Dr.

RAM MANOHAR LOHIYA NATIONAL

LAW UNIVERSITY, LUCKNOW
2019-2020

ECONOMICS-III
TOPIC

FLOW AND DETERMINANTS OF FOREIGN CAPITAL IN INDIAN

ECONOMY

SUBMITTED TO: SUBMITTED BY:

SUBMITTED BY:

Dr. Mitali Tiwari Sushant Kumar

Assistant Professor Semester III

Economics Enrolment No: 180101142

 INFLOW AND DETERMINANTS OF FOREIGN CAPITAL IN INDIAN ECONOMY

TABLE OF CONTENTS

ACKNOWLEDGEMENT.................................................................................................................4

CHAPTER I..................................................................................................................................5

INTRODUCTION......................................................................................................................5

CHAPTER II.................................................................................................................................5

LITERATURE REVIEW...........................................................................................................5

CHAPTER III................................................................................................................................7

TYPES OF FOREIGN CAPITAL...............................................................................................7

CHAPTER IV...............................................................................................................................8

ROLE OF FOREIGN CAPITAL................................................................................................8

CHAPTER V...............................................................................................................................10

TRENDS IN INDIA.................................................................................................................10

CHAPTER VI.............................................................................................................................11

FACTORS GOVERNING INFLOW OF FOREIGN CAPITAL....................................................11

CHAPTER VII............................................................................................................................12

DETERMINANTS OF FDI......................................................................................................12

Policy Framework of FDI in India...............................................................................13

Market Size & GDP.......................................................................................................14

Economic Determinants of FDI....................................................................................14

Economic stability..........................................................................................................16

Political Factors..............................................................................................................16

CHAPTER VIII...........................................................................................................................17

DETERMINANTS OF FPI......................................................................................................17

Host country determinants............................................................................................17

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Other Determinants.......................................................................................................18

CHAPTER IX.............................................................................................................................19

BENEFITS OF FOREIGN CAPITAL........................................................................................19

CHAPTER X...............................................................................................................................20

WHY INDIA IS LESS ATTRACTIVE TO FOREIGN INVESTORS?..........................................20

CHAPTER XI.............................................................................................................................21

SUGGESTIONS FOR INCREASED FLOW OF FDI INTO THE COUNTRY...............................21

REFERENCES............................................................................................................................23

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ACKNOWLEDGEMENT

I express my gratitude and deep regards to my teacher for the subject Dr. Mitali Tiwari, for
giving me such a challenging topic and also for her exemplary guidance, monitoring and
constant encouragement throughout the course of this project report.

I would also like to thank the librarians of Dr. Madhu Limaye Library who extended their
assistance to me by helping me out consult the relevant books and provided me with research
material and good books to work upon and the distinguished authors, jurists and journals for
providing in the public domain such invaluable information. I also thank all of my friends and
seniors who aided me along the way.

Lastly, I thank almighty, my family and friends for their constant encouragement throughout
this assignment.

I know that despite my best efforts some discrepancies might have crept in which I believe
my humble Professor would forgive.

Thanking You All.

Sushant Kumar.

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 INFLOW AND DETERMINANTS OF FOREIGN CAPITAL IN INDIAN ECONOMY

CHAPTER I

INTRODUCTION

The capital, in financial terms, refers to those funds which are used for investment. In a
physical sense, capital means all capital equipment, plant, machinery, etc. which is used in
the production process. Thus, finances are to be used through savings and used for buildings,
plants and equipment’s for use in production. In other words, savings and investments are
two acts which create capital.

‘Capital and investments along with human resources are the essential hub of development’.
This statement has gained lot of importance in recent times. FDI has been instrumental in
economic growth of developed countries. Almost every developed country has had the
assistance of foreign finance to supplement its own meagre savings during the early stages of
its development. This has prompted India and other developing countries to reform their
economic policies to attract FDI.

When residents of a country provide their savings for investment, their capital is called
Domestic Capital and owned by residents. But when the investment is made either directly by
the non-residents, institutions or governments this is called capital inflows (Foreign capital)
and owned by non-residents. Thus, for e.g., Campa Cola company represents domestic
capital, whereas Coca Cola represents foreign capital. The non-residents may provide funds
for investments by way of equity, loans, and grants or make direct investment.

CHAPTER II

LITERATURE REVIEW

Markusen and Maskus (1999); Moosa (2000): They highlight how the domestic market size
and differences in factor costs can relate to locational FDI. From the point of view of foreign
investors this factor is important where the industries are characterized by relatively large
economies of scale.

