Xavier Institute of

Management and
Research – MMS II
Group # 9

Foreign Institutional Investors

and Foreign Direct Investment

Bhumika Shah – 509

Kanishka Sakrikar – 521
Nilay Parikh – 533
Raquel Rodrigues - 545
 FOREIGN INSTITUTIONAL
INVESTORS

INTRODUCTION
The term Foreign Institutional Investment denotes all those investors or investment
companies that are not located within the territory of the country in which they are
investing. The types of institutions that are involved in the foreign institutional investment
include Mutual Funds, Hedge Funds, Pension Funds and Insurance companies.

In this age of transnational capitalism, a significant amount of capital is flowing from

developed world to emerging economies. Portfolio investments brought in by FIIs have
been the most dynamic source of capital to emerging markets since 1990s. Since the
beginning of liberalization in 1990s, FII flows to India have steadily grown in importance.
From a near absence of FII inflows till 1992, today such inflows represent a dominant
proportion of total flows. Positive fundamentals, gradual removal of structural barriers
combined with fast growing markets have made India an attractive destination for foreign
institutional investors. Today, FIIs are the key drivers of the Indian equity market and rising
stakes in Indian companies. But, at the same time there is unease over the volatility in
foreign institutional investment flows and its impact on the different segments of the
economy.

India, among the world investors, is believed to be a good investment destination in spite of
political uncertainty, bureaucratic hassles, shortages of power supply and infrastructural
deficiencies. India presents a vast potential for overseas investment and is actively
encouraging the entrance of foreign players into the market. No company, aspiring to be a
global player can ignore this country. FIIs have recognized the fact and unlike other
countries where FDI has gained predominance India has seen significant growth in FII
investment. Budget 2011-12 has raised foreign institutional investor limit in 5-year
corporate bonds for investment in infrastructure by $20 billion. The combination of gradual
removal of structural barriers and an improving economic environment is likely to lead to a
significant amount of value being unlocked.

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 FIIS INVESTMENT POLICY OF INDIA
Ever since September 14, 1992, when FIIs were first allowed to invest in all the securities
traded on the primary and secondary markets, including shares, debentures and warrants
issued by companies which were listed or were to be listed on the Stock Exchanges in India
and in the schemes floated by domestic mutual funds. The holding of a single FII and of all
FIIs, NRIs and OCBs in any company was subject to the limit of 5 per cent and 24 per cent of
the company’s total issued capital, respectively.

Initially, Pension Funds, Mutual Funds, Investment Trusts, Assets Management Companies
nominee companies and incorporated institutional portfolio managers were permitted to
invest directly in the Indian stock market. In 1995, Security Exchange Board of India (SEBI)
empowered by the Securities and Exchange Board of India Act, 1992 institutionalized the
FII regulations, known as the Securities and Exchange Board of India (Foreign Institutional
Investors) Regulations, November 14, 1995. These regulations allowed an institution
established or incorporated outside India as a Pension Funds, Mutual Funds, Investment
Trusts, insurance company or reinsurance company; any Asset Management Company or
Nominee Company, Bank or Institutional Portfolio Manager, established or incorporated
outside India and proposing to make investments in India on behalf of broad based funds;
any Trustee or Power of Attorney holder, incorporated or established outside India, and
proposing to make investments in India on behalf of broad based funds to apply for FII
status to carry out trading in equities and debentures listed on the Indian stock exchanges.

As per regulation 6 of SEBI (FII) Regulations, 1995, FIIs are required to fulfill the following
conditions to qualify for grant of registration.

 Applicant should have track record, professional competence, financial soundness,

experience, general reputation of fairness and integrity;
 The applicant should be regulated be an appropriate foreign regulatory authority in
the same capacity/category where registration in sought from SEBI. Registration
with authorities, which are responsible for incorporation, is not adequate to qualify
as FII;
 Permission under the provisions of the Foreign Exchange Regulation Act 1973 (46
of 1973) by RBI for making investment in India as a FII;
 The applicant is required to have the permission under the provisions of the Foreign
Exchange Management Act, 1999 from the RBI;
 Applicant must be legally permitted to invest in securities outside the country or its
incorporation;
 The applicant must be a “fit and proper person”;

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 The applicant has to appoint a local custodian and enter into an agreement with the
custodian. Besides it also has to appoint a designated bank to route its transactions
‟Payment of registration fee of US$5,000”
Beginning 1996-97, the group was expanded to include registered University Funds,
Endowment, Foundations, Charitable Trusts and Charitable. Furthermore, funds
invested by FIIs had to have at least 50 participants with no one holding more than
5 per cent to ensure a broad base and preventing such investment acting as a
camouflage for individual investment in the nature of FDI and requiring
Government approval.

