Fundamentals of Foreign Investments
Any investment in India which has its source any other country than India is Foreign Investment. The foreign money can be invested in India by Foreign Corporate and nationals or Non Resident Indians. The money can be invested in shares, properties, ownership / management or collaboration. On the basis of this, the Government of India classifies the Foreign Investment into the following forms:
- Foreign Direct Investment (FDI)
- Foreign Institutional investment (FII)
- Non-resident Indian (NRI) investment
- Differences between FDI and FII
- Why Foreign Investors go for FDI?
- Why Foreign Investors go for FII?
- How a Foreign Company can enter in India?
- What attracts Foreign Direct Investment?
- What is the impact of FDI on Inflation?
- What is the impact of FII on Inflation or vice-versa?
- What are benefits of FII?
- Why FII inflows are volatile?
- Key factors that influence the Foreign Investment Decisions
- Important Terms Related to FDI
The Foreign Direct Investment refers to the direct investment into the production and management. This can be one by either buying a company or by expanding operations of an existing business. One example is Unilever which has its own subsidiary and long term investment here via its subsidiary Hindustan Unilever. This means that FDI brings foreign capital, technology & management.
FII (Foreign Institutional Investment) and FPI (Foreign Portfolio Investment) are same things. The foreign institutions invest in a capital / money market which is not their home country. Such kinds of investments are seen in the Mutual Funds, Investment Companies, Pension Funds and Insurance Houses. This means that FII/ FPI brings only capital. FII is also called Foreign Indirect Investment.
QFI (Qualified Foreign Investor) is an individual, group or association, resident in a foreign country that is compliant with Financial Action Task Force (FATF) standard and that is a signatory to International Organization of Securities Commission’s Multilateral Memorandum of Understanding. Though, QFI are also portfolio investors, yet in context with India, QFIs do not include Foreign Institutional Investors or Sub-accounts as per the regulations.
Differences between FDI and FII
The first notable difference is that while FDI brings foreign capital, technology & management, FII brings only foreign Capital.
Second difference we can understand with an example. Suppose, Wal-Mart comes to India and opens up stores here, this means that the investment made by Wal-Mart would come with a long term commitment. Thus, FDI brings in funds with long term commitments. On the other hand, if the company of Warren Buffett buys shares of an Indian company, they can sell it any time (as per regulations). This means that FII does not come with long term commitment. This also means that the money invested in India via FII can be taken back more easily than FDI. Thus, there is always a risk of flight of capital in terms of FII outflows but not generally in FDIs.
Why Foreign Investors go for FDI?
Foreign direct investment is done for many reasons including to take advantage of cheaper wages in the country, special investment privileges such as tax exemptions offered by the country as an incentive to gain tariff-free access to the markets of the country. FDI can be done to acquire lasting interest in enterprises operating in the target country.
Why Foreign Investors go for FII?
A portfolio investment does not entail active management or control of the target organization. This is done by the investors if they are not interested in involvement in the management of a company. The objective of the indirect investment is to financial gain only and does not create a lasting interest in or effective management control over an enterprise.
How a Foreign Company can enter in India?
A foreign company planning to set up business operations in India need to set up a company under the Companies Act, 1956. For example, Hindustan Unilever is the Indian subsidiary of Unilever, British–Dutch multinational consumer goods company. The incorporation of the company can be done via a Joint Venture or Wholly owned Subsidiary. Foreign equity in such Indian companies can be up to 100% depending on the requirements of the investor, subject to equity caps in respect of the sector/area of activities under the FDI policy.
These companies enter into India via an office or representation in India which is known as Liaison Office/Representative Office or Project Office or even Branch Office. Such offices can undertake activities permitted under the Foreign Exchange Management Regulations, 2000 (Establishment in India of branch or office of other place of business).
What attracts Foreign Direct Investment?
The growth rate of the source economy is an important determinant of FDI into the country. The political and economic stability of the target region attracts FDI. Any FDI investment into the target country depends upon how ‘open’ the economy is towards foreign trade (both imports and exports). Apart from that, the policies, rule, regulations and loopholes incidental thereto also affect the flow of FDI. For example, Mauritius has been top FDI source for India due to the later reasons.
What is the impact of FDI on Inflation?
FDI has been generally touted as a measure to dampen inflation. But this can NOT be concluded in all situations. The FDI’s impact on dampening the inflation is based upon the assumption that FDI would result in the developing of country’s back-end infrastructure and crack the supply bottlenecks. Practically, it may or may not happen. Economics has no rule to link FDI and Inflation because Inflation may have many reasons behind it rather than only infrastructure and supply bottlenecks. Generally the FDI’s role in containing inflation is supported by the facts that:
- It improves Infrastructure
- It improves supply chain
- It brings permanent investment
What is the impact of FII on Inflation or vice-versa?