Lokesh and Leelavathy (2012): Macroeconomic policies that shape the underlying
fundamentals of cost competitiveness, economic stability of the country and degree of
integration with the world economy have also become more important over time in attracting
FDI. The significance of specific determinants appears to be dependent upon the type of FDI.
While some determinants such as socio-political stability could well be relevant for every
kind of investment, other determinants may not be capable of explaining all types of FDI.

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Pati (1999): Stated that the liberalization reforms which were started in post nineties era had
been responded well by the foreign investment in India which was evident in the form of
good foreign capital flows. The study also revealed that in order to attract more foreign
capital flows, political stability would be very important, and to attract FPI, a good depository
system, shorter settlement period, efficient custodial services and transparent stock market
trading etc. would play an important role.

Kohli (2003): He analyzed that the whole world including India had witnessed significant
changes in the composition and direction of capital flows during the last decade (1990-2001).
As per the study, it was revealed that private capital flows had dominated overall capital flow
components. Such developments had created a good amount of interest amongst the
economists and academicians to understand and analyze the trends of foreign capital flows,
and had also motivated them to create an environment where it became desirable for the
government to bring in important policy changes.

Sikdar (2006): He studied the relationship between foreign capital flows (FDI, FPI) and other
economic variables during 1997 to 2003. The study observed that under the regime of
liberalization policy, the outcomes were highly surprising. Dependence on foreign aid had
come down drastically. And funds in the form of Foreign Portfolio Investment (FPI), Foreign
Direct Investment (FDI), external commercial borrowings and non- resident Indians deposits
had come to be recognized as the major sources of capital flows in India as concluded by this
study.

Nanda (2015): The size of net capital inflows to India has increased significantly in the post
reform period. It is also important to note that capital inflows increased extensively since
2005. However, capital inflows declined during 2007-08 to 2008-09 as a consequence of
global financial crisis. The movement of capital inflows clearly indicates that capital inflows
in India are highly volatile.

Anitha (2012): A typical characteristic of these developing and underdeveloped economies is

the fact that these economies do not have the needed level of savings and income in order to
meet the required level of investment needed to sustain the growth of the economy. In such
cases, foreign direct investment plays an important role of bridging the gap between the
available resources or funds and the required resources or funds.

Lakhwinder (2007): Foreign direct investment has been seen as a dominant determinant to
achieve high rate of economic growth because it brings in scarce capital resource, raise

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technological capability and increase efficiency through enhancing domestic competition.

Chinese experience of achieving high growth through foreign direct investment has been
cited as worth emulating policy lesson for the Indian economy.

CHAPTER III

TYPES OF FOREIGN CAPITAL

Foreign capital flows fall into five principal categories: Foreign Direct Investment (FDI),
Foreign Portfolio Investment (FPI), Depository Receipts (DRs), External Commercial
Borrowing (ECBs), and Non-Residents Receipts (NRDs).

1) Foreign Direct Investment: Investment that is made to acquire a controlling interest

(usually 10 percent of voting stock) in an enterprise operating in a country other than that of
the investor. The investor gets an effective voice in the management of the company. Most
concretely, it may take the form of buying or constructing a factory in a foreign country or
adding improvements to such a facility, in the form of property, plants, or equipment. FDI is
calculated to include all kinds of capital contributions, such as the purchases of stocks, as
well as the reinvestment of earnings by a wholly owned company incorporated abroad
(subsidiary), and the lending of funds to a foreign subsidiary or branch. The reinvestment of
earnings and transfer of assets between a parent company and its subsidiary often constitutes
a significant part of FDI calculations. According to the United Nations Conference on Trade
and Development (UNCTAD), the global expansion of FDI is currently being driven by over
64,000 transnational corporations with more than 800,000 foreign affiliates, generating 53
million jobs. An Indian company may receive FDI under the two routes Automatic Route and
Government Route.

2) Foreign Portfolio Investment: It consists of Depository Receipts (DR), Foreign

Institutional Investment (FII) in debt and equity (direct purchase of shares). The major
institutional investors are mutual funds; asset management companies (AMCs), pension
funds and insurance companies. The Reserve Bank of India monitors the ceilings on
FII/NRI/PIO investments in Indian companies on a daily basis.

