Tinkering with FDI

Recent policy changes will worry foreign investors

In an ideal situation, the government’s policy on foreign direct investment (FDI) should seek to achieve at least two clear objectives. One, the policy should be able to channel more investment flows into the country in greenfield or existing projects. Two, the rules under the policy should be transparent and non-discretionary. It is, therefore, surprising and disturbing that a key change introduced in the government’s FDI policy early this month is unlikely to achieve either objective. Shorn of its legalese, what the changed policy has done is to deny FDI status to all investments in convertible debentures or mandatorily convertible preference shares if they have in-built options of any type. And if these instruments with such options are issued or transferred to non-residents, they would have to comply with the existing guidelines on external commercial borrowing. In other words, investments that were hitherto treated as FDI have overnight turned into debt instruments.

The new policy does not deem it necessary to explain why such instruments would now be treated as a debt investment merely because someone else had agreed to acquire the instrument from the investor as a condition. The government may well argue that introducing such a condition is necessary in a bid to prevent the possibility of a breach of the FDI caps enforced in many sectors. But there are better ways to ensure compliance with FDI caps and certainly introducing what looks like a retrospective amendment of rules is not a desirable practice. Nor does it set a healthy precedent in law-making. Worse, it is reminiscent of the pre-1991 days when most policy changes either lacked transparency or failed to follow a non-discretionary decision-making process.

Note that once a non-resident investment in convertible debentures with an underlying option is governed under the guidelines for external commercial borrowing, a host of new conditions kick in. These include restrictions on end use of the funds and a fixed financial liability of servicing the debt instrument. Moreover, companies are not likely to enjoy the prospect of converting their risk capital into debt and thereby incurring a higher fixed cost, which may have adverse implications for their debt-equity ratios. That apart, such a move has implications for the country’s external debt profile. With almost a third of total foreign debt already in the form of external commercial borrowing, it is a moot point if the government should have pondered whether any FDI policy change should be allowed to result in reclassification of foreign equity investments as foreign debt. This is no longer just a definitional issue. Foreign investment flows into the country, after peaking at $37 billion in 2008-09 and staying around that figure in the following year, slowed down to only $30 billion in 2010-11. Foreign investment flows in the first four months of the current fiscal year have improved to $14 billion, almost double the amount in the same period last year. However, with the prospects of a global economic downturn looming large, attracting more foreign investment in the remaining months of the year will be a formidable task. If instead of further liberalising foreign investment rules, the government makes the policy more restrictive with such tinkering, that task will no longer be just formidable. It will become impossible.