FDI (Foreign Direct Investment)

(FDI stocks: the accumulation of previous FDI flows)

 Why does a country invite FDI and why do MNCs invest in foreign countries, despite
it exposed to political, currency risk and other complexities.
 It is the outcome of the mutual interest of multinational firms and host countries.
Both gets benefit from foreign ventures.
 While MNCs expect to earn higher rate of return on their investments, host country
explore economic development through it.
 The higher rate of return is, the result of existing market opportunity along with the
host’s country’s policies towards FDI.
 MNCs have expanded their production, distribution and research facilities whenever
permitted and economically feasible, moving towards a global scale of operation
(including production/marketing) and to produce G/S most efficiently and
economically
 Has forced the domestic firms to face competition from MNCs
 Countries (who lack adequate capital and appropriate technology) invite FDI for the
sake of developing production sites and facilities, building infrastructure, and
productively utilizing national resources.
 While firm to maximize their market value, takes various strategic actions including
foreign investments. And for this, firms continuously explore new markets, ways to
lower cost of production, minimize risk, and exploit any market opportunities.
 FDI is increasing as the international mobility of factors (Capital, Labour or Tech.)
and Products are increasing.
 The fast growth in FDI reflects that international investments command a higher
rate of return than comparable domestic investments.
 FDI involves the establishment of new production facilities in foreign countries or
acquisitions of existing foreign business. Whether FDI involves a Greenfield-
investment (i.e. building brand-new production facilities) or Cross-border acquisition
of an existing foreign business, it gives the MNCs a Measure of Control. FDI thus
represents an internal Organizational expansion by MNCs. It occurs when a firm
invests directly in facilities to produce and/or market a product in a foreign country.
Why MNCs prefer FDI over other forms of international business?

 Opportunity for higher rate of return

 Global market share, Market opportunity
 Accessibility to production inputs,
 Foreign government import restrictions
 Opening of new market
 Incentives for foreign investment
 Close presence in the host market

ISSUE: Why do firms locate production overseas rather than exporting from the home
country OR licensing production to a local firm in the Host Country? OR why do firms
seek to extend corporate control overseas by forming Multinational Corporation?
Key factors in firm’s decision to invest overseas

1. Trade barriers through Tariffs, quotas, restriction of G/S; hindering the free flow of
products: Facing barriers to exporting its foreign markets, a firm may decide to
move production to foreign countries as a means of circumventing the trade barriers.
Trade barriers can also arise from Transportation costs.
2. Imperfect labour market i.e. wage differential among countries: Labour services in a
country can be severely underpriced relative to its productivity because workers are
not allowed to free move across national boundaries to seek higher wages. Among all
factor markets, the labour market is the most imperfect.
3. “Kindleberger and Hymer (1969) emphasize various market imperfections, that is
imperfection in Product, Factor and Capital markets, as the key motivating forces
driving FDI.
4. Intangible assets: MNCs have comparative advantage due to special ‘intangible
assets’ they posses. Like Technological, managerial, Marketing Know-how, Superior
R&D and brands names…
5. Internationalization theory of FDI: Firms that have intangible assets with a public
good property tend to invest directly in foreign countries in order to use these assets
 on a larger scale and, at the same time, avoid the misappropriations of intangible
assets.
6. Coco-cola has invested in bottling plant all over the world through FDI, rather than
local firms to produce Coke. Reason: To protect the formula for its famed soft drink.

7. Vertical integrations:
a) Royal Dutch Shell (RDS); the down stream firm, would like to hold the crude oil
price down, where as
b) Saudi Oil Company (SOC); an upstream firm, would like to push the price up
c) If the SOC has stronger bargaining power (on global oil demand fluctuation), RDS
may be forced to pay a higher price, affects its profits.
d) The conflict between the upstream and downstream firms can be resolved, if the two
firms form a vertical integration firm.
e) That’s why, MNCs undertake FDI in countries where inputs are available in order to
secure the Supply of Inputs at Stable Price, to have monopolistic/oligopolistic control
over the input market; to locate manufacturing/processing facilities near the natural
resources to save transportation costs.
f) “Majority of Vertical FDIs are Backward, in that FDI involves an industry abroad
that produces inputs for MNCs.
g) Foreign investments can take form of Forward vertical FDI when they involve an
industry abroad that sells a MNCs outputs.
h) Product life cycle: FDI takes place when the product reaches maturity and cost
becomes an important consideration. PLC theory predicts that over the time the US
switches from an exporting country of new product to an importing country.
i) Share holder diversification services: Capital market imperfections may motivate
firms to undertake FDI. (indirect diversification by making direct investments in
foreign countries)
International Risk:

