Investment that involves the injection of foreign funds into an enterprise that operates in a different country of origin from that of the investor is foreign direct investment. The investing company may make its overseas investment in a number of ways:
By setting up a subsidiary or associate company in the foreign country
By acquiring shares of an overseas company
Through a merger or joint venture
The accepted threshold for a foreign direct investment relationship, as defined by the OECD is 10%. This means that the foreign investor must own at least 10% or more of the voting stock or ordinary shares of the investee company.
This does not include foreign investments in the stock markets. Instead FDI refers more specifically to the investment of foreign assets into domestic goods and services. FDIs are generally favored over equity investments which tend to flow out of an economy at the first sign of trouble which leaves countries more susceptible to shocks in money markets.
Advantages of FDI
One of the measurements of economic development in low-income economies is the increase in the nation's level of capital stock. A developing nation may increase the amount of capital stock by encouraging and incentivizing capital inflows, and this is done more commonly through the attraction of foreign direct investments, or FDIs. Amongst various forms and modes of capital inflows, FDIs are favored in particular because of its long term commitment to the host countries' economy and would be less susceptible to short term changes in market conditions, thus ensuring a certain level of continuity and stability in the money flow. Major advantages of FDI are as follows:
Economic Development
FDI helps in the economic development of the country where the investment is being made. FDIs not only provide foreign capital and funds, but also provide domestic countries with an exchange of skill sets, information and expertise, job opportunities and improved productivity levels.
Source of Financing
During 1990s, foreign direct investment was one of the major external sources of financing for most countries that were growing economically. It has also been noted that foreign direct investment helped several countries when they faced economic hardship. For e.g. during the 1997 Asian financial crisis the amount of foreign direct investment made in these countries was held steady while other forms of cash inflows suffered major setbacks.
Reduction of Costs
FDI provides the benefits of reduced costs through the realization of economies of scale, and coordination advantages, especially for integrated supply chains. The preference for a direct investment approach rather than licensing and franchising can also been viewed in terms of strategic control where management rights allows for technological know-how and intellectual property to be kept in-house.
Entering Newer Markets
In recent years, FDI has been used more as a market entry strategy for investors rather than an investment strategy. The move into local markets also ensures that companies are closer to their consumer market especially if companies set up locally-based (national) sales offices.
Internationalization
Aside from using FDIs as an investment channel and a method to reduce operating costs, many companies and organizations are now looking at FDI as a way to internationalize. FDIs allow companies to avoid governmental pressure on local production and cope with the protectionist measures by circumventing trade barriers.
Disadvantages of FDI
Many developing economies have tried to restrict and even resist foreign investments because of nationalist sentiments and concerns over foreign economic and political influence. One pertinent reason for this sentiment is that many developing countries or at least countries with a history of colonialism fear that foreign direct investment may result in a form of modern day economic colonialism exposing host countries and leaving them and their resources vulnerable to the exploitations of the foreign company.
Capital Returns to the home country
While FDIs may increase the aggregate demand of the host economy in the short run via productivity improvements and technological transfers, critics have raised concerns over the efficacy of purported benefits of direct investments. This theory follows the rationale that the long-run balance of payment position of the host economy is jeopardized once the investor manages to recover its initial outlay. Once the initial investment starts to turn profitable it is inevitable that capital returns from the host country to where it originated from, that is the home country.
Disrupt the Local Employment Market
FDIs generate negative externalities in the labor market of host economy. Multinational companies pay a slight premium over local wages. Paying a premium for the price of labor may improve the consumption power of workers but it also has the detrimental ability of disrupting the local employment market. When prices rise, supply increases while demand falls. Similarly, when the price of labor increases, wage premiums in this case, this creates a distortion and creates disequilibrium in the labor market.
Determinants of Foreign Direct Investment
Size of Market
If the country has a big market it can grow quickly from an economic point of view and it is concluded that the investors would be able to make the most of their investments in that country.
Population
The population of a country plays an important role in attracting foreign direct investors to a country since a huge customer base.
