SEMESTER-II

2019-20

A research paper on:

Foreign Exchange with special reference to FDI & FPI

Submitted to:

Prof. Ganesh Munnorcorde

Assistant Professor, NMIMS SCHOOL OF LAW

Submitted by:

Maarij Ahmad

D061
 TABLE OF CONTENTS

Sr. No. Topic

ABSTRACT

Foreign Exchange (forex or FX) is the trading of one currency for another. For example, one
can swap the U.S. dollar for Indian Rupee. Foreign exchange transactions can take place in
the foreign exchange market, also known as the Forex Market. The forex market is the
largest, most liquid market in the world, with trillions of dollars changing hands every day.
There is no centralized location, rather the forex market is an electronic network of banks,
brokers, institutions, and individual traders.

FDI is investment by non-resident entities like MNCs to carryout business operations in one
country with management of investment, production of goods or services, employing people
and marketing their products. In FDI, both the ownership and control of the firm is with the
investor. The foreign investor usually takes a considerable stake or shareholding in the
company and exerts management influences completely or partially, depending on his
shareholding.

FPI on the other hand is investment in shares, bonds, debentures, etc. According to the IMF,
portfolio investment is defined as cross-border transactions and positions involving debt or
equity securities, other than those included in direct investment or reserve assets.

INTRODUCTION
What Is Foreign Exchange (Forex)?

A foreign exchange rate is the rate at which one currency is exchanged for another. Thus, an
exchange rate can be regarded as the price of one currency in terms of another. Exchange rate
is usually measured in terms of rupees per unit of foreign currencies. Thus, an exchange rate
indicates external purchasing power of money.

A fall in the external purchasing power or external value of rupee (i.e., a fall in exchange rate,
say from Rs. 80 = £1 to Rs. 90 = £1) amounts to depreciation of the Indian rupee.
Subsequently, an appreciation of the Indian rupee occurs when there occurs an increase in the
exchange rate from the existing level to Rs. 78 = £1. In other words, external value of the
rupee rises. This indicates strengthening of the Indian rupee. Conversely, the weakening of
the Indian rupee occurs if external value of rupee in terms of pound falls.

Demand-Supply Approach of Foreign Exchange:

Since the foreign exchange rate is a price, economists apply supply-demand conditions of
price theory in the foreign exchange market. A simple explanation is that the rate of foreign
exchange equals its supply.

Suppose that there are two countries: India and the USA. Let the domestic currency be rupee.
US dollar stands for foreign exchange and the value of rupee in terms of dollar (or conversely
value of dollar in terms of rupee) stands for foreign exchange rate. Now the value of one
currency in terms of another currency depends upon demand for and supply of foreign
exchange.

(1) Demand for foreign exchange: When Indian people and business firms want to make
payments to the US nationals for buying US goods and services or to make gifts to the US
citizens or to buy assets there, the demand for foreign exchange is generated. In other words,
Indians demand or buy dollars by paying rupee in the foreign exchange market.

A country releases its foreign currency for buying imports. Thus, what appears in the debit
side of the BOP account is the sources of demand for foreign exchange. The larger the
volume of imports the greater is the demand for foreign exchange.
The demand curve for foreign exchange is negative sloping. A fall in the price of foreign
exchange or a fall in the price of dollar in terms of rupee (i.e., dollar depreciates) means that
foreign goods are now more cheaper.

Thus, an Indian could buy more American goods at a low price. Subsequently, imports from
the USA would increase resulting in an increase in the demand for foreign exchange, i.e.,
dollar. Alternatively, if the price of foreign exchange or price of dollar rises (i.e., dollar
appreciates) then foreign goods will be expensive leading to a fall in import demand and,
hence, fall in the demand for foreign exchange.

Since price of foreign exchange and demand for foreign exchange move in opposite direction,
the importing country’s demand curve for foreign exchange is downward sloping from left to
right.

