1992, as per changes made in the FERA, FERA
companies have been permitted to use their trade mark, accept appointment as agent or
technical or management advisers, borrow and accept deposits from the public, open
branches and liaison offices, acquire and sell immovable property provided the proceeds
are not remitted abroad, and export goods on rental, hire or lease basis as long as long as
these goods are reimported after the expiry of the contract.
Again, as announced on January 22, 1992, FERA companies have been granted
freedom to invest and disinvest their stocks at the market price. Earlier, the price at which

8
these companies were allowed to sell their stocks was decided by the Controller of capital
Issues.
FERA companies are no more obliged to export a part of their turnover. Earlier,
to keep a 74 percent stake, FERA companies had to commit 74 percent turnover, from
priority sector activity. In order to retain a 51 to 60 percent stake they had to commit
themselves to a 60 percent turnover in priority or sophisticated technology industries with
a minimum 10 percent export commitment or to a 60 percent turnover in exports. Now,
all such commitments stand annulled.