Dr Anirvinna

CA Course

Paper No. 8B - Economics for Finance

INTERANTIONAL CAPITAL MOVEMENTS

Dr C Anirvinna

• At the end of this unit, you will be able to:

❖ Describe the nature and types of foreign capital

❖ Distinguish between foreign direct investment and foreigninstitutionalinvestment

❖ Outline the factors influencing foreign investments

❖ Elucidate the potential costs and benefits of foreign direct investment

❖ Explain the state-of-affairs of foreign direct investment inIndia

Learning Outcomes

1.Foreign aid or assistance which may be:

a) Bilateral or direct inter government grants : Aid is given by one government directly to other country’s government with view to improving economic development, peace and humanitarian interests.

b) Multilateral aid : Multilateral aid is like bilateral aid, except it is provided by many governments instead of one. A single international organization, such as the World Bank, often pools funds from various contributing nations and executes the delivery of the aid.

c) Tied aid and untied aid: If strings attached or conditional aid with respect to project /location /technology specific, location so on . On the other hand if receipt country can decide their own priority

d) Foreign grant: which are voluntary transfer of resources by governments, institutions, agencies ororganizations.

2.Borrowings which may take different forms such as

a) Direct inter government loans

b) Loans from international institutions (e.g. world bank, IMF, ADB)

c) Soft loans for e.g. from affiliates of World Bank such as IDA

d) External commercial borrowing, and

e) Trade credit facilities

Types of Foreign capital

3. Deposits from non-resident Indians (NRI)

4. Investments in the form of :

a. FPI & FII

b. FDI

Types of Foreign Capital

• International investments are two types namely FPI & FII and foreign direct investment (FDI)

• FPI & FII or financial capital or hot money refers to short term investment made by individuals and institutions in financial stocks such as equity and bonds.

• Impact on balance of payments or exchange rates rather than on production or incomegeneration.

• It is not concerned with either manufacture of goods or with provision of services.

• Such investors also do not have any intentionof exercising voting power or controlling ormanaging the affairs of the companyin whose securities they invest.

• The sole intention of a foreign portfolio investor isto earn a remunerative return throughinvestment in foreign securities and is primarily concerned about the safety of their capital,the likelihood of appreciation in its value, and the return generated

Foreign Institutional Investment (FII) & Foreign Portfolio Investment (FPI)

• It is not intended to enhance the productive capacity of an economy by the creation ofcapital assets that is why is called short term investment

• It can fly easily to other countries to seek more if anything happens to the economy such as low growth rate, corporate scandal , political unrest or government policy

FPI & FII

• If a foreign firm sets up their own factory, bring their own capital or machinery ,managerial personnel either through acquisition or construction or establishment of subsidiaries or joint ventures etc then it is called FDI

• It is a long term investment resulting creating of ownership management and control over the assets of the host country.

• The foreign investor is given at least 10% voting rights in the day to day functioning of the firm. Therefore, under FDI , the investors holds a certain degree of influence on the management of the enterprise where investments is being mad

• FDI has three components: equity capital, reinvested earnings and intra-company loans.

• FDI may be categorized as horizontal, vertical or conglomerate.

Foreign Direct Investment (FDI)

i) A horizontal FDI : refers to the foreign manufacturing of products and services roughly like those the firmproduces in its home market. This type of FDI is called “horizontal” because the multinational duplicates thesame activities in different countries. Horizontal FDI arises because it is too costly to serve the foreign marketby exports due to transportation costs or trade barriers for example, a cell phone service provider based inthe China moving to India to provide the same service. Porsche acquired VW

ii) A vertical FDI: refers to one in which a firm establishes or acquires a business activity in a foreigncountry which is different from the firm’s main business activity yet in some way supplements its majoractivity. A vertical FDI consists of two groups backward integration and forward integration. E.g. Amazon ownstransportation and distribution, which is backward integration – toward suppliers – and forward integration,as well because Amazon delivers directly to end users.

iii) A conglomerate type of FDI refers to one in which a firm direct investment into a business that is unrelatedto its existing business in its home country. A firm will acquire new products or services in which it hasno previous.E.g Kingfisher into Liquor , TATA