Figure 1

In Fig. 1, DD1 is the demand curve for foreign exchange. We measure exchange rate
expressed in terms of domestic currency that costs 1 unit of foreign currency (i.e., dollar per
rupee) on the vertical axis. This makes demand curve for foreign exchange negative sloping.

If exchange rate is expressed in terms of foreign currency that could be purchased with 1 unit
of domestic currency (i.e., dollar per rupee), the demand curve would then exhibit positive
slope. Here we have chosen the former one.

(b) Supply of foreign exchange: In a similar fashion, we can determine supply of foreign
exchange. Supply of foreign currency comes from its receipts for its exports. If the foreign
nationals and firms intend to purchase Indian goods or buy Indian assets or give grants to the
Government of India, the supply of foreign exchange is generated.

In other words, what the Indian exports to the rest of the world is the source of foreign
exchange. To be more specific, all the transactions that appear on the credit side of the BOP
account are the sources of supply of foreign exchange.

A rise in the rupee-per-dollar exchange rate means that Indian goods are cheaper to foreigners
in terms of dollars. This will induce India to export more. Foreigners will also find that
investment is now more profitable. Thus, a high price or exchange rate ensures larger supply
of foreign exchange. Alternatively, a low exchange rate causes exchange rate to fall. Thus,
the supply curve of foreign exchange, SS1, is positive sloping.

Now we can bring both demand and supply curves together to determine foreign exchange
rate. The equilibrium exchange rate is determined at that point where demand for foreign
exchange equals supply of foreign exchange. In Fig.1, DD1 and SS1 curves intersect at point
E. The foreign exchange rate thus determined is OP. At this rate, quantities of foreign
exchange demanded (OM) equals quantity supplied (OM). The market is cleared and there is
no incentive on the part of the players to change the rate determined.

Illustration 1: Suppose that at the rate OP, Rs. 50 = $1, demand for foreign exchange is
matched by the supply of foreign exchange. If the current exchange rate OP1 exceeds the
equilibrium rate of exchange (OP) there occurs an excess supply of dollar by the amount
‘ab’(Fig.1). Now the bank and other institutions dealing with foreign exchange wishing to
make money by exchanging currency would lower the exchange rate to reduce excess supply.

Thus, exchange rate will tend to fall until OP is reached. Similarly, an excess demand for
foreign exchange by the amount ‘cd’(Fig.1) arises if the exchange rate falls below OP, i.e.,
OP2. Thus, banks would experience a shortage of dollars to meet the demand. Rate of foreign
exchange will rise till demand equals supply.

The exchange rate that we have determined is called a floating or flexible exchange rate.
(Under this exchange rate system, the government does not intervene in the foreign exchange
market.) A floating exchange rate, by definition, results in an equilibrium rate of exchange
that will move up and down according to a change in demand and supply forces. The process
by which currencies float up and down following a change in demand or change in supply
forces is, thus, illustrated in Fig. 2.

Figure 2

Figure 3

Illustration 2: Let us assume that national income rises. This results in an increase in the
demand for imports of goods and services and, hence, demand for dollar rises. This results in
a shift in the demand curve from DD1 to DD2. Subsequently, exchange rate rises as from
OP1 to OP2 determined by the intersection of new demand curve and supply curve. Note that
dollar appreciates from Rs. 50 = $1 to Rs. 53 = $1, while rupee depreciates from $1 = Rs. 50
to $1 = Rs. 53.

Similarly, if supply curve shifts from SS1 to SS2, as shown in Fig.3, new exchange rate thus
determined would be OP2. If Indian goods are exported more, following an increase in
national income of the USA, the supply curve would then shift rightward. Consequently,
dollar depreciates and rupee appreciates. New exchange rate is settled at that point where the
new supply curve (SS2) intersects the demand curve at E2.

Balance of payments theory of exchange rate determination.

Wherever government does not intervene in the market, a floating or a flexible exchange rate
prevails. Such system may not necessarily be ideal since frequent changes in demand and
supply forces cause frequent as well as violent changes in exchange rate.