Per capita Income
If the country has a high per capita income or if the citizens have reasonably good spending power then it would offer the foreign direct investors with the scope of excellent performances.
Availability of Natural Resources
If a particular country has abundant natural resources it always finds investors willing to put their money in them. Saudi Arabia and other oil rich countries have had overseas companies investing in them in order to tap the unlimited oil resources at their disposal.
Inexpensive Labor Force
Inexpensive labor force is an important determinant of attracting foreign direct investment. The BPO revolution as well as the boom of the Information Technology companies in countries like India has been a proof of the fact that inexpensive labor force has played an important part in attracting overseas direct investment.
Infrastructure in the Host Country
Infrastructural factors like the status of telecommunications and railways play an important part in having the foreign direct investors getting lured to a particular country.
If a country has extended its arms to overseas investors and is able to get access to the international markets then it stands a better chance of getting higher amounts of foreign direct investment.
Foreign Direct Investment in India
Entry Routes for foreign investment in India
Under the Foreign Direct Investments (FDI) Scheme, investments can be made in shares, mandatorily and fully convertible debentures and mandatorily and fully convertible preference shares of an Indian company by non-residents through two routes:
Automatic Route: Under the Automatic Route, the foreign investor or the Indian company does not require any approval from the Reserve Bank or Government of India for the investment.
Government Route: Under the Government Route, the foreign investor or the Indian company should obtain prior approval of the Government of India, Ministry of Finance, Foreign Investment Promotion Board (FIPB) for the investment.
RBI guidelines for FDI in India
Modes of Investment under Foreign Direct Investment Scheme
Foreign Direct Investment in India can be done through following modes:
Issuance of fresh shares by the company
An Indian company may issue fresh shares /convertible debentures under the FDI Scheme to a person resident outside India (who is eligible for investment in India) subject to compliance with the extant FDI policy and the FEMA Regulation.
Acquisition by way of transfer of existing shares by person resident outside India
Foreign investors can also invest in Indian companies by purchasing /acquiring existing shares from Indian shareholders or from other nonresident shareholders. General permission has been granted to non residents / NRIs for acquisition of shares by way of transfer in the following manner:
Non Resident to Non-Resident (Sale / Gift): A person resident outside India (other than NRI and OCB) may transfer by way of sale or gift, the shares or convertible debentures to any person resident outside India (including NRIs)
NRI to NRI (Sale / Gift): NRIs may transfer by way of sale or gift the shares or convertible debentures held by them to another NRI
Non Resident to Resident
Gift: A person resident outside India can transfer any security to a person resident in India by way of gift.
Sale: General permission is also available for transfer of shares / convertible debentures, by way of sale under private arrangement by a person resident outside India to a person resident in India, subject to the pricing, reporting and other guidelines as given in Annex - 3.
Resident to Non-resident (Sale): A person resident in India can transfer by way of sale, shares / convertible debentures (including transfer of subscriber's shares), of an Indian company in sectors other than financial services sector (i.e. Banks, NBFC, Insurance, Asset Reconstruction Companies (ARCs), Credit Information Companies(CICs), infrastructure companies in the securities market viz. Stock Exchanges, Clearing Corporations, and Depositories, Commodity Exchanges, etc.) under private arrangement to a person resident outside India, subject to the pricing, reporting and other guidelines given in Annex - 3. However, this general permission is not available in case of transfer of shares / debentures by gift from a Resident to a Non-Resident / Non-Resident Indian.
Non-resident on the Stock Exchange: A person resident outside India can sell the shares and convertible debentures of an Indian company on a recognized Stock Exchange in India through a stock broker registered with stock exchange or a merchant banker registered with SEBI.
Prior Permission of Reserve Bank in certain cases for acquisition/transfer of security
The following instances of transfer of shares or convertible debentures from residents to non-residents by way of sale requires Reserve Bank approval:
Transfer of shares or convertible debentures of an Indian company engaged in financial services sector (i.e. Banks, NBFCs, ARCs, CICs, Insurance, Infrastructure companies in the securities market such as, Stock Exchanges, Clearing Corporations, and Depositories, Commodity Exchanges, etc.).
