Investment Decisions

Chapter 06 1
6.1 Introduction to Foreign Capital

Foreign capital refers to the investment of capital by a

foreign government, institution, private individual and
international organization in a country.
Foreign capital includes foreign aid, commercial
borrowing and foreign investment. Foreign aid includes
foreign grants, concessional loans etc.
Foreign capital is invested in the form of foreign
currency, foreign machines, and foreign technical
know-how.
Foreign Collaborations
Loan in Foreign Currency
Foreign capital
Investment in Equity Capital
Chapter 06 2
6.2 Need for Foreign Capital

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 country gets
foreign exchange through FDI. It helps to increase the
investment level and thereby income and employment
in the recipient country.
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.
Chapter 06 3
6.2 Need for Foreign Capital

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.
High Standards:
Foreign capital brings with it the tradition of high
quality, higher real wages to labour and sound business
practices. This serves the interest of the investor and
brings up quality / efficiency of local enterprises.
Chapter 06 4
6.2 Need for Foreign Capital

Marketing facilities:
Foreign investor provides new marketing outlets, starts
imports and exports among units located elsewhere.
Reduces trade deficits:
Foreign capital helps host country to increase exports
by raising quality and lowering costs and thereby,
reduce trade deficit.
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.
Chapter 06 5
6.3 FOREX MANAGEMENT

Until the end of 1670’s, international capital market

mainly focused on debt financing, but equity financing
was raised only by corporates in the domestic markets
as there were restrictions on cross border equity
investments.
Early 1680’s witnessed Liberalization and Globalization
of many domestic economies. This gave a boost to the
developing countries where issue of dollar or foreign
currency denominated equity shares were not
permitted. Now they are able to access international
equity markets through Depository Receipts.
Chapter 06 6
6.4 FOREX MANAGEMENT

1. A Depository Receipt is a negotiable certificate

issued by a depository bank that represents the
beneficial interest in shares issued by a company.
2. These shares are deposited with a local custodian
appointed by the depository, which issues receipts
against the deposit of shares. Each of these
depository receipts represents a specified number
of shares in the domestic market.
3. According to the placement planned, depository
receipts are classified into three categories, as
follows.
Chapter 06 7
6.4 FOREX MANAGEMENT
e i p t (G D R)
po s i to r y Rec
Global De e s imu lt a n e o us ly
ca n b
which sto rs i n two
s ue d to i nve
is o un t r ie s.
or more c

American Depository Receipt (ADR)

which are issued only to
investors in America

o s ito ry Re ce ip t (ID R)
Indian Dep
ic h a re is sue d o n ly to
w h
investors in India

Chapter 06 8
6.4 FOREX MANAGEMENT

4. The main objectives of a company going for an

international capital market are:
1. the size of the fund that can be raised.
2. currency choice.
3. large shareholder base
4. international brand image ; and
5. presence that emerges out of the issue.

Chapter 06 9
 6.5 Global Depository Receipt
(GDR)

GDR is a negotiable instrument in the

form of depository receipts or
certificate created by the overseas
depository bank outside India and
issued to non-resident investor
against the issue of ordinary shares
of Foreign Currency Convertible
Bonds (FCCB) of the issuing company.

Chapter 06 10
6.5 Global Depository Receipt (GDR)

A. The Characteristic Features

GDR’s are issued to investors in more than one country
and may be denominated in any acceptable freely
convertible currency.
The equity share holder may deposit the specified
number of shares and obtain the GDR and vice versa.
A typical GDR is denominated in any foreign currency
whereas the underlying shares would be denominated
in the local currency of the issuer. The holder is entitled
to the dividend, bonus on the value of shares
underlying the GDR.
Chapter 06 11
6.5 Global Depository Receipt (GDR)

A. The Characteristic Features- contd.

GDR may be, at the request of the investor, converted
into equity shares by cancellation of GDR’s through the
intermediation of the depository and the sale of
underlying shares in the domestic market through the
local custodian. This provision can be used after a
‘cooling off’ period of 45 days from the date of issue.

GDR’s are considered as common equity of the issuing

company. The company effectively transacts with only
one entity; i.e. the overseas depository for all its
transactions.
Chapter 06 12
6.5 Global Depository Receipt (GDR)

A. The Characteristic Features- contd.

The foreign currency funds acquired by the company
through a GDR issue are permitted to be used for any
normal business activity, but cannot be used for trading
in international securities or real estate.