• Two-Way Direct Foreign Investments: which are reciprocal investments between countries. Theseinvestments occur when some industries are more advanced in one nation (for example, the computer industry in the United States), while other industries are more efficient in other nations (such as the automobileindustry in Japan

FDI Types

FPI/FII FDI

Investment in financial assets such as bonds and equity

Investment in creation of physical assets

Short term investment Long term investment

hot money it can be withdrawn as and when require

relatively difficult

Speculative in nature Not in speculative

No Transfer of Technology Involves Technology transfer

No Direct expand employment opportunities and income

Direct expand employment opportunities and income

Does not involve ownership, management and control over the business unit

No significant degree influence over the management of the company with the

Involves ownership, management and control over the business unit

Significant degree of influence over the management

Difference between FPI AND FDI

• FDI movement depends upon the prosperity of host country. It moves seeking higher returns on investment due to the following reasons

1. Growing interdependence : National economies have become interdependent in globalized world resulting inincrease in trade relations and international industrial cooperation's established among them

2. Internationalization: Transitional companies have internalized their production and investment in their subsidiariesand affiliates

3. Economies of large scale : arising from technological growth

4. Lack of feasibility of licensing agreements: The rapid change in technological innovations resulting in lack offeasibility of agreements with foreign producers.

5. Necessity to retain direct control: MNCs believe in retaining direct control over of production knowledge ormanagerial skill of markets of monopolistic or oligopolistic t o r e a p t h e p r o f i t s .

6. Avoid competition and loss of export markets: A firm wants to procure a promising foreign firm to avoid futurecompetition andthe possible loss of export markets

7. Risk diversification: severe slow downs/ recessions are part and parcel of any economy. Hence operating inseveral markets of the world provides the necessary cushion.

8. Geographical Proximity: shared common language or common boundaries r e s u l t i n g i n saving in time andtransport costs thanks to geographical proximity

Reasons for FDI

9. Trade patents and quality : Sometimes it is necessary to retain complete control over its trade patents and to ensureconsistent quality and service or for creating monopolies in a global context

10. Optimum Utilization of Resources: An MNC through FDI will help in optimal utilization of physical, human, financial andother resources

11. Emerging markets : such as India provides huge untapped potential markets coupled with substantially larger population.

12. Unfavorable Trade policy of Emerging markets : The emerging markets to protect their economies may use tariff and non tariff barriers if require blanket bans to make the lives of foreign firms to sell their goods . Hence FDI is the only option to penetrate into these

13. Lower environmental standards : MNCs will fully make use of the host country lower environmental standards to save the costs

14. Favourable environment and climate :stable political environment and overall favourable investment climate in the hostcountry

15. Country’s openness : If host country shows a higher degree of openness to foreign capital and the prevalence ofpreferential investment systems such as special economic zones to encourage direct foreign investments

16. Key raw material :t A firm wants to get control of strategic raw material or resource so as to ensure their uninterruptedsupply at the lowest possible price; usually a form of vertical integration.

17. Key minerals : FDI happens due to key minerals deposits located elsewhere and earn profits through processing themto finished form (Eg.FDI in petroleum

Reasons for FDI

18. Low Labour cost: Developing countries such as India offers low wage rate in relative incomparison with China . That is the reason why many MNCs are moving out from China torelocate their factories in India such as Foxconn, Xiaomi etc

19. Identifiable gaps : There is a identifiable gap in host countries due to lower level ofeconomic efficiency.

20.Tax attractiveness: tax differentials and tax policies of the host country which supportforeign direct investment. However, a low tax burden cannot compensate for a generallyfragile and unattractive FDI environment.

21. Firm’s Competitive position: necessitates defensive investments in order to preserve afirm’s competitive position.

22. High Economic Growth: There is not even a blade of doubt FDI indeed promotes higheconomic growth of the host country not to speak of infrastructure development, reductionpoverty levels , high per capita income and a good quality of life with great social amenitiesetc,

Reasons for FDI

a. infrastructure lags,

b. high rates of inflation,

c. balance of payment deficits,

d. poor literacy and low labour skills,

e. rigidity in the labour market,

f. bureaucracy and corruption, unfavourable tax regime,

g. cumbersome legal formalities and delays, difficulties in contract enforcement,

h. land acquisition issues,

i. small size of market and lack of potential for its growth,

j. political instability, absence of well-defined property rights,

k. exchange rate volatility,

l. poor track-record of investments,

m. prevalence of non-tariff barriers, stringent regulations,

n. lack of openness, language barriers,

o. high rates of industrial disputes,

p. lack of security to life and property,

q. lack of facilities for immigration and employment of foreign technical and administrative personnel,

r. double taxation and lack of a general spirit of friendliness towards foreign investors.

