An empty decision

Sub-limits for portfolio investment in FDI policy can be counter-productive

Last week, markets were cheered by the government's announcement that it would now treat all forms of foreign investment in Indian companies under a single, composite ceiling. Many sectors now have no limit on foreign direct investment (FDI). Foreign portfolio investment (FPI) refers to the positions that foreign institutional investors (FIIs) take in companies. Their boards have to decide whether this is to be taken above the default cap of 24 per cent. Consequently, sectors that would have directly been affected by the composite cap decision are banking, defence, single-brand retail, credit information and power and commodity exchanges, all of which have limits on FDI. When the announcement came, banking stocks rose sharply, based on the interpretation that bank boards could now vote to increase FPI limits up to the overall limit in the sector. But the government's position on banking and defence is now being made explicit; these two sectors will continue to operate under separate caps - one for foreign portfolio investment and the other for overall foreign investment. Consequently, foreign portfolio investment in banks could go up to only 49 per cent within the overall sectoral foreign investment cap of 74 per cent. For defence, the overall foreign investment cap will continue to be 49 per cent, within which FPI can be up to 24 per cent.

With the continuation of these restrictions, the exercise is empty. In theory, the basic premise underlying the unified ceiling may be a sound one. The distinction between FDI and FPI is very clear in terms of both investor motivations and actions. Direct investors are driven by strategic objectives and see their association with the Indian partner as a reflection of their larger global strategy. They put money into the venture with a long-term horizon and play a significant role in strategy and execution, which involves board representation. Short-term variations in market capitalisation do not typically cause them to increase or decrease their shareholding. Portfolio investors, on the other hand, do exactly the opposite. They are driven by returns on their investment and will increase or decrease their holdings in the company based on their assessment of its prospects in relation to others in their portfolio. Typically, they do not play a role in managing the company's business. Given this, when a cap on FDI is imposed for strategic reasons by the government, but for whatever reason is not fully used up, the managements should have the flexibility to allow FIIs to increase their exposures to these companies, leading to a more efficient discovery of their market value.

However, the problem arises when the composite level of foreign investment includes the FPI component and is used to define ownership controls as well as foreign investment share in downstream industries, which come under a separate set of sectoral foreign investment caps. Calculating the FPI component while defining foreign ownership can thus lead to avoidable complications. It also defies logic as foreign portfolio investment is unlike FDI and can move in or move out at very short notice. Moreover, sub-limits require detailed monitoring by both the company and, more importantly, the regulator. Conscientious investors have to track the movement of aggregate FPI ownership in companies in these sectors that they might want to invest in. Since FPIs move in and out of companies regularly, tracking by all entities has to be in real time, without which there is a constant risk of investors failing to comply, even if unintentionally. All this imposes costs on all participants, from which the benefits accruing to anybody are questionable. With the government showing such a firm commitment to making doing business in India easier, the decision to persist with these sub-limits and keeping them within the broad definition and cap for foreign investment represents a significant departure from that agenda. If it cannot be justified on the basis of a reasonable cost-benefit assessment, it must be done away with.