Maharashtra National Law University, Mumbai

Term Paper towards Fulfilment of The Assessment

In The Subject Of Economics

TOPIC: GROWTH AND DETERMINATION OF FOREIGN DIRECT

INVESTMENT

Submitted To: Prof. Sarama Pani Submitted By: Ranu Anand

Chouhan

: Prof. Rohit Jadhav

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 (Course Instructor) Roll no. : 201804
Table of content
SUBJECT PAGE NUMBER

INTRODUCTION 3-4

DETERMINANT OF FDI IN INDIA 4-5

GROWTH AND CHANGE IN 5-7

PATTERN OF FDI

GOVERNMENT SCHEMES TO 7-8

BOOST FDI

PROBLEM IN FI 8-9

P-NOTE 9-10

CONCLUSION 11

REFERENCE 11-12

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INTRODUCTION
Foreign investment (FI) has played an important role in the process of globalization during
the past two decades. The rapid expansion in FI by multinational enterprises since the mid-
eighties may be attributed to significant changes in technologies, greater liberalization of
trade and investment regimes, and deregulation and privatization of markets in many
countries including developing countries like India. Capital formation is an important
determinant of economic growth. While domestic investments add to the capital stock in an
economy, FI plays a complementary role in overall capital formation and in filling the gap
between domestic savings and investment. At the macro-level, FI is a non-debt-creating
source of additional external finances. At the micro-level, FI is expected to boost output,
technology, skill levels, employment and linkages with other sectors and regions of the host
economy.

In India FI inflow made its entry during the year 1991-92 with the aim to bring together the
intended investment and the actual savings of the country. To pursue a growth of around 7
percent in the Gross Domestic Product of India, the net capital flows should increase by at
least 28 to 30 percent on the whole. But the savings of the country stood only at 24 percent.
The gap formed between intended investment and the actual savings of the country was lifted
up by portfolio investments by Foreign Institutional Investors, loans by foreign banks and
other places, and foreign direct investments. Among these three forms of financial assistance,
India prefers as well as possesses the maximum amount of Foreign Direct Investments.
Hence FDI is considered as a developmental tool for growth and development of the country.
Therefore, this study is undertaken to analyse the flow of FDI into the country identifying the
various set of factors which determine the flow of FDI.

There are three types of foreign investment (a) foreign direct investment (FDI) is an
investment made by a company or individual who us an entity in one country, in the form of
controlling ownership in business interests in another country. FDI could be in the form of
either establishing business operations or by entering into joint ventures by mergers and
acquisitions, building new facilities etc. (b) Foreign Portfolio Investment (FPI) is an
investment by foreign entities and non-residents in Indian securities including shares,
government bonds, corporate bonds, convertible securities, infrastructure securities etc.  The
intention is to ensure a controlling interest in India at an investment that is lower than FDI,

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with flexibility for entry and exit. (c) Foreign Institutional Investment (FII) is an investment
by foreign entities in securities, real property and other investment assets. Investors include
mutual fund companies, hedge fund companies etc. The intention is not to take controlling
interest, but to diversify portfolio ensuring hedging and to gain high returns with quick entry
and exit. The differences in FPI and FII are mostly in the type of investors and hence the
terms FPI and FII are used interchangeably.

DETERMINANT OF FDI IN INDIA

There are so many determinants of FDI in the economy as suggested by existing literature
available on this issue. There is need to know the expected relation between FDI and these
determinants before doing empirical investigation regarding relationship of FDI and some
variables taken in this study so as to find main determinants of FDI in India.

 Market Size: Market size which is measured in terms of GDP is expected to have
positive relationship with FDI. Countries having more GDP growth rate can attract
more FDI inflows. Market oriented FDI aims to set up enterprises to supply goods and
services to the local market. This kind of FDI may be undertaken to exploit new
markets. The market size of host countries is very important location factor for market
oriented FDI. The general implication is that host countries with larger market size,
faster economic growth and higher degree of economic development will provide
more and better opportunities for these industries to exploit their ownership
advantages and therefore, will attract more market-oriented FDI. Even for export-
oriented FDI, the market size of host countries is an important factor because larger
economies can provide larger economies of scale and spill-over effects (OECD,
2000).

 Portfolio Diversification: The diversification of portfolio is also considered to be

another determinant. The approximate mix of bonds, securities, stock, debenture,
depository receipts, etc. refers to portfolio investment. The maturity of these
instruments may vary from few months to few years. The concern of an investor is for
these instruments at a time of risk perceptions. It implies that the investors are able to
invest in or take out their capital for diversification of their portfolio assets due to
perceived risk in a country. The higher is the perceived country risk due to political,

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 economic and financial changes in one country, an investor would like to take out his
capital out of the country.