Factors Hindering FDI

1. Licensing (Microsoft Office) and Franchising (Dominos, KFC, Subway etc)

2. Opening of a subsidiary or associate company in a foreign country (Amazon, JP Morgan Chae, Bank of America)

3. Mergers and acquisitions(M&A) – (Walmart acquisition of Flipkart)

4. Joint venture with a foreign company – (Mahindra-Renault Ltd, Bharti-AXA General Insurance Co Ltd).

5. Green field investment (establishment of a new overseas affiliate for freshly startingproduction by a parent company) (McDonald's Starbucks)

6. Brownfield investments (a form of FDI which makes use of the existing infrastructure bymerging, acquiring or leasing, instead of developing a completely new one. For e.g. in India 100% FDI under automatic route is allowed in Brownfield Airport projects, Vodafone's acquisition of Hutch, TATA acquisition of Jaguar land rover automotive

Modes of Foreign Direct Investment (FDI)

❑ Foster Competition: The domestic companies need the competition to improve theirefficiency. FDI gives enough of that opportunity for domestic firms.

❑ Low savings : Low savings have no option to opt for foreign capital for much needinvestment in the economy.

❑ Rapid Economic development: Developing countries economic development hinges up onthe capital, technological know how , managerial skills, marketing methods etc

❑ Competition for FDI : There is a growing competition among the countries to attract FDI bybring in necessary reforms in political, legal and structural reforms with suitablemacroeconomic policies.

❑ Multiplier effects: Since FDI involves setting up of factories in variety of industries w i l lge n e ra t e direct employment in the recipient country. Subsequent FDI as well as domesticinvestments propelled in the downstream and upstream projects that come up in multitudeof other services, generate multiplier effects on employment and income/GDP

Benefits of FDI

❑ Relatively higher wages : It promotes relatively higher wages for skilled jobs. More indirect employment will begenerated to people in the lower-end services sector occupations even to the less educated and unskilledpersons engaged in those units.

❑ Bilateral Trade :FDI generally entails people-to-people relations andis usually considered as a promoter of bilateral and international relations.

❑ Promotion of Ancillary units :There is also greater possibility for the promotion of ancillary units resultinginjob creation and skill development for workers

❑ Promotes Exports : Foreign enterprises possessing marketing information with their global network of marketing are in a unique position to utilize these strengths to promote the exports of developing countries.

❑New Tax Revenue :If the host country can implement effective tax measures, the foreign investment projects also would act as a source of new tax revenue which can be used for development projects

❑ Benefits of Economies of Scale :It is likely that foreign investments enter into industries in which economiesof scale can be realized so that consumer prices may be reduced. Domestic firms might not always be able togenerate the necessary capital to achievethe cost reductions associated with large-scale production.

❑ Contain Domestic Monopolies :Increased competition resulting from the inflow of foreign direct investmentsfacilitates weakening of the market power of domestic monopolies resulting in a possible increase in output andfall in prices

Benefits of FDI

❑ Favourable Impact of BOP: it is considered to have a favorable impact on the host country’sbalance of payment position by bringing not only necessary foreign exchange reserves andalso increasing in exports of goods and services.

❑ Human Resource Development: Better work culture and higher productivity standardsbrought in by foreign firms may possibly induce productivity related awareness and may alsocontribute to overall human resources development.

Benefits of FDI

• foreign entities are highly focused on profits and have an eye on exploiting the natural resourcesand are almost always not genuinely interested in the development needs of host countries. Foreign capital is perceived by the critics as an instrument of imperialism, perpetrator of dependenceand source of inequality between and within the nations

1. Highly Capital Intensive FDI : It may not help country like India in providing job opportunities

2. Creates Regional Disparity: The inherent tendency of FDI flows to move towards regions or states which are well endowed in terms of natural resources and availability of infrastructure has thepotential to accentuate regional disparity.