3) Depository Receipts: These are equity instruments issued outside the country to non-
resident investors by authorized overseas depository banks. DRs issued in the USA are
American Depository Receipts (ADR), those issued elsewhere is Global Depository Receipts
(GDR). Foreign Currency Convertible Bonds (FCCBs) are subscribed to by nonresidents in

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foreign Currency and are convertible into ordinary shares of the issuing companies. Among
the emerging economies, India ranks first in terms of the value of DR issued.

4) Foreign Institutional Investment: 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. These are actually the outsiders in the financial markets
of the particular company. Foreign institutional investment is a common term in the financial
sector of India. International institutional investors must register with the Securities and
Exchange Board of India to participate in the market. One of the major market regulations
pertaining to FIIs involves placing limits on FII ownership in Indian companies.

5) External Commercial Borrowings: It includes commercial bank loans, buyer’s credit,

suppliers’ credits, fixed and floating rate bonds (without convertibility) and borrowings from
multilateral financial institutions such as an International Financial Corporation (IFC) and
Asian Development Bank (ADB). Euro-issues include Euro-convertible bonds and GDRs. In
India, External Commercial Borrowings are being permitted by the Government for
providing an additional source of funds to Indian corporates and PSUs for financing
expansion of existing capacity and as well as for fresh investment, to augment the resources
available domestically. ECBs can be used for any purpose (rupee-related expenditure as well
as imports) except for investment in the stock market and speculation in real estate.

6) Non-Resident Deposits: Deposits made in domestic banks by non-resident citizens of a

country. Capital flows can be classified as either debt finance or equity finance. Debt finance
(bonds and bank loans) requires repayment of interest and principal in contractually fixed
amounts. In equity finance, in contrast, foreign investors hold shares or have direct control of
companies. Repayments in the form of profits and dividends are of variable amount
depending on performance.

CHAPTER IV

ROLE OF FOREIGN CAPITAL

In the early stages of industrialization in any country foreign capital plays an important role.
Their role can he better understood under the following heads:-

1. Increase in Resources: Foreign capital not only provides an addition to the domestic
savings and resources, but also an addition to the productive assets of the country. The

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country gets foreign exchange through FDI. It helps to increase the investment level
and thereby income and employment in the recipient country.
2. Risk Taking: Foreign capital undertakes the initial risk of developing new lines of
production. It has with it experience, initiative, resources to explore new lines. If a
concern fails, losses are borne by the foreign investor.
3. Technical Know-how: Foreign investor brings with him the technical and managerial
know how. This helps the recipient country to organize its resources in most efficient
ways, i.e., the least costs of production methods are adopted. They provide training
facilities to the local personnel they employ.
4. High Standards: Foreign capital brings with it the tradition of keeping high
standards in respect of quality of goods, higher real wages to labour and business
practices. Such things not only serve the interest of investors, but they act as an
important factor in raising the quality of product of other native concerns.
5. Marketing Facilities: Foreign capital provides marketing outlets. It helps exports and
imports among the units located in different countries financed by the same firm.
6. Reduces Trade Deficit: Foreign capital by helping the host country to increase
exports reduce trade deficit. The exports are increased by raising the quality and
quantity of products and by lower prices.
7. Increases Competition: Foreign capital may help to increase competition and break
domestic monopoly. Foreign capital is a good barometer of world's perception of a
country's potential.

It is rightly said that a satisfied foreign investor is the best commercial ambassador a country
can have. To sum up, foreign capital helps three important areas that are necessary for the
economic development of a country. These three areas are savings, trade and foreign
exchange and technology. Foreign capital performs three gaps filling function, i.e.

i. savings gap,
ii. trade gap, and
iii. technological gap in the recipient country's economy.

It encourages development of technology, managerial expertise, and integration with other

economies of the world, export of goods and services and higher growth of country's
economy.

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CHAPTER V

TRENDS IN INDIA

During the early phase of planning era, the national policy towards foreign capital did
recognize the need of foreign capital, but decided not to permit it a dominant position.
Consequently, foreign collaboration had to keep their equity within the ceiling of 49 per cent
and allow the Indian counterpart a majority stake. Moreover, foreign collaborations were to
be permitted in priority areas, more especially those in which India had not developed
capabilities. But in an overall sense, India’s policy towards foreign collaborations remained
restrictive and selective. Consequently, during 1948 to 1960, a total of 1,080 foreign
collaborations were approved and during the next decade (1961-70), a total of 2, 475 foreign
collaborations were approved. During 1971-80 and 1981-90 the collaborations were 3,041
and 7,436 respectively.

