Foreign funding: Higher FDI to improve growth outcomes for Indian economy

India needs sustained higher investment to grow at an increased rate for an extended period. Given its stage of development, India’s domestic savings are insufficient to finance its growth, requiring the import of capital from the rest of the world. Foreign capital flowing into India comes in various forms and with diverse objectives. For instance, some foreign portfolio investors (FPIs) may be coming just to take advantage of the interest-rate differential between India and their home country, say, the United States. Such investment may be of a short-term nature and reverse quickly. The most stable variety of foreign investment is what is classified as foreign direct investment (FDI). Here the investor, often a large multinational corporation, brings a substantial amount of capital with a long-term horizon to set up a business independently or in association with an Indian partner. Besides capital, such investors also bring best management practices and technology, which has a much wider impact on the economy. Therefore, from a macroeconomic policy standpoint, FDI is seen as the most preferred method of capital import.

 

The Reserve Bank of India (RBI), in consultation with the Securities and Exchange Board of India (Sebi), on Monday issued guidelines for reclassifying FPI as FDI when holdings in individual companies exceed the prescribed limit. Under the Foreign Exchange Management Act (Fema), FPIs can hold up to 10 per cent of the paidup capital of a company. If an FPI exceeds the limit, it is expected to divest the excess holding or, according to the new guidelines, get it reclassified as FDI. Once the reclassification is done, even if the holding falls below 10 per cent, it will continue to be classified as FDI. However, the shift will not happen automatically. The FPI will need approval from the government and the concurrence of the investee company. This will help in complying with other conditions such as the FDI limits in some sectors. The reclassification will also be subject to conditions like investment from bordering countries.

 

The option of reclassification will help portfolio investors looking to increase their stake in a particular company and boost foreign investment. However, it must be recognised that FPIs are essentially financial investors and will not fit into the usual understanding of FDI. Some FPIs likely remain invested for a much longer duration, but they remain financial investors with expertise in asset management. From the policy point of view, such reclassification may end up showing an artificial bump in FDI flows. There could also be quick outflows. While the policy change may help some companies raise foreign equity more easily, subject to regulatory conditions, the reclassification may end up increasing noise in FDI numbers and convolute the overall understanding. A better way would have been to persuade Parliament to suitably amend Fema and make more room for portfolio investors to increase their holdings in Indian companies, possibly with conditions to ensure the stability of investment. India needs higher FDI and the flow has improved in recent years. However, there have been concerns about repatriation and disinvestment, which have increased in recent years. India needs to continuously improve its business environment to attract durable foreign savings.