In February 2000, the FII regulations were amended to permit foreign firms and high net-
worth individuals to invest in sub-accounts of SEBI-registered FIIs. FIIs were also permitted
to seek SEBI registration in respect of sub-accounts for their clients under the regulations.
FII ceiling under special procedure was enhanced to 49 per cent in March 2001. The
objective was to increase FIIs participation. Securities and Exchange Board of India (SEBI)
amended SEBI (Foreign Institutional Investors) Regulations, 1995 by Notification dated 22
May 2008. The FII Regulations of 1995 have been one of the most debated pieces of SEBI
regulations, as uncertainty has shrouded many of its provisions whether these were related
to eligibility norms for registration, Know Your Client requirements or issuance of ODIs. In
an attempt to clear this ambiguity, SEBI made a substantive amendment in the form of SEBI
(FIIs-Amendment) Regulations 2008. While on the one hand this amendment sees the
earlier policy measures on ODIs and the eligibility criterion modifications of October 2007
being incorporated in the regulations, it also sees fresh and significant modifications to the
eligibility definitions for FII and sub accounts, measures that are intended to overall
smoothen the registration process In another significant inclusion, NRIs are now eligible to
be registered as FIIs.
Institutional investors including FIIs and their sub-accounts-have been allowed to
undertake short selling, lending and borrowing of Indian securities from February 1, 2008.
In October 2008, SEBI lifted the curbs, with the pace of slowing economic growth,
companies facing a credit crunch and foreign investors fleeing the stock market.
Interestingly, in the period from October to December 2008, when the Sensex dropped to
the year’s lowest, at least 100 new FIIs registered with SEBI. In June 2008, while reviewing
the External Commercial Borrowing policy, the Government increased the cumulative debt
investment limits from US $3.2 billion to US $5 billion and US $1.5 billion to US $3 billion for
FII investments in Government Securities and Corporate Debt, respectively. In order to give
a boost to the corporate bond market, the FII investment limit in rupee-denominated
corporate bonds has been increased from $6 billion to $15 billion in January 2009. FIIs can
now invest in interest rate futures that were launched at the National Stock Exchange on
31st August 2000. As a result of encouraging policy measures by government of India,
Foreign institutional investors have registered a remarkable growth in India.

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 GROWTH OF FOREIGN
INSTITUTIONAL INVESTORS IN
INDIA
FII flows to India formally began in September 1992 under the foreign portfolio Investment
(FPI) scheme, when the Government of India issued the Guidelines for Foreign Institutional
Investment. In the beginning, the number was quite low. However, as of November, 2010
the number of FIIs is 1738 and that of registered sub-accounts is 5592. Any of the below
categories can be registered as FII. They are:

 Pension Funds
 Mutual Funds
 Investment Trust
 Insurance or reinsurance companies
 Endowment Funds
 University Funds
 Foundations or Charitable Trusts or Charitable Societies who propose to invest on
their own behalf, and
 Asset Management Companies
 Nominee Companies
 Institutional Portfolio Managers
 Trustees
 Power of Attorney Holders
 Bank

In 2001, there were 482 foreign investors registered with SEBI. The number kept increasing
over the years. With the increase in the number of FIIs, the number of subaccounts
registered with FIIs also hit an all-time high.

The number of new FIIs coming to Indian touched a six year low in 2008 global financial
crisis. New FIIs registered with the SEBI declined by 70 per cent in the 2008-09. Only 111
new FIIs got registered with SEBI till November, 2009 against as many as 375 in calendar
year 2008 and 226 in 2007.

MAGNITUDE OF FII’S IN INDIA

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During the year 1994, net investments by FIIs were US $ 2164 million, which came down to
US $ 1191.4 million in 1995. During 1996, net FII investments were at US $ 3058 million.
Again, in 2001 there was a marginal fall in FII inflows. Decline in FIIs inflows in 2001 is
largely attributed to 9/11 attacks on USA. However, the effect has tended to be short lived.
Evidently, FII flows turned negative in September 2001 following the terrorist attacks, but
recovered after a month.

In 2005-06, the net investment by FIIs declined mainly due to large net outflows from the
debt segment. FIIs declined by 46 percent in 2006-07. Since August 2007 till June, 2008,
there was a net outflow of FII investment, with the largest pull out of US $ 2727 million in
January, 2008. During 2008-09, till June 2008, FIIs have been net sellers to the tune of US $
4,189 million. This can be attributed to the generally weak sentiments of investors
following the global credit crisis, which has engulfed the developed countries and is seen to
be affecting the developing countries as well. However, after the global financial crisis, a
record of over Rs 80,500 crores (Rs 805 billion) was poured in domestic equities in 2009
through FIIs. It broke the previous high of Rs 71,486 crores parked by foreign fund houses
in domestic equities in 2007. The inflow in 2009 was different from the previous bull
market year of 2007 because a good portion of the FII investments was coming in through
subscription to qualified institutional placements (QIPs), rather than the secondary market.
FII flows remained dull until March 2009 due to a combination of factors such as global
liquidity crunch and the Satyam fraud.

But inflows started to swell from April 2009. The Congress-led UPA government won a
decisive mandate without requiring the support of the Left. This gave confidence to FIIs that
India will keep going on the road to reform and they invested massive sums in May 2009
(net investments: Rs 20,117 crore). Also aiding this inflow was the fact that central banks
around the world had eased interest rates and infused capital into banks, which flooded the
markets with abundant liquidity.

