T C A Srinivasa-Raghavan: The nuts and bolts of American FDI

OKONOMOS

The capital structure of US firms is highly sensitive to political risk and varies accordingly.

In 1996, Indian firms invested $600 million abroad. In 2003, this figure had increased to $5.1 billion, giving India the 14th rank among developing economies. It seems reasonable to assume that the figure now stands at least around $10 billion.

Given the political risk that is always present in every country, what sort of capital structure should Indian firms have? In a recent paper* Mihir A Desai and C Fritz Foley of Harvard and James R Hines Jr of the University of Michigan provide some pointers.

Political risk can be of many kinds, ranging from outright nationalisation to policy idiosyncrasy to coalitions, in which Prakash Karat calls the tune. Regardless, it increases uncertainty arising from arbitrariness and this has an impact on the capital structure of the firm. Basically, it makes equity less attractive and debt more costly.

Based on data collected by the US Bureau of Economic Analysis (and, the Reserve Bank of India may please note, released as well) by the authors have studied the capital structures of US firms operating in different types of political risk environments. They conclude that "foreign subsidiaries located in politically risky countries have significantly more debt than do other foreign affiliates of the same parent companies." In other words, US firms use less equity in politically more risky countries, which makes sense.

They also say that US firms operating in politically risky countries tend to share ownership with local partners so that if something goes wrong, the locals will also be hit and this possibility will reduce the chances of something going wrong. Local fat cats can grease local palms more effectively to minimise arbitrary action. Sometimes, US firms borrow more from local lenders. This, too, has the same effect.

That said, the use of local ownership may well be because of local laws, rather than any commercial preference for the locals. India doesn't insist on local ownership so several US firms have de-listed from the stock exchange, thus leaving Indians out of the profits they are making here. A study by the US Embassy, I am reliably informed, suggests that the returns are as high as 40 per cent.

What sort of guidance does this constitute for Indian firms investing abroad? There appear to be two broad choices: one is the mix between debt and equity, and the other is the mix between domestic and local debt. Just how an Indian firm should structure its capital will depend on the cost trade-offs.

The paper also assumes that political risk in the US is very low. For US firms, this may well be the case, but what about for foreign firms?

In fact, a recent book* by Edward M Graham and David M Marchick suggests the opposite. True, the political risk may not be of the same type as in the developing countries.

But the fact that it is different does not mean it is not there. Certainly, it has the same effect of lowering the return for foreign investors. The book takes the view that American politicians are being silly and that policy towards FDI in the US should not be like them.

A rather more important lesson from this book is for those in charge of India's national security. It deals extensively with critical infrastructure and how FDI in those should be regulated. It also deals with the issue of foreigners in such and other industries.

Now that several Indian ports are under foreign control and operation, someone in the government needs to read this book.

*Capital Structure with Risky Foreign Investment, NBER Working Paper No. 12276 May 2006

**US National Security and Foreign Direct Investment, Institute of International Economics, Washington, May 2006, 220 pp, $23.95 http://bookstore.iie.com/merchant.mvc?Screen=PROD&Product_Code=3918