Transactions which attract the provisions of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997.
The activity of the Indian company whose securities are being transferred falls outside the automatic route and the approval of the FIPB has been obtained for the said transfer.
The transfer is to take place at a price which falls outside the pricing guidelines specified by the Reserve Bank from time to time.
Transfer of shares or convertible debentures where the non-resident acquirer proposes deferment of payment of the amount of consideration, prior approval of the Reserve Bank is required. Further, in case approval is granted for the transaction, the same should be reported in Form FCTRS to the AD Category - I bank, within 60 days from the date of receipt of the full and final amount of consideration.
The following instances of transfer of shares from residents to non-residents by way of sale or otherwise requires government approval followed by permission from the Reserve Bank:
Transfer of shares of companies engaged in sectors falling under the Government Route
Transfer of shares resulting in foreign investments in the Indian company, breaching the sectoral cap applicable
A person resident in India, who intends to transfer any security, by way of gift to a person resident outside India, has to obtain prior approval from the Reserve Bank. While forwarding the application to the Reserve Bank for approval for transfer of shares by way of gift, the documents mentioned in Annex - 4 should be enclosed. The Reserve Bank considers the following factors while processing such applications:
The proposed transferee is eligible to hold such security under Schedules 1, 4 and 5 of Notification No. FEMA 20/2000-RB dated May 3, 2000, as amended from time to time.
The gift does not exceed 5 per cent of the paid-up capital of the Indian company / each series of debentures / each mutual fund scheme.
The applicable sectoral cap limit in the Indian company is not breached.
The transferor (donor) and the proposed transferee (donee) are close relatives as defined in Section 6 of the Companies Act, 1956, as amended from time to time. The current list is reproduced in Annex - 5.
The value of security to be transferred together with any security already transferred by the transferor, as gift, to any person residing outside India does not exceed the rupee equivalent of USD 25,000 during a calendar year.
Such other conditions as stipulated by the Reserve Bank in public interest from time to time.
Transfer of shares from NRI to NR requires prior approval of the Reserve Bank of India
Issue of Rights / Bonus shares
An Indian company may issue Rights / Bonus shares to existing nonresident shareholders, subject to adherence to sectoral cap, reporting requirements, etc. Further, such issue of bonus / rights shares have to be in accordance with other laws / statutes like the Companies Act, 1956, SEBI (Issue of Capital and Disclosure Requirements), Regulations 2009, etc.
Issue of Right shares to OCBs
OCBs have been de-recognized as a class of investors with effect from September 16, 2003. Therefore, companies desiring to issue rights share to such erstwhile OCBs will have to take specific prior permission from the Reserve Bank9. As such, entitlement of rights share is not automatically available to OCBs. However, bonus shares can be issued to erstwhile OCBs (which are not in the adverse list of the Reserve Bank of India) without prior approval of the Reserve Bank, provided that the OCB is not in the adverse list of RBI.
Additional allocation of rights share by residents to nonresidents
Existing non-resident shareholders are allowed to apply for issue of additional shares / convertible debentures / preference shares over and above their rights share entitlements. The investee company can allot the additional rights shares out of unsubscribed portion, subject to the condition that the overall issue of shares to non-residents in the total paid-up capital of the company does not exceed the sectoral cap.
Prohibition on foreign investment in India
(i) Foreign investment in any form is prohibited in a company or a partnership firm or a proprietary concern or any entity, whether incorporated or not (such as, Trusts) which is engaged or proposes to engage in the following activities:
Business of chit fund, or
Nidhi company, or
Agricultural or plantation activities, or
Real estate business, or construction of farm houses, or
Trading in Transferable Development Rights (TDRs)
(ii) It is clarified that "real estate business" means dealing in land and immovable property with a view to earning profit or earning income therefrom and does not include development of townships, construction of residential / commercial premises, roads or bridges, educational institutions, recreational facilities, city and regional level infrastructure, townships. It is further clarified that partnership firms /proprietorship concerns having investments as per FEMA regulations are not allowed to engage in print media sector.
