Should FII investments be included in FDI limits?

ICICI Securities Ltd

It is indeed a travesty of sorts that this debate occupies centrestage a dozen years after the reform process to unleash India's innate potential was set in motion.

More so because the cascading socio-economic benefits of foreign investment in infrastructure sectors such as telecom, ports, insurance and roadways are ubiquitous and well documented.

In fact, the growth multiplier of infrastructure capital formation on India's GDP is just manifesting itself, and so it is imperative to ensure the momentum does not slacken.

As statistics indicate, gross domestic capital formation in infrastructure has hit a plateau and by corollary, is declining as a percentage of GDP. Clearly, the foreign direct investment (FDI) catalyst needs rejuvenation without further ado.

Factoring in the socio-political aspects of the issue, an optimal mix of FDI and foreign institutional investor (FII) inflows that enables India to bridge the widening investment gap is a sine qua non.

This assumes greater import given the shallow domestic corpus available for long-term equity investment that infrastructure projects require and the need for policy initiatives to forestall any crowding out of resource mobilisation in the current stage of India's rate-capital expenditure cycle.

There is general agreement about the positive impact of FDI on the welfare of receiving countries. A fungible FDI+FII equation within an broader overall framework will, in a way, ensure that some of the touted virtues of FDI "" enhancing per capita incomes by creating jobs; increasing exports; and improving consumer welfare through reduced costs, wider choice and better quality "" rub off onto FII flows as well. It is pertinent that over the past few years, FII inflows have caught up with FDI flows as the latter is tapering off.

While the current approach to subsume FII investments within the overall FDI cap has worked reasonably well, the timing is opportune to (i) raise the overall limit (FDI + FII) so that any sectoral FDI cap no longer inhibits investments; and (ii) permit inter se fungibility between FDI (subject to the sectoral cap) and FII to enable optimal determination of equity structure on a case-by-case basis.

There are several upsides to be unlocked by such a move. First, with several infrastructure projects in telecom, seaports, power and even an airport moving into profit and free cash mode, the leverage to raise equity resources to fund the much-needed expansion is obvious.

Second, fungibility for FIIs facilitates the equation for existing venture capital investors to divest part of their holdings and very likely funnel the proceeds to catalyse more ventures in India.

Finally, it allows for "mega-IPOs (initial public offerings)" and partially addresses the oft-repeated (and reasonable) criticism of foreign portfolio investors "" very few large, liquid (read > $ 5 billion market cap) investment opportunities. Besides, it also ensures a wider distribution of wealth creation by permitting domestic savers to supplement FIIs in an IPO.

A concurrent play-out of all the above factors would propel India into the business headlines globally (akin to China's unique positioning over the past decade) and trigger a virtuous cycle: FDI "" better infrastructure "" jobs "" exports "" India awareness "" more FDI.

Needless to add, this has unequivocally delivered in the IT space "" with, inter alia, 100 per cent FDI a key factor. We need to replicate that success across more sectors "" telecom, insurance, airports, civil aviation and tourism and so on "" while adequately addressing issues on competition policy, labour standards and regulatory framework. India must attract over 3 per cent of GDP by way of foreign investment in infrastructure projects alone.

A recent survey by Unctad is optimistic on global FDI flows over 2004-07, with China and India as the hotspots. Yet, the difference in the amount of interest (by a factor of 10 for China) says an altogether different story even as all countries are expected to intensify efforts to attract FDI through further liberalisation, incentives and increased targeting.

Another report by the Institute of International Finance indicates private direct equity investments into emerging economies will rebound this year after two years of decline. All told, the global environment is conducive and the India story credible. But as the quote goes, the world talks on principle but acts on interest "" both FDI and FII, without doubt.

U R BHAT
Investment professional

Foreign direct investment (FDI) is generally seen by capital deficient countries such as India as a convenient method to access modern technologies and export markets.

This generally involves setting up a production base, thus generating direct and indirect employment because FDI stimulates new investment in downstream and upstream projects.

However, FDI crowds out domestic investment opportunities and, hence, most host countries impose some conditions on FDI in the form of minimum level of local content, export commitment, technology transfer, forex neutrality, compulsory listing/ dilution in the local market and so on.

Burgeoning forex reserves and the increasing confidence of the Indian corporate sector to take on international competition have made some of these conditionalities less relevant.

Returns from FDI are generally possible only in the medium- to long-term and the physical assets built from such investments offer an element of comfort to the host country about the strategic nature of the commitment.

Foreign institutional investors (FIIs), too, bring in non-debt-creating portfolio investment through financial markets. However, FIIs are generally seen as fair-weather friends who will stick around as long as the recipient market is expected to generate superior, risk-adjusted returns.

The beneficial effects of such flows are in terms of providing access to large chunks of capital; improving disclosure and governance standards; better risk management; making the markets deeper and more liquid; providing an efficient transmission mechanism for feeding new information into prices; and better allocation of capital to the internationally-competitive sectors of the economy, thus integrating the local market with the international financial markets.

While these portfolio flows can technically reverse at any time, frequently this very fear ensures that the host country follows sensible economic policies.

FII flows, too, help capital formation by making available risk capital for entrepreneurs with viable investment ideas, irrespective of whether they are multinational or domestic firms.

Most developing countries prefer FDI to foreign portfolio flows because of the direct visible benefits in terms of new physical assets and employment generation. The strict segregation of foreign investments into FDI and FII has become somewhat redundant because not all portfolio flows are passive.

Investments by financial investors like private equity, venture capitalists and even some active portfolio investors involve participation in management and in the transfer of relevant technology in developing new export markets and in upgrading management capability.

Capital raised through American depository receipts/ global depository receipts is classified as FDI in India, possibly because the holders could be multinational companies using the route as a proxy for FDI.

To address such issues, we have ended up with myriad rules and regulations that turn logic on its head as in the case of civil aviation where foreign airlines with the expertise to develop the sector are denied access but financial investors with no expertise in the sector are welcome.

Given the problems in classifying foreign investments into watertight compartments and prescribing myriad rules for this segregation, it would be prudent to continue with one composite limit for foreign investments.

However, except for the basic limit of 24 per cent for FIIs, it would be open for the domestic company to prefer one form of foreign investment to the other.

The usual arguments against increasing foreign investment limits are national security, creation of monopolies, allowing foreign control over natural resources and reduced investment opportunities for citizens in the light of restrictions on their investing abroad.

Effective regulation, competition law, transfer pricing rules and enforcement of appropriate resource rent would address most of the concerns.

Prescribing low limits for foreign investment on a small negative list of sectors and opening up other sectors subject to large composite limits would be the appropriate path ahead.

Instead of protecting the business turf for inefficient producers of goods and services by preventing access to foreign capital that comes along with a wealth of experience and technology, one needs to be more concerned about rising consumer expectations for quality.

The interests of consumers should supersede the narrow interests of a few producers or of a small labour force. The paradigm change in the Indian telecom sector over the last few years is a case in point.