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 IMPACT OF FOREIGN
INSTITUTIONAL INVESTORS
International capital investment can play a useful role in development by adding to the
savings of low and middle- income developing countries in order to increase their pace of
investment. However, foreign investment can also prove unproductive to developing
economies by exposing them to disruptions and distortions from abroad, and by subjecting
them to surges of capital inflows or massive outflows of capital flight. Thus, foreign capital
has several implications for any economic system. But, implications of foreign capital
largely depend on many factors like absorption capacity of host country, size of investment
and above all nature of investment. For the long-term investment there is little reason for
worry, but short-term traders are adversely getting affected by the role of FIIs. Some people
have argued that, far from being healthy for the economy, FIIs inflows have actually
imposed certain burdens on the Indian economy. Sudden fall and sudden increase in FIIs in
India has raised several issues before the policy makers regarding the real implications of
FIIs. Impact of FIIs can largely be observed at: (1) stock market (2) exchange rate

FII’S IN STOCK MARKETS

The above figure clearly shows that FII’s profit from investing in emerging financial stock
markets. If the cap on FII is high then they can bring in lot of funds in the countries stock
markets and thus have great influence on the way the stock markets behaves, going up or
down. The FII buying pushes the stocks up and their selling shows the stock market the
downward path. So this is how influencing FII can be, as is seen in the present downtrend of
the stock markets in India courtesy heavy FII selling.
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Long-term investors can track the FII investment data released by SEBI. The net FII
investment data helps in understanding the mood of the FIIs. Since they are key drivers of
stock markets, tracking their investment data helps in understanding the decisive direction
of the stock markets. However, there are also evidences that relationship between FII and
Stock market is weak. But, in general, FIIs buying pushes the stocks up and their selling
shows the stock market the downward path. Thus, FII contribution to the rise of the Sensex
is more psychological than real.

FII AFFECTING THE EXCHANGE RATES

The above figure clearly indicates that there is relationship between FIIs inflows and value
of Indian rupee. To understand the implications of FII on the exchange rates we have to
understand how the value of one currency goes up (appreciates) or goes down against the
other currency. The simple way of understanding is through Demand and Supply. If say US
imports from India it is creating a demand for Rupee thus the Indian rupee appreciates w.r.t
the dollar. If India imports then the dollar appreciates w.r.t the Indian rupee.

Now considering FII’s for every dollar that they bring into the country, there is a demand for
rupee created and the RBI has to print and release the money in the country. Since the FII’s
are creating a demand for rupee, it appreciates w.r.t the dollar. Thus if for e.g. if prior to the
demand the exchange rate was 1 USD = Rs 40, it could become 1 USD = Rs 39 after they
invest. Similarly when FII withdraw the capital from the markets, they need to earn back the
green buck (USD) so that leads to a demand for dollars the rupee depreciates. 1 USD goes
back to Rs. 40. 

Thus FII inflows make the currency of the country invested in appreciate (e.g. FII investing
in India may lead to Rupee appreciating w.r.t several other currencies) and their selling and
disinvestment may lead to depreciation.

The huge amount of FII fund inflow into the country creates a lot of demand for rupee, and
the RBI pumps the amount of Rupee in the market as a result of demand created by the FII’s.
This situation could lead to excess liquidity (amount of excess cash floating in the market)
thereby leading to Inflation, where too much money chases too few goods (perfect example
of demand-pull inflation). Thus there should be a limit to the FII inflow in the country. FII
8
bring lot of funds to the country’ markets leading to free availability of funds for the local
companies in need of funds to carry on expansion in their production capacities or starting
new ventures.

DEPRECIATING CURRENCY NOT FAVORABLE TO THE FII’S

Considering a simple hypothetical example. I invested 1 USD in India at an exchange rate of

1 USD = Rs. 40. If rupee appreciates the exchange rates become 1 USD = Rs. 20. Now if I
disinvest I get 2 dollars, whereas I invested only 1 USD thereby a gain of 1 USD. (Though in
real terms the purchasing power of my dollar might decrease as my import cost would
increase, and cost of living back home may increase, but when I do consider practical
examples there is always a gain for FII whenever the currency of the country invested in
appreciates w.r.t the home currency).

Similarly when rupee depreciates w.r.t US Dollar and exchange rate becomes 1 USD = Rs. 80
I get only 0.5 Dollar and I lose 0.5 of the 1 USD invested.

Thus we observe that for the FII’s to gain investing in India the rupee should appreciate
w.r.t the dollar.

FII AND INFLATION

The huge amount of FII fund inflow into the country creates a lot of demand for rupee, and
the RBI pumps the amount of Rupee in the market as a result of demand created by the FII’s.
This situation could lead to excess liquidity (amount of excess cash floating in the market)
thereby leading to Inflation, where too much money chases too few goods (perfect example
of demand-pull inflation). Thus there should be a limit to the FII inflow in the country.

FII AND LOCAL COMPANIES

FII bring lot of funds to the country’ markets leading to free availability of funds for the local
companies in need of funds to carry on expansion in their production capacities or starting
new ventures.

FII AND EXPORTS

However because the FII lead to appreciation of the currency, they lead to the exports
industry becoming uncompetitive due to the appreciation of the rupee. For e.g. if 1 USD =
Rs.40 and a soap costs 1 USD. Now when the rupee appreciates 1 USD = Rs. 20, I will have to
sell the same soap to the US for 2 US Dollars in order to sustain the same income that I have
been making i.e. Rs.40. Thus excess FII fund inflow in the country can also make a negative
impact on the economy of the country.
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 ISSUES OF CONCERNS
FIIs have strong implications on the economy. In fact, FIIs are more than just money. It
represents investor’s sentiments. The importance of such capital is foremost for the
developing countries like India. FIIs inflows bring global liquidity into the equity markets
and raise the price-earnings ratio and thereby reduce the cost of capital domestically. FIIs
inflows help supplement domestic savings and smoothen inter-temporal consumption.
However, the recent upsurge of FIIs has raised several issues before the policy makers.
Some of the basic issues are:

PROBLEMS OF INFLATION

Huge amounts of FII fund inflow into the country creates a lot of demand for rupee and the
RBI pumps the amount of Rupee in the market as a result of demand created. During April-
October 2010-11, Foreign Institutional Investor (FII) inflows increased sharply to USD 27.5
billion, compared to 18.4 billion a year ago. FII, also called portfolio investment, go largely
into stock and debt markets. The current account deficit is widening while capital flows
continue to be dominated by volatile components. External sector ratios have deteriorated,
fiscal conditions are still under pressure and inflationary pressures still persist.

