FDI vs FII

THE Common Minimum Programme of the new Government at the Centre 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.
Cynics will no doubt point disdainfully in this connection to the Finance Minister, Mr P. Chidambaram's recent statement about the need to take a second look at the policy of foreign investors having to get the permission of their local collaborators before branching out on their own. The position of the Common Minimum Programme on FII inflows is spelt out many pages later, in the section dealing with the capital market. 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."
It is against this background that one must view Mr Chidambaram's comment about the need to take a second look at the concessional rate of capital gains tax levied on short-term gains (10 per cent) that applies to FII investments but not to those made by domestic players in the secondary market. It needs to be noted in this connection that a former Finance Minister, Mr Yashwant Singh, announced some years ago that the government knew all along that domestic investors, too, were using the Mauritius channel, but chose not to clamp down on this, presumably in the interest of ensuring a level playing field between domestic `FIIs' and FIIs that were really foreign.
Be that as it may, it is worth noting that the section in the CMP dealing with capital market opens with the statement that the government "is deeply committed, through tax and other policies, to the orderly development and functioning of capital markets that reflect the true fundamentals of the economy," before going on to talk of FIIs. Actually the latter half of this sentence is a mere platitude; it is an open secret that the one thing the capital market the world over pay little or no attention to is the `true fundamentals'. (No one I have spoken to or read has ever meaningfully discussed the relation of `fundamentals' to the stock market.)
The concern of market regulators the world over is focussed, rather, on ensuring a well-ordered market. One SEBI chairman in fact specifically stated that he was least interested in the question of whether the stock market was or was not in tune with the fundamentals. The level of share prices, he said, was not his job; his job was to avoid large and sudden fluctuations in these levels. This may have be one of the things the present Finance Minister has in mind when he speaks of `going back' to reforms.
The economic policy of the BJP-led coalition was, especially the past few years, was very much focussed on the stock market rather on the growth of productivity and on sustainable increases in GDP; apparently in an effort to indirectly boost the rate of growth of the market. A number of analysts of the US economy have pointed out that every dollar of growth in market capitalisation boosts spending by 5-7 cents. Sauce for the gander, sauce for the goose? Not really.
The estimates about the effect of the amount by which stock market increases or decreases spending relate to situations in which the market is relatively stable, and therefore might have a somewhat more limited effect in the Indian case, particularly when the stock market is on way up. It is, therefore, in our best interests to be cautious about the demand-enhancing aspects of runaway booms, rather than getting excited every time the market seems suddenly to be reaching new highs. Whenever the market seems all set to touch the skies, it is the pessimists that we ought to pay more attention to than the optimists. The point is not that a rising market is bad in itself; but rather that one needs to pay serious attention to the fall that might follow.
Pumping public sector funds to prop or push up the market is not healthy. It only heightens the risks. This logic particularly applies to situations in which market regulators seem better at `tackling' crises after they arise than at preventing them from happening.
One last thing: Foreign investments in supply-side infrastructural investments will probably look a great deal less appealing to foreign investors than we try to make them out to be. Costs are large and certain; benefits can at best be termed dubious. Things are very different in the case of direct foreign investments in fast moving goods; but in the context of a low-tariff regime, many potential investors could well look at imports as a better and safer way of getting more bang for their buck.

What does India Need - FDI or FII

FDI usually is associated with export growth. It comes only when all the criteria to set up an export industry are met. That includes, reduced taxes, favorable labor law, freedom to move money in and out of country, government assistance to acquire land, full grown infrastructure, reduced bureaucratic involvement etc. IT, BPO, Auto Parts, Pharmaceuticals, unexplored service sectors including accounting; drug testing, medical care etc are key sectors for foreign investment. Manufacturing is a brick and mortar investment. It is permanent and stays in the country for a very long time. Huge investments are needed to set this industry. It provides employment potential to semi skilled and skilled labor. On the other hand the service sector requires fewer but highly skilled workers. Both are needed in India. Conventional wisdom is that China will have an upper hand in manufacturing for a long time. If India plays its cards right India may be the hub for the service sector. Still high end manufacturing in auto parts and pharmaceuticals should be India’s target.
The FII (Foreign Institutional Investor) is monies, which chases the stocks in the market place. It is not exactly brick and mortar money, but in the long run it may translate into brick and mortar. Sudden influx of this drives the stock market up as too much money chases too little stock. In last four months an influx of about $1.5 Billion has driven the Indian stock market 20% higher.
Where FDI is a bit of a permanent nature, the FII flies away at the shortest political or economical disturbance. The late nineties economic disaster of Asian Tigers is a key example of the latter. Once this money leaves, it leaves ruined economy and ruined lives behind. Hence FII is to be welcomed with strict political and economical discipline.
China receives mainly the FDI. They do not have instruments to receive the FII i.e. laws, institutions and political and judicial framework. On the contrary, India should welcome both and work hard to retain both.
Infrastructure Renewal
To keep the Indian economy growing the infrastructure sector like power, transport, mining & metallurgy, textiles, housing, retail, social welfare, medical etc. has to be upgraded. After the Enron fiasco, it is difficult to persuade anybody in the west to take interest in any of these sectors. Hence India is left to its own devices to raise money and build this sector. Borrowing abroad supplemented with Indian resources is the only way open to India. This upgrade is needed prior or in step with the industrial and service exports sector growth. It has to be placed on a higher priority. Only recently a suggestion to use a small portion of India’s foreign reserves met with howl of protests. The protestors in the Indian Parliament did not understand the proposal. Hence the government is stuck to steam roller its proposal through the legislative process or succumb to political pressure and do nothing. The latter is not acceptable.
If India finds its own $4 Billion a year for infrastructure then foreign investors will kick in another similar portion. The resulting money will very quickly rebuild the now cumbersome infrastructure.

