[Updated] Foreign Direct Investment (FDI) in India

Despite the slowdown in the global economy, inflows of foreign investment into India has not been impacted. In fact, India is among the top 10 recipients of the FDI in 2019, attracting $49 billion inflows, a 16% increase when compared to last year. However, the majority went to the service sector. India has failed to attract investments in other vital sectors like the manufacturing sector that is currently facing a crisis. To add to the woes of these sectors, recently, new modifications were made in India’s FDI policy as a countermeasure to “opportunistic takeover” of domestic firms by foreign entities. This new rule targets China in particular as it is currently making use of the economic crisis by investing in stressed sectors in many countries across the world.

This topic of “[Updated] Foreign Direct Investment (FDI) in India” is important from the perspective of the UPSC IAS Examination, which falls under General Studies Portion.

What is Foreign Direct Investment?

• A Foreign Direct Investment (FDI) is an investment made by a firm or individual in one country into business interests located in another country.
• It is different from when companies simply put their money into assets in other countries, which is called portfolio investment.
• With FDI, foreign companies are directly involved with day-to-day operations in the other country.
• FDIs are commonly made in open economies that offer a skilled workforce and above-average growth prospects for the investor, as opposed to tightly regulated economies.
• FDIs, apart from being involved in capital investment, also include the provisions of management or technology.
• The key feature of FDI is that it establishes either effective control of or at least a substantial influence over the decision-making of the foreign business.
• The FDI can be made in various ways, including the opening of a subsidiary or associate company in a foreign country or ensuring a merger or joint venture with a foreign company.

What are the types of FDI?

• FDI can be categorised into horizontal, vertical or conglomerate.
• A horizontal direct investment happens when an investor sets up the same type of business operation in a foreign country as it operates in its home country.
• A vertical investment is one in which different, but related business activities from the investor’s main business is established or acquired in a foreign country. For instance, when a manufacturing company acquires an interest in a foreign company that supplies parts or raw materials required for the manufacturing its finished goods, it is called vertical investment.
• A conglomerate type of FDI is the one where a company or an individual makes foreign investment in a business that is unrelated to its existing business in its home country.
• Since this type of investment involves entering a new industry where the investor has no experience, it often takes the form of a joint venture with a foreign company already operating in the country.

What are the methods of FDI?

• The methods of FDI can be divided into two broad categories:
• Greenfield investment
• Brownfield investment

Greenfield Investment:

• When companies are interested in FDI, they build up their own factory in a different country and train people to work in their factor/organisation.
• For instance, McDonald and Starbucks started everything from scratch and trained their employees themselves.
• This method is called greenfield investments.

Brownfield investment:

• In this method, the foreign companies do not build something from scratch in another country.
• These companies expand their business by either going for cross-border mergers and acquisitions (M&As).
• This allows the companies to immediately start their operations without necessary preparations.

What are the factors that affect FDI?

Wage rates:

• One of the major incentives for a company to invest abroad is to outsource labour-intensive production in countries with lower wages.
• Countries in the Indian subcontinent are one of the major hubs for labour outsourcing.
• However, the wage rate alone does not determine FDI.
• It should also be accompanied by other aspects such as infrastructure and transport.
• In this context, countries that have low transportation cost and have access to sea hold a significant advantage.
• For instance, a firm may be reluctant to invest in Sub-Saharan Africa because the advantage of the low wage labour force is outweighed by the other drawbacks like high transportation costs and lack of necessary infrastructure.

Skilled labour force:

• Some industries require skilled labour force for its operation. Example: pharmaceuticals and electronics.
• For instance, India has attracted significant investment in call centres as it has a high percentage of English-speaking population, but wages are low.
• This makes it an attractive place for outsourcing and therefore attracts investment.

Tax rates:

• Large Multinational Companies like Apple, Google and Microsoft have sought to invest in countries that have lower corporate tax rates.
• For instance, Ireland has been able to attract high investments from Google and Microsoft due to its low corporate tax rate.

Economic growth potential:

• FDI is often targeted to sell goods directly to the country involved in the investment.
• Therefore, the size of the population and the economic growth potential plays an important role in attracting investment.
• For instance, a large country with a huge population that is willing to spend has a large market that allows investors to increase their sales.
• Small countries, in this context, may be at a considerable disadvantage as it is not worth investing for a small population.

Political stability:

• FDI is a risky venture.
• Countries with an uncertain political situation will be a major disincentive.
• Furthermore, an economic crisis can discourage investment in that country.
• This is one of the reasons behind many former communist countries from Eastern Europe joined the European Union. EU was seen as a signal of political and economic stability, which encourages foreign investment.
• Corruption and trust in institutions like judiciary, law and order also play a crucial role in influencing FDI inflow.

