Dissecting FDI aspects in Union Budget 2016-17

Introduction

In order to attract foreign investments, Finance Minister Arun Jaitley has proposed in his budget speech significant liberalization in the Foreign Direct Investment (‘FDI’) regulations in a variety of sectors. The opening of the sectoral caps in various sectors is considered by many as a positive development and is another step in a series of steps taken by the government to encourage FDI in the country. Not only has the Government opened up new avenues to overseas investors but it has also promised a more conducive business environment with simpler rules.

Key Proposals

The following proposals were announced by the finance minister in his budget speech.

i. In order to resolve the issue of bad debts and non-performing assets plaguing banks and financial institutions, the government has allowed 100% FDI in Asset Reconstruction Companies (‘ARC’s’) through automatic route. Corresponding amendments to the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (‘SARFESI Act’) have been proposed. The government also stated that foreign portfolio investors (‘FPIs’) will be allowed up to 100 per cent of each tranche in securities receipts issued by ARC’s subject to sectoral caps. The business of Asset Reconstruction companies did not gain the expected impetus in India as less business entities were willing to take risks. With the involvement of more foreign investments in ARC’s, the likelihood of its expansion is expected. However, this expectation would not come to fruition without major reforms in the disposal rate of cases relating to stressed assets. For tackling this issue, the government has also proposed strengthening of Debt Recovery Tribunals with focus on improving the existing infrastructure, including computerised processing of court cases, among other things. If the promises are met, this may prove to be a welcome move for banks and financial institutions.

ii. Secondly, the FDI cap in Insurance sector was increased from 26% to 49% in November 2015. In the insurance and pension sectors, the government announced, foreign investment will be allowed through automatic route for up to 49 per cent subject to the guidelines on Indian management and control, to be verified by the regulators.

iii. In another move that is expected to entice overseas investors  and  provide the necessary push to the food industry, 100% FDI with clearance from the Foreign Investment Promotion Board(‘FIPB’)will be allowed in marketing of food products produced and manufactured in India.

iv. The government of India is also promoting ‘Mega Food parks’ in an attempt to further attract FDI in the Food processing Industry. The devil as always would be in the details of the definition of “marketing” in food industry. The Department of Industrial Policy and Promotion is going to seek the comments of stakeholders in Food Industry following this announcement. Whether this will lead to any change in the policy or not remains to be seen.

v. Furthermore, investment limit for foreign entities in Indian stock exchanges will be enhanced from 5 per cent to 15 per cent on par with domestic institutions. The Securities Exchange Board of India (SEBI) is likely to finalize guidelines on this issue. This change is in response to the demand that is long pending by various stakeholders. The proposed change is aimed at increasing the global competitiveness of domestic Stock exchanges. It is important to remember that the Securities and Exchanges Board of India, in November 2015 had revised regulations for the listing of domestic stock exchanges aimed at improving regulation and bring more transparency.

vi. Additionally, the Finance Minister has stated that residence status will be provided to foreign investors, which will go beyond five-year visas. The details would be thrashed out in consultation with the home ministry and Ministry of external affairs, but investors with investment beyond a specified limit would get residence permits. This will significantly reduce the compliance burden of the Foreign Investors and may encourage long term investments.

vii. Another significant change is the government’s proposed policy of ‘cooperative and competitive federalism’ wherein the government has proposed to introduce a Centre-State Investment Agreement. This proposal is in the light of the International Bilateral Investment Treaties signed by India with other countries. Implementation and ratification of the obligations under these treaties would be facilitated by the ‘Centre-State investment agreement’. It will also ensure equal participation of the States and will provide additional impetus to foreign investments. States opting to work in tandem with Centre will obviously be seen as more attractive destinations by foreign investors.

Further, the existing 24% limit for investment by FPIs in Central Public Sector Enterprises, other than Banks, listed in stock exchanges, will be increased to 49% to obviate the need for prior approval of Government for increasing the FPI investment.  The government is also mulling allowing FDI beyond the 18 specified NBFC activities in the automatic route.