3. Income Inequalities : It widens the already existing income inequalities in the host country.

4. Possibility of loss of Tax Revenues: If a foreign firms secures incentives in the form of tax holidays or similar other provisions the host country will lose tax revenues..

5. Raise in the interest Rate: More often than not , the foreign firms may partly finance theirdomestic investments byborrowing funds in the host country's capital market. This action can raiseinterest rates in the host country and lead to a decline in domestic investments through ‘crowding-out’ effect

Potential Problems Associated with FDI

6. Bias nature of Financial Institutions: The financial institutions of developing economies would prefer foreign firms due toperceived lower risks and such shifts of funds may divert capital away from investments which are crucial for thedevelopment needs of the country

7. Pressure on exchange rate and BOP when profits are repatriated,a strain is placed on the host country's balance of payments and the home currency leading to its depreciation. Thus large scale repatriation of profits can be stressful on exchange rates and the balance of payments.

8. Focus on elite items : FDI might lead to a distorted pattern of production and investment such that production couldget concentrated on items of elite and popular consumption and on non- essential items.

9. Anti –ethical :Foreign entities are usually accused of being anti-ethical as they frequently resort to methods like aggressive advertising and anticompetitive practices which would induce market distortions

10.Deep Pockets :A large foreign firm with deep pockets may destroy the local domestic firms with their technology for egOla and Uber undercut a competitive local industry resulting in serious problems of displacement of labour as well

11. Off-Shoring :FDI usually involves domestic companies ‘off –shoring’, or shifting jobs and operations abroad in pursuit oflower operating costs and consequent higher profits. This has deleterious effects on employment potential of homecountry

Potential Problems of FDI

12. Exploitation of labour and Environmental Standards : A foreign firm will exploit the labour and environmental standards much to the annoyance of host country interests.

13. Threat to National Security: The foreign firms can be threat to national security especially when relationship between home country and host country are bad. That is reason why India did not encourage Huawei from China for its 5 G trails

14. Adverse effect on terms of Trade : It may create adverse impact on the host country's commodity terms oftrade (defined as the price of a country's exports divided by the price of its imports). This could occur if the investments go into production of export- oriented goods and the country is a large country in the sale of its exports. Thus, increased exports drive down the price of exports relative to the priceof imports.

15. Environmental Damage: FDI is also held responsible by many for ruthless exploitation of natural resources andthe possible environmental damage

16. Dual economy: With substantial FDI in developing countries there is a strong possibility of emergence of a dualeconomy with a developed foreign sector and an underdeveloped domestic sector.

17. Corruption: They are are often criticized of corruption issues, unduly influencing policy making and evasionof corporate social responsibility

Potential Problems of FDI

• FDI is an important monetary source for India's economic development. Economic liberalisation started in India in the wake of the 1991 crisis and since then, FDI has steadily increased in the country. India, today is a part of top 100-club on Ease of Doing Business (EoDB) and globally ranks number 1 in the greenfield FDI ranking.

• Currently, an Indian company may receive foreign direct investment eitherthrough ‘automatic route’ without any prior approval either of the Government or the Reserve Bank of India or through ‘government route’with prior approval ofthe Government.

• According to the Reserve Bank of India Bulletin, July 2020, the Gross Inflows/Gross Investments to Indiaamounted to US$ 74390million. The total direct investments India received during May 2020 is US$2535 million. During the same period, the Foreign Direct Investment by India abroad amounted to US$ 519 million,making the Net Foreign Direct Investment US$ 2016 million.

• During 2019-20, India received the maximum FDI equity inflow from Singapore (US$ 14.67 billion), followed byMauritius (US$ 8.24 billion), Netherlands (US$ 6.50 billion), USA (US$ 4.22 billion) and Japan (US$ 3.22 billion).

• The services sector (Finance., Banking, Insurance, Non-Finance/Business, Outsourcing, R&D, Courier, Tech.Testing and Analysis, Others) attracted the highest amount of FDI with 17.45 percent of the total; followed bycomputer software & hardware (7.93%).