Exchange Rates:

• A weak exchange rate in the host country can attract more FDI as it will be cheaper for companies to purchase assets.
• However, exchange rate volatility could discourage investment in the country.

Free trade:

• Free trade area, along with low non-tariff barriers attracts huge investments into the country.
• For instance, UK post-Brexit is likely to be less attractive to FDI due to its restriction of the movement of people and goods.

Other Factors:

• Numerous other factors determine FDI inflow and it is hard to isolate individual factors, as there are many different variables.
• Some of them include the type of industry, macroeconomic stability, political openness etc.

What are the advantages of FDI?

Increase in production:

• Allowing FDI inflow ensures an increase in investment in key areas such as infrastructure development, which may lead to an upsurge in capital goods production.
• For instance, investment in power generation can generate more electric power, which would enable the growth of more industries.

Increase in capital inflow:

• FDI promotes more capital inflow into the countries, especially in key sectors.
• It can address the shortage of money and materials, which can rapidly enhance the growth of the country.

Increase in employment opportunities:

• FDIs in developing countries have enhanced the service sectors.
• This increased the employment opportunities within these countries, leading to an increase in economic growth.
• Educated unemployment has also been reduced by the FDIs as they can absorb some of the workforces.

Strengthening of financial services:

• FDIs can enhance financial services of a country by not only entering its banking industry but also by extending other activities like merchant banking, portfolio investment etc.
• This, in turn, can result in the promotion of more companies.
• It has also helped the capital market within the country.

Exchange rate stability:

• RBI has been maintaining the exchange rate in the country through its exchange control measures.
• However, the constant and continuous supply of foreign exchange is vital for the continuation of exchange rate stability.
• FDI inflow plays a crucial role in this aspect by helping RBI to have comfortable foreign exchange reserve position of more than 1 billion dollars.

Economic development:

• FDIs, in the past, have played a crucial role in developing backward areas by starting industries.
• This resulted in many of these areas becoming industrial centres, with improvement in the standard of living of the people in these areas.

Efficient use of natural resources:

• The natural resources in the country are put to better use by the FDI, which may otherwise have been unutilised.

Improved knowledge and technology:

• One of the crucial benefits received by the host countries through the FDIs is access to new technologies and expertise from foreign companies.
• This can result in enhancement of the country’s growth potential.

Maintenance of Balance of Payments:

• FDI growth can help maintain the Balance of Payments.
• It can also maintain the value of countries’ currencies.

What are the issues that may arise due to FDI?

• Foreign ownership of strategically important sectors cannot favour the countries.
• Foreign investors might strip the business of its value.
• They could sell unprofitable portions of the company to the local, less sophisticated investors.
• They can use the company’s collaterals to get low-cost, local loans.
• Instead of reinvesting it, they lend the funds back to the parent company.
• The MNCs, through FDIs, can get controlling rights within the foreign countries.
• FDI can also be a convenient way to bypass local environmental laws.
• Developing countries are tempted to reduce environmental regulations to attract FDI inflows.
• FDI does not always benefit host countries as it enables foreign multinationals to gain from ownership of raw materials and even exploit labour force by not distributing its wealth to the backward society.
• MNCs are often criticised for their poor working conditions in foreign countries.
• The entry of large firms can often displace local businesses and may drive them out, as these small companies cannot compete.

How does India get FDIs?

India gets FDI via two routes. They are:

Automatic route:

• Approvals from Government or RBI are not needed for those FDIs that are coming through the Automatic route.

Approval route:

• Under the approval or government route, the foreign investor or the Indian company should obtain prior approval from the government agencies or bodies specified.
• Proposals for foreign investments under this route are considered by either the Foreign Investment Promotion Board (FIPB) or Cabinet Committee on Economic Affairs (CCEA) or Cabinet Committee on Securities.
• In certain cases, the Department of Economic Affairs (DEA) or the Department of Industrial Policy & Promotion also assists these agencies. The FIPB considers those investments up to Rs.5000 crores for approval.
• Above this limit, the CCEA approval is needed.
• Approvals are made by different bodies or agencies based on the sector and nature of investment specified by FDI proposal.
• Some of the sectors that require government approvals include defence, telecom, media, pharmaceuticals, insurance etc.

FDI prohibition:

• There are 9 sectors where FDI is prohibited.
• It includes lottery business, gambling and betting, chit funds, Nidhi company, real estate business, and manufacturing of cigars, cheroots, cigarillos and cigarettes using tobacco.

