Updated: Feb 19 2005, 05:30am hrs
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.