Chapter-1

Introduction

Foreign investment refers to investments made by the residents of a country in the financial assets and

production processes of another country. The effect of foreign investment, however, varies from country

to country. It can affect the factor productivity of the recipient country and can also affect the balance of

payments. Foreign investment provides a channel through which countries can gain access to foreign

capital.

It can come in two forms:

Foreign direct investment (FDI)

Foreign institutional investment (FII)

About Foreign Direct Investment

Is the process whereby residents of one country (the source country) acquire ownership of assets for the

purpose of controlling the production, distribution, and other activities of a firm in another country (the

host country)

According to the International monetary fund FDI is an investment that is made to acquire a lasting

interest in an enterprise operating in an economy other than that of the investor. The investors’ purpose

being to have an effective voice in the management of the enterprise.

The united nations 1999 world investment report defines FDI as an investment involving a long term

relationship and reflecting a lasting interest and control of a resident entity in one economy (foreign direct

investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct

investor ( FDI enterprise, affiliate enterprise or foreign affiliate).

About Foreign Institutional Investment

Foreign institutional investment is a short-term investment, mostly in the financial markets. Hence,

understanding the determinants of FII is very important for any emerging economy as FII exerts a larger

impact on the domestic financial markets in the short run and a real impact in the long run. India, being a

capital scarce country, has taken many measures to attract foreign investment since the beginning of

reforms in 1991.The Foreign direct investment (FDI) and foreign institutional investment (FII) flows are

Usually preferred over the other form of external finance, because they are not debt creating, nonvolatile

in nature and their returns depend upon the projects financed by the investor. The Foreign direct

investment (FDI) and foreign institutional investment (FII) would also facilitate international trade and

transfer of knowledge, skills and technology.

Foreign direct investment v/s foreign institutional investment

Both FDI and FII are related to investment in a foreign country. FDI or Foreign Direct Investment is an

investment that a parent company makes in a foreign country. On the contrary, FII or Foreign Institutional

Investor is an investment made by an investor in the markets of a foreign nation. In FII, the companies

only need to get registered in the stock exchange to make investments. But FDI is quite different from it as

they invest in a foreign nation. 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. Specific enterprise. 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. While the FDI flows into the primary

market, the FII flows into secondary market. While FIIs are short-term investments, the FDI’s are long

term.

FDI is an investment that a parent company makes in a foreign country. On the contrary, FII is an

investment made by an investor in the markets of a foreign nation.

FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and

exit easily.

Foreign Direct Investment targets a specific enterprise. The FII increasing capital availability in

general.

The Foreign Direct Investment is considered to be more stable than Foreign Institutional

Advantages and disadvantages of FDI for the host country

Advantages of Foreign Direct Investment

Foreign Direct Investment has the following potential benefits for less developed countries.

Raising the Level of Investment : Foreign investment can fill the gap between desired investment

and locally mobilized savings. Local capital markets are often not well developed. Thus, they

cannot meet the capital requirements for large investment projects. Besides, access to the hard

currency needed to purchase investment goods not available locally can be difficult. FDI solves

both these problems at once as it is a direct source of external capital. It can fill the gap between

desired foreign exchange requirements and those derived from net export earnings.

Up gradation of Technology : Foreign investment brings with it technological knowledge while

transferring machinery and equipment to developing countries. Production units in developing

countries use out-dated equipment and techniques that can reduce the productivity of workers and

lead to the production of goods of a lower standard.

Improvement in Export Competitiveness : FDI can help the host country improve its export

performance. By raising the level of efficiency and the standards of product quality, FDI makes a

positive impact on the host country’s export competitiveness. Further, because of the international

linkages of MNCs, FDI provides to the host country better access to foreign markets. Enhanced

export possibility contributes to the growth of the host economies by relaxing demand side

constraints on growth. This is important for those countries which have a small domestic market

and must increase exports vigorously to maintain their tempo of economic growth.

Employment Generation : Foreign investment can create employment in the modern sectors of

developing countries. Recipients of FDI gain training of employees in the course of operating new

enterprises, which contributes to human capital formation in the host country.

Benefits to Consumers : Consumers in developing countries stand to gain from FDI through new

products, and improved quality of goods at competitive prices.