PROBLEMS FOR SMALL INVESTOR

The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high
then they can bring in huge amounts of funds in the country’s stock markets and thus have
great influence on the way the stock markets behaves, going up or down. The FII buying
pushes the stocks up and their selling shows the stock market the downward path. This
creates problems for the small retail investor, whose fortunes get driven by the actions of
the large FIIs.

ADVERSE IMPACT ON EXPORTS

FII flows leading to appreciation of the currency may lead to the exports industry becoming
uncompetitive due to the appreciation of the rupee.

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 HOT MONEY

“Hot money” refers to funds that are controlled by investors who actively seek short-term
returns. “Hot money” can have economic and financial repercussions on countries and
banks. When money is injected into a country, the exchange rate for the country gaining the
money strengthens, while the exchange rate for the country losing the money weakens. If
money is withdrawn on short notice, the banking institution will experience a shortage of
funds.

ISSUES THAT ARE CURRENTLY

AFFECTING THE INDIAN ECONOMY
REGARDING FIIS ARE:
1. With the increasing number of FIIs dominating the capital markets and a sizeable
portion of foreign investment coming in through FIIs, their taxation in India has
assumed considerable significance. There has always been ambiguity in respect of
characterization of income earned by FIIs on transfer of securities as capital gains or
business income. Historically, most FIIs have been offering gains from transfer of
securities to tax as capital gains-a position that has also been accepted by the
revenue authorities. Another issue faced by FIIs is the manner of set-off of capital
losses incurred prior to April 1, 2002. Up to (and including) financial year ended
March 31, 2002, the Act permitted a tax payer to set-off losses from one source
against income from another source under the same head of income (the Act was
later amended and was effective from April 1, 2002 restricting the manner of set-off
of long-term capital losses).

2. Another issue is related with P-Notes (PNs). Investing through P-Notes is very
simple and popular. ‘Hedge funds’, which invest through participatory notes,
borrow money cheaply from Western markets and invest these funds into stocks in
emerging markets. This gives them double benefits: a chance to make a killing in a
stock market where stocks are on the rise; and a chance to make the most of the
rising value of the local currency. P-Notes are issued to the real investors on the
basis of stocks purchased by the FII. The registered FII looks after all the
transactions, which appear as proprietary trades in its books. It is not obligatory for
the FIIs to disclose their client details to the SEBI, unless asked for specifically.
However, Indian regulators are not very happy about participatory notes since they
have no way in knowing who owns the underlying securities. Regulators fear that
the hedge funds, acting through participatory notes, will cause economic volatility in
India’s exchanges. Hedge funds were largely blamed for the sudden sharp falls in
indices. Unlike FIIs, hedge funds are not directly registered with SEBI, but they can
operate through sub-accounts with FIIs. These funds are also said to operate
through the issuance of participatory notes. According to the SEBI, the current
position of these instruments is as follows: Currently, 34 FIIs /Sub-accounts issue
ODIs19. This number was 14 in March 2004. The notional value of PNs outstanding,
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 which was at Rs 31,875 crore (20 per cent of Assets under Custody (AUC) of all
FIIs/Sub-Accounts) in March 2004, increased to Rs 3, 53,484 crore (51.6 per cent of
AUC) by August 2007. The value of outstanding ODIs, with underlying as derivatives,
currently stands at Rs 1, 17,071 crores, which is approximately 30 per cent of total
PNs outstanding. The notional value of outstanding PNs, excluding derivatives, as
underlying a percentage of AUC is 34.5 per cent at the end of August 2007. This
implies that more than 50 per cent of the funds are flowing through this anonymous
route, which needs to be rethought with regard to this entire issue.

3. There is a question whether India should tax capital inflows to the stock market on
the lines of Brazil. Many emerging economies are reluctant to impose such controls.
They fear such a move will cast doubt on their commitment to market friendly
policies. Brazil seems almost apologetic about its taxes, which it insists are meant
only to prevent excesses. India is proud of its ‘carefully calibrated’ easing of capital
restrictions over the past 18 years. It has no need to impose a tax on foreign
investment because such purchases are still banned beyond a fixed amount.
However, experts argue that investments in Indian equities are likely to exceed
record levels of close to US$ 18 billion in the current fiscal. If this goes unchecked,
neither the rupee appreciation can be stopped nor inflation put to check and India's
exports competitiveness would gradually fizzle out. Imposing the tax would help the
RBI to manage rupee at reasonable levels to safeguard and support Indian
exporters, hit hard by input cost and appreciating rupee.

