Is FDI really a gift horse?

Background: Foreign Direct Investment (FDI) policy, Portfolio investment, Organisation for Economic Cooperation and Development (OECD) and International Monetary Fund (IMF), UN Conference on Trade and Development (UNCTAD), Bilateral Investment Promotion and Protection Agreement (BIPA), Investor-State Dispute Settlement (ISDS) mechanism.

  • In less than a year, the Government of India has announced yet another set of radical changes in FDI policies. The earlier announcement in Nov 2015 introduced changes in 15 major sectors, and the latest announcement covers nine sectors.
  • The recent amendments seek to further simplify the regulations governing FDI in the country and make India an attractive destination for foreign investors.
  • The Consolidated FDI Policy states that it is the intent and objective of the Government of India to attract and promote FDI in order to supplement domestic capital, technology and skills, for accelerated economic growth.
  • As distinguished from portfolio investment, FDI has the connotation of establishing a lasting interest in an enterprise that is resident in an economy other than that of the investor.
  • Economists have always treated FDI as that component of foreign investment in an enterprise that confers control to the foreign investor over the enterprise. All other foreign investment was defined as portfolio investment, and this component was considered footloose.
  • In recent decades, the OECD and IMF have pushed for a globally acceptable definition of FDI, according to which 10 percent or more of foreign equity constitutes the controlling share in an enterprise. But not all countries have adopted the OECD-IMF definition.
  • For instance, in India all investments other than those through the stock market are reported as FDI. Therefore India does not make any distinction between the controlling share and the others as far as FDI is concerned. This implies that data on FDI for India do not allow us to make the distinction between long-term investments and portfolio investments.
  • Foreign investors consider controlling share to be vital for bringing in state-of-the-art technologies. However, given the fact that developing countries have been struggling to get access to proprietary technologies despite steep increases in FDI inflows over time, there seems to be the proverbial slip between access to technology and FDI inflows.
  • The OECD-IMF duo introduced some other components in the definition of FDI, the most significant of these being the inclusion of reinvested earnings. While it may be justified for balance of payments purposes, the fact is that retained earnings increase the host country’s liabilities without actually transferring resources from abroad.
  • Retained earnings are a part of the profits earned by foreign companies in their host countries, which are in domestic currencies. Once capitalised and absorbed in the equity stock, retained earnings become conduits for larger dividend remittances in future.
  • Further, if such earnings are used to take over domestic companies or to buy back shares from the public, then they would not add to the existing capacities.
  • Data provided by the UNCTAD show that the share of reinvested earnings has increased progressively during the recent past and by 2013 they constituted two-thirds of the FDI outflows from the developed countries. In fact, more money was flowing into the developed countries as dividend income than that was flowing out as direct investment. Thus actual cross-border equity flows that meet conventional definition of FDI are only a fraction of the reported global FDI flows.
  • According to official statistics, India has seen a steep increase in FDI inflows totalling over $55 billion in 2015-16. However, in the world of high finance, FDI is not a gift horse – there are at least 2 sets of costs that host countries have to bear.
  • The first is the direct cost stemming from outflows on account of operation of foreign companies. Apart from the direct costs, foreign investors are able to extract indirect benefits from their host economies by using BIPA.
  • In recent years, India has faced a number of disputes with foreign investors, which arose because the latter was able to invoke the ISDS mechanism included in the BIPAs that allows disputes to be taken to private international arbitration panels.
  • The government has amended the model BIPA ostensibly to blunt the ISDS mechanism. The new model BIPA includes a strong stricture to foreign investors to make timely payment of their tax liabilities in accordance with India’s laws.

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