Resilience Factor: FDI has proved to be resilient during financial crisis. For instance, in East

Asian countries such investment was remarkably stable during the global financial crisis of 1997-

98. In sharp contrast, other forms of private capital flows like portfolio equity and debt flows were

subject to large reversals during the same crisis. Similar observations have been made in Latin

America in the 1980s and in Mexico in 1994-95. FDI is considered less prone to crises because

direct investors typically have a longer-term perspective when engaging in a host country. In

addition to risk sharing properties of FDI, it is widely believed that FDI provides a stronger

stimulus to economic growth in the host countries than other types of capital inflows. FDI is more

than just capital, as it offers access to internationally available technologies and management

know-how.

Revenue to Government : Profits generated by FDI contribute to corporate tax revenues in the

host country

Disadvantages of Foreign Direct Investment

FDI is not an unmixed blessing. Governments in developing countries have to be very careful while

deciding the magnitude, pattern and conditions of private foreign investment. Possible adverse

implications of foreign investment are the following:

1. When foreign investment is competitive with home investment, profits in domestic industries fall,

leading to fall in domestic savings.

2. Contribution of foreign firms to public revenue through corporate taxes is comparatively less because

of liberal tax concessions, investment

3. Allowances, disguised public subsidies and tariff protection provided by the host government.

4. Foreign firms reinforce dualistic socio-economic structure and increase income inequalities. They

create a small number of highly paid modern sector executives. They divert resources away from

priority sectors to the manufacture of sophisticated products for the consumption of the local elite. As

they are located in urban areas, they create imbalances between rural and urban opportunities,

accelerating flow of rural population to urban areas.

5. Foreign firms stimulate inappropriate consumption patterns through excessive advertising and

monopolistic market power. The products made by multinationals for the domestic market are not

necessarily low in price and high in quality. Their technology is generally capital-intensive which does

not suit the needs of a labour-surplus economy.

6. Foreign firms able to extract sizeable economic and political concessions from competing

governments of developing countries. Consequently, private profits of these companies may exceed

social benefits.

7. Continual outflow of profits is too large in many cases, putting pressure on foreign exchange reserves.

Foreign investors are very particular about profit repatriation facilities.

8. Foreign firms may influence political decisions in developing countries. In view of their large size and

power, national sovereignty and control over economic policies may be jeopardized. In extreme cases,

foreign firms may bribe public officials at the highest levels to secure undue favors. Similarly, they

may contribute to friendly political parties and subvert the political process of the host country.

9. Key question, therefore, is how countries can minimize possible negative effects and maximize

positive effects of FDI through appropriate Policies.

Types of Foreign Direct Investment: An Overview

On the basis of Direction

1. Inward: Inward foreign direct investment is when foreign capital is invested in local resources.

Inward FDI is encouraged by

Tax breaks, subsidies, low interest loans, grants, lifting of certain restrictions

Inward FDI is restricted by:

Ownership restraints or limits Differential performance requirements

2. Outward: Outward foreign direct investment, sometimes called "direct investment abroad", is when local capital is invested in foreign resources.

Outward FDI is encouraged by:

Government-backed insurance to cover risk Outward FDI is restricted by Tax incentives or disincentives on firms that invest outside of the home country. Subsidies for local businesses.

On the Basis of Target

1. Greenfield investment

It is direct investment in new facilities or the expansion of existing facilities. Greenfield investments are the primary target of a host nation’s promotional efforts because they create new production capacity and jobs, transfer technology and know-how, and can lead to linkages to the global marketplace.

2. Horizontal FDI

Investment in the same industry abroad as a firm operates in at home.

3. Vertical FDI

Backward Vertical FDI: Where an industry abroad provides inputs for a firm's domestic production process.

Forward Vertical FDI: Where an industry abroad sells the outputs of a firm's domestic production.

On the basis of Motive

FDI can also be categorized based on the motive behind the investment from the perspective of the investing firm

Resource-Seeking

Investments which seek to acquire factors of production that is more efficient than those obtainable in the home economy of the firm. In some cases, these resources may not be available in the home economy at all (e.g. cheap labor and natural resources). FDI into developing countries, for example seeking natural resources in the Middle East and Africa, or cheap labor in Southeast Asia and Eastern Europe.

Market-Seeking

Investments which aim at either penetrating new markets or maintaining existing ones. FDI of this kind may also be employed as defensive strategy it is argued that businesses are more likely to be pushed towards this type of investment out of fear of losing a market rather than discovering a new one.