(iii) In addition to the above, Foreign investment in the form of FDI is also prohibited in certain sectors such as (Annex-2):
Retail Trading (except single brand product retailing)
Atomic Energy
Lottery Business including Government / private lottery, online lotteries, etc.
Gambling and Betting including casinos, etc
Manufacturing of Cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes.
Note:
1. Besides foreign investment in any form, foreign technology collaboration in any form including licensing for franchise, trademark, brand name, management contract is also completely prohibited for Lottery Business and Gambling and Betting activities.
2. Foreign investment in Trusts other than investment by SEBI registered FVCIs in domestic VCF under Schedule 6 to FEMA Notification no 20 is not permitted.
References:
http://www.economywatch.com/foreign-direct-investment/definition.html
http://www.economywatch.com/foreign-direct-investment/disadvantages.html
http://www.economywatch.com/foreign-direct-investment/benefits.html
http://www.economywatch.com/foreign-direct-investment/definition.html
http://www.economywatch.com/foreign-direct-investment/attract-more-fdi.html
http://www.economywatch.com/foreign-direct-investment/determinants.html
http://www.investopedia.com/terms/f/fdi.asp
http://rbidocs.rbi.org.in/rdocs/notification/PDFs/15MFI300611F.pdf
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 country. These investment proposals by the FIIs are made on behalf of sub accounts which may include foreign corporate, individuals, funds etc.
The types of institutions that are involved in the foreign institutional investment are as follows:
Mutual Funds
Hedge Funds
Pension Funds
Insurance Companies
The biggest source through which FIIs invest is the issuance of Participatory Notes (P-Notes), which are also known as Offshore Derivatives.
The money, which is coming through the foreign institutional investment, is referred as 'hot money' because the money can be taken out from the market at anytime by the investors.
The liberalization of international capital markets has given rise to large amounts of international equity flows in recent years. These foreign inflows have had a major impact on the cost of capital, on the volatility of capital markets, and even on economic growth.
RBI guidelines for FII
An Individual FII/ SEBI approved sub accounts of FIIs can invest up to a maximum of 10 per cent of the total paid-up capital or 10 per cent of the paid-up value of each series of convertible debentures issued by the Indian company. The 10 per cent limit would include shares held by
SEBI registered FII/ SEBI approved sub accounts of FII under the PIS (by way of purchases made through a registered broker on a recognized stock exchange in India or by way of offer/private placement) as well as shares acquired by SEBI registered FII under the FDI scheme.
Total holdings of all FIIs / SEBI approved sub accounts of FIIs put together shall not exceed 24 per cent of the paid-up capital or paid-up value of each series of convertible debentures. This limit of 24 per cent can be increased to the sectoral cap / statutory limit, as applicable to the Indian company concerned, by passing a resolution of its Board of Directors followed by a special resolution to that effect by its General Body and subject to prior intimation to the Reserve Bank.
Exchange Traded Derivative Contracts
SEBI registered FIIs are allowed to trade in all exchange traded derivative contracts12 approved by RBI/SEBI on recognised Stock Exchanges in India subject to the position limits and margin requirements as prescribed by RBI / SEBI from time to time as well as the stipulations regarding collateral securities as directed by the Reserve Bank from time to time.
The SEBI registered FII / sub-account may open a separate account under their SNRR A/c through which all receipts and payments pertaining to trading / investment in exchange traded derivative contracts will be made (including initial margin and mark to market settlement, transaction charges, brokerage, etc.).
Further, transfer of funds between the SNRR A/c and the separate account maintained for the purpose of trading in exchange traded derivative contracts can be freely made.
However, repatriation of the Rupee amount will be made only through their SNRR A/c subject to payment of relevant taxes. The AD Category - I banks have to keep proper records of the above mentioned separate account and submit them to the Reserve Bank as and when required.