Table: Foreign Collaboration Approvals in Pre-Reform Period

Period Technical Foreign Total Number of

Collaboration Collaboration Foreign
Agreement Agreement Collaboration
1948-60 1,080 - 1,080
1961-70 1,675 800 2,475
1971-80 2,623 418 3,041
1981-90 5,595 1,841 7,436
Total 10,973 3,059 14,032

It is revealed from the table that 78 per cent of total agreements (14,032) were technical
collaboration agreements and only 22 percent were related to direct foreign investment. With
the introduction of the reform process in the early 1990s and after the announcement of New
Industrial Policy, 1991, India has witnessed a significant increase in cross-border capital
flows, a trend that represents a clear break from the previous two decades.

The trends in Capital flows into India follow the same momentum as that for other emerging
markets. India has high domestic savings to GDP and, prima facie, some may argue that the
damage from the reversal in capital inflows should be negligible, but clearly, the recent trend
indicates that is not the case.

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In the post reform period there has been a remarkable increase in foreign capital. It is also
important to note that capital inflows increased extensively since 2005. However, capital
inflows resumed during 2007-08 to 2008-09 as a consequence of a global system awash with
liquidity. Presently, while most “emerging markets” in Latin America and Asia are
expressing concern about and responding with capital controls to the surge in foreign capital
inflows into their financial markets, policymakers in India are more optimistic and are
declaring that the country can absorb far more than the net capital inflows it currently attracts.
India needs to increase the long term investments to expand the economy stronger, foreign
direct investment (FDI), although short term capital inflows from foreign institutional
investor investments (FII) are rising quickly. The net FII recorded US$34 billion in the 10
month period since January 2010. However, the long term investment of FDI dropped to
US$16 billion in the period from January to September 2010, down from US$21 billion for
the same period last year.

CHAPTER VI

FACTORS GOVERNING INFLOW OF FOREIGN CAPITAL

The inflow of foreign capital is determined by a series of factors.1 They are:

The Rate of Interest

The difference in the rate of interest between countries serves as the most important stimulus
to inflow of foreign capital. Capital flows from that country in which the interest rates are
low to those where interest rates are high because capital yields high returns there.

Bank Rate

A stable bank rate of the Central Bank of a country influences the capital inflow because
market interest rates depend on it. The raising of bank rate thus may stimulate the inflow of
foreign capital.

1
Mithani,D.M, International Economics, Himalaya Publishing House, New Delhi, 1996, p 240.

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Marginal Efficiency of Capital

Foreign investors generally compare the marginal efficiency of capital with the interest rate
in different countries and prefer to invest in that country where the rate of return is likely to
be higher.

Production Costs

Capital flow depends on production costs in other countries. More capital tends to flow to
those countries where labour, raw materials etc. are cheap and easily available.

Political Stability

Political stability, security of life and property, friendly relations with other countries, etc.
encourage the inflow of foreign capital.

Government’s Policy

If the government is bent upon nationalisation and expansion of public sector and adopts a
hostile attitude towards foreign capital, foreign capital will not move into such a country. If
the government adopts an encouraging policy with respect to foreign capital, it induces
inflow of foreign capital.

Economic Climate

Overall healthy economic position of the country, such as development of infrastructure of

the economy, growth of financial institutions, availability of trained and skilled labour and
other production facilities will play a significant role in attracting foreign capital from abroad.

Business Conditions

Capital will tend to flow from a country experiencing depression into a country which enjoys
prosperity.

CHAPTER VII

DETERMINANTS OF FDI

Aykut and Ratha (2003) have broadly categorized the determinants of FDI into demand side
pull factors and supply side push factors in the Asian developing countries. Pull factors are
the micro and macro characteristics of the host country markets that attract FDI towards them
and push factors are the micro and macro characteristics of the home country that push
outward FDI into the destination economies.

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Pull factors are location specific characteristics of the host country markets that induce home
country investments.