Efficiency-Seeking

Investments which firms hope will increase their efficiency by exploiting the benefits of economies of scale and scope, and also those of common ownership. It is suggested that this type of FDI comes after either resource or market seeking investments have been realized, with the expectation that it further increases the profitability of the firm.

The types of institutions that are involved in the foreign institutional investment:

1. Mutual Funds

An investment vehicle that is made up of a pool of funds collected from many investors for the

purpose of investing in securities such as stocks, bonds, money market instruments and similar

assets.

2. Pension Funds

A fund established by an employer to facilitate and organize the investment of employees'

retirement funds contributed by the employer and employees. Pension funds are commonly run by

some sort of financial intermediary for the company and its employees, although some larger

corporations operate their pension funds in-house. Pension funds control relatively large amounts

of capital and represent the largest institutional investors in many nations.

Chapter 2

India’s Historical Economic Direction and the Rationale for Emergence of FDI

as a Source of Economic Growth

After getting independence in 1947, the government of India envisioned a socialist approach to

developing the country’s economy – broadly based on the USSR system. The government decided

to adopt an economic agenda that would follow five year plans. Each five year plan was focused

on certain sectors of the economy that the government felt needed to be developed for the

countries progress. The government followed an interventionist policy and dictated most of the

norms of running a business by favoring certain sectors and ignoring others.

Until 1991, India was primarily a closed economy. The industrial environment in India was highly

regulated and a license system – known as “license raj” - was in place to ensure compliance with

the government regulations and directives. Under the Industries Development and Regulations act

(1951) starting and operating any industry required approval - in the form of a license - from the

government. Any change in production capacity or change in the product mix also called for

obtaining government approval. This led to the development of increasingly complex and opaque

procedures for obtaining a license and led to a burgeoning bureaucracy. The license system thus

shifted lot of power and perverse incentives in the hands of file pushing bureaucrats (or “Babus”).

This directly led to increased corruption as the procedure for obtaining a license was vaguely

defined and left open to individual interpretations. In addition, there was no monitoring system in

place to ensure speedy disposal of license applications. Also, the labor markets were highly

regulated and the government did not allow the companies to lay off its workers. This meant that

even in severe downturns the companies kept bleeding but could not rationalize its workforce.

Eventually these companies - majority of them public sector companies – would become

chronically sick and the government kept subsidizing them at huge costs to the taxpayer.

One draconian measure was the introduction of the Foreign Exchange Regulation act (FERA) of

1973 which curtailed foreign investment to 40% in Indian companies. This had a very adverse

impact and companies such as Coca-Cola and IBM exited the country. The impact of this could be

seen in the slow growth of the Indian economy as compared to its neighbors over a 30 year period.

Table 1 shows a comparison between the Indian industrial development and that of some of the

other developing countries in the region. From the data it is clear that India lagged behind other

countries in its growth rates over a sustained period of time and this led to increased poverty.

Surprisingly, there were some very strange reasons given for this lag in economic performance.

The excuses went to such ridiculous extents as to the development of a “Hindu rate of return”

theory which stated that the “Hindu rate of return” was lower than that of the western nations and

thus a comparison of India’s economic return with that of western nations was inappropriate.

The government also adopted a policy of import substitution and the idea was to help the domestic

industry improve in a safe environment until the local industries could compete internationally.

This was implemented by levying extremely high tariffs or completely banning imported goods.

Table 2 in the appendix shows the nominal tariff rates in effect in 1985. Due to the government’s

protection most of the industries failed to catch up with the technological innovations taking place

around the world. As they were shielded from imports due to extremely high import tariffs the

industries had no incentive to improve their operations. This led to a vicious circular logic where

the tariffs were not reduced since domestic companies could not compete and the high tariffs

prevented industries from innovating. Corruption and opaqueness of the system added to the

difficulties and the situation became extremely complex.