The FII impact inflation indirectly rather than directly. If there an excess inflow of FII, it may shoot the prices of stocks very high. When stocks become costly, there would be a huge demand for Indian rupees. To fulfil that demand, RBI would need to print more money and pump this money to economy. All of a sudden, if FII withdraw the funds, there would be an excess of liquidity in the markets. This would lead to a situation of too much money chasing too few goods and thus things would become costlier. Thus, unchecked FII inflow and outflow can bring into demand pull inflation.
When there is a high inflation in the country, it repels FII. Rising inflation in India makes the investors bothering.
What are benefits of FII?
Controlled FII helps in improving the local environment. When huge FII comes in, there is much availability of fund for local companies to increase their capacity. The sufficient FII inflow in the country means that the need to borrow from international sources seldom arrives. This helps in those countries where domestic saving is not sufficient for funding the expansion plans.
Why FII inflows are volatile?
FII inflows are aimed at making money on the invested capital i.e. Capital gains. The capital gains are linked to the interest rates and stock market environment. If the interest rates / potential gains in one country go down in comparison to other target country, the FII inflow may halt or outflow may begun. That is why FII money is called hot money sometimes. In summary, the most suitable conditions for FII are as follows:
- Attractive Interest Rates
- Adequate money supply and stable rate of inflation
- Stable exchange rates
- Low deficit in Balance of payments.
Key factors that influence the Foreign Investment Decisions
Government may impose tariffs, quotas, embargo and other restrictions on export and imports goods and services hindering the free flow of these products across national boundaries.
Sometimes governments may even impose complete bans in the international trade of certain products. Foreign investors can circumvent these restricitons by establishing production facilities in foreign countries.
Imperfect labor market
Labor is immobile because of immigration barriers, firm themselves should move the workers in order to benefit from the underpriced labor services.
This one reasons MNCs are making FDIs is less developed countries such as Mexico, China, India and Southeast Asian countries like Thailand, Malaysia and Indonesia, where the labor services are underpriced relative to their productivity.
MNCs often enjoy comparative advantages due to special intangible assets they posses. Example including technological, managerial and marketing know-how, superior R&D capabilities and brand names.
These intangible assets are often hard to packages and sell to foreigners.
In addition the property rights in intangible assets are difficult to establish and protect, especially in foreign countries where legal resources may not be readily available.
As a result, firms may find it more profitable to establish foreign subsidiaries and capture returns directly by internalizing transactions in these assets.
The theory internalization of FDI, stated that the firms 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 that may occur while transacting in foreign markets.
- MNCs may undertake FDI in countries where inputs are available in order to secure the supply of inputs at a stable price.
- MNCs with monopolistic / oligopolistic control over the input market, this can be served as a barrier to entry to the industry.
- Many MNCs often find it profitable to locate their manufacturing / processing facilities near the natural resources (oil fields, mine deposits and forest) in order to save transportation costs.
- Backward vertical FDI – an industry abroad that produces inputs for MNCs.
- Forward vertical FDI can take an example where they involve industry abroad that sells a MNC’s output.
Product life cycle (Raymond Vernon Model)
Raymond Vernon (1966) firm undertake FDI at a particular stage in the life cycle of the product that they initially introduced. This can be understood by an example. The personal computers (PCs) were first developed by US firms ( such as IBM and Apple Computer) and exported to overseas markets. As PC’s became a standardized commodity, however, the US became a net importer of PCs from foreign producers based in such countries as Japan, Korea and Taiwan as well as foreign subsidiaries of US firms.
Shareholder diversification services
If investors cannot effectively diversify their portfolio holdings internationally because of barrier to cross border capital flows, firms may be able to provide their shareholders with indirect diversification services by making their direct investments in foreign countries.
When a firm holds assets in many countries, the firm’s cash flows are internationally diversified.
Thus, shareholders of the firm can indirectly benefit international diversification even if they are not directly holding foreign shares.
Important Terms Related to FDI
When a foreign country invests in the country in question.
When the home country invests abroad.
Green field investment
Building new production facilities in a foreign country.
It refers to investment in a manufacturing, office, or other physical company-related structure or group of structures in an area where no previous facilities exist.
Used for purchasing or leasing existing production facilities to launch a new production activity.
Backward Vertical FDI
Where an industry abroad provides inputs for a firm’s domestic production process.
Forward Vertical FDI
Where an industry abroad sells the outputs of a firm’s domestic production.