4. Today, India is in a situation where, purely due to a excess of capital flows, equity
primary market issuances are aggressively priced and are getting subscribed largely
by institutional investors with limited participation by retail. Not surprisingly, most
of them are quoted at a discount post listing. Land and real estate prices increased
greatly. India is witnessing the adverse effects of overpricing even now.

5. Another issue is of concern is hedge funds. The problem with hedge funds is that
they operate in unregulated realms; their dealings are secret and operational
methods opaque. Many of them could be Overseas Corporate Bodies which have
been banned after the Joint Parliamentary Committee (JPC) report on stock scam.
Much of it is “round tripping.”

6. Lastly, FIIs are not allowed to trade in currency futures. Currency futures trading
currently are being offered by MCX-SX21, NSE and BSE. Lessons from domestic
stock markets indicate that FII participation has the potential to make currency
futures segment more speculative and volatile. Rupee being the currency of a major
economy such as India, contrarian views on its current strength and position could
lead to wide swings in currency rates affecting trade balance.

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 FOREIGN DIRECT INVESTMENT

POLICY OVERVIEW AND ITS

IMPLICATIONS
In the early years of independence, India’s development strategy was inward-oriented. The
government emphasized on self-reliance to build a strong industrial base, especially after
the Second Industrial Policy Resolution of 1956. Subramanian identified four phases in the
evolution of India’s FDI policy.

The first phase of FDI was from 1948 to mid-1960. In this period, the Government of India
announced two industrial policy resolutions (1948 and 1956), where the entry of FDI was
marked by cautious welcome. The controlling interest was expected to be with the Indians.
During this period, the government introduced the Industries (Development and
Regulation) Act, 1951 to regulate and control the development of private sector. The basic
objective was to save scarce capital resources and to utilize these resources for
development of priorities.

The second phase began by the mid-1960 and lasted till the late 1970s.Monopolies and
Restrictive Trade Practices (MRTP) Act was introduced in 1969 to prevent concentration of
economic power and to control monopoly. Thereafter, the Industrial Policy Statement
(1973) was formulated which made licensing compulsory for all the firms above certain
size. In this period, external balance was not favorable and FDI outflows through transfer
payment further deepened the situation. Therefore, the Government of India in 1973
formulated the Foreign Exchange Regulatory Act (FERA) that came into effect in January 1,
1974, to curtail the outflow of foreign exchange. With tightening of restrictions, this phase
saw the exit of many leading MNCs, like IBM, Coca-Cola, etc., from India.

By late 1970s, the country entered into the third phase with partial liberalization policy
marked by selective relaxation of controls in line with the recommendation of various
committees set up by the government in the context of industrial stagnation since the mid-
1960s. In this phase, particularly in the 1980s, foreign firms were allowed to invest in India,

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but in collaboration with Indian firms. 100% foreign-owned firms were permitted only in
highly export-oriented industries. Industrial Policy, 1980 was drafted with the aim to
improve the competitiveness of firms along with technological up-gradation and
modernization. Likewise, MRTP Act was a domestic mended in 1985, the maximum asset
limit for identified monopolies was raised and large businesses were permitted to invest in
some restrictive sectors. A number of policy and procedural changes were announced in
1985 and subsequent years, with the objective to overcome the inefficiency developed in
Indian industries during the restrictive policy regime. Following this partial liberalization
phase, the Government of India announced a series of liberalization measures in the early
1990s with the aim of improving industrial competitiveness as well as to prepare Indian
industries to stand on their own to face international competition.

In line with the liberalization measures announced during the 1980s, the Government of
India announced ‘New Industrial Policy’ (NIP) on July 24, 1991 as a part of ‘New Economic
Policy’. With the announcement of 1991 reform packages, India entered into the fourth
phase known as the period of ‘open door policy’ or ‘market-led development strategy’. The
NIP deregulated the industrial economy in a substantial manner. Among others, the
fundamental aim of 1991 industrial policy was to improve efficiency of domestic industries
and thereby to attain international competitiveness by improving competitiveness of Indian
industries

To attain these objectives, the government introduced a series of initiatives with regard to
policies such as industrial licensing, public sector policy, MRTP Act, 1969, foreign
investment and technology collaboration, industrial location policy, phased manufacturing
programs for new projects, and FERA. The royalty payment limits were increased to
encourage technology import. Moreover, foreign equity holding level was raised to 50%,
74% and 100%. Thereafter, the government allowed free repatriability, except where FDI
approval was subject to specific conditions.

In the light of the above discussion, one can say that India’s FDI policy became highly liberal
in the post-reform period. Now, FDI in India is approved through two routes: automatic and
case-by-case government approval. In order to mobilize investment from Non-Resident
Indians (NRI) and Overseas Corporate Bodies (OCB), the government has allowed them to
invest in housing and real estate development sector. Furthermore, government has
allowed them to hold up to 100% equity in civil aviation companies, where earlier only up
to 40% foreign equity was allowed. As a result of the liberalization of India’s highly
regulated FDI policy, there has been a voluminous increase in the inflow of FDI into the
country.

In the budget for the year 2011-12, the finance minister has agreed to further liberalize the
FDI policies so as to encourage the growth of foreign investment and increase the growth
potential of the Indian economy. This would liberalise the portfolio investment route and
enable Indian mutual funds to have direct access to foreign investors in Indian equity
market, which had hitherto been restricted to only Foreign Institutional Investors, sub-
accounts registered with SEBI and NRIs.