The BOP Crisis

Gulf war broke out in 1990 and the resulting oil shock was enough to trigger a serious balance of

payment (BOP) crisis for India in 1991. The cost of oil imports went up to 10,820 crores from the

estimated 6,400 crores. Traditionally, India received lot of remittances from the expatriates

working in the Gulf countries and this source also dried up as the migrant Indian workers were

forced to return home due to the war. The problem was compounded due to an extremely high

inflation of about 16% and a fiscal deficit of about 8.5%. The situation was so severe that India

had foreign reserves of only around $1 Billion – barely enough to cover two weeks of its payment

obligations. India’s credit rating was downgraded as its debt servicing capability was critically

impaired and the government had to pledge its gold reserves to soothe creditors. Ostensibly, the

trigger for the BOP crisis was the oil shock but the deeper issue was that the government’s heavy

hand in trying to regulate businesses and to move the country towards economic progress had

failed to produce results and drastic measures were now called for. Faced with these

insurmountable problems, the Indian government turned to the IMF and thus began a series of far

reaching reforms in the India economy which envisioned transforming the country’s economy

from an interventionist and overly-regulated economy to a more market oriented one.

Historical trends in FDI in India

Starting with the market reforms initiated in 1991, India gradually opened up its economy to FDI

in a wide range of sectors. The “license-raj” system was dismantled in almost all the industries.

The infrastructure sector which was in dire need of capital welcomed foreign equity. FDI was

especially encouraged in ports, highways, oil and gas industries, power generation and

telecommunication. Consumer goods and service sector which was once completely off-limits for

foreign equity was also gradually opened up. The reserve bank of India set up an automatic

approval system which allowed investments in slabs of 50, 51 or 74% depending on the priority of

the industry, as defined by the government. The foreign investment limits were slowly raised and

some sectors saw the limits raised to 100%.

The reforms thus led to a gradual increase in FDI in India. Table 3 shows the FDI flow to India

after the structural reforms began in 1991. As can be seen from the table, FDI increased from a

non-existent value in the start to about $4 billion a year. It should be noted that till 2000, the figure

of FDI reported actually underestimates the amount of FDI according to IMF definition. This is

because the Indian government had its own definition of FDI and did not include heads like

reinvested earnings, proceeds of foreign listings and foreign subordinated loans to domestic

subsidiaries. But, the government recognized this problem and after a study undertaken in 2003,

the standard definition of FDI as suggested by the IMF was adopted by the Indian government

Foreign direct investment: Indian scenario

Foreign Direct Investment (FDI) is permitted as under the following forms of investments

Through financial collaborations.

Through joint ventures and technical collaborations.

Through capital markets.

Through private placements or preferential allotments.

Forbidden Territories

FDI is not permitted in the following industrial sectors:

Arms and ammunition. Atomic Energy. Railway Transport. Coal and lignite. Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper, zinc.

Foreign direct investments in India are approved through two routes

1. Automatic approval by RBI

The Reserve Bank of India accords automatic approval within a period of two weeks (subject to compliance of norms) to all proposals and permits foreign equity up to 24%; 50%; 51%; 74% and 100% is allowed depending on the category of industries and the sectoral caps applicable. The lists are comprehensive and cover most industries of interest to foreign companies. Investments in high-priority industries or for trading companies primarily engaged in exporting are given almost automatic approval by the RBI.

2. The FIPB Route – Processing of non-automatic approval cases

FIPB stands for Foreign Investment Promotion Board which approves all other cases where the parameters of automatic approval are not met. Normal processing time is 4 to 6 weeks. Its approach is liberal for all sectors and all types of proposals, and rejections are few. It is not necessary for foreign investors to have a local partner, even when the foreign investor wishes to hold less than the entire equity of the company. The portion of the equity not proposed to be held by the foreign investor can be offered to the public.

The policy framework for permitting FII investment was provided under the Government of India guidelines vide Press Note date September 14, 1992. The guidelines formulated in this regard were as follows:

1) Foreign Institutional Investors (FIIs) including institutions such as Pension Funds, Mutual Funds, Investment Trusts, Asset Management Companies, Nominee Companies and Incorporated/Institutional Portfolio Managers or their power of attorney holders (providing discretionary and non-discretionary portfolio management services) would be welcome to make investments under these guidelines.

2) FIIs would be welcome to invest in all the securities traded on the Primary and Secondary markets, including the equity and other securities/instruments of companies which are listed/to be listed on the Stock Exchanges in India including the OTC Exchange of India. These would include shares, debentures, warrants, and the schemes floated by domestic Mutual Funds. Government would even like to add further categories of securities later from time to time.

3) FIIs would be required to obtain an initial registration with Securities and Exchange Board of India (SEBI), the nodal regulatory agency for securities markets, before any investment is made by them in the Securities of companies listed on the Stock Exchanges in India, in accordance with these guidelines. Nominee companies, affiliates and subsidiary companies of a FII would be treated as separate FIIs for registration, and may seek separate registration with SEBI.