I. Economic Risk
II. Currency Risk
III. Market Risk
IV. Political Risk:
a. Political disturbances: Maoists close ITC factory in Nepal – JV SURYA
NAPAL, ITC’s SURYA NEPAL is the largest FDI in Nepal, ITC holds 59%
shares in JV
b. Uncertain policies
c. Government Actions
d. Anti-foreign Sentiment
e. Home-host country relation

Despite problem and risk, FDI have become a popular mode of conducting international
business, reason Mutual interest, it is not a Zero-sum game.
If the risk is high, the expected premium has to be high enough to attract foreign
investors. If the market does not provide enough premiums, it is necessary for the host
Govt. to provide enough incentives to compensate the deficiency.
The common types of incentives offered in many countries are;
o Direct Cash Grants (Capital grants)
o Employment grants and training allowances
o Subsidies on land and building purchases
o Interest subsidies
o Tariff Protection
o Exemption of imports and export duties
o Exemption of income taxes, dividend and capital gain taxes
o Guarantee for currency conversion
o Guarantee for profit and capital repatriation

Foreign Direct Investment (FDI): Indian Scenario

o FDI has been recognized as one of the important drivers of the economic growth.
o Government have therefore, been making all efforts to invite and facilitate FDI to
complement and supplement domestic investment.
o FDI flows are usually preferred over other forms of external finance.

o These are non-debt fund creating non-volatile valuations and their return; depend on
the performance of the projects financed by the investors.

o FDI facilitates international trade and transfer of knowledge, skill and technology.
o In a world of increased competition and rapid technological change, its
complimentary and catalytic role can be very valuable.

o FDI in India has constituted 1% of gross fixed capital formation in 1993, which went
upto 4% in 1997 and the tenth plan approach paper postulates a GDP growth rate of
8% during 2002-07.
o This implies an increase in FDI from the present level of $ 3.9 billion in 2001-02 to at
least around US $ 8billion a year during 2002-07.
o India’s share in FDI inflows among developing countries reached a peak of 1.9% in
1997 and declined sharply to 1% in 1999-2000 but has recovered to 1.7% in 2001.
o In comparison to the global FDI, India is receiving low. The reasons are,
 Ceiling on equity,
 Entry barriers to several industries,
 Export obligations,
 Phased domestic manufacturing programme,
 Ceiling on royalty and other payments.
o
FDI is preferred over portfolio investments, as the repatriation begins only after the
company starts operation and earns profit.

o
If the host country is faced with recession, no profits will be made on the FDI. There
is no pressure on the BOP.
o
Further, FDI is preferred to portfolio investment, as portfolio investment is more
volatile and has no long-term commitment. Also, that portfolio investment is easy to be
pulled out, at a short notice.

o
In FDI, little risk is involved for the host country, as the foreign-investor has to bring
in capital and setup production or trading facilities in the host countries through
either Greenfield investments or M&A. It is not easy to move investment from one
country to another.
o
INR is not fully convertible on Capital account. Repatriation of profit is permissible
with full convertibility of INR only on the Current account.
o
Foreign investment through GDRs/ADRs is treated as FDI in the issuing company
and is subject to the policies governing FDIs in the country.
o
For a country facing a shortage of foreign exchange, FDIs can be a cheaper source of
foreign exchange than borrowings. The cost of borrowing has to be met regardless of
the use or returns, while cost of FDI have to be met only if the enterprise concerned
is successful and could make profits.
o
There are many factors which influence and attract foreign investment, for security,
profitability, lower tax rates, avoidance of double taxation, percent of equity
permitted, freedom to manage corporate enterprises, expectations about the customs
and excise duty and freedom to repatriate dividend and capital.
o
After reaching to highest ever IIP growth of 13.1% during 1995-96, the same has put
to cross 8% again after 2004-05. FDI had reached to high $3.562 billion during 1997-
98, taking this clue from previous high of IIP, started to dwindle till 1999-2000 to $
2.167 billion, which has come upto $ 7.691 billion by 2005-06.
FII means an institution established or incorporated outside India which proposes to
make investment in India in securities, has been in existence for a period of at least 5
years; is legally permissible for the applicant to invest in securities outside the country
of its incorporation or establishment; and registered with any statutory authority in the
country of their incorporation or establishment.
FIIs include institutions such as
Pension Funds,
Mutual Funds,
Investment Trusts,
Insurance Company or Re-Insurance Company,
International or Multilateral Organization or an agency thereof or
a Foreign Governmental Agency or a Foreign Central Bank;
an Asset Management Company,
Investment Manager or Advisor,
Nominee Company, Bank or Institutional Portfolio Manager, established or
incorporated outside India and proposing to make investments in India on behalf of
broad based funds and its proprietary funds, if any; a Trustee or a Power of Attorney
holder, incorporated or established outside India, and proposing to make investments in
India on behalf of broad based funds [and its proprietary funds, if any]; and University
fund, Endowments, Foundations or Charitable Trusts or Charitable Societies.