Attracting foreign direct investment has become a key part of national development
strategies for many countries. They see such investments as bolstering domestic capital,
productivity, and employment, all of which are crucial to jump-starting economic growth.
While many highlight FDI’s positive effects, others blame FDI for "crowding out" domestic
14
investment and lowering certain regulatory standards. The effects of FDI can sometimes
barely be perceived, while other times they can be absolutely transformative. While FDI’s
impact depends on many conditions, well-developed and implemented policies can help
maximize its gains.

THE ECONOMIC EFFECTS OF

FOREIGN DIRECT INVESTMENT
FDI was an important source of developing country external finance for about 25 years after
World War II. The reason of eased restrictions on FDI was diminishing lending of
commercial banks to developing economies. The composition of external capital underwent
a dramatic transformation during this period. Because of the Asian and Russian financial
and economic crises, official capital flows in these countries either stagnated or declined. In
their place, private capital flows became the major source of external finance for a good
number of emerging market economies. Foreign direct investment accounted for only about
30 per cent in early 1980s but over 60 per cent of private capital flows in 2000 and next few
years then.

Latest picture is different again. Amid a sharpening financial and economic crisis, global FDI
inflows have made one more significant slide down. This slide was from historic high of
$1,979 billion in 2007 to $ 1,697 billion in 2008, a decline of 14%. The slide continued into
2009.

Theory provides conflicting predictions concerning the effects of direct foreign investments.
Several approaches regarding the effects of FDI exist: Neo-liberal, Keynesian, so called
dependency and new dependency schools are among best- known ones. Neo-liberals have a
number of arguments defending foreign direct investment and explaining how they are
beneficial for developing country as they contribute to development. They advocate free
flow of capital arguing that it ensures economic efficiency; allows capital to seek the highest
return across the borders; fastens economic growth as the free flow of capital reduces
investors risk enabling them to diversify their investment better. Pro- FDI economists
assert that the result of coming FDI is limited ability of host government to implement bad
policies. If the government tends to do so. Moreover, that foreign flow of capital might
spread the best practices of corporate governance, accounting rules, and legal traditions to
less developed countries (LDCs). Some more arguments used by supporters of FDI are that
they, firstly, enable technology transfer in form of capital inputs, which could not be
achieved by trade. Secondly, via FDI a competition is likely to be encouraged in domestic
input markets. Thirdly, FDI contributes to human capital development as foreigners engage
in employee training. In addition, profits from corporate taxes may be used to encourage
host country’s development while investing in infrastructure for example. In addition,
sometimes the investment from a core country encourages domestic investment as well.

15
FDI brings in financial resources, which are scarce in receiving country, creates new jobs,
increases exports by raising efficiency and enhancing marketing opportunities, increases
the availability and reduce the costs of public utilities, consumption goods and investment
goods.

NEGATIVE EFFECTS

Keynesians argue that if FDI brought benefits in one country it does not necessary mean
that the same will happen in another. Many things depend on prevailing conditions in
receiving country.

Advocates of Keynesian approach believe that there exist market failures what means that
free market it self cannot ensure efficiency. Firstly, information is not always perfect.
Insufficient or incorrect information can lead to attraction of insufficient or wrong kind of
investment. Secondly, sometimes interests of investors diverge from interest of receiving
economy. That is why government regulations must be in place. Increased competition may
be beneficial for the host economy, however, not always. Coming international corporations
may push out potentially more productive local business as they are yet not able to
compete. In that case many jobs might be lost instead of creating. Therefore government
protection of local activities is needed. Often it is difficult for developing country
governments to manage foreign investment to their advantage as there is a large
asymmetry in bargaining power between core countries investors on the one hand and host
governments - especially those from countries that are poor, lack scarce natural resources
and/or small - on the other.

Countries not clearly understanding all the effects that FDI can bring to their economies
sometimes engage in such kind of actions which ultimately can actually hamper growth.
Some economist claim that countries trying to attract investment by subsidies and tax
breaks can lead to substantial reduction of government revenues which could otherwise be
used to invest in education and infrastructure what ultimately creates attractive
environment to FDI it self, fastens economic growth and increases total welfare. Such
environment may be even more important than tax breaks. Finally, the country finds it self
in a situation when it is not attractive to FDI though their actions should have attracted it.

FINAL NOTE

According to the dependency school, in the long- run, FDI tends to impede economic growth
and development of recipient economies. Although underdeveloped countries lack capital
and industrial technology, they often are rich in natural resources and/or inexpensive labor.
While income or wealth is created in the host country, it does not lead to an accumulation of
wealth that would benefit the host economy. On the contrary, this wealth is transferred to
the core countries. Consequently, the core stands to benefit from this structural dichotomy
of the host economy because the foreign sector (i.e., the sector associated with FDI) does
not benefit the rest of the host country because of lack of integration.
16
 FOREIGN TRADE INDICATORS
The Exports of India grew from $2 bn in 1970 to $7.8 bn in 1979. In this decade, the highest
annual growth rate was 34.6 % in 1974. However, the average exports in the decade are
given in table.1. In the next decade (1980-1989), the amount of imports was far greater
than that of exports as compared to previous decade. As a result, the ratio of exports to
imports was less as compared to 1970-1979. During the decade 1990 – 1999, since 1991,
the Exports of India had grown substantially. The value of Exports grew from $17.7 bn in
1991 to $35.7 bn in 1999. Again, in period of 2000-2007, the Exports of India had grown
sizably. The following table.1 shows the exports, imports and FDI of India since 1970.