Indian Agricultural Economy

India has burgeoning population and a huge poverty. To reduce poverty, population growth has to be controlled (in addition to economic progress). The agricultural output at the moment barely feeds the population. The caloric intake is low as compared to the West. Production of meat and milk has to increase significantly to increase the caloric intake and improve the health of the populace. The agricultural production, which has slowed down a bit in last 3 years, has to maintain a pace well above the population growth. To maintain 4% growth in agriculture sector, capital input in form of fertilizer, power, improved seeds, storage of floodwater and transferring surplus water to deficient areas has to be increased. Monsoon vagaries will have to be overcome with water resources management.
Agricultural capital input takes about ten years to mature and give results, hence this investment is to be made today to reap benefits in the future. This capital input has to be internally generated. World Bank and other long-term lending institutions could provide some help, but most monies have to come from within. About $10 Billion a year is to be invested in this enterprise. This has priority over all other enterprises.

Hence How much FDI and FII India Needs

Economists believe that additional $20 Billion a year for next ten years will drive up GDP growth additional 2 –3% from the current level of 6.5 –8%. If these monies arrive in form of FDI, it is good for the country. If it arrives in form of FII, it is still good, but it has to be controlled. Internal resources and withdrawal from foreign reserves, trade loans, long term financing from World Bank etc. will add additional luster to the investment plans.
All the above will happen, if the planned structural changes to the Indian economy are concurrently made and country’s bureaucratic structure is made investor friendly. Other legislative changes needed to ensure the safety of investor’s money are made concurrently. The recent changes in India’s patent rules and regulation are steps in the right direction.
All in all India has to become investor friendly. It is need of the hour. Left leaning politics will not help. Opportunism in politics, which endangers the welfare of the people, is to be thoroughly discouraged.

Don’t be shy about FII

Portfolio flows reflect sound companies and a well-designed equity market

India attracts about one-fourth of the world’s portfolio flows and barely 3 per cent of the world’s FDI. Is this something to worry about?
FII inflows to India in the last six months have exceeded US $8 billion. FDI flows have been less than one third of this amount. Very often arguments are made that this is not good. Instead of having so much portfolio investment, India should have been attracting more FDI. However, contrary to this common belief, research suggests that attracting FII may be a sign of good health and attracting FDI, a sign of bad health of the economy. In contrast to the commonly held unfavorable 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.
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.
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.
In the light of the above evidence, it is not surprising that the share of FII in total capital flows to China are very low. It is an indication of the bad accounting, bad corporate governance, market design problems, and the fundamental inconsistency between communism and the stock market. 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.

But what about the impact upon the economy, of FDI versus FII? In the conventional argument, there are two 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. The dominant view is that FDI is “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 with short term debt, FDI has indeed 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. Indeed, economists Graham Bird and Ramkishen Rajen have found that despite the bulk of capital inflows into Malaysia being FDI, there was a currency crisis.
The argument that FDI raises the growth rate of a country also finds only mixed support. 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, cross-country evidence does suggest that 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 spillover 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.
The message for India is clear: instead of trying to increase FDI flows artificially, and restrict FII flows artificially, India must focus on improving markets, institutions and the regulatory framework to encourage investment — whether domestic or foreign. Domestic investment is largely responsible for growth in any economy. Whether foreign investment comes or not should be a side show. Policies should focus on creating a healthy well-functioning market and world-class infrastructure.

WHAT'S BETTER FOR INDIA, FDI OR FII?

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.