Policy Framework of FDI in India

Government policies are a possible determinant of FDI since the government considers FDI
flows as means to tight unemployment and enhance national growth rate. The significant
policies are: liberalized industrial policy, trade policy, tax policy, intellectual protection
regime, international trade agreements of a country etc.

a) Liberal Industrial Policy: Indus trial policy liberalization is one of the most
important determinants of FDI in India. Several liberal policies have been adopted
since 1991. This policy, while freeing the Indian economy from official controls,
promoted the opportunities for foreign investment in India and liberalised the
economy towards foreign investment and technology. In the pre-liberalisation era,
foreign equity participation was restricted normally to 40 percent and technology
agreements needed prior approval. As against this, the new policy has allowed 51 per
cent foreign equity participation and also allowed majority foreign equity with
automatic approval in a large number of industries.
b) Liberal Trade Policy: Theoretical literature suggests that the liberal trade regime of
the host country may have two counteracting influences on the inflow of FDI. Firstly,
open regimes that facilitate intra-firm trade, allow greater freedom to TNCs and are
export-friendly may make the host country a better place to do business for foreign
enterprises and FDI inflows may increase. On the other hand, restrictive trade regimes
with high tariffs offer a location advantage for tariff jumping import substituting FDI
by TNCs.
c) Foreign Exchange Policy & Exchange Rate Regime: Foreign exchange policy
represents the investment climate in the country. There have been some changes
introduced in the foreign exchange regulations in India. The amendment to FERA has
removed a major hurdle to the FDI inflows into the Indian industry. The operating
environment has received a major fillip with the introduction of a single market
determined exchange rate for the rupee since 90s. All import and export transactions
are now conducted at the market rate of exchange. The market rate also applies to
other transactions like payments in respect of repatriation of dividends, jump sum fees
and royalties and foreign trade. The government also introduced current account
convertibility in 1994.

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d) Intellectual Property Protection Regime: The Uruguay round negotiations

presumed that stronger patent regime improves the investment climate in the host
country and encourages the inflow of foreign direct investment, intellectual property
protection links more directly with R&D activity. MNCs may be apprehensive of
locating their key R&D centres in countries with weak patent regimes, therefore, the
relative strength of patent protection available in a country may be a factor in
determining the overseas R&D activity of the MNC's. India is a signatory of the
Uruguay round negotiations which strongly protect IPR and hence has good
environment for host countries to invest in India.
e) Tax Policy: Fiscal policies deter mine the general tax levels, including corporate and
personnel tax rates and thereby influence inflow of FDI. Any change in tax rates on
corporate income like dividend, royalty, technical fees and capital gains received by a
foreign company is expected to influence the inward flow of FDI. In India during
1993-94 the tax rate on short term capital gains were reduced from 75 percent to 30
percent. An Electronic Hardware Technology Park (EHTP) scheme was set-up to al
low 100 percent equity participation, duty free import of capital goods and a tax
holiday.

Market Size & GDP

Market size, income of its population and GDP growth are considered as important
determinants of FDI in India. Large markets can accommodate more firms, both domestic
and foreign, and can help producing tradable products to achieve scale and scope. As growth
is a magnet for firms, a high growth rate in host country tends to stimulate investment by both
domestic and foreign producers.

Traditionally size and growth as FDI determinants relate to national markets for
manufacturing products which is sheltered from international competition by high tariffs or
quotas that trigger tariff jumping. The commerce department of USA calls India as one of the
10 emerging markets in the world, which means that big growth in investment will come to
the big emerging markets from the developed countries. Similarly, the World Bank has
categorized India as the fifth largest economy of the world after USA, China, Japan and Ger
many. The largest market causes high GDP growth and there by attract huge FDI.

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Economic Determinants of FDI

a) Foreign Exchange Reserve: The higher level of foreign exchange reserve in terms of
import cover reflects the strength of external payment position and helps to improve
the confidence of the prospective investors. Increasing foreign exchange reserve
implies improving financial health of a country which induces FDI. India has
managed to build up its foreign exchange reserve to the desired level during the
reforms period. India's foreign exchange reserve in dollar term has increased by
around 60 times from US$2.23 billion in March 1991 to, 263.1 billion in 2009 and to
299 billion in January 2011. It shows her growing strength of external payment
position. Therefore higher level of foreign exchange reserve leads to inflow of more
FDI.
b) Infrastructure: Availability of low cost infrastructure enables the host country to
attract more FDI. The establishment of industry requires developed infrastructure. In
2006, India has 3.3 million kilo meters of roads out of which 66 thousand kilo meters
are national highways. 5846 kilo meters of roads connect the five corners of the
country. The biggest challenge of infrastructure is power, which is now being well
taken care both in the production and distribution aspects. There are more than 135
million telephone connections in India. These infrastructural facilities are responsible
for the attraction of FDI in India.
c) Cost of Capital/ Interest Rate: Cost of capital is another important component of
financial cost. Generally foreign firms try to reduce their financial cost in order to
maintain price competitiveness. Rashmi Banga (2003) found that the availability of
capital at cheap lending rate may enable the foreign direct investors not only to locate
better partners in the host country with sufficient domestic investment to supplement
but also maximize the return on their investment. Hence easy availability of capital at
lower interest rate in the host country would attract the direct investors from foreign
countries. It can also be argued that the host country's cost of capital lends its impact
directly on domestic consumption. Thus lower the cost of capital in the host country,
the higher the domestic consumption and hence higher the FDI in inflows. Element or
interest represents the component of cost in the Indian production system, since long
time which may hold back investors from investing.
d) Cost of Labour: Cost of labour is one among the factors that cause investment costs
differential across the countries. So wage differential is one factor which can ensure

