Don't fear FII inflows

The nature of foreign investment coming into the country is changing rapidly. Foreign investment comes in two ways. Foreign companies often establish factories in India. They remit monies for this purpose. This is called Foreign Direct Investment (FDI) because the investment is made directly by the principal. Control over the Indian factory rests with the foreign principal.

The foreign principal decides what goods will be produced, at what price they will be sold, whether the manager will be an Indian or an expatriate, whether the profits will be reinvested or repatriated to the foreign headquarters, etc.

The other way in which foreign investment comes is through Indian share markets. These investors are called Foreign Institutional Investors (FII). They earn by buying and selling shares when the prices are low and high respectively. They also earn some monies by the way of dividends. The control over the company in which money is invested remains with the Indian owners.

The inflow of FDI was large previously. An amount of $164 billion has been invested in India in the 10 years ending at March 2010. FII inflows were less in comparison. Only $70 billion FII had been received in that same period. The situation has changed dramatically since April 2010. FDI of only $15 billion has been received till October last year. FII inflows were nearly three times at $51 billion. This indicates that foreign investors preferred FDI previously and have now shifted their preference to FII.

Analysts are expressing concern at this change. The main apprehension is that FII money can reverse suddenly and cause a collapse in our share markets and devaluation of our currency as has happened earlier. But it is necessary to understand the overall advantages and disadvantages of the two types of investments in order to take a position on this matter.

First issue is regarding efficiency of production. FDI comes with advanced technologies. Foreign companies start making advanced products in the country. As a result domestic manufacturers are forced to upgrade their technologies. For example, only Ambassador and Fiat cars were manufactured in the country till the 80s. These cars gave an average of 12-13 km per litre.

Production of Maruti-Suzuki cars started in the country in 1985. This car gave an average of 18-19 km. This forced Indian manufacturers to make fuel efficient engines. Today the ‘made in India’ Indica is giving an average of 22-23 km. The entire domestic automobile industry has been forced to technologically upgrade because of the coming of FDI.

It must be admitted that certain technologies are patented by foreign companies. These technologies can be available to us only through FDI. But such technologies are limited in number hence FDI may be preferred only in those select industries.

Integration with India

There is a difference in the impact of FDI and FII in other aspects. First difference is in the depth of integration with the Indian economy. Foreign investors have a spontaneous tendency to employ foreign managers and engineers and also use imported components and raw materials. Maruti-Suzuki, for example, imported many components from Japan for nearly two decades. The tendency of Indian businessmen, on the other hand, is more towards using Indian personnel and components as being done by Tata Motors in the manufacture of Indica and Nano cars.

Second difference is in profit repatriation. The objective of both, FDI as well as FII, is to remit profits to their foreign headquarters. This remittance is made of dividends and capital gains. Both FDI and FII remit dividends. The difference is that FII remittance simultaneously leads to increased payment of dividends to domestic shareholders. Say a FII bought shares of Tata Motors. The company was able to establish a new factory with this money and pay higher dividends. The domestic investors who bought shares of Tata Motors also benefited from this higher payout. FII, therefore, leads to greater spread of income in the country.

Both FDI and FII wish to repatriate capital gains as well. Foreign companies often sellout their factories and repatriate the monies received as was done by Sinar Mass which sold its paper factory in India and took the money home. FIIs also sell their shares and repatriate the monies earned. Yet there is a difference between the two.

A factory established by a foreign company suppresses and hurts domestic companies. For example, establishment of Maruti Suzuki led to the closure of the Premier Motors that was manufacturing Fiat cars in the country. Thus FDI has a negative impact on domestic companies.

In contrast, FII has a clearly positive impact on domestic companies. It provides more capital for them to grow. FII is better than FDI on this point as well. FII is, therefore, better than FDI due to deeper integration with the domestic economy and wider spread of dividend earned.

FIIs have one major disadvantage. They can quickly sell their shareholdings and cause a collapse of our share markets as happened in 2008 when the sensex was driven down from nearly 21k to 8k. The consequent remittances of proceeds also lead to a collapse of our currency. The rupee declined from 40 to 50 in the wake of this exit. The collapse of the share markets should not worry us much. Such losses are in the nature of speculation and speculators should be ready to bear consequences of the same.

The decline of our currency can be managed. The RBI should build greater foreign exchange reserves to meet such a situation. The money remitted by exiting FIIs can be made up by bringing back part of these reserves. There is no reason to fear FII for this reason.