Collateral for FIIs
Derivative Segment:
FIIs are allowed to offer foreign sovereign securities with AAA rating as collateral to the recognised Stock Exchanges in India in addition to the cash for their transactions in derivatives segment of the market. SEBI approved clearing corporations of stock exchanges and their clearing members are allowed to undertake the following transactions subject to the guidelines issued from time to time by SEBI in this regard:
to open and maintain demat accounts with foreign depositories and to acquire, hold, pledge and transfer the foreign sovereign securities, offered as collateral by FIIs;
to remit the proceeds arising from corporate action, if any, on such foreign sovereign securities; and
to liquidate such foreign sovereign securities, if the need arises
Clearing Corporations have to report, on a monthly basis, the balances of foreign sovereign securities, held by them as non-cash collaterals of their clearing members to the Reserve Bank. The report should be submitted by the 10th of the following month to which it relates.
Equity Segment:
The above guidelines are also applicable to the equity segment. Further, Domestic Government Securities (subject to the overall limits specified by the SEBI from time to time; the current limit being USD 10 billion) also can be kept as collateral to the recognized Stock Exchanges in India in addition to the cash for their transactions in cash segment of the market. However, cross-margining of Government Securities (placed as margins by the FIIs for their transactions in the cash segment of the market) shall not be allowed between the cash and the derivative segments of the market.
Custodian banks are allowed to issue Irrevocable Payment Commitments (IPCs) in favor of Stock Exchanges / Clearing Corporations of the Stock Exchanges, on behalf of their FII clients for purchase of shares under the PIS. Issue of IPCs should be in accordance with the Reserve Bank regulations on banks' exposure to the capital market issued by the Reserve Bank from time to time and instructions issued vide DBOD Circular no. DBOD.Dir.BC. 46/13.03.00/2010-11 dated September 30, 2010.
Short Selling By FIIs
FIIs registered with SEBI and SEBI approved sub-accounts of FIIs are permitted to short sell, lend and borrow equity shares of Indian companies. Short selling, lending and borrowing of equity shares of Indian companies shall be subject to such conditions as may be prescribed by the Reserve Bank and the SEBI / other regulatory agencies from time to time. The permission is subject to the following conditions:
Short selling of equity shares by FIIs shall not be permitted for equity shares of Indian companies which are in the ban list and / or caution list of the Reserve Bank.
Borrowing of equity shares by FIIs shall only be for the purpose of delivery into short sales.
The margin / collateral shall be maintained by FIIs only in the form of cash. No interest shall be paid to the FII on such margin/collateral.
Prohibition on investments by FIIs
FIIs are not permitted to invest in the capital of an Asset Reconstruction Company.
Both FIIs and NRIs are not allowed to invest in any company which is engaged or proposes to engage in the following activities:
Business of chit fund, or
Nidhi company, or
Agricultural or plantation activities, or
Real estate business* or construction of farm houses, or
Trading in Transferable Development Rights (TDRs)
* Real estate business" does not include construction of housing / commercial premises, educational institutions, recreational facilities, city and regional level infrastructure,
townships
References:
http://finance.mapsofworld.com/investment/foreign-institutional.html
http://rbidocs.rbi.org.in/rdocs/notification/PDFs/15MFI300611F.pdf
Differences between FDI and FII
FDI is long term investment subject to dividend tax if any while FII is short term investment subject to capital gains tax.
FDI is regulated by RBI and FIPB while FII is regulated by SEBI
FDI has automatic routes and approval routes while FII has equity funds, debt funds, and balanced funds
The Economy high and low depends on the FDI's Investment where as the Stock mark fluctuations are generally because of FII
FDI investments are illiquid and more difficult to sell, and thus FII investments become more desirable in the face of expected liquidity needs
Foreign Direct Investment only targets a specific enterprise. It aims to increase the enterprises capacity or productivity or change its management control. In an FDI, the capital inflow is translated into additional production. The FII investment flows only into the secondary market. It helps in increasing capital availability in general rather than enhancing the capital of a specific enterprise.
Effectively, FDI investors are the managers of the firms under their control; whereas FII investors effectively delegate decisions to managers.