Such uncertainty may be damaging for the smooth flow of trade. To prevent this situation,
government intervenes in the foreign exchange rate. It may keep the exchange rate fixed. This
exchange rate is called a fixed exchange rate system where both demand and supply forces
are manipulated or calibrated by the central bank in such a way that the exchange rate is kept
pegged at the old level.

Often managed exchange rate is suggested. Under this system, exchange rate, as usual, is
determined by demand for and supply of foreign exchange. But the central bank intervenes in
the foreign exchange market when the situation demands to stabilise or influence the rate of
foreign exchange. If rupee depreciates in terms of dollar, the RBI would then sell dollars and
buy rupee in order to reduce the downward pressure in the exchange rate.

FOREIGN DIRECT INVESTMENT

Foreign direct investment (FDI) involves establishing a direct business interest in a foreign
country, such as buying or establishing a manufacturing business, building warehouses, or
buying buildings. Foreign direct investment tends to involve establishing more of a
substantial, long-term interest in the economy of a foreign country. Due to the significantly
higher level of investment required, foreign direct investment is usually undertaken by
multinational companies, large institutions, or venture capital firms. Foreign direct
investment tends to be viewed more favourably since they are considered long-term
investments, as well as investments in the well-being of the country itself.

At the same time, the nature of direct investment, such as creating or acquiring a
manufacturing facility, makes it much more difficult to liquidate or pull out of the
investment. For this reason, direct investment is usually undertaken with essentially the same
attitude as establishing a business in one's own country with the intention of making the
business profitable and continuing its operation indefinitely. Direct investment includes
having control over the business invested in and being able to manage it directly, but it also
involves more risk, work, and commitment.

FOREIGN PORTFOLIO INVESTMENT

Foreign portfolio investment (FPI) refers to investing in the financial assets of a foreign
country, such as stocks or bonds available on an exchange. This type of investment is at times
viewed less favourably than direct investment because portfolio investments can be sold off
quickly and are at times seen as short-term attempts to make money, rather than a long-term
investment in the economy.

Portfolio investment typically has a shorter time frame for investment return than direct
investment. As with any equity investment, foreign portfolio investors usually expect to
quickly realize a profit on their investments. Unlike direct investment, portfolio investment
does not offer control over the business entity in which the investment is made.

As securities are easily traded, the liquidity of portfolio investments makes them much easier
to sell than direct investments. Portfolio investments are more accessible for the average
investor than direct investments because they require much less investment capital and
research.

RELATIONSHIP BETWEEN FDI & FPI

Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) are the two
important forms of foreign capital. The real difference between the two is that while FDI
aims to take control of the company in which investment is made, FPI aims to reap profits by
investing in shares and bonds of the invested entity without controlling the company.

Both FDI and FPI are the most well sought type of foreign capital by the developing world.
Usually, both these are measured in terms of the percentage of the shares they own in a
company (i.e., 10%, 20% etc.,).
According to the existing regulation by the SEBI, FPI is investment in shares of a company
not exceeding 10% of the total paid up capital of the company. Any investment above 10% is
FDI as with that size of shareholding, the foreign investor can exert control in the
management of the company.

A marvellous advantage of both FDI and FPI is that the receiving country need not repay the
debt like in the case of External Commercial Borrowings (foreign loans). Both are thus
described as non-debt creating, and hence involve no payment obligations. Their own
servicing depends on future growth of the economy. This is why most developing countries
prefer FDI and FPI compared to other forms of foreign capital like ECBs.

A one-to one comparison will reveal that FDI is superior to FPI from the angle of a
developing country like India.

FDI means real investment; whereas FPI is monetary or financial investment. Here, FDI
means the investor making investment in buildings and machineries directly in the company
in which he has made the investment. FPI doesn’t create such productive asset creation
directly. It is just financial investment. FDI is certain, predictable, takes production risks,
have stabilizing impact on production. It directly augments employment, output, export etc.
The major merit of FDI is that it is non debt creating as well as non-volatile (less fluctuating).