Table.1

Years Exports Imports Fiscal deficit FDI Export/

(Average in $ (Average in $ (Average in $ (Average in $ Import
Billions) Billions) Billions) Billions)

1970- 4.4 5.2 .8 .045 84.62

1979

1980- 10.4 16.2 6 .105 64.2

1989
1990- 27 32.1 5 1.517 84
1999
2000- 79.7 108 28 9.375 74.07
2007

Since 2007, FDI increased but FIIs reduced considerably on account of recession. The FIIs
feared that this recession would also affect the developing economies. However, again in
2009, the number of FIIs increased as seen in table.2.

Exports recorded high growth during the first half of 2008-09 although a deceleration was
witnessed during the subsequent month which was again due to global economic
slowdown.

17
 The global slowdown affected India’s exports by way of:

 Default in payment or delayed realization for exports resulting in cash difficulties

for the exports.

 Difficulty in executing orders due to lack of additional credit limit.

 Reluctance of exporters to execute orders for fear of defaults.

The following table explains the economic situation since 2007.

Table.2

Yrs Exports Imports Fiscal FDI Export/ GDP GDP F F

(Avg in $ (Avg in $ deficit (Avg in $ Import growth o I
billions) Billions) (Avg in $ Billions) (in $ r I
Billions) Billions) (%) e s
x

R
e
s
e
r
v
e
s

2007 163 251.6 88.6 24.579 .65 1231 9.2 3 6

- 0 2
2008 9 .
. 1
7

2008 185.3 303.7 118.4 27.309 .61 1222 6.7 2 2

- 5 1
2009 2 .
3

2009 178.7 286.8 108.1 34.167 .62 1317 7.4 2 6

- 7 9
2010 7 .
6

18
 TRENDS AND PATTERNS OF FDI IN
INDIA
With the initiation of new economic policy in 1991 and subsequent reforms process, India
has witnessed a change in the flow and direction of foreign direct investment (FDI) into the
country. This is mainly due to the removal of restrictive and regulated practices.

Given the policy initiatives announced by the Government of India, the FDI inflows into
India increased sharply in the post-reform period. In an effort to bring the Indian definition
in line with that of IMF, the coverage of FDI since 2001-02 includes, besides equity capital
(i.e. RBI automatic route, SIA/FIPB route, NRI acquisition of shares, etc.), reinvestment
earnings (including earnings of FDI companies), and other direct capital (like, inter
corporate debt transactions between related entities).

Comparing India’s FDI trend with that of China and other countries reveals that it is not so
remarkable, but compared to India’s past FDI inflows, it has increased at an unprecedented
rate in the recent period. Furthermore, FDI inflow into India has improved at much faster
pace in comparison to that of the other developing countries since 2000. India emerged as
the second most important destination after China for foreign investors. It has been ranked
second in global foreign direct investments in 2010 and is believed to remain among the
top five attractive destinations for international investors during 2010-12 period, according
to United Nations Conference on Trade and Development (UNCTAD) in a report on world
investment prospects titled, 'World Investment Prospects Survey 2009-2012'.

India’s share in world FDI has increased considerably during the liberalization period. For
instance, India’s share in world FDI increased from 0.11% in 1990 to 0.79% in 2005, and
subsequently to 1.25% in 2007. However, negative growth rate is noticed during the period
1998-2000. This slowdown in FDI might be attributed to the negative spillover caused by
the East Asian Crisis in 1997.

India attracted FDI equity inflows of US$ 2,014 million in December 2010. The cumulative
amount of FDI equity inflows from April 2000 to December 2010 stood at US$ 186.79
billion, according to the data released by the Department of Industrial Policy and Promotion
(DIPP).

19
The major chunk of FDI inflows into India from the top investors is primarily invested in
fuels, electrical equipment, telecommunications, food processing, service, power, and
transportation sectors The sectors receiving the largest shares of total FDI inflows up to
arch 2010 were the service sector and computer software and hardware sector, each
accounting for 22.14 and 9.48 percent respectively. These were followed by the
telecommunications, real estate, construction and automobile sectors.

Mauritius emerged as one of the largest foreign investors in India during the period 1991-
2010. During April-December 2010, Mauritius has led investors into India with US$ 5,746
million worth of FDI comprising 42 per cent of the total FDI equity inflows into the country.
However, the FDI inflow from Mauritius to India is misleading. This is so because Mauritius
has low rates of taxation and an agreement with India on double-tax avoidance regime. In
order to get benefits out of the low tax agreement between Mauritius and India, large
number of foreign firms and even some Indian firms started dummy companies in
Mauritius, and then invested in India via Mauritius

FDI inflow as percentage of GDP has improved significantly during the liberalization era.
The sudden rise in FDI is believed to be a result of liberalization of India’s highly regulated
FDI policy and improvement in structural factors, such as market size, quality of
infrastructure, tax concession, etc. The change in approvals and the percentages of
realization of FDI over time indicates that India’s approach (policy and procedures) toward
FDI has undergone significant changes.

In the year 2010, India has assumed a notable position on the world canvas as a key
international trading partner, majorly because of the implementation of its consolidated FDI
policy. The consolidation, first undertaken in March 2010, pulls together in one document
all previous acts, regulations, press notes, press releases and clarifications issued either by
the DIPP or the Reserve Bank of India (RBI) where they relate to FDI into India.