Indian companies with good financial track record of

three years are readily allowed access to international
markets through such issues. Clearances are required
from the Foreign Investment Promotion Board (FIPB)
and the Ministry of Finance.

Chapter 06 13
6.5 Global Depository Receipt (GDR)

B. Advantages of a GDR issue:

GDR holders do not acquire voting rights and,
therefore, the promoters are not in the danger of losing
management control.
Companies having international operations are able to
build brand image which helps in their marketing
efforts.
Investors have the benefit of having access to good
quality companies in other countries without political
risk, operational risk and excessive regulatory control.

Chapter 06 14
 6.5 Global Depository Receipt
(GDR)

B. Advantages of a GDR issue: contd.

Through a GDR issue the company is
able to create a potential demand for
its shares at the international level
which results in higher valuation for
its shares in the domestic market.
This increases company’s P/E ratio
which in turn reduces the cost of
capital.

Chapter 06 15
 6.5 Global Depository Receipt (GDR)
It’s a nine step

#6
C. Mechanism of Issue:
process.
Listing on Stock #8
Exchange #4
Investor /
#6 Depository Bank Deposit Receipt
Custodian
Holder
Bank
#2
Lead Manager

#1 #3
Issuing Company Book Runners

Chapter 06 16
6.5 Global Depository Receipt (GDR)

C. Mechanism of Issue: contd.

Step 01: The domestic company wishing to issue equity

shares favoring international investors is called ‘The
Issuing Company’

Step 02: The issuing company appoints an international

merchant bank to act as a lead manager required to
market the issue to international investors by
conducting “Road Shows” with respect to background,
financial status and future prospects of the issuing
company.
Chapter 06 17
6.5 Global Depository Receipt (GDR)

C. Mechanism of Issue: contd.

Step 03: After the road shows the lead manager

arranges “book runners” who are specialized agencies
for establishing and analyzing investor response to the
issue, the purpose being to help the issuing company to
price the issue at an appropriate level.
Step 04: After issue price is decided, the lead manager
collects subscription money from potential investors
and after deducting their fees transfers the collected
amount to the depository bank.

Chapter 06 18
6.5 Global Depository Receipt (GDR)

C. Mechanism of Issue: contd.

Step 05: The issuing company now issues physical

shares in favour of the depository bank.
Step 06: These shares issued in favour of the depository
bank are submitted with the domestic bank of the
issuing company which is also called custodian bank.
Step 07: The custodian bank then confirms the receipt
of underlying shares issued by issuing company in
favour of depository bank.

Chapter 06 19
6.5 Global Depository Receipt (GDR)

C. Mechanism of Issue: contd.

Step 08: As soon as depository bank receives the

confirmation from the custodian bank, it issues GDR’s
to the investors /deposit receipt holders.

Step 06: The issuing company helps the depository

bank to arrange listing of the GDR’s. Most Indian
companies list the GDR’s on the international stock
exchanges in London, and Luxemburg.

This helps investors to freely trade on GDR’s.

Chapter 06 20
6.6 American Depository Receipt (ADR)

Till 1660s the companies had to issue separate

depository receipts for markets in each country, ADR
for US and EDR for European market.
There was no cross border trading possible, as ADRs
and EDRs could be traded, settled and cleared in US
and European markets respectively.
However, since 1660, non-US companies could raise
capital in the US market with registration with SEC
(Securities Exchange Commission).
ADR is a dollar denominated negotiable certificate that
represents a non-US company in US the market. They allow
US citizens to invest in overseas securities.
Chapter 06 21
 6.6 American Depository Receipt (ADR)

ADRs can be diagrammatically represented as follows:

Types of ADR

A B
Un-
Sponsored
Sponsored

B1 B2 B3 B4
Level 1 Level 2 Level 3 Restricted

B4a B4b
Regulation
Section 144A
“S”

Chapter 06 22
6.6 American Depository Receipt (ADR)
AUnsponsored ADR:
Unsponsored ADRs are issued by one or more
depository banks based on market demand.
Unsponsored ADRs are issued without the cooperation
of the foreign company, but it has to be reporting
company as per US Exchange Act of 1634.
BSponsored ADR:
Sponsored
B1 Level 1 ADR Program:
This is the first step for an issuer. In this instrument
only minimum disclosure is required by the SEC. The
issuer is not allowed to raise fresh capital or list itself
on any of the National Stock Exchanges.
Chapter 06 23
6.6 American Depository Receipt (ADR)

Sponsored
B ADR:
Sponsored
B2 Level 2 ADR Program:

The Company is allowed to enlarge the investor base

for existing shares to greater extent. But significant
disclosure has to be arranged. The Company now can
test itself on American or New York Stock Exchange.

