After prolonged subdued growth, inflows of foreign direct investment (FDI) received by India surged from the middle of the last decade. While this appeared to be a welcome augury considering that the policymakers were longing to see the emergence of the country as a major destination for foreign investors, a significant factor contributing to this situation was the change in the definition of FDI.
Traditionally, FDI has been seen as long term capital flows, which, apart from augmenting domestic savings, bring with them critical intangible assets like advanced technologies and better managerial skills, thus enhancing efficiencies in the host countries. In contrast, the definition of FDI that is used to collate global FDI data, as set out by the IMF for balance of payments purposes, and which India adopted less than a decade back, focuses on ?control? and ?long term interest?, but ignores the nature of the foreign investor and the motivation for exercising control. Importantly, ?long term? has not been specified, and ?control? is seen to be exercised as long as the foreign investor has 10% voting rights.
Control holds the key, because the foreign investor can then influence the operations of the investee company. Even though control can be exercised by a financial investor, it will be only to secure his own interest. These being essentially financial investments, even if there is some temporary hand-holding (in the case of new or distressed ventures), there is no question of integrating the host country operations. Private equity (PE), venture capital (VC), sovereign wealth funds (SWF), hedge funds (HF) and other financial investors, who essentially look for returns on their investments and who have become components of global FDI flows, especially those related to M&As, belong to this category.
However, there are cases where the source of control of FDI can be traced back to the host country, a phenomenon that has been termed as ?round-tripping?. These cases occur when host country entities transfer funds abroad through various channels (both legal and illegal) and then bring the funds back. Host country nationals can also set up bases abroad or raise capital in the international markets through special purpose vehicles. In those cases, too, a part of the investment could be money returning to the country of origin. When such investments are also treated as FDI, the benefits accruing to the host countries could be vastly reduced, for these investments do not bring with them critical intangible assets for enhancing economic efficiencies.
An exercise to understand the nature and character of FDI inflows into India revealed some interesting facts. This exercise was based on the top 2,748 individual cases of FDI, each accounting for at least $5 million, that were reported for the period September 2004 to December 2009. These cases accounted for four-fifths of the total inflows received during the period.
FDI, as was traditionally understood, accounted for nearly 48% of the total inflows, while the share of PE/VC/HF/SWF and other financial investors, including banks, was 32%. Round-tripped investment was the next major contributor, with a 14% share. What is even more interesting is that the share of round-tripped investments increased progressively and peaked in 2009 at 21%. The above-mentioned figures thus blur the distinction between direct and portfolio investors on the one hand, and foreign and domestic investors on the other.
The share of services in India?s reported FDI inflows exceeded two-thirds of the total while manufacturing lost its position substantially. The manufacturing sector, in which the Government of India has renewed its trust and is expecting its share to GDP to increase to 25% within the next decade, accounted for only about one-fifth of the reported inflows. In fact, its share in total inflows halved between 2005 and 2009.
The construction, real estate and financial sectors were the leading services sectors leaving behind IT and telecom. The construction and real estate sectors attracted a high proportion of round-tripped investments, but could attract only about 13% of the traditional forms of FDI.
With Singapore, Cyprus and UAE joining Mauritius as leading home countries, the share of tax havens shot up from about 45% during 2001-2004 to 69% during 2005-2009. Most of the PE/VC/HF and round-tripping variety of inflows entered via tax havens. This tendency was displayed more by PE/VC/HFs promoted by Indians.
The tax haven route that foreign investors had exploited for entry into India also meant that the exchequer would not have gained much from the profits/capital appreciation they earned. Since PE/VC/HF investments, which seek higher and quicker gains, are prone to speculative expectations, there is no guarantee that there would be net additions to domestic investable resources even in the medium term.
Most of the investments in the telecom, IT&ITES, construction and real estate sectors passed though such countries. About 90% of such investments in the construction and real estate sector were routed through the tax havens and have the benefit of automatic entry.
This raises the conundrum: while adopting the international best practices for reporting FDI data, are the official agencies using the criterion for distinguishing between foreign ?direct? and ?portfolio? investment inflows based on the criterion of 10% or more or voting rights?
KS Chalapati Rao is professor, Institute for Studies in Industrial Development and Biswajit Dhar is director general, Research and Information System for Developing Countries