Last year, foreign institutional investors pumped to India a record $8.5 billion, a figure that made India the third largest recipient of FII money in the world in 2004.In contrast, FDI flows have remained stuck in the $3-4 billion groove for the past many years. India attracts about one-fourth of the world’s portfolio flows and barely 3 per cent of the world’s FDI. It’s just the reverse in China. FDI is in the range of $50 billion, while portfolio flows are much lower, in the range of $4-5 billion. The question arises: why the foreigner looking at India’s stock markets is far more excited than the company looking at building factories in the country? There are, of course, differences, between FDI and the other flows. FDI is problematic for foreign investors because it means bringing into a country managerial capacity and organisation. In contrast, FII is easy. Only money needs to be invested for earning returns. No effort is required to build organisational capacity for operating in that market. But if a country does not have a well-developed stock market, foreign investment has limited choices. In the well-developed markets of Europe, for instance, the share of FII in total capital flows is high. In contrast, in the countries of Africa, FDI is the dominant form of foreign investment flows. However, too many investors do not want to venture into poor countries so the total foreign private inflows are small.
Today, it is relatively effortless for a foreign institutional investor (FII) to enter the capital market. A Sebi registration, preceded by a fairly perfunctory due diligence, is all it takes before an FII can enter the Indian stock market and commence trading. Exit is equally simple. For FDI, however, both entry and exit are far more difficult. Even in sectors opened to FDI on paper, problems remain at the grassroots. There are innumerable clearances that need to be obtained at the state and district levels. There are also a number of practical hurdles, such as infrastructure bottlenecks, all of which make entry difficult. Exit is more complicated. Archaic labour laws, such as the Industrial Disputes Act, prohibit the closure of any company employing more than 100 workers without obtaining prior state government permission. Bankruptcy laws are convoluted and legal processes costly and long-winded. The Common Minimum Programme of the central government stresses Foreign Direct Investment over Foreign Institutional Investment. Its position is that "FDI will continue to be encouraged and actively sought, particularly in areas of infrastructure, high technology and exports and where local assets are created on a significant scale. The country needs and can easily absorb at least two to three times the present level of FDI inflows," after which the document hurries to add that "Indian industry will be given every support to become productive and competitive" and that all efforts will be made to provide a level playing field. The position of the Common Minimum Programme on FII inflows is spelt out. The FIIs, too, the CMP says, "will continue to be encouraged," but immediately thereafter goes on to state, in the very same sentence that "the vulnerability of the financial system to the flow of speculative capital will be reduced."
Very often arguments are made that this is not good. Instead of having so much portfolio investment, India should have been attracting more FDI. It’s argued that FDI boosts the investment rate directly whereas remittances and FII inflows would be transfers, only a portion of which translates into savings and investment. However, in terms of the impact on balance of payments or the interest rate, it is the totality of inflows a country is able to attract that matters, not its composition. Research suggests that attracting FII may be a sign of good health and attracting FDI, a sign of bad health for the economy. In contrast to the commonly held unfavourable view of FII flows, evidence suggests that countries with good institutions and markets attract more FII, while countries with poor laws and institutions attract more FDI. In the poor countries of Africa, often the share that goes into the primary and extraction sector — such as mining and oil — is high. In rich OECD countries the share of FDI in total capital flows is low at barely 12 per cent. As countries develop, the total capital flowing to them goes up with the increase in per capita income. However, the share of FDI in it goes down. Foreigners learn to trust their markets and institutions and do not feel the need to go there physically to earn returns. That is why economists in Latin America have been getting concerned about the rise in the share of FDI in total flows. The share of portfolio investment has collapsed and this is seen to be a loss of confidence in their markets and institutions.
India should not be embarrassed about attracting portfolio flows. This in fact reflects its success in building sound companies and a well-designed equity market. It is a sign of good health. There two basic reasons why FDI is preferred to portfolio investment. First, it is believed that FDI will stay in India in the event of a currency crisis and, second, it is believed that FDI has a greater impact on growth. FDI is considered “bolted down” as it involves investment in physical plants and equipment and these are very hard to get rid of. Studies of currency crisis usually compare the stability of FDI with that of debt, particularly short-term debt, and in comparison, FDI has been found to be more stable. But that does not mean that FDI cannot move. Latin American economist, Ricardo Hausmann, has argued that there are important mistakes that flow from problems of measurement. In a country’s balance of payments, FDI flows are defined as the increase in the equity position of a non-resident owner who holds more than 10 per cent of the shares of a firm. It also includes the loans received by a local company from the parent owner. About 20 per cent of FDI takes the form of loans from the parent company. Moreover, since the firm is merely a set of assets that are “owned” — in other words, financed — by creditors and shareholders, we must not think of FDI as the firm and its assets. Instead, it is just one of the sources of financing for the firm. FDI is not bolted down, machines are. At the time of a crisis, the foreign company can either sell its equity or take a loan against physical assets and take money out of the country.
Economists Graham Bird and Ramkishen Rajen have shown that despite the fact Malaysia attracts huge FDI, there was a currency crisis. The argument that FDI raises the growth rate of a country is also not watertight. FDI is not found to raise growth when it goes into the primary sector. The impact is ambiguous in the case of services. When it comes to manufacturing, FDI raises growth. But, here again, growth can remain limited to the specific industry in which the FDI went. Worse, it may even remain limited to the firms with FDI. The spill-over effects of technology, management and corporate governance that is often expected to accompany FDI is not automatic. The growth impact of FDI is thus not automatic. It is only countries that have good institutions, skilled labour, openness to trade and well-developed financial markets that gain from FDI. In the absence of these, even if a country attracts FDI, its usefulness is limited. So, instead of trying to be bullish on FDI flows, and restrict FII flows artificially, India must focus on improving markets, institutions and the regulatory framework to encourage foreign investment. Policies should focus on creating a clutter-free market and world-class infrastructure.
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