Sponsored
B3 Level 3 ADR Program

This level is to raise fresh capital through public offering

in the US capital market.
Chapter 06 24
6.6 American Depository Receipt (ADR)

Sponsored
B ADR:

Restricted
B4 ADR

In addition to the sponsored ADR issues a company can

also access the US and other capital markets through
ADR program falling under rule 144 or regulation ‘S’ of
the SEC.

These issues have certain limitations in terms of target

investors etc.

Chapter 06 25
 6.6 American Depository Receipt (ADR)
B4Restricted ADR
Rule
B4 a 144:
This rule provides for raising capital through private
placement of ADRs with large institutional investors
called qualified institutional bodies (QIB’s). Such issues
operate at Level 1 status and do not require fulfillment
of GAAP standards.
Regulation
B4 b ‘S’:
Regulation ‘S’ provides for raising capital through the
placement of ADR’s to offshore non-US investors.
Section ‘S’ of the SEC regulation permits ADR’s to be
issued to individuals and corporate entities without any
restrictions outside the US
Chapter 06 26
 6.7 Comparison Between Different Levels of ADR

PARTICULARS Level 1 Level 2 Level 3

Trading Pattern Only on OTC Listing Listing

market allowed on allowed on
stock stock
exchanges in exchanges in
the US the US

Registration with ADR’s are Both ADRs Both ADRs

SEC registered but and and
underlying shares underlying underlying
are not registered. shares shares
registered registered

Chapter 06 27
 6.7 Comparison Between Different Levels of ADR
- contd.
PARTICULARS Level 1 Level 2 Level 3
Adherence to Only nominal Partial Full
GAAP norms fulfillment compliances compliance

Disclosure norms Limited Stringent Very

stringent

Capital raising No public issue. Public issue Public issue

Only private without fresh with fresh
placement capital. capital.

Chapter 06 28
6.8 Advantages of ADRs and GDRs
ADVANTAGES TO THE ISSUING COMPANIES

i. Provides access to the more liquid markets.

ii. Provides funds at lower costs and better terms.
iii. It expands the investor base for the issuing
company.
iv. Establishes name recognition for the company in
new capital markets.
v. Provides marketing advantages due to improved
brand image.
vi. Source for foreign currency resources for overseas
acquisitions, joint ventures, import financing,
project funding, etc.
Chapter 06 29
6.8 Advantages of ADRs and GDRs
ADVANTAGES TO THE INVESTORS

i. Access to the best investment possibilities across

the world.
ii. It is an easy and cost effective way for individuals to
hold and own shares in a foreign company.
iii. The mechanism helps investors to avoid foreign
procedural hurdles and clearances.
iv. Means of wealth protection and investment
diversification.
v. Hedge against adverse development in domestic
economy.

Chapter 06 30
6.6 Distinction Between GDR & ADR

No Global Depository Receipts American Depository Receipts

1 Can be denominated in any Can be denominated only in

freely convertible currency. US dollars.

2 Can be issued to investors Can be issued only to investors

in one or more markets resident in the US.
simultaneously.

3 Depository bank can be Depository bank needs to be

any international located in the US
investment bank

Chapter 06 31
6.6 Distinction Between GDR & ADR
No Global Depository Receipts American Depository Receipts

4 Issue does not require Issues require approval from

foreign regulatory
clearances
5 There is no sub-
classification in this
instrument.
6 GDRs are normally co-
related to equity shares of
the issuing company
expressed in whole
numbers.
the Securities and Exchange
Commission(SEC) of the US
They are sub-classified in
terms of the level of clearance
of the SEC
In many cases ADR’s are co-
related to equity shares of the
company expressed as a
fraction.

Chapter 06 32
6.10 Indian Depository Receipt (IDR)

IDR’s are financial instruments that allow foreign

companies to mobilize funds from Indian markets by
offering entitlement to foreign equity and getting listed
on Indian Stock Exchange.
This instrument is similar to the GDR and ADR. IDRs
need to be registered with SEBI.