Issues to be addressed

Having seen the proposed changes, it is also important to analyse the manner in which FDI practically ends up shaping the economy. In theory, FDI is a part of risk capital. Only if the equity value of a venture shows growth and enhancement, would the foreign exchange outlay increase. For an investee company it is the most expensive instrument of investment. As the value of equity goes up, so does the equivalent amount of foreign exchange outflow on repatriation basis. Thus, the capital inflow is always more than capital outflow and thus the economy would always be surplus on Foreign Exchange. The growth achieved by the foreign investment always remains in the country. 100% FDI would mean 100% risk for the investee Company. Compared with ECB or any other debt that has to be repaid in foreign currency, where the outlay is determinate and provisioning for repayment has to be made, FDI scores over any other investment vehicle. The economic theory on FDI cannot be flawed. However in practice, the FDI logic takes a totally different shape.

There are many pitfalls that need to be taken into consideration while assessing the veritable impact of FDI. Some of the factors that get ignored often but play a major role are –

• The under-reporting of FDI owing to many factors like significant amount of manipulation of profits through misreporting and mispricing of trade and financial transactions especially with affiliated companies., In India if a company or multinational company subsidiary has to remit any amount towards royalties, franchisee fees, trade mark license fee or like, no permissions are required, no cap is prescribed nor any restrictions are imposed. Practically this outflow is never captured in relation to the FDI. Thus companies can actually hedge their risk capital by these operational arrangements and real FDI Profit Remittances would be heavily underreported.
• FDI Profit Remittances have also increased.  It is believed that FDI earnings reinvestments that amount to about 40% of the FDI are not reported.
• Round Tripping - As the incentives offered to foreign investors have grown, the motivation for domestic investors to pretend to be foreign investors in order to take advantage of special tax breaks etc. has also grown. This has meant that in the past decade or so, as much as 20%-30% of new FDI coming into countries such as China, where the tax on foreign MNCs is half of their domestic counterparts, is actually not real FDI but domestic investors posing as foreign investors. This practice is called “round tripping”. Investors are able to engage in round tripping by siphoning money out of the country in the form of capital flight and then reinvesting through tax heavens. The “round tripping” in India is not a factor of routing through tax heavens alone, but the rate of return enjoyed as well.
• Companies transfer assets (on paper) from one country to another to take advantage of special tax regimes without any contribution to the host economy. The funds are then transferred to a third country for investment.
• Account of FDI - The current method of measuring FDI is not able to distinguish these types of transfers mentioned above. In fact the Budget 2016 has raised lots of questions on the manner in which statistics is rolled out and considered by the Indian Statistics Office
• Lastly, another important point of consideration in the context of FDI are the Bilateral Investment Treaty Obligations (BIT’s). The BITs mean that many of the investment provisions originally being pushed by developed countries now would have the force of law. A growing number of bilateral treaties allow investors to sue governments in international commercial courts for compensation on account of regulatory changes, even when these are in the public interest. The Finance Minister realising the downside and has already started mitigation measures. Well before the Budget, in January the Ministry of Finance called for empanelment & engagement of international lawyers & law firms for representing the Government in BITs disputes & arbitrations. More than 170 countries have now signed international investment agreements that provide foreign investors with the right to turn immediately to international investor–state arbitration to settle disputes, without first trying to resolve the matter in national courts. Such arbitration fails to consider the public interest, basing decisions exclusively on commercial law. This may well be a matter of concern as it has the potential of directly hitting the economy.

Conclusion:

By increasing the FDI caps of additional sectors, by making provisions for smooth running of businesses attractive to foreign investors, and by securing Centre-State partnership, the government is intending to raise India’s global ranking in ‘ease of doing business’. However while the developments promised in the Budget speech are positive,  as highlighted in the article, certain additional issues need to be addressed to be make industrial environment truly efficient for foreign investors.  

Following the major announcements of the Union Budget 2015, the Regulatory bodies like the Reserve Bank of India, Insurance Regulatory and Development Authority of India, Securities and Exchange board of India, etc. would now be playing the crucial role of implementing and regulating the proposed reforms.