According to the modified policy, foreign investors can inject their funds though the
automatic route in the Indian economy. Such investments do not mandate any prior
government permission. However, the Indian company receiving such investment would be
required to intimate the RBI of any such investment.

The FDI rules applicable to such sectors are, therefore, fairly clear and unambiguous.

FDI INFLOWS IN INDIA (AMOUNT US$ MILLION)

Financial Year

(April-March)

Total FDI Inflows into India

% growth over previous year

20
 2000-01

4,029

2001-02

6,130

(+) 52 %

2002-03

5,035

(-) 18 %

2003-04

4,322

(-) 14 %

2004-05

6,051

(+) 40 %

2005-06

8,961

(+) 48 %

2006-07

22,826

(+) 146 %

2007-08

34,835

(+) 53 %

2008-09

37,838

(+) 09 %

2009-10

37,763

21
(-) 0.2 %

2010-11 ( up to Nov’10)

19,002

-/

Source: RBI’s Bulletin February 2011

CONCLUSION
In such fast moving times it is imperative for a developing country to take the help of FDIs
and FII to fuel the needs of the thriving economy. As we have seen in the report, these
humungous investments do come with their fare share of adverse impacts. These negative
effects if not managed properly might lead to the downfall of the entire sector if not
economy itself. Although the Indian domestic supply is adequate to fulfill the domestic
demand, the Indian companies are not limiting themselves to the country and have firmly
set their sights on the global markets waiting to be tapped.

Thus we reach a stage wherein we need to understand which one of these foreign
investments would be more beneficial and why it is so. The Foreign Institutional Investor is
also known as hot money as the investors have the liberty to sell it and take it back. But in
Foreign Direct Investment, this is not possible. In simple words, FII can enter the stock
market easily and also withdraw from it easily. But FDI cannot enter and exit that easily.
This difference is what makes nations to choose FDI’s more than then FIIs. FDI is more
preferred to the FII as they are considered to be the most beneficial kind of foreign
investment for the whole economy. It aims to increase the enterprises capacity or
productivity or change its management control. In an FDI, the capital inflow is translated
into additional production. The FII investment flows only into the secondary market. It
helps in increasing capital availability in general rather than enhancing the capital of a
specific enterprise. The Foreign Direct Investment is considered to be more stable than
Foreign Institutional Investor. FDI not only brings in capital but also helps in good
governance practices and better management skills and even technology transfer. Though
the Foreign Institutional Investor helps in promoting good governance and improving
accounting, it does not come out with any other benefits of the FDI. Also it is important to
note that FIIs are mostly short term in nature and thus do not have the obligation to stay on
in the country. On the other hand, FDI have a stipulated time period for which they have to
keep the investment in the country.

According to another school of thought in the long- run, FDI tends to impede economic
growth and development of economies. Although underdeveloped countries lack capital and
industrial technology, they often are rich in natural resources and inexpensive labor. While
income or wealth is created in the host country, it does not lead to an accumulation of
wealth that would benefit the host economy. On the contrary, this wealth is transferred to
the core countries. Consequently, the core stands to benefit from this structural dichotomy
of the host economy because the foreign sector (i.e., the sector associated with FDI) does
not benefit the rest of the host country because of lack of integration.

22
Even though both have their own pros and cons it can be safely said that a country like India
can benefit from both the FIIs and the FDIs provided the foreign investors are open to the
idea of investing in India over a long period of time. FDIs would ensure that the Indian
companies do not fall short of capital but also absorb the latest technologies and techniques
from the FDI Company. The FIIs on the other hand would ensure that they provide a sound
background and support for the economy to flourish. Whatever are the consequences, one
thing is for certain and that is , if India is to grow and establish itself as a super power in the
coming decades then it has to do so with the help of FDIs and FIIs.

BIBLIOGRAPHY

Articles from Ebsco

 “A Causal Relationship between Trade, Foreign Direct Investment and

Economic Growth for India “ by G.Jayachandran and A. Seilan

 “Does Economic Growth Promote Foreign Direct Investment?“ by Rudra

PraUash Pradhan

 “Economic Reforms and Foreign Direct Investment in India: Policy, Trends and
Patterns” by Jatinder Singh

 “Economic growth in India: does FDI inflow matter?” by Dukhabandhu Sahoo

and Maathai K Mathiyazhagan

 “Economic policy: government mulls new FDI rules” by Economic Intelligence

Unit Limited

 “Liberalization of Foreign Institutional Investments (FIIs) in India: Magnitude,

Impact Assessment, Policy Initiatives and Issuers” by Singh Sumanjeet and
Minakshi Paliwal

 “Foreign Direct Investments Expansion – Essential Globalization Factor” by

Că tă lin Emilian

 “Foreign Direct Investment and Economic Development of India: A Diagnostic

Study” by A S Shiralashetti and S S Hugar

 “FDI rising up the ranks” by Asia monitor.com

 “Foreign Direct Investment in India During the Post-Liberalization Period” by

S Rameshkumar and V Alagappan

 “Negative and positive effects of FDI” by Asta Ž ilinskė

 “Position of Foreign Direct Investment in India” by Komal Narang and Ravi Inder
Singh

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Websites

 www.rbi.org.in

 www.sebi.gov.in

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