4) Since there were foreign exchange controls in force, for various permissions under exchange control, along with their application for initial registration, FIIs were also supposed to file with SEBI another application addressed to RBI for seeking various permissions under FERA, in a format that would be specified by RBI for the purpose. RBI's general permission would be obtained by SEBI before granting initial registration and RBI's FERA permission together by SEBI, under a single window approach.

5) For granting registration to the FII, SEBI should take into account the track record of the

FII, its professional competence, financial soundness, experience and such other criteria

that may be considered by SEBI to be relevant. Besides, FII seeking initial registration

with SEBI were be required to hold a registration from the Securities Commission, or the

regulatory organization for the stock market in the country of domicile/incorporation of the

FII

6) SEBI's initial registration would be valid for five years. RBI's general permission under FERA to the FII would also hold good for five years. Both would be renewable for similar five year periods later on.

7) RBI's general permission under FERA would enable the registered FII to buy, sell and

realize capital gains on investments made through initial corpus remitted to India,

subscribe/renounce rights offerings of shares, invest on all recognized stock exchanges

through a designated bank branch, and to appoint a domestic Custodian for custody of

investments held.

8) This General Permission from RBI would also enable the FII to:

Open foreign currency denominated accounts in a designated bank. (There could even

be more than one account in the same bank branch each designated in different foreign

currencies, if it is so required by FII for its operational purposes)

Open a special non-resident rupee account to which could be credited all receipts from

the capital inflows, sale proceeds of shares, dividends and interests

Transfer sums from the foreign currency accounts to the rupee account and vice versa,

at the market rate of exchange

Make investments in the securities in India out of the balances in the rupee account

Transfer repairable (after tax) proceeds from the rupee account to the foreign currency

account(s)

Repatriate the capital, capital gains, dividends, incomes received by way of interest,

etc. and any compensation received towards sale/renouncement of rights offerings of

shares subject to the designated branch of a bank/the custodian being authorized to

deduct withholding tax on capital gains and arranging to pay such tax and remitting the

net proceeds at market rates of exchange

Register FII's holdings without any further clearance under FERA.

9) There would be no restriction on the volume of investment minimum or maximum-for the

purpose of entry of FIIs, in the primary/secondary market. Also, there would be no lock-in

period prescribed for the purposes of such investments made by FIIs. It was expected that

the differential in the rates of taxation of the long term capital gains and short term capital

gains would automatically induce the FIIs to retain their investments as long term

investments.

10) Portfolio investments in primary or secondary markets were subject to a ceiling of 30% of

issued share capital for the total holdings of all registered FIIs, in any one company. The

ceiling was made applicable to all holdings taking into account the conversions out of the

fully and partly convertible debentures issued by the company. The holding of a single FII

in any company would also be subject to a ceiling of 10% of total issued capital. For this

purpose, the holdings of an FII group would be counted as holdings of a single FII.

11) The maximum holdings of 24% for all non-resident portfolio investments, including those

of the registered FIIs, were to include NRI corporate and non-corporate investments, but

did not include the following: A) Foreign investments under financial collaborations

(direct foreign investments), which are permitted up to 51% in all priority areas.

B) Investments by FIIs through the following alternative routes

i. Offshore single/regional funds

ii. Global Depository Receipts

iii. Euro convertibles.

12) Disinvestment would be allowed only through stock exchange in India, including the OTC

Exchange. In exceptional cases, SEBI may permit sales other than through stock

exchanges, provided the sale price is not significantly different from the stock market

quotations, where available.

13) All secondary market operations would be only through the recognized intermediaries on

the Indian Stock Exchange, including OTC Exchange of India. A registered FII would be

expected not to engage in any short selling in securities and to take delivery of purchased

and give delivery of sold securities.

14) A registered FII can appoint as Custodian an agency approved by SEBI to act as custodian

of Securities and for confirmation of transactions in Securities, settlement of purchase and

sale, and for information reporting. Such custodian should establish separate accounts for

detailing on a daily basis the investment capital utilization and securities held by each FII

for which it is acting as custodian. The custodian was supposing to report to the RBI and

SEBI semi-annually as part of its disclosure and reporting guideline.