FDI in India

• According to the guidelines issued by the Government, foreign investment of less10% in a listed Indian Company is considered as Portfolio Investment. Foreign Investment of 10% or more in a listed Indian company is considered as Foreign Direct Investment.

• FDI leads to both ownership and management control of a company, while FPI provides for only ownership in accordance with the shareholding.

• An Indian Company can receive foreign investment by issue of ‘FDI compliantinstruments’ namely: equity shares, fully and mandatorily convertible preferenceshares and debentures, partly paid equity shares and warrants.

• These have to be issued in accordance with the provisions of the Companies Act, 2013 and the SEBI guidelines, as applicable.

• Since, the 1991 LPG Reforms, the Government of India has opened up FDI in almost all the sectors of Indian Economy as shown below:

FDI in India

S.NO Sector FDI limit Route

1 Agriculture and Allied Activities 100% Automatic

2 Coal Mining 100% Automatic

3 Airports 100% Automatic

4 Defense 100% Automatic up to 49%.Govt Route beyond 49%

5 Telecom 100% Automatic up to 49%.Govt Route beyond 49

6 Single Brand Retail 100% Automatic up to 49%.Govt Route beyond 49

7 Private Sector Banks 74% Automatic up to 49%.Govt Route beyond 49

8 Insurance and Pension 49% Automatic up to 49%.Govt Route beyond 49

9 Print Media 26% Govt Route

10 Public Sector Banks 20% Govt Route

FDI in India

• Under old regime citizen of Bangladesh or an entity incorporated in Bangladesh and Pakistan can invest only under the Government route. Further, FDI from Pakistan is not allowed in sectors such as defense, space and atomic energy

• According to the new regime, entities from countries which share a land border with India will now be permitted to invest only under approval route.

• This means that the FDI proposal from bordering countries will now require government clearance, even if foreign investments for that sector is placed under approval route.

• So, going forward, FDI from China, Pakistan, Bangladesh, Nepal, Myanmar, Bhutan and Afghanistan would compulsorily require Government’s approval.

• The rules have been tightened not just for fresh but existing FDI as well. Transfer of ownership of any existing or future FDI where the direct or indirect beneficiary is from these countries will also require government approval.

FDI New Regime in India

• Sectors where FDI is prohibited

➢Lottery Business including Government/private lottery, online lotteries, etc.

➢Gambling and Betting including casinos etc.

➢Chit funds and Nidhi company

➢Trading in Transferable Development Rights (TDRs)

➢Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes

➢Activities/sectors not open to private sector investment such as Atomic Energy and Railway operations

FDI in India

• Overseas direct investments by Indian companies (Outbound FDI), made possible byprogressive relaxation of capital controls and simplification ofprocedures, have undergonesubstantial changes in terms of size, geographical spread and sectoral composition. OutwardForeign Direct Investment (OFDI) from India stood at US$ 1.86 billion in the month of June2016.

• The overseas investments have been primarily driven by resource seeking, market seeking ortechnology seeking motives. Many Indian IT firms like Tata Consultancy Services, Infosys, WIPRO, and Satyam acquired global contracts and established overseas offices in developedeconomies to be close to their key clients. Recently, there has been a surge in resourceseeking overseas investmentsby Indian companies, especially to acquire energy resourcesin Australia, Indonesia and Africa.

• Indian entrepreneurs are also choosing investment destinations in countries such asMauritius, Singapore, British Virgin Islands, andthe Netherlands on account of higher taxbenefits they provide

Overseas Direct Investment by Indian Companies

1. Differentiate between FPI and FDI with suitable examples.

2. Discuss the pros and cons of FDI.

3. What are the hindrances for FDI for a country like India?

4. Write a note on the status of FDI in India

5. What are the various modes of entering FDI?

PRACTICAL QUESTIONS

1. There is no difference between FPI and FII

2. A conglomerate FDI is one where a firm indulges in related businesses

3. If a firm does same business of home country in host country then it is called vertical integration

4. FPI will impact the exchange rate

5. FII will help in controlling current account deficit in BOP

6. Airlines FDI approval is both automatic and government route

True or False questions

END OF PRESENTATION