A Foreign Institutional Investor may invest only in the following:-

a) Securities in the primary and secondary markets including shares, debentures
and warrants of companies [unlisted] listed or to be listed on a recognized stock
exchange in India;
 b) units of schemes floated by domestic mutual funds including Unit Trust of India,
whether listed on a recognized stock exchange or not
c) dated Government Securities;
d) derivatives traded on a recognized stock exchange;
e) commercial paper;
f) Security receipts.

Foreign Institutional Investors (FII): FII means an entity established or incorporated

outside India which proposes to make investment in India

Sub-account: Sub-account includes those foreign corporates, and institutions, funds or

portfolios established or incorporated outside India on whose behalf investments are
proposed to be made in India by a FII.

Designated Bank: Designated Bank means any bank in India which has been authorized
by the Reserve Bank of India to act as a banker to FII.

Domestic Custodian: Domestic Custodian means any entity registered with SEBI to
carry on the activity of providing custodial services in respect of securities.

What is a Broad Based Fund: Broad Based Fund means a fund established or
incorporated outside India, which has at least twenty investors with no single individual
investor holding more than 10% shares or units of the fund. Provided that if the fund
has institutional investor(s) it shall not be necessary for the fund to have twenty
investors

Provided further that if the fund has an institutional investor holding more than 10% of
shares or units in the fund, then the institutional investor must itself be broad based
fund

Following entities / funds are eligible to get registered as FII:

1. Pension Funds
2. Mutual Funds
3. Insurance Companies / Reinsurance Company
4. Investment Trusts
5. Banks
6. International or Multilateral Organization or an agency there of or a Foreign
Government Agency or a Foreign Central Bank
7. University Funds
8. Endowments (Serving broader Social Objectives)
9. Foundations (Serving broader Social Objectives)
10. Charitable Trusts / Charitable Societies

Parameters on which SEBI decides eligibility of a FII applicant:

a) Applicant’s track record, professional competence, financial soundness, experience,

general reputation of fairness and integrity. (The applicant should have been in
operation for at least one year)
b) Whether the applicant is registered with and regulated by an appropriate Foreign
Regulatory Authority in the same capacity in which the application is filed with SEBI
c) Whether the applicant is a fit & proper person.

Form needs to be filled in when applying for FII registration: “Form A” as prescribed in
SEBI (FII) Regulations, 1995.

Fee for registration as FII: US $ 10,000, at the time of submitting the application for
registration by Demand Draft in favour of “Securities and Exchange Board of India”
payable at New York

Validity period of FII registration is for 3 years. After expiry of 3 years, the registration
needs to be renewed with renewal fee of US $ 10,000.

100 % debt FIIs are debt dedicated FIIs which invest in debt securities only.

Institution or funds or portfolios established outside India, whether incorporated or not,

Proprietary fund of FII, and Foreign Corporates Can get registered as sub-account

Financial instruments available for FII investments are

a) Securities in primary and secondary markets including shares, debentures and

warrants of companies, unlisted, listed or to be listed on a recognized stock exchange in
India;
b) Units of mutual funds;
c) Dated Government Securities, other debt instruments;
d) Derivatives traded on a recognized stock exchange;
e) Commercial papers.
f) Security Receipts

Investment limits on equity investments by FII/sub-account are as;

a) FII, on its own behalf, shall not invest in equity more than 10% of total issued capital
of an Indian company.
b) Investment on behalf of each sub-account shall not exceed 10% of total issued capital
of an India company.
c) For the sub-account registered under Foreign Companies/Individual category, the
investment limit is fixed at 5% of total issued capital.
These limits are within overall limit of 24% / 49 % / 74% or the sectoral caps, as
applicable and prescribed by Government of India / Reserve Bank of India.

Investment limits on debt investments by FII/sub-account?

The FII investments in debt securities are governed by the policy of the Government of
India. Currently following limits are in effect:
For FII investments in Government debt, currently following limits are applicable:
100 % Debt Route US $ 2.0 billion
70: 30 Route US $ 0.6 billion
Total Limit US $ 2.6 billion

For corporate debt following limits are applicable:

100 % Debt Route US $ 1.0 billion
70: 30 Route US $ 0.5 billion
Total Limit US $ 1.5 billion

For Upper Tier II instruments following limits are applicable:

100 % Debt Route US $ 390 million
70 : 30 Route US $ 110 million
Total Limit US $ 500 million

What other investment limits are there?

Normal FII (70:30 Route) 100% Debt FII

Total investment in equity and equity related instruments shall not be less than 70% of
aggregate of all
investments. 100% investment shall be made in debt security only.

There are DERIVATIVES POSITION LIMITS also,

a) The FII position limits in stock based derivative contracts
b) FII Position limits in Index derivative contracts
c) FII Position Limits in Interest rate derivative contracts