What are the recent initiatives taken by the government to increase FDI inflow?

• The government has been liberalising policies to include more items in the automatic list rather than the restrictive list.
• In December 2019, the government had permitted 26% FDI in digital sectors.
• In August 2019, the government permitted 100% FDI under the automatic route in coal mining for open sale (as well as in developing allied infrastructures like washeries).
• In the Union Budget 2019-2020, the Indian Government had proposed opening of FDI in aviation, media and insurance sectors in consultation with all stakeholders.
• In March 2020, the government had permitted non-residential Indians (NRIs) to acquire up to 100% stake in Air India.
• 100% FDI is also permitted for insurance intermediaries.
• In February 2019, the government of India released the Draft National E-Commerce Policy, which encourages FDI in the market place model of e-commerce.
• In September 2018, the government released the National Digital Communications Policy, 2018, which aims to increase FDI inflows in the telecommunications sector to $100 billion by 2022.
• In January 2018, the government allowed foreign airlines to invest in Air India up to 49% with government approval. The investment cannot exceed 49% directly or indirectly.
• Government approval is not required for FDI up to an extent of 100% in Real Estate Broking services.
• The government is planning to continue with the FDI relaxations in more sectors to attract more investors into the country.
• Foreign companies look into the World Bank’s Ease of Doing Business ranking before investing in a country and India has improved its ranking as it jumped to 63^rd position in the latest ranking.

FDI inflows in India:

• FDI into India dipped marginally by 1.4% (about Rs.76,800 crore) during October-December period of 2019-20.
• The sectors that attracted maximum FDI inflows during the nine months include services, computer software and hardware, telecommunications, automobile and trading.
• Singapore continued to be the largest FDI source in India during the April-December period of FY2019-20.
• It is followed by Mauritius, the Netherlands, Japan and the US.

What are the issues that India need to address pertaining to FDI inflows?

• Make in India, which was launched in 2014, aims to attract foreign investments to industrialise India.
• The objective was to increase the manufacturing sector‘s share in the GDP from 16% to 25% by 2022 and also create an additional 100 million jobs by then
• Until now, this policy has increased FDI from $16 billion in 2013-14 to $36 billion in 2015-16.
• However, FDIs showed no significant progress since then and have not contributed to India’s industrialisation.
• FDIs in the manufacturing sector showed a decline. In 2017-18, they were just above $7 billion, as against $9.6 billion in 2014-15.
• In contrast, the service sector attracted more FDIs.
• This trend clearly reflects that the Indian economy’s strong points like the service sector are remarkably developed.
• Also, the Make in India initiative aimed to promote export-led growth where the foreign investors are invited to make in India, not necessarily for India.
• However, few investors are attracted to this prospect and India’s share in global exports of manufacturing products remain around 2%, lesser than China’s share of around 18%.
• The reasons for this trend are as follows:
• Indian FDI is neither foreign nor direct as it comes from Mauritius-based shell companies and these investments are mostly black money from India.
• It is also found that India’s manufacturing sector’s labourers are almost four to five times less productive, on average than their counterparts in China and Thailand. This is not only due to insufficient skills but also because of the size of the industrial units, which is too small to attain economies of scale, investing in modern equipment and developing supply chains.
• Labour regulations in India are too complicated for plants with more than 100 employees. Government’s approval is mandatory under the Industrial Disputes Act of 1947 before laying off any employee and the Contract Labour Act of 1970 requires government and employee approval for a simple change in employee’s job description or duties.
• Infrastructure is also one of the issues that need to be addressed.
• Though electricity costs are about the same in India and China, power outages are much higher in India.
• Transportation is also time-consuming in India due to poor planning of roads. Railways are saturated while ports are constantly outperformed by many Asian countries.
• Bureaucratic procedures and corruption continue to make India less attractive to foreign investors.
• The existence of these issues makes it difficult for India to attract FDI inflow by just liberalising the norms.

Which are the agencies that monitor FDI trends across the world?

Three agencies keep track of FDI statistics. They are as follows:

• UN Conference on Trade and Development (UNCTAD) publishes Global Investment Trends Monitor to summarise FDI trends across the world.
• The Organisation for Economic Cooperation and Development (OECD) publishes quarterly FDI statistics for several countries. It reports on both inflows and outflows.
• The IMF published its first Worldwide Survey of Foreign Direct Investment Positions in the year 2010. This annual survey covers investment positions for 72 countries.