 Differential Rate of Return: This theory explains mostly the held belief that the FDI
flows to that country which has relatively higher return on the investment. No investor
would like to invest if the rate of return on investment is low. Therefore, the flow of
capital will be in those countries which ensure the highest possible rate of return.

 Foreign Exchange Reserves: The high level of foreign exchange reserves in terms of
import cover reflects the strength of external payments position and help to improve
the confidence of the prospective investors. Therefore, a positive relationship is
postulated between the foreign exchange reserves and the inflow of foreign direct
investment.

 Government Regulations: This consists of rules and regulations governing the entry
and operations of foreign investors. FDI cannot take place unless it is allowed to enter
in a country. Its potential relevance is evident when policy changes sharply in the
direction of more or less openness. It should be noted, however that policy changes in
the direction of openness differ in an important way from those in the direction of
restriction. Open policies are basically intended to induce FDI while restrictive
policies such as sweeping nationalization of foreign affiliates, can effectively close
the door to FDI.

 Tax Policies: Fiscal policies determine general tax levels, including corporate and
personnel tax rates and thereby influence inward FDI. Other things being equal a
country with lower tax rates should stand a greater chance of attracting FDI project
than a country with higher rates. It is difficult to ascertain how much influence it can
have on the total inflows of FDI.

 Inflation: Low inflation rate is considered to be a sign of internal economic stability

in the host country. High inflation rate indicates incapability of the government to
balance its budget and failure of the central bank to conduct appropriate monetary
policy. Changes in inflation rates of the domestic or foreign country are anticipated to
alter the net returns and optimal investment decisions of the MNEs. It is expected to
give negative impact on FDI. Etc.

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 GROWTH AND CHANGE IN PATTER OF FOREIGN INVESTMENT

“The external debt crisis of 1991brought India close to default in meeting its international
payments obligations. The Government of India was following a highly restrictive policy
towards foreign investment until mid 1991. As a part of the economic reforms initiated
from 1991, the attitude of the government towards foreign investment-both direct and
portfolio-changed dramatically. The policy reforms have enabled the country to overcome
the crisis.

The Government of India initiated wide ranging reform of the policy regime beginning in
July 1991. The change in the policy regime related to foreign investment resulted in
unprecedented capital inflows in the post reform period. Both foreign direct investment
and portfolio flows have been encouraged in the post reform period. The inflow of
foreign investment is likely to have macroeconomic repercussions on the Indian
economy. It is important to understand the impact of foreign investment on
macroeconomic aggregates like current account balance, foreign currency assets,
exchange rate, composition of capital inflows, money supply and sources of external
financing. These are areas that remain seriously unexplored”1.

“By catching the attention of the economies worldwide, India has been able to gain a huge
sum by the way of equity inflows. Singapore has become the largest investor with a total
investment of $13.69 billion during the financial year 2015-16. Followed by Singapore are
the economies including Mauritius and USA investing $8.35 and $4.19 billion respectively.
The aggregate Merger and Acquisition (M&A) deals as well as the private equity deals,
which are the methods of foreign direct investment inflow, have grown up 2 times from the
last year of 2015 (IBEF, 2016a).

Foreign direct investment in India has shot up 318.2 times starting from the year 1991 to
2005, from $129 million in 1991-92 to $41050 million (Dutta & Sarma, 2008). Before the
year 2015-16, Mauritius was the topmost investor in the country as succeeded by Singapore.
Still, the country is the major investor with its cumulative percentage share to total inflows
being 34% more than double the percentage of Singapore.

1
http://shodhganga.inflibnet.ac.in/bitstream/10603/15840/9/09_chapter%201.pdf

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The report of the department of industrial policy and promotion has shown that India has
been able to gain value in various sectors including the service sector, information technology
(IT) sector, automobile industry, pharmaceutical sector, power industry and construction
business from the period of 2000 until 2015”2

Major sources of foreign direct investment in India

GOVERNMENT SCHEMES TO BOOST FOREIGN INVESTMENT

“Taking cue from the ‘Singapore model’, the Government of India devised a new policy
whereby foreign investors would be granted residency status if they invest over Rs 10 crore
(£1 million) in India. Under this new scheme, investors would be granted permanent
residency status for 10 years and this could be extended to up to 20 years at a later date.
Additionally, investors would be allowed to buy a residential property and their family would
be eligible to study or work in the private sector in India during their stay.