The Government opened this avenue for the foreign

companies to raise funds from the country, as a step
towards globalizing the Indian capital market and to
provide local investors exposure in global companies.
Chapter 06 33
 6.11 Distinction Between FDI & FPI
Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI)
FDI can be defined as FPI can be defined as investment
investment made by Non- by Non-Resident investors in the
Resident investors in the equity equity of a domestic company
shares of a domestic company with the intention of getting quick
with the intention of capital gains.
participating in the
management of the company.

FDI normally involves a long FPI normally involves a short term

term association between the investment in the target company
investors and the target
company.

Chapter 06 34
 6.11 Distinction Between FDI & FPI
Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI)
FDI normally takes place FPI does not involve any
through a direct transaction interaction between the investor
between existing promoters and the target company and such
and the investors by private investments are made through
placements. the stock exchange.

FDI is usually a primary market FPI is usually a secondary market

transaction transaction
FDI has an impact on the FPI has no such direct impact
balance sheet of the company since secondary market
through introduction of fresh transaction involves exchange
capital, technology etc. among investors.

Chapter 06 35
 6.11 Distinction Between FDI & FPI

Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI)

FDI normally involves FPI does not involve any direct

introduction of new linkage between the new investor
technology, financing and the management. Investors
arrangement, etc. as the new do not wish to take part in
investor actively participates in management.
management process.

FDI leads to economic growth FPI does not create any economic
since it increases employment. growth.

Chapter 06 36
 6.11 Distinction Between FDI & FPI

Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI)

FDI is normally desired by all Due to the problem of HOT

Governments as a catalyst for MONEY associated with FPI, most
economic growth. Governments impose restrictions
on such investments.

FDI involves investment in FPI involves investment in

physical assets. financial assets.

Chapter 06 37
6.12 Hot Money

FDI provides the host country with foreign currency

resources which are in most cases permanent whereas
FPI provides short term foreign currency resources
helping to reduce the use of existing reserves for
meeting BOP deficits.
FPI contributors include a diversified set of investors
with different risk profiles and investment horizons.
Macroeconomic fundamentals do not play a critical
role in such investments. The intention is to make quick
profits out of opportunities provided by emerging
markets.
Chapter 06 38
6.12 Hot Money

Movements of such funds distort the exchange rates

and disrupt the capital market both when entering and
exiting a market

These monetary flows are called ‘Hot Money’.

Operations of domestic entities gets adversely affected,

therefore, to safeguard against the ill effect of such
fund movements, most governments introduce
exchange control regulations.

Chapter 06 39
6.13 Participatory Notes

In India, generally stated, investments by non-residents

under the Portfolio Investment Scheme are permitted
only as foreign institutional investments.

For purpose of eligibility for investment under this

route, a non-resident has to register with the SEBI as a
Foreign Institutional Investor (FII) or as a sub-account
of an existing FII.

Registration as an FII requires fulfillment of various

conditions as prescribed by SEBI.

Chapter 06 40
6.13 Participatory Notes

Investors
abroad
BSE FII registered in India
give
money to
FII.
Investors
FIIs buy shares not
on behalf of such registered
Investors. in India

FIIs issue them a contract paper called as

Participatory Note
Chapter 06 41
6.13 Participatory Notes
Further, SEBI requires that any sub-account can be
registered under an FII only if that FII is the investment
manager for such sub-account.
Indian stocks, like those of other emerging market
economies, are in great demand by overseas investors.
Some of these investors do not want to register
themselves with SEBI or due to conditions prescribed
for FII registration, are unable to register themselves.
It is in this context that the practice of FIIs issuing
Participatory Notes, equity Linked Notes etc. to such
overseas investors has become prevalent recently.
Chapter 06 42
6.13 Participatory Notes

Thus Participatory Notes (PN or P-Notes) are

instruments used by foreign funds, not registered in the
country, for trading in domestic market.
Participatory notes are like contract notes and are
issued by foreign institutional investors, registered in
the country, to their overseas clients who may not be
eligible to invest in the Indian stock markets.

FIIs invest funds on behalf of such investors, who prefer

to avoid making various disclosures required by the
regulators.

Chapter 06 43
6.14 Foreign Direct Investment in India

FDI is a matter of special interest in developing

countries because such countries are continuously in
competition to attract foreign capital for enhancing
availability of investible funds in their economies as
also to acquire new technology and managerial skills.

This competitive environment results in developing

countries providing several financial incentives such as
tax concessions, liberal regulations and concessions for
repatriation of profits.