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profit by creating a low cost atmosphere to attract multinational investment in the host
country. Foreign direct investment does now to the countries where there is
availability of comparatively cheap labour than in the home countries. The survey
conducted by Mercer Human Resource consulting, the world’s largest employee
consultancy, shows that labour costs in India are among the world's lowest. So, in
India the low labour costs create a low cost environment to attract multinational
investment.

Economic stability

Economic stability of the country strengthens the economy to attract FDI. The stability
factors which determine FDI are as follows:

a) Debt-GDP Ratio: Increasing debt liabilities would deteriorate the financial health of
the country that ultimately causes instability in the economy. Lower the external debt
to GDP ratio, higher is the economic stability and inflow of FDI. The level of
indebtedness exhibits the burden of repayment and debt servicing on the economy,
making the country less attractive for foreign investors. Consistent reforms in India
made possible to recover from the debt trap. Debt-GDP ratio began to fall from 38.7
percent in 1990-91 to 17.6 percent in 2003-04. Debt service ratio also declined from
35.3 per cent in 1990-91 to 14.1 percent in 2001 02 due to the sharp fall in the rates of
interest in the world market. India is expected to attract more FDI with the declining
trend of Debt-GDP ratio.
b) Industrial Disputes: Industrial disputes capable of increasing the pro auction costs
through labour cost and work stoppages hamper the production process. Hence,
industrial disputes are potential constraint for foreign direct investment. Foreign
investors would prefer to invest only in those locations where there is continuous
availability of labour and less number of strikes.
c) Inflation Rate: Inflation is harm to economic stability of the host country. It is a sign
of internal economic tension. In this environment, the government will be unable to
balance the budget. RBI will restrict the money supply leading to low FDI inflows.
d) Balance of Payment Deficit: A large deficit in the balance of payment indicates that
the country lives beyond its means. The danger decreases the free capital movement
and that it will be more difficult to transfer the profits from the direct investment into
the in vesting count.

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Political Factors

United Nations Economic Commission for Asia and the Far East has drawn up some
conditions that have to be met if foreign capital is to be attracted to underdeveloped countries.
They are: political stability and freedom from external aggression, security of life and
property, reasonable opportunities for earning profits, prompt payment of fair and
transferable compensation in case of nationalization of foreign owned enterprises, facilities
for immigration and employment of foreign technical and administrative personnel, freedom
from double taxation, a general spirit of friendliness towards foreign investors.

CHAPTER VIII

DETERMINANTS OF FPI

Whereas FDI determinants are well researched, the determinants driving portfolio investors
are more complex, involving the interactions of factors related to external environment,
investors’ strategies and specific host country determinants. As many developing countries
and countries in transition have embarked on a process of investors were able to allocate their
savings has grown substantially over the last ten years. In parallel, the tremendous growth of
investible assets managed by institutional investors in OECD countries has flooded
international capital markets with liquidity. For example in 1998, the total net assets of
OECD pension funds were estimated at around 11 trillion US$ (14% of which were cross-
border investment), while total assets of mutual funds in the world exceeded 8 trillion US$
(with US funds alone accounting for more than 5 trillion US$). Accompanied by rapid
financial innovation, the combination of these events produced change in investor strategies
as well as a re-allocation of funds towards emerging markets.

There are two key factors which explain the increased interest, until the Asian crisis, of
international investors towards emerging markets as a group: potentially higher returns and
the benefits of diversification. Once the decision is taken to invest in emerging markets, some
host country determinants are of critical importance for fixed income investors and are of
minor importance to equity investors and vice-versa.

