FDI versus FII

Sudhanshu Ranade

THE Common Minimum Programme of the new Government at the Centre stresses Foreign Direct Investment over Foreign Institutional Investment. Its position is that "FDI will continue to be encouraged and actively sought, particularly in areas of infrastructure, high technology and exports and where local assets are created on a significant scale. The country needs and can easily absorb at least two to three times the present level of FDI inflows," after which the document hurries to add that "Indian industry will be given every support to become productive and competitive" and that all efforts will be made to provide a level playing field. Cynics will no doubt point disdainfully in this connection to the Finance Minister, Mr P. Chidambaram's recent statement about the need to take a second look at the policy of foreign investors having to get the permission of their local collaborators before branching out on their own. The position of the Common Minimum Programme on FII inflows is spelt out many pages later, in the section dealing with the capital market. The FIIs, too, the CMP says, "will continue to be encouraged," but immediately thereafter goes on to state, in the very same sentence that "the vulnerability of the financial system to the flow of speculative capital will be reduced." It is against this background that one must view Mr Chidambaram's comment about the need to take a second look at the concessional rate of capital gains tax levied on short-term gains (10 per cent) that applies to FII investments but not to those made by domestic players in the secondary market. It needs to be noted in this connection that a former Finance Minister, Mr Yashwant Singh, announced some years ago that the government knew all along that domestic investors, too, were using the Mauritius channel, but chose not to clamp down on this, presumably in the interest of ensuring a level playing field between domestic `FIIs' and FIIs that were really foreign. Be that as it may, it is worth noting that the section in the CMP dealing with capital market opens with the statement that the government "is deeply committed, through tax and other policies, to the orderly development and functioning of capital markets that reflect the true fundamentals of the economy," before going on to talk of FIIs. Actually the latter half of this sentence is a mere platitude; it is an open secret

that the one thing the capital market the world over pay little or no attention to is the `true fundamentals'. (No one I have spoken to or read has ever meaningfully discussed the relation of `fundamentals' to the stock market.) The concern of market regulators the world over is focussed, rather, on ensuring a well-ordered market. One SEBI chairman in fact specifically stated that he was least interested in the question of whether the stock market was or was not in tune with the fundamentals. The level of share prices, he said, was not his job; his job was to avoid large and sudden fluctuations in these levels. This may have be one of the things the present Finance Minister has in mind when he speaks of `going back' to reforms. The economic policy of the BJP-led coalition was, especially the past few years, was very much focussed on the stock market rather on the growth of productivity and on sustainable increases in GDP; apparently in an effort to indirectly boost the rate of growth of the market. A number of analysts of the US economy have pointed out that every dollar of growth in market capitalisation boosts spending by 5-7 cents. Sauce for the gander, sauce for the goose? Not really. The estimates about the effect of the amount by which stock market increases or decreases spending relate to situations in which the market is relatively stable, and therefore might have a somewhat more limited effect in the Indian case, particularly when the stock market is on way up. It is, therefore, in our best interests to be cautious about the demandenhancing aspects of runaway booms, rather than getting excited every time the market seems suddenly to be reaching new highs. Whenever the market seems all set to touch the skies, it is the pessimists that we ought to pay more attention to than the optimists. The point is not that a rising market is bad in itself; but rather that one needs to pay serious attention to the fall that might follow. Pumping public sector funds to prop or push up the market is not healthy. It only heightens the risks. This logic particularly applies to situations in which market regulators seem better at `tackling' crises after they arise than at preventing them from happening. One last thing: Foreign investments in supply-side infrastructural investments will probably look a great deal less appealing to foreign investors than we try to make them out to be. Costs are large and certain; benefits can at best be termed dubious. Things are very different in the case of direct foreign investments in fast moving goods; but in the context of a low-tariff regime, many potential investors could well look at imports as a better and safer way of getting more bang for their buck.

What explains the greater attraction of the Indian market for portfolio investors as compared to foreign direct investment (FDI)? In his column Bullish FII versus cautious FDI in these pages (FE, February 14), Senthil Chengalvarayan has compared the Indian scenario, characterised by strong portfolio inflows and much weaker foreign direct investment (FDI), with China, where the situation is the reverse. He attributes the difference to the opening of the capital market. Open up the real sector and investments will flow, he argues. While his broad thrust is correct, there is another factor thats just as critical, if not more. Ease of entry and exit. Today, it is relatively effortless for a foreign institutional investor (FII) to enter the capital market. A Sebi registration, preceded by a fairly perfunctory due diligence, is all it takes before an FII can enter the Indian stock market and commence trading. Exit is equally simple. For FDI, however, both entry and exit are far more difficult. Even in sectors opened to FDI on paper, problems remain at the grassroots. There are innumerable clearances that need to be obtained at the state and district levels. There are also a number of practical hurdles, such as infrastructure bottlenecks, all of which make entry difficult. Exit is more complicated. Archaic labour laws, such as the Industrial Disputes Act, prohibit the closure of any company employing more than 100 workers without obtaining prior state government permission. Bankruptcy laws are convoluted and legal processes costly and long-winded. No wonder portfolio inflows into India far exceed direct investment flows. FII flows topped $8.5 billion last year and have already exceeded $1 billion in the current year to date. In contrast, FDI flows have remained stuck in the $3-4 billion groove for the past many years. Its just the reverse in China. FDI is in the range of $50 billion, while portfolio flows are much lower, in the range of $4-5 billion. Part of the reason is that equity markets are far less open than in India. The market is segregated between resident and non-resident investors and there are strict controls. Given that FDI is far more beneficial to the recipient country than FII, the big question troubling Indian policymakers is how do we replicate the Chinese example. We would say open up and, equally, make exit easier as well.