FPI on the other hand is investment aimed at getting profits from shares, interests from
deposits etc. It is otherwise known as hot money. The portfolio investors keep their money in
the capital market only for a short period of time. Its destination period is so small and is
empirically considered as fluctuating (often short term) capital, it is highly volatile. It is
destabilizing in the foreign exchange market. Fluctuations in the mobility of FPI affects
foreign exchange rate, domestic money supply, value of rupee, call money rates, security
market etc.

FDI is certain, long term and less fluctuating, whereas FPI is speculative, highly volatile and
un-predictive. Hence, FDI is superior to FPI.
 DIFFERENCE BETWEEN FDI & FPI

Foreign Direct Investment Foreign Portfolio Investment

FDI is an investment made by a company or FPI is an investment made by a company or an individual in the
individual in the business of another country in the stock markets or debt markets of another country. FPI investors
form of either establishing a new business or merely purchase equities/shares/bonds/debentures of foreign based
acquiring the existing business. countries.

FDIs are mainly made in Open Economies as opposed FPIs are mainly made with the objective of making quick profits
to tightly controlled closed economies. by buying and selling shares, bonds and debentures.

FDIs are made for a longer period as the foreign FPIs are made for shorter periods as the foreign investor do not
investor’s controls and owns the companies in which own the companies and only invest in shares of the existing
they have invested. companies.

FDIs are much Stable. FPIs are highly volatile.

As per Organisation of Economic Cooperation and As per Organisation of Economic Cooperation and Development
Development (OECD), the threshold for an (OECD), investment of less than 10 percent in foreign companies
investment to be considered as FDI is 10 percent or is treated as FPIs. All FPI taken together cannot acquire more than
more ownership stake. 24 per cent of the paid-up capital of an Indian Company.

FDIs are normally categorised as being Horizontal or

 A Horizontal investment refers to the foreign firms FPI investor includes Foreign Institutional Investors (FIIs), Foreign
establishing the same type of Business operations in Qualified Investors (FQIs).
the host country as it operates in his home country.
 Institutional investors are big institutions like Asset Management
Example; Apple opening up Apple manufacturing Companies, Mutual Funds, Insurance Houses etc. RBI has
unit in India. mandated such big institutions to established to make investments
in India’s security markets.
 FQIs are individual investors or associations residing in Foreign
 A Vertical investment refers to the foreign firms
establishing different but related business in host countries. FQIs are small individual investors who invest in foreign
countries. Example: Hyundai Motors acquiring or countries securities.
establishing a company in India that supplies car
spare parts/raw materials required for manufacturing
Cars by Hyundai.
 CONCLUSION

It is found that FDI is a strategic component of investment needed by India for its sustained
economic growth and development. FDI is necessary for creation of jobs, expansion of
existing manufacturing industries and development of the new one. Indeed, it is also needed
in the healthcare, education, R&D, infrastructure, retailing and in long-term financial
projects.

Policy makers should design policies where foreign investment can be utilized as means of
enhancing domestic production, savings, and exports; as medium of technological learning
and technology diffusion and also in providing access to the external market. Indian economy
is largely agriculture based. There is plenty of scope in food processing, agriculture services
and agriculture machinery. FDI in this sector should be encouraged

FDI in Education Sector is less than 1%. Given the status of primary and higher education in
the country, FDI in this sector must be encouraged. However, appropriate measure must be
taken to ensure quality. The issues of commercialization of education, regional gap and
structural gap have to be addressed on priority. It can also be suggested that the government
should invest more for improvement of infrastructure sectors, R&D activities, human capital,
education sector, technological advancement to attract more of FDI.

Government should ensure the equitable distribution of FDI inflows among states. The
central government must give more freedom to states, so that they can attract FDI inflows at
their own level. The government should also provide additional incentives to foreign
investors to invest in states where the level of FDI inflows is quite low. FDI can be
instrumental in developing rural economy. But the issue of land acquisition and steps taken to
protect local interests by the various state governments are not encouraging.
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