Host country determinants: Determinants of FPI can be put into two groups: economic
determinants and policy/regulatory determinants. Economic determinants are not directly
linked to policies aimed at attracting foreign portfolio flows. Instead, they are a reflection of
the general health of the economy, the potential for the firms operating in such a business

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environment to earn profits, and to obtain a satisfactory return on fixed income investment.
Investors will typically focus on the following factors2:

 High economic growth rate

 Exchange rate stability
 Macroeconomic stability
 Level of foreign exchange reserves
 Health of domestic banking system
 Stock and bond market liquidity
 Real interest rates

Some of the above factors will be of more importance to equity investors and others to fixed
income investors such as high economic growth rates and the liquidity if the stock market
will be of particular importance to portfolio managers specializing in equity investments. On
the other hand, the degree of bond market liquidity and the level of real interest rates will be
of particular importance for fixed income investors. Although the amount of portfolio capital
invested in emerging markets has increased countries which are associated with sound macro-
economic policies and relatively high growth rates. Thus, Africa which continues to have
uncertain growth prospect, received less than one per cent of total equity assets invested in
emerging markets. Even in Asia, which accounted for over a half of cumulative foreign
portfolio investment between 1990 and 1997, a few countries3 account for the quasi-totality
of such inflows.

Other Determinants: The other set of determinants of which foreign investors pay particular
attention includes policy and regulatory frameworks in individual emerging markets. These
are the factors over which domestic governments have a direct influence. The main
determinants in this group are the following:

 Ease of repairing dividends and capital

 Domestic capital gains tax
 Stock and bond market regulation
 Quality of domestic accounting disclosure standards
 Speed and reliability of settlement system
 Availability of domestic custodians and brokers

2
See host country determinants as included in the UNCTAD questionnaire, reported in the appendix.
3
China, Hong Kong SAR, Singapore, Malaysia, the Philippines, Thailand and Indonesia.

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 Degree of investor rights protection

It is not possible to isolate any single factor as being the most important, although some tend
to carry more weight than others. For example, the degree of investor rights protection and
the ease of repatriating dividends and capital are often cited as being closely watched by
potential investors. Some governments have used very innovative ways to promote foreign
portfolio investment and to facilitate the access of their companies to international finance.
For example, as the country moves along the path of liberalization and the opening of capital
markets, the government of Mexican corporate bonds in international markets. The logic
behind this move stems from the fact that corporate bonds across the maturity spectrum are
priced in direct relation to sovereign debt, according to the perceived risk of each company
relative to the sovereign risk. By issuing government bonds of various maturities, the
international market was able to price the sovereign debt, and by using the risk premium of
each company relative to the sovereign risk, corporate debt could be also be priced easily.
The move by the Mexican government was widely welcomed by the international investment
community as it increased the transparency of pricing corporate debt. In parallel, this policy
the way for corporate issuers to access the international investors would be ready to lend
those funds for various lengths of time.

CHAPTER IX

BENEFITS OF FOREIGN CAPITAL

Benefits of capital inflow are:4

1. Foreign capital can serve as an additional source of capital formation in a capital-

deficient country. Without curbing its current consumption level, the borrowing
nation can accelerate its pace of economic development with the help of foreign
capital.
2. Foreign capital brings entrepreneurial talents and technical know-how to a poor
country which lacks such pre-requisites of growth.
3. A country for defence purpose can make use of foreign capital as a source of
financing war.
4. Foreign capital plays a significant adjusting role in respect of several types of
disturbances, such as differences in the timing and amplitudes of the trade cycle
between countries or their differing rates of growth.

4
Ibid.

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5. Foreign capital can supplement domestic savings and stimulate economic growth.
6. International borrowing and lending enable countries to neutralise fluctuations in
income and attain smooth consumption streams.
7. Increased inflow of foreign capital increases the allocation efficiency of capital in a
country.

CHAPTER X

WHY INDIA IS LESS ATTRACTIVE TO FOREIGN INVESTORS?

Although India has undergone a sea change in its outlook towards foreign investment and
global collaboration, it attracts a very low foreign investment when comparing with other
developing countries. Foreign investors are exposed to number of risks.

High risk of instability of capital market, unreliable company information and speculative
nature of market and lack of price transparency are creating poor confidence in the minds of
foreign investors. Regular adverse reaction of Indian stock market for new information makes
the Indian stock market as most unreliable and unpredictable.