What does the latest Global Investment Trend Monitor report of UNCTAD say?

• The Global Investment Trend Monitor Report compiled by the UNCTAD stated that the global FDI remained flat in 2019 at $1.39 trillion, a 1% decline from a revised $1.41 trillion in 2018.
• This is because of weak macroeconomic performance and policy uncertainties, including trade tensions.

Developing economies:

• Developing economies have continued to absorb more than half of global FDI flows.
• South Asia recorded a 10% increase in FDI to $60 billion and this growth is driven by India with a 16% increase in inflows from the previous year.
• India is also among the top 10 recipients of the FDI in 2019, attracting $49 billion in inflows, majority of which went to service industries, including information technology.

Developed Countries:

• The FDI flows to developed countries remained at a historically low level, decreasing by further 6% to an estimated $643 billion.
• The FDI in the EU declined by 15% to $305 billion, while there was zero-growth of flows to the US, which received $251 billion FDI in 2019, as compared to $254 billion in 2018.
• Despite this, the US remains the largest recipient of FDI, followed by China with an inflow of $140 billion and Singapore with $110 billion.
• The FDI in the UK saw a 6% decline due to Brexit.

Cross-border Merger and acquisitions (M&As):

• The report stated that the cross-border merger and acquisitions decreased by 40% in 2019 to $490 billion. This is the lowest level since 2014.
• The fall in global cross-border Merger and acquisitions sales was deepest in the service sector (56% decline), followed by manufacturing (19% decline) and the primary sector (14% decline).
• In particular, sales of assets related to financial and insurance activities and chemicals fell sharply.

Forecast:

• UNCTAD, through the estimation, expects the FDI flows to increase moderately in 2020, as current projections show the global economy to improve somewhat from its weak performance since the global financial crisis in 2009.
• Corporate profits are expected to remain high and trade tensions may reduce.
• However, the decline of announced Greenfield projects by 22% indicates future trends of high geopolitical risks and concerns of the further shift towards protectionist policies.
• The report predicted an increase in GDP growth and gross fixed capital formation and trade in several large emerging markets.
• However, according to the report, significant risks will persist, including high debt accumulation among emerging and developing economies.

How would the Coronavirus outbreak affect global FDI?

• The outbreak of COVID-19 is expected to adversely affect the global FDI flows.
• Those countries that are severely hit by the pandemic will be the most affected, although negative demand shocks and the economic impact of supply chain disruptions will affect the investment prospects of other countries.
• Many MNEs have issued statements on the impact of COVID-19 on their businesses.
• Many are slowing down capital expenditures in affected areas.
• Also, lower profits will translate into lower reinvested earnings (a major component of FDI).
• On average, major MNEs that account for a significant share of global FDI, have seen downward revisions of 2020 earnings estimates of 9% due to COVID-19.
• The worst-hit includes the automotive industry, airlines, energy and basic materials industries.
• MNE profits based in emerging economies are predicted to be more at risk than those of developed country MNEs.
• Other aspects that will be affected include the on-going greenfield investment projects, announcement of new greenfield projects and merger and acquisitions (M&As).
• According to a report by UBS, an investment banking company, multinational companies looking to diversify their supply chains away from China due to trade protectionist measures and rising risks of coronavirus, could look at India as an alternative as it is the top destination for companies moving out of China.
• For this to happen, India must provide necessary facilities like land and electricity, along with easier clearance procedures and lower tax rates.

Updated*

India’s new FDI rules:

What were the recent modifications made in India’s FDI rules?

• On 18^th April, the Finance Ministry has amended its existing FDI policy to make prior government approval mandatory for foreign investments from countries that share land borders with India.
• This was done to curb “opportunistic takeovers” of domestic firms at a time when coronavirus pandemic is upsetting the economies across the world.
• Countries that share India’s land borders are China, Bangladesh, Pakistan, Bhutan, Nepal, Myanmar and Afghanistan.
• Of these, China has the highest investment in India.
• According to the Department for Promotion of Industry and Internal Trade (DPIIT) data, India received FDI from China worth $2.34 billion (Rs.14,846 crore) between April 2000 and December 2019.
• During the same period, India has attracted Rs.48 lakh from Bangladesh, Rs.18.18 crore from Nepal, Rs.35.78 crore from Myanmar, and Rs.16.42 crore from Afghanistan.
• There weren’t any investments from Pakistan and Bhutan.
• This new rule is widely considered as a countermeasure against the Chinese takeover of India’s domestic firms that are struggling because of the coronavirus-led economic crisis.

Why has India decided to enforce this new FDI rules?