Chapter 06 44
6.14 Foreign Direct Investment in India

However, FDI also has adverse side effects due to which

governments of developing countries need to control the
quantity of such inflows, their end utilization and the
investment agreements between the contracting parties.
Despite very liberal and transparent FDI mechanism and
sound macroeconomic fundamentals, India has not been
able to achieve the expected level of FDI inflows.
This is due to the slow process of policy and regulatory
changes. Economic reforms were introduced in India in
1661 with Liberalization, Privatization and Globalization
(LPG) model.

Chapter 06 45
6.15 Factors Contributing to the Slow Flow of FDI into
India

Despite attractiveness of the Indian market in terms of

size, demographics of the population, the liberalized
terms for inward FDI etc., the record of the country in
this regard has been poor. The factors that contributed
to this poor performance are:-
1. India has a highly regulated business environment
in terms of controls and procedures.
2. The government enjoys a monopoly in several key
sectors of the economy.
3. There are limitations on acquisition of real estate.

Chapter 06 46
6.15 Factors Contributing to the Slow Flow of FDI into
India

4. The labor laws require reframing in an environment

of market economies.
5. The infrastructure, especially in terms of
transportation is inadequate.
6. The modern communication systems available in
urban India need to percolate to rural areas.
7. The fiscal deficit arising out of government
borrowing is too large resulting in very high debt.

Chapter 06 47
6.16 Foreign Investment Promotion Board (FIPB)

1. The FIPB mechanism was specially designed to

permit FDI proposals not falling under the
automatic route.

2. There are no specific pre-established parameters for

deciding on such proposals.

3. Each proposal is considered on merit, based on

potential for economic benefit to the country.
Chapter 06 48
6.16 Foreign Investment Promotion Board (FIPB)

4. Each proposal is considered in totality and the

outcome is advised within 30 days of submission.

5. The recipient company , however, needs to intimate

to the concerned regional Office of RBI regarding
the receipt of investment amount within 30 days of
receipt and file the necessary documents 30 days of
issuing equity to foreign entity

Chapter 06 49
6.17 Foreign Investment Promotion Council (FIPC)

1. Despite efforts and progressive liberalization of

investment norms in terms of quantitative ceilings
for various sectors and the conditions / terms of
investment, the country has failed to attract the
expected level of FDI.
2. The Government, therefore, constituted the Foreign
Investment Promotion Council to promote and
market India as an investment destination.
Chapter 06 50
6.17 Foreign Investment Promotion Council (FIPC)

3. The FIPC is expected to play a proactive role in

identifying both domestic entities which can benefit
from FDI and the foreign counterparts and countries
which can be tapped for such partnerships.
4. While the FIPB only comes into the picture when
there is an actual proposal for evaluation, the FIPC
would actively pursue generation of such proposal.
5. The FIPC is set up under the Industry Ministry to
ensure greater co-ordination of efforts towards
desired objective.

Chapter 06 51
6.18 Offshore Banking

1. In today’s highly integrated global network,

international offshore centers are playing a vital
role in facilitating investment worldwide. An
offshore center exists by usage and they are known
as Offshore Financial Centers (OFCs).

2. OFCs are also known as Offshore Bank’s centers.

They conduct a wide range of business activities
such as banking, insurance, securities transactions,
trusts and some non-financial activities such as
shipping, registries etc.

Chapter 08 52
6.18 Offshore Banking

3. An Offshore Banking Unit (OBU) of a bank is a

deemed foreign branch of the parent bank situated
within India and shall undertake International
Banking business involving foreign currency
denominated assets and liabilities.
4. Offshore banking is, thus, an extension of the Euro-
currency concept used in offshore financial centers.
5. Offshore Banking has taken a great shape in India
since 2002. The seeds for OFCs were sown in the
EXIM policy 2002 – 07 that targeted export growth
from 0.67% to 1.00% of the world trade..
Chapter 08 53
6.18 Offshore Banking

6. The Government of India has introduced the Special

Economic Zone (SEZ) scheme with a view to provide
an internationally competitive and a hassle free
environment for export production.
7. As per the Government’s policy, SEZs will be a
specially made duty free enclave and deemed to be
a foreign territory for the purpose of trade
operations and duties/tariffs so as to usher in
export led growth of the economy. Offshore banks
are the foreign branches of Indian Bank located in
India.
Chapter 08 54