An important clause in the scheme states that the foreign investment must generate at least 20
jobs for resident Indians every year. The scheme is designed to encourage foreign investment
in India and support Modi’s ‘Make in India’ programme. Interestingly, this scheme will not

2
https://www.projectguru.in/publications/trends-of-foreign-direct-investment-in-india/

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be available to Chinese and Pakistani citizens. It is not clear as of now why both these
countries have been excluded, and an official statement on the issue is awaited.

This scheme can be availed if a minimum of 10 crores is brought within 18 months or 25

crore (£2.5 million) within 36 months. Initial reaction has been positive and it has been hailed
as an “indication of more broad mindedness towards foreign investors” by Mohan
Guruswamy, chairman at the Centre for Policy Alternatives in New Delhi. The proposed
incentives are expected offer stability during an investor’s stay in India, allowing them to live
in India while they ‘Make in India”3.

PROBLEM IN FOREIGN INVESTMENT

“The new Modi government is committed to improving the foreign direct investments in
India, particularly in the areas of defense, insurance and infrastructure. The companies which
are considering in investing in India will look at several parameters. Some of them are
discussed here.

Ease of doing business in India. This is probably one of the biggest stumbling blocks India
faces in attracting FDI. The bureaucracy, corruption, labour and land acquisition laws are
frighteningly complicated and slows down the entire process of setting up a business. A
country which is anxious to attract business should look to see how other countries are
managing these issues and what steps they have taken to make it attractive for the foreign
companies to set up their shops.

Taxation that is applicable to the corporate profits. The global tax landscape has seen
considerable changes in the recent past and this will continue to be the same in the near term.
In the context of India, the total amount of revenues collected through the various taxes and
duties falls extremely short of the requirements. For ex., in the last budget presented by FM
Jaitley which states that for every 100rs our government spends, Rs.24 is borrowed money.
This is already extremely high, so our government is not in a position to lower the corporate
taxes as the revenue collected will make the deficit even higher. Each country uses a
particular tax rate which depends upon a number of factors including the historical baggage it
carries. In the current state of the economy large amounts of money is required for socio-

3
Maitreya Thakur, Indian Government Announces New Schemes to Boost Foreign Investment, UK India
Business Council (07 SEP, 2016), https://www.ukibc.com/indian-government-announces-new-scheme-boost-
foreign-investment/

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economic development and subsidies, etc. Currently, our Indian corporate tax for a domestic
companies stands at 33.99% when the net income exceed 10 crores.

Besides the taxes, corruption adds up significantly to the cost of doing business. It will not be
far-fetched to say that 1-2% surrogate has been added due to corruption. In the last few years,
the land prices have shot through the roof. One estimate shows that the production costs in
India is very much affected because of the land prices. The BJP government should ponder
over this problem before they arrive at a reasonable tax rate for multinational companies.
Things such as education cess and surcharge should be totally removed to lower the tax rate.
Unfortunately for India the tax collected from individuals is limited since less than 3% of the
population pay income tax at all. India continues to be a welfare state and most of the costs
associated with welfare are borne through deficits. The budget deficit in India is a nightmare
and the accumulated deficits (debt) are around 77% of the GDP.

When you want to attract foreign capital, we should make it attractive for them to earn an
reasonable rate of return from their investments. If taxes take away bulk of their earnings,
then the amount they can distribute to the share-holders gets much smaller. The foreign
investment also faces currency value changes and this makes it even more difficult for
foreign companies to set up shops in India. While in India, we clammer for FDI, we also find
that we are being marginalized because of the not-so-friendly nature of doing business here.
Its time our government recognizes this and takes necessary steps to attract more and more
FDIs. Every year, nearly 1 crore people join in the job market and hoping to find something
useful to do with their lives. If the business climate is not favourable to foreign companies,
they have alternative places to go, which is only at the cost of India’s growth opportunities.
Finally, the investors, no matter where they live in the world, will always prefer a higher rate
of return for a given level of risk, the question to answer is whether India can deliver that”4.

P-NOTES

4
Bobby Shriniwasan and sudhakar balachanderan, challenges to foreign direct investment in india,(18 sept.
2014) https://www.greatlakes.edu.in/blog/challenges-foreign-direct-investment-india-dr-bobby-srinivasan-dr-
sudhakar-balachandran/

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“Participatory notes also referred to as P-Notes, or PNs, are financial instruments required by
investors or hedge funds to invest in Indian securities without having to register with the
Securities and Exchange Board of India (SEBI). Any dividends or capital gains collected
from the securities goes back to the investors. Indian regulators are generally not in support
of participatory notes because they fear that hedge funds acting through participatory notes
will cause economic volatility in India's exchanges.