• The immediate cause for bringing this amendment may be due to public criticism that came in response to People’s Bank of China (PBoC) raising its stake in HDFC from 0.8% to 1.01%.
• Chinese companies are currently taking the opportunity from the economic crisis, not just in India, but also in the rest of the countries.
• The on-going economic crisis is presenting opportunities for takeover in several sectors and India will need to safeguard its own technological assets at a time when China’s cumulative investment has been exceeding $8 billion December 2019
• In particular, Chinese investors have been investing in India’s startup sector aggressively.
• Additionally, they have also been acquiring distressed assets in strategic sectors.
• India emerged as an attractive destination for the Chinese firms ever since the initiation of the US-China trade war.

Has India done this before?

• The move to impose additional requirements for certain countries to invest in India is not unprecedented.
• Restrictions have been imposed on certain specific sectors previously.
• For instance, the FDI in pharmaceuticals had been allowed under the automatic route until 2011. During that year, the government had mandated approval for any investment coming into the sector.
• This was because of certain foreign firms’ intensions to increase investments in India’s pharmaceutical industry to potentially take full control over the domestic entities.
• This threatened the health security of the country.
• In 2014, this policy was liberalised though investments were limited to 74% under the automatic route.
• In the past, India has blocked certain Chinese FDI investments during the bilateral tensions with Beijing.

What will be the impact of this new FDI rules?

• This restriction may hurt bilateral trade relations with China while hampering future investments from other neighbouring countries.
• However, many experts believe that industries will not be affected by this change in the long run.
• According to reports, some Chinese firms are concerned that the change in FDI norms will affect their projects and investment deals and that the government’s approval may take months, leading to delays in projects.
• In short-term, New Delhi’s decision may affect the liquidity in Indian firms, especially the startups.
• At least 18 out of 23 Indian startups, including Paytm, Snapdeal, Ola, Swiggy, Zomato and Big Basket are backed by top Chinese investors like Alibaba, Tencent etc. These companies may face a financial crunch during the current economic crisis.
• Therefore, these entities may have to start looking for new investors to support their functioning.
• This may prove to be a difficult feat as China is among the few countries that are currently having the ability to ensure liquidity during these trying times. Major economies like the US and Europe are also facing economic crises, reducing the possibility of them investing in India.
• The growth-stage startups will also see investments drying up, potentially harming their development.
• Furthermore, Chinese investments are a part of India’s technology ecosystem, in startups, mobile apps, smartphone manufacturing and assembly, to name a few.
• This step would not only affect India’s startup ecosystem but also its already crisis-driven manufacturing sector.
• It should be noted that though investments may be impacted temporarily, it is unlikely that China will stop investing in India, or is it possible that India will block investment proposals from China.
• This measure will significantly protect the Indian economy during the current economic crisis.

Is India the only country that is implementing such restrictions?

• Countries across the world are tightening their trade restrictions in response to the economic decline.
• The European Union (EU) Commission had recently issued guidelines to protect “critical assets from foreign investment” in both strategic industries and medical and other related industries.
• Italy has announced measures against “foreign takeovers” in sectors ranging from energy to insurance-healthcare.
• Spain has constituted new laws on FDI, making government authorisation mandatory for certain investments.
• Australia has also enacted laws to prevent a “fire sale of Australian businesses to foreign interests”.
• Canada too introduced new rules to restrict foreign investments.

What is the way ahead?

• It should be noted that these new rules do not ban the investments from China as they only initiate screening process to examine the implications of the investment to prevent opportunistic investments that may threaten the domestic market and economic stability.
• India is currently planning to hasten the review process of some investment proposals from neighbouring countries following concerns that the new screening rules could affect plans of investors and companies.
• This would enable the survival of those firms that are dependent on foreign investments.
• These new FDI rules may significantly threaten the bilateral ties with China as trade has often been considered as a positive in India-China ties.
• However, there is no other option for New Delhi due to Beijing’s reluctance to adequately address Indian concerns and challenges posed by the latter’s predatory trade practices.
• This move should be a temporary solution to protect the Indian economy during the pandemic stress.

Conclusion:

Currently, some of the top recipients of the FDI inflow like the US and China are reeling under the numerous pressures like trade tensions and coronavirus outbreak. Taking advantage of this situation, India can attract more FDI inflows by addressing the issues of land acquisitions, taxation etc. However, this should not allow for taking over of domestic firms by foreign investors.

Practice Question for mains:

Critically examine how China is making use of the coronavirus-led economic crisis to its advantage. (250 words)