15) The RBI should make available to the designated bank branches a list of companies where

no investment will be allowed on the basis of the upper prescribed ceiling of 30% having

Been reached under the portfolio investment scheme.

16) Reserve Bank of India may at any time request by an order a registered FII to submit

information regarding the records of utilization of the inward remittances of investment

capital and the statement of securities transactions. Reserve Bank of India and/or SEBI

may also at any time conduct a direct inspection of the records and accounting books of a

registered FII.

17) FIIs investing under this scheme will benefit from a concessional tax regime of a flat rate

tax of 20% on dividend and interest income and a tax rate of 10% on long term (one year

or more) capital gains.

These guidelines were suitably incorporated under the SEBI (FIIs) Regulations, 1995. These

regulations continue to maintain the link with the government guidelines through an inserted

clause that the investment by FIIs should also be subject to Government guidelines. This linkage

has allowed the Government to indicate various investment limits including in specific sectors.

Chapter 3

Sector Specific Foreign Direct Investment in India

Hotel & Tourism: FDI in Hotel & Tourism sector in India

100% FDI is permissible in the sector on the automatic route, The term hotels include restaurants,

beach resorts, and other tourist complexes providing accommodation and/or catering and food

facilities to tourists. Tourism related industry include travel agencies, tour operating agencies and

tourist transport operating agencies, units providing facilities for cultural, adventure and wild life

experience to tourists, surface, air and water transport facilities to tourists, leisure, entertainment,

amusement, sports, and health units for tourists and Convention/Seminar units and organizations.

For foreign technology agreements, automatic approval is granted if

i. Up to 3% of the capital cost of the project is proposed to be paid for technical and

consultancy services including fees for architects, design, supervision, etc.

ii. Up to 3% of net turnover is payable for franchising and marketing/publicity support fee,

and up to 10% of gross operating profit is payable for management fee, including incentive

fee.

Private Sector Banking: Non-Banking Financial Companies (NBFC)

49% FDI is allowed from all sources on the automatic route subject to guidelines issued from RBI

from time to time. FDI/NRI investments allowed in the following 19 NBFC activities shall be

as per levels indicated below:

1. Merchant banking 2. Underwriting 3. Portfolio Management Services 4. Investment Advisory Services 5. Financial Consultancy 6. Stock Broking 7. Asset Management 8. Venture Capital 9. Custodial Services 10. Factoring 11. Credit Reference Agencies 12. Credit rating Agencies13. Leasing & Finance 14. Housing Finance 15. Foreign Exchange Brokering16. Credit card business17. Money changing Business18. Micro Credit 19. Rural Credit.

Insurance Sector: FDI in Insurance sector in India

FDI up to 26% in the Insurance sector is allowed on the automatic route subject to obtaining

license from Insurance Regulatory & Development Authority (IRDA)

Telecommunication:

FDI in Telecommunication sector

i. In basic, cellular, value added services and global mobile personal communications by

satellite, FDI is limited to 49% subject to licensing and security requirements and

adherence by the companies.

ii. ISPs with gateways, radio-paging and end-to-end bandwidth, FDI is permitted up to 74%

with FDI, beyond 49% requiring Government approval. These services would be subject to

licensing and security requirements.

iii. FDI up to 100% is allowed for the following activities in the telecom sector :

a. ISPs not providing gateways (both for satellite and submarine cables);

b. Infrastructure Providers providing dark fiber (IP Category 1);

c. Electronic Mail; and

d. Voice Mail

Trading: FDI in Trading Companies in India

Trading is permitted under automatic route with FDI up to 51% provided it is primarily export

activities, and the undertaking is an export house/trading house/super trading house/star trading

house. However, under the FIPB route.

100% FDI is permitted in case of trading companies for the following activities:

Exports

bulk imports with ex-port/ex-bonded warehouse sales

cash and carry wholesale trading

Other import of goods or services provided at least 75% is for procurement and sale

of goods and services among the companies of the same group and not for third

party use or onward transfer/distribution/sales.

FDI up to 100% permitted for e-commerce activities subject to the condition that such companies

would divest 26% of their equity in favor of the Indian public in five years, if these companies are

listed in other parts of the world. Such companies would engage only in business to business

(B2B) e-commerce and not in retail trading.

Power:

FDI in Power Sector in India Up to 100% FDI allowed in respect of projects relating to electricity

generation, transmission and distribution, other than atomic reactor power plants. There is no limit

on the project cost and quantum of foreign direct investment.

Drugs & Pharmaceuticals

FDI up to 100% is permitted on the automatic route for manufacture of drugs and pharmaceutical,

provided the activity does not attract compulsory licensing or involve use of recombinant DNA

technology, and specific cell / tissue targeted formulations.

FDI proposals for the manufacture of licensable drugs and pharmaceuticals and bulk drugs

produced by recombinant DNA technology, and specific cell / tissue targeted formulations will

require prior Government approval.

Roads, Highways, Ports and Harbors

FDI up to 100% under automatic route is permitted in projects for construction and maintenance

of roads, highways, vehicular bridges, toll roads, vehicular tunnels, ports and harbors.

Pollution Control and Management

FDI up to 100% in both manufacture of pollution control equipment and consultancy for

integration of pollution control systems is permitted on the automatic route.

Ranking of sector wise FDI Inflow in India since April 2000-Dec 2011

Pie representing % of Total FDI Inflows in Different Sectors.

Trends of Foreign Institutional Investments in India.

The Indian stock markets were opened up for direct participation by FIIs. They were allowed to

invest in all the securities traded on the primary and the secondary market including the equity

and other securities/instruments of companies listed/to be listed on stock exchanges in India. It

can be observed from the table below that India is one of the preferred investment destinations

for FIIs over the years. As of March 2007, there were 996 FIIs registered with SEBI

Table NO: SEBI Registered FIIs in India

Year End Of March1992-93 01993-94 31994-95 1561995-96 3531996-97 4391997-98 4961998-99 4501999-2000 5062000-01 5272001-02 4902002-03 5022003-04 5402004-05 6852005-06 8822006-07 996

Analysis of FDI in India Year wise

Chapter 4

India compared with China

Since India and China are perceived to be the two most attractive locations for FDI in the future

apart from the United States, it would be good to just compare some key statistics of the two

countries.

FDI Inflows in India and China

India ChinaTop 3 FDI destination sectors IT & software

Business servicesConsumer electronics

ChemicalsMachinery & industrial goodsIT & software

Top 3 business functions Research & developmentManufacturingSales marketing & support

ManufacturingSales marketing & supportBusiness services

Top 3 source countries US, UK, Germany Japan, US, GermanyTop 3 investors LG, General Electric,

IntelToyota, LG, Formosa Plastics Group

Beginning of FDI reforms Early 90’s Late 70’s / Early 80’s

On comparing the key attributes between China and India, China comes out more favorable in

terms of market size and growth potential, access to export markets, higher government

incentives, financial/economic/political/social stability, quality of life and Infrastructure

availability whereas India comes out on top with respect to providing a highly educated

workforce, management talent, rule of law, transparency, fewer cultural barriers and a relatively

strong regulatory environment.

Based on these different attributes investors perceive China and India as two different markets for

potential investment. India is identified as the upcoming business process and IT services provider

and there are more investments in sectors and activities such as IT & software, business services

and research & development. China is recognized as the fastest growing consumer market and the

world’s leading manufacturer and is seem as an investment centre for sectors and activities such as

manufacturing of chemicals, machinery & industrial goods and automobiles.

Analysis of share of top ten investing countries FDI equity in flows

Sr. No Country % As To

Total FDI

Inflow

1. Mauritius 44.01

2. Singapore 8.72

3. U.S.A. 7.64

4. U.K. 5.53

5. Netherlands 4.08

6. Japan 3.44

7. Cyprus 3.04

8. Germany 2.57

9. France 1.42

10. U.A.E. 1.17

Chapter 5

Current Challenges and Improvement Areas

As explained above, India is definitely a lucrative place for FDI, but there are certainly some

challenges and areas for improvement still present. Until, these areas are honed to perfection,

India will not become the number one place for FDI. Some of the key areas are listed below:

a) Political risk: Amongst the top items is the political instability of the country. On one hand the

fact that India is the world’s largest democracy does add a sense of pride and security, but the hard

reality is that there is insurmountable instability present. Just the fact that the past two

governments have been based on coalitions between a few parties is reason enough to be skeptical.

Moreover, each new government has certain policies which are different from the ruling

government and if there is frequent change in government, this will lead to changes in policy and

increased uncertainty. Just take the example of the last elections in 2004, where by a sudden

change of event the Indian National Congress was able to come into power by forming a coalition

government, by soliciting the vast majority of the poor people of the country, surprising the

incumbent government which was relying heavily on a fast growing economy, increased

privatization and a thriving middle class.

b) Bureaucracy: Another very important factor that affects India’s competitiveness on the world

standing is the Bureaucracy. Particularly in the FDI process the Indian Government has already

invested a lot of time and effort but there is still a lot of room for improvement in the

identification, approval and implementation process e.g. creating more centers for assistance,

more user friendly processes, effective use of technology, being as clear as possible leaving no

room for interpretation, assisting in identifying new areas for investment etc.

c) Security risk: Another important factor that needs to be handled with care and worked upon is

the ever present security risk. This risk includes the geopolitical risk with Pakistan and the

ongoing dispute over the Kashmir issue, which on numerous occasions has brought these two

countries armed with nuclear weapons to the brink of war. The other security risks would include

incidences of domestic terrorism, not only in the Kashmir valley but also in Assam, Manipur and

Nagaland, where numerous separatists group operate.

d) Cost advantage: One of the attractions of India is the lower cost advantage as compared to

most western economies. The Indian Government would have to work on creating an atmosphere

where this advantage can be maintained else it might result in India not seem as attractive. One of

the key drivers would be to try and control inflation because if there is increased level of inflation

then there would be increased costs and reduced returns. Other factors which would act in similar

respects would be increased tax incentives and reduced tariffs

e) Intellectual Property (IP) Rights & Piracy: With the increased instances of Piracy around the

world and the extreme importance placed by Investors on maintaining their IP rights, this is

definitely an area which needs improvement in India. India has begun instilling intellectual

property rules and regulations into the country but there is still a long road ahead. The main area

for improvement in this respect is the enforcement, which is the most crucial part but the weakest

at present in the country. The enforcement of IP rights included the increased crackdown in the

market on pirated and knock-downed good.

f) Privatization and deregulation: Increased privatization of various sectors would definitely

enhance the attractiveness of India as an FDI destination. India has already taken steps to privatize

areas such as electricity, telecommunication etc. and increase the foreign holding capacity in

sectors such as banking and insurance which is a first step.

g) Infrastructure: It definitely is an added bonus to the investor if there is adequate infrastructure

present in the country. In India there is substantial lack of robust infrastructure around the country,

e.g. proper roads, highways, adequate supply of clean water, uninterruptible supply of electricity

etc. But there is a flipside to this lack of Infrastructure. Quoting the Prime Minister Dr. Manmohan

Singh on a recent speech at the NYSE,

“When I talk to business people, they tell me, ‘Well, India’s infrastructure is a problem’. I do

agree with them that infrastructure is our biggest problem and also the biggest opportunity. In the

next 10 years we must invest at least $150 billion to modernize and to expand India’s

infrastructure, and we have major investments needed in energy sector, in power sector, in oil

exploration, in roads programmed, in modernizing our railway system, food system, airports. This

is where, I feel, we need a new experimentation with public-private sector participation because

the public sector may have a role, but by itself it cannot meet all the requirements. As I see an

expanding and very profitable role of foreign direct investment in meeting the challenge of

modernizing India’s infrastructure.”

So the lack of infrastructure can definitely be seen as a blessing in disguise and be a substantial

source of FDI, but nevertheless if this FDI does not materialize, the Government will have to

invest their own funds into it and try and attract other investments.

Chapter 6

Conclusion

Keeping in mind the humble beginning of India and the stage at which it is right now goes to show

how much potential is present in this country and if the Indian government works on the areas for

improvement mentioned above and continues to support and assist the encouragement of FDI into

India, there is no stopping India into becoming the number one destination for FDI in the world,

far beyond China.

REFERENCES

A number of websites, newspaper article annual reports of RBI, magazines etc.

Internet sites: www.rbi.org.in/home.aspx www.sebi.gov.in www.fdimagazine.com www.members.aol.com/RTMadaan1/sectors http://dipp.nic.in/fdi_statistics/india_fdi_index.htm www.nseindia.com

Journals:

ICFAI Journal: E.g. the ICFAI journal of public finance, issue- February, vol. VI. Handbook of statistics on the Indian securities market 2008.

Books:

Foreign direct investment in India by Lata Chakravarthy. FDI (issues in emerging economies) by K. Seethe Pathi. Foreign institutional investors by G Gopal Krishna Murthy.