Participatory notes are easily traded overseas through endorsement and delivery. They are
popular because investors anonymously take positions in Indian markets, and hedge funds
may anonymously carry out their operations. Some entities route their investments through
participatory notes to take advantage of tax laws that are available in certain countries.

However, because of the anonymity, Indian regulators face difficulty determining a

participatory notes original owner and end owner. Therefore, substantial amounts
of unaccounted for money enters the country through participatory notes. This flow of
untracked funds has raised some red flags”5.

“Participatory notes remain vulnerable to regulatory rulings. In late 2017, Indian regulators
determined that P-Notes cannot take any derivative positions in Indian markets for reasons
other than hedging. As reported by EconomicTimes.IndiaTimes.com, this stringent regulatory
intervention caused investments through P-Notes to drop throughout 2018, finally hitting a
more than 9-1/2 year low in November 2018. However, investments rebounded in December
2018 after regulators relaxed some of the more restrictive requirements.

P-Notes can be used to purchase any Indian security an investor wants through a series of
steps.

An investor deposits funds with the U.S. or European operations of a registered foreign
institutional investor (FII), such as HSBC or Deutsche Bank. The investors then inform the
bank the Indian security or securities they wish to purchase. Funds transfer from the investor
to the FII account, and the FII issues the participatory notes to the client and buys the
underlying stock or stocks in the correct quantities from the Indian marketplace.

5
Alexandra Twin, Participatory notes, Investopedia (Feb 25, 2019),
https://www.investopedia.com/terms/p/participatorynotes.asp

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The investor is eligible to receive dividends, capital gains and any other payouts due to
stockholders holding the shares of the Indian company. The FII reports all of its issuances
each quarter to the Indian regulators, but as per law, does not disclose the identity of the
actual investor”6.

CONCLUSION

India has already marked its presence as one of the fastest growing economies of the world. It
has been ranked among the top 10 attractive destinations for inbound investments. Since
1991, the regulatory environment in terms of foreign investment has been consistently eased
to make it investor-friendly.

The measures taken by the Government are directed to open new sectors for foreign direct
investment, increase the sectoral limit of existing sectors and simplifying other conditions of
the FDI policy. FDI policy reforms are meant to provide ease of doing business and
accelerate the pace of foreign investment in the country.

A large number of changes that were introduced in the country’s regulatory economic
policies heralded the liberalization era of the FDI policy regime in India and brought about a
structural breakthrough in the volume of FDI inflow into the economy maintained a
fluctuating and unsteady trend during the study period. It might be of interest to not that more
than 50% of the total FDI inflow received by India, came from Mauritius, Singapore and the
USA.

The main reason for higher level of investment from Mauritius was that the fact that India
entered into a double taxation avoidance agreement (DTAA) with Mauritius were protected
from taxation in India. Among the different sectors, the services sector had received the
larger proportion followed by computer software and hardware sector and telecommunication
sector.

According to findings and results, we have concluded that FII did have significant impact on
sensex but there is less co-relation with banker and IT. One of the reasons for high degree of
any linear relation can also be due to the sample data. The data was taken on monthly basis.
6
Ibid

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The data on daily basis can give more positive results. Also FII is not the only factor affecting
the stick indices. There are other major factors that influences the bourses in the stock
market.

REFERENCES

 Himani Madaan and Indra Giri, Trends of Foreign Direct investment in India, Project
Guru ( july 2, 2016), https://www.projectguru.in/publications/trends-of-foreign-direct-
investment-in-india/
 Maitreya Thakur, Indian Government Announces New Schemes to Boost Foreign Investment,
UK India Business Council (07 SEP, 2016), https://www.ukibc.com/indian-government-
announces-new-scheme-boost-foreign-investment
 Bobby Shriniwasan and sudhakar balachanderan, challenges to foreign direct
investment in india,(18 sept. 2014) https://www.greatlakes.edu.in/blog/challenges-
foreign-direct-investment-india-dr-bobby-srinivasan-dr-sudhakar-balachandran

 Alexandra Twin, Participatory notes, Investopedia (Feb 25, 2019),

https://www.investopedia.com/terms/p/participatorynotes.asp

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