This trend created poor confidence in the minds of foreign investors and make the portfolio
investment more volatile than foreign direct investment. India faces the problem of non
availability of company oriented policies. To attract more foreign investment, government
sector based policy should be changed into company oriented one.

Disadvantages of Investment in India

i. Investors in India will have to be prepared for certain shortcomings in the

investment environment:
ii. The insufficient infrastructure, such as electricity and transportation requires
investors to usually facilitate themselves with their own captive power generation
facilities, and spacious stockyards to keep ample inventory at hand.
iii. The time needed for training the skilled labourers to have them adjusted to the
specific production system is often perceived as a lengthy trial and error process,
thus pushing the real labour cost often very high.
iv. The ways of thinking between the foreign and Indian counterparts sometimes are
so far apart that it may take endless hours trying to make both ends meet, thus
delaying smooth business judgment.

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v. The uniqueness of the Indian consumer market especially in the consumer durables
sector, e.g., home electronic appliances and automobiles, lies in their tendency to
place more weight on the price and less on the quality of the products. Also they
tend to be very slow to jump onto the new model.
vi. The Indian domestic manufacturing sector enjoys a wide base of part industries on
its own, however, it is lacking in its adaptability to the global standard products or
usually perceived as difficult to suffice the needs of quality to be achieved.
vii. The double-digit high interest rate plus the lengthy time usually needed for
normally stringent approval of loans by the domestic banks is also an obstacle
when ample volume of working capital is required due to the preparatory stocks
carried over as fail-safe measures. The overdose of meticulous regulations is often
pointed out as a weak point that hinders smooth operation.

In a nutshell, as the Indian business environment consists of both advantages and

disadvantages, it may be difficult for foreign investors to make his last minute decision.

CHAPTER XI

SUGGESTIONS FOR INCREASED FLOW OF FDI INTO THE COUNTRY

 Flexible labour laws needed: China gets maximum FDI in the manufacturing sector,
which has helped the country become the manufacturing hub of the world. In India
the manufacturing sector can grow if infrastructure facilities are improved and labour
reforms take place. The country should take initiatives to adopt more flexible labour
laws.
 Relook at sectoral caps: Though the Government has hiked the sectoral cap for FDI
over the years, it is time to revisit issues pertaining to limits in such sectors as coal
mining, insurance, real estate, and retail trade, apart from the small-scale sector.
Government should allow more investment into the country under automatic route.
Reforms like bringing more sectors under the automatic route, increasing the FDI cap
and simplifying the procedural delays has to be initiated. There is need to improve
SEZs in terms of their size, road and port connectivity, assured power supply and
decentralized decision-making.
 Geographical Disparities of FDI should be removed: The issues of geographical
disparities of FDI in India need to address on priority. Many states are making serious

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efforts to simplify regulations for setting up and operating the industrial units.
However, efforts by many state governments are still not encouraging. Even the state
like West Bengal which was once called Manchester of India attracts only 1.2% of
FDI inflow in the country. West Bengal, Bihar, Jharkhand, Chhattisgarh are endowed
with rich minerals but due to lack of proper initiatives by governments of these states,
they fail to attract FDI.
 Promote Greenfield Projects: India’s volume of FDI has increased largely due to
Merger and Acquisitions (M&As) rather than large Greenfields projects. M&As not
necessarily imply infusion of new capital into a country if it is through reinvested
earnings and intra company loans. Business friendly environment must be created on
priority to attract large Greenfields projects. Regulations should be simplified so that
realization ratio is improved (Percentage of FDI approvals to actual flows). To
maximize the benefits of FDI persistently, India should also focus on developing
human capital and technology.
 Develop Debt Market: India has a well developed equity market but does not have a
well developed debt market. Steps should be taken to improve the depth and liquidity
of debt market as many companies may prefer leveraged investment rather than
investing their own cash. Therefore it is said that countries with well-developed
financial markets tend to benefits significantly from FDI inflows.
 Education Sector should be opened to FDI: India has a huge pool of working
population. However, due to poor quality primary education and higher education,
there is still an acute shortage of talent. FDI in Education Sector is lesser than one
percent. By giving the status of primary and higher education in the country, FDI in
this sector must be encouraged. However, appropriate measure must be taken to
ensure quality education. The issues of commercialization of education, regional gap
and structural gap have to be addressed on priority.
 Strengthen Research and Development in the Country: India should consciously
work towards attracting greater FDI into R&D as a means of strengthening the